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Highlights Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. Profit growth has accelerated at a faster pace than our top-down model had projected and we expect growth to accelerate further into year end. We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth over rest of 2017. Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge. Feature The S&P 500 is attempting to break through the 2400 barrier as we go to press. This is impressive given that the flagging relative performance of infrastructure stocks and highly-taxed companies suggests that investors have given up hope of ever seeing significant tax cuts, infrastructure spending and incentives for capital spending. As we discuss below, disappointment on the policy front has thankfully been offset by solid corporate earnings figures. We believe that investors have gone too far in pricing out tax reform. True, the growing number of White House scandals will serve to delay the GOP's market-friendly policy agenda. Nonetheless, the President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans are on the same page. Capital spending is the part of the economy that could benefit the most from tax reform. Surprising Support From Capex Business capital spending is still trending up, adding another layer of support for the U.S. economy in the next 6-12 months. The post-election rollover in C&I loan growth worried investors that rising rates and election-related uncertainty had cut the flow of credit to the business sector, thus putting capex at risk (Chart 1, top panel). That concern was overdone, as we pointed out in a recent report.1 Business expenditures on plant, equipment and software were a surprising source of strength in first-quarter GDP, and bank lending has stabilized in the past six weeks. The FOMC minutes of the May 2-3 meeting noted that "financing conditions for large nonfinancial firms stayed accommodative." The minutes also stated that, while there was weaker demand for C&I loans in April, the weakness "pertained to customers' reduced needs for financing." The reduced need likely reflected a preference to issue corporate bonds. Chart 1Outlook For Capex Looks Solid Our BCA Capex indicator for business investment points to solid business spending in the next few quarters. (Chart 1, bottom panel) Our past research shows that sustainable capital spending cycles only get underway when businesses see evidence that consumer final demand is on the upswing. While consumer expenditures were quite soft (+0.3% annualized gain) in Q1, our view is that the weakness was transitory.2 This view was confirmed by the FOMC minutes. A rebound in consumer spending in the second quarter will boost CEO confidence that increased capital spending will be justified in terms of future sales. Our base case is that at least some tax cuts will be enacted by year end, but the risk is that political turmoil further delays a fiscal package or even totally derails the GOP legislative agenda. This scenario would be negative for stocks temporarily, but could end up being positive over the medium term by extending the expansion in the economy and corporate profits. U.S. Profits, Beats And Misses Profit growth has accelerated at a faster pace than our top-down model had projected earlier this year (Chart 2). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at just under 20%, before moderating in 2018. The favorable profit picture reflects two key factors. First, profits are rebounding from a poor showing in 2016, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart 3). Earnings are of course leveraged to corporate sales, helping to explain why profits are highly correlated with industrial production in the major countries. BCA's U.S. Equity Strategy service estimates that operating leverage for the S&P 500 is 1.4x.3 Chart 2Impact Of Stronger Dollar Is Fading Chart 3IP On The Rebound Globally Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row. Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.4 The hiatus of wage pressure may not last long, but for now our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). What About The Dollar? We estimate that the delayed pass-through of previous dollar strength will remain a slight drag on U.S. EPS growth of about one percentage point for the remainder of this year, assuming no change in the dollar from today's level (Chart 2, second and third panels). However, our base case remains that the dollar will appreciate by another 10% in trade-weighted terms. A 10% appreciation would trim EPS growth by roughly 2½ percentage points, although most of this would occur in 2018 due to lagged effects. The key point is that another upleg in the dollar, on its own, should not provide a major headwind for the stock market. Indeed, the dollar would only be rising in the context of robust U.S. economic growth and an expanding corporate top line. Even though the message from our EPS model is upbeat, it still falls short of bottom-up estimates for 2017. Is this a risk for the equity market, especially since valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table 1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in 2008, which was a recession year. But even outside of the recession, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart 4 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years considered. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the direction of 12-month forward estimates (which remains up at the moment). Table 1Bottom Up Estimates Are##BR##Always Too Optimistic Chart 4Oil Related##BR##Dip In 2015 The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. Gold Update Our tactical view on gold remains bearish, but the BCA Commodity & Energy Strategy service sees strategic value in gold as a hedge against rising inflation and inflation expectations, geopolitical risk and increased equity volatility.5 Chart 5A shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel that it has been in since early 2012 (Chart 5B). There has been a big gap between the model value and the actual price of gold for the past three years. The real price of gold remains elevated despite the fact that inflation has been well contained.6 Chart 5AModel Suggests Gold Is Overvalued Chart 5BIn A Downward Channel Since 2012 Our 6-12 month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year end, just enough to keep the Fed on track this year as it begins to shrink its balance sheet and raise rates two more times. Thus, we do not see a great need to hold gold as a hedge against inflation over the next year. Nonetheless, for those investors concerned about a pullback that turns into a correction or a bear market, we mention that gold has a 33% weight in our Protector Portfolio.7 Chart 6Core Inflation To Stay Near##BR##Fed's Target This Year Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, the yellow metal may have value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Earnings Rebound Will Earn Some Respect", April 10, 2017. Available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation And The Fed", May 8, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Operating Leverage To The Rescue?," published April 17, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Spring Snapback?," published April 24, 2017. Available at usis.bcaresearch.com. 5 Please see Commodity & Energy Strategy Weekly Report, "Go Long Gold As A Strategic Portfolio Hedge," published May 4, 2017. Available at ces.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report, "Gold: The Asset Allocation Dilemma," published August 1, 2011. Available at usis.bcaresearch.com. 7 Please see U.S. Investment Strategy Weekly Report, "Still Awaiting The Next Pullback," published May 15, 2017. Available at usis.bcaresearch.com.

Highlights On the European side, the key risk to our bullish DXY stance is that European growth is strong, the labor market seems to be tightening, and core CPI has perked up. These risks are real but mitigated by budding signs that European growth is at its best, by the abundance of hidden labor market slack, and by the high chance that the CPI spike was transitory. On the U.S. side of the ledger, the key risks are that wages do not pick up, that credit growth continues to act as a break on activity, and that political risks hamper fiscal dynamics. All would mean a more dovish Fed than we anticipate. These risks are mitigated by the fact that hidden U.S. labor market slack is only now low enough for wages to improve, credit looks set to turn around as financial conditions are supportive, and fiscal policy should surprise to the upside. USD/NOK has upside as Norway experiences declining inflation. Go long CAD/NOK. Feature Last week, we augmented our cyclically dollar bullish view by removing our tactical bearish bias on the USD. In our eyes, the market is underestimating the capacity of the Fed to increase rates and is also overestimating the economic impact of the fiasco surrounding Trump's alleged relationship with Russia. Despite our high conviction view that the dollar can rally 10% or more from current levels, we cannot be blind to the key risks surrounding it. This week, we explore where our stance on Europe and the Fed can go wrong. ECB Tapering = Upcoming Tightening Campaign? The key risk to our negative euro stance is the ECB. The market has moved to discount the first rate hike in Europe to happen in barely two years, an event we judge highly unlikely. However, if the market is right that a tapering of asset purchases in 2018 and a potential increase in the rates on deposit facilities to 0% are the opening salvos of an imminent campaign to push up the repo rate, the EUR/USD rally is only in its early days. Here are the key factors that would support this bullish euro view: The European economy is in a major economic upswing. Not only have PMIs surged, the IFO has hit an all-time high (Chart I-1). If this pace of growth can be maintained for an extended period of time, the European output gap will close faster than we anticipate, providing a stronger basis for the ECB to nudge all rates higher. The euro area labor market is tightening. Euro area unemployment rate is at 9.5%, only 0.7% above the OECD's estimate for NAIRU (Chart I-2). Thus, it would paint a picture where there is little slack in the economy at large and in the labor market in particular. In this environment, a continuation of the elevated growth currently experienced by the euro area could boost wages. Core inflation has picked up to 1.2% (Chart I-3). The ECB has historically displayed a tight reaction function to inflation. In the past, headline CPI mattered, but since Mario Draghi took the helm of this institution, the focus has switched to underlying pricing pressures. Thus, if euro area core inflation continues to move up, especially as U.S. core PCE inflation has weakened to 1.6%, the market will be vindicated and the euro could rebound on a more hawkish ECB. Chart I-1Europe Is Booming Chart I-2Low Labor Market Slack In Europe Chart I-3That Should Help The ECB To Hike Why Are These Factors Risks And Not Base Cases? To begin with, these factors have been discounted by the markets, a fact highlighted by the 42-month fall in the month-to-hike for the ECB since July 2016 to 24 months today. Also, as the European surprise index has outperformed the U.S. one, EUR/USD has rallied by 6%. In the process, investors have switched from being massively short the euro to being the most aggressively long in three years (Chart I-4). Risk-reversals in EUR/USD options are also at elevated levels, highlighting the potentially too-bullish disposition of investors toward the euro. On the growth front, some factors suggest that European growth may soon peak. The large improvement in the amount of industrial activity and capacity utilization in Europe relative to the U.S. was reflective of the big easing in monetary conditions that followed the collapse of the euro after 2014. But, as Chart I-5 illustrates, European industrial production needed a falling euro to beat that of the U.S., soon after the euro stabilized, the growth outperformance began to recede and is now near inexistent based on this metric. Thus, the euro rebound removes one of the key factors that supported the European economy in the first place. Chart I-4Investors Have Discounted##br## The Good News In Europe Chart I-5Europe's Growth Outperformance ##br##Was Because Of Policy Additionally, some economic data are showing disturbing signs. While Germany's IFO stands at a record high, Belgian business confidence has rolled over. In fact, export orders have been particularly weak (Chart I-6). This is of importance as Belgium has long been a logistical center for the euro area, and is a small open economy deeply integrated in the European economic infrastructure. This, therefore, portends to emerging risks to the whole euro area. Monetary dynamics too raise questions. European business confidence, a key piece of soft data that has underpinned investors increased bullishness on the euro is led by dynamics in M1 money supply. The roll over in M1 implies that business conditions in Europe are slowly passing their best period (Chart I-7). If euro area growth peaks, this also raises concerns about the state of the labor market. This is especially worrisome as we think the unemployment gap based on the OECD's estimate of NAIRU misses key elements of the European labor market slack. As we wrote last week, the key problem in Europe is labor underutilization; hidden labor market slack remains a serious concern.1 With workers in irregular contracts being a key source of job creation since the end of the 2013 recession, there are plenty of workers willing to change jobs without the incentive of a higher pay, limiting the upside in wages. Without wage growth, it will be difficult for European core inflation to continue its uptrend, especially as there are many signs that the rebound that has excited investors' imagination may have been a transitory event. Worryingly for euro bulls, our Core CPI A/D line for Europe, which tends to lead core CPI itself, rolled over last year and points to lower core CPI.2 Industrial good prices excluding energy have also been weakening for 15 months now, suggesting this inflation rebound may be an aberration (Chart I-8). Chart I-6Where Belgium Goes, ##br##So Does Europe Chart I-7Money Trends Point To A Deceleration##br## In European Soft Data Chart I-8Europe Core CPI ##br##Will Roll Over Bottom Line: Investors have become very bullish of the euro based on the fact that the economy has been very strong, the European headline unemployment rate is moving closer to NAIRU, and core inflation has perked up; raising the specter of high rates sooner than we anticipate. These economic developments need to be monitored closely, but the growth impulse in Europe is likely to soon deteriorate, broader measures of labor market slack in the euro area are far from being at full employment, and the tick up in core inflation is likely to prove to have been only a temporary blip. These forces should weigh on the euro for the rest of 2017. Maybe The Fed Will Not Tighten That Much? Meanwhile, in the U.S., investors only expect three rate hikes over the next 24 months. Markets have begun doubting the fed's capacity or resolve to hike interest rates as aggressively as we envision. A slew of disappointing data and political developments have cemented this opinion among investors. Among the most crucial factors are the following: Chart I-9Disappointing U.S. Wages Wage growth in the U.S. remains poor, especially as per average hourly earnings which are still only growing at a disappointing 2.3% rate (Chart I-9). This raises the specter that consumption will remain tepid and that inflationary dynamics will never take hold in the U.S. This risk is perceived as especially salient as core inflation and core PCE have slowed below the 2% objective of the FOMC. Slowing credit growth has also garnered a lot of attention among the public. Credit is the life blood of the economy, and this slowdown has prompted many investors to begin questioning whether or not the U.S. economy would ever be able to take off. This compounded worries around the perennially weak Q1 GDP growth. Finally, the myriad of scandals surrounding Trump and his dealings with Russia have raised much questions about his ability to ever implement fiscal stimulus. Moreover, the punitive terms associated with the repeal of Obamacare and the implementation of the American Health Care Act (AHCA) - which according to the CBO could leave as many as 23 million individuals without health insurance by 2023 and cause sharp increases in insurance premia - may dull any growth boosting impact of potential tax cuts. Thus, the political backdrop may prompt the Fed to be easier than was anticipated as recently as December 2016. Why Are These Factors Risks And Not Base Cases? To begin with, BCA still hold the view that wages in the U.S. are set to accelerate in the coming quarters. The Phillips Curve continues to be a reality, as the Atlanta Fed Wage Tracker still display a tight relationship with the unemployment gap (Chart I-10). Moreover, it is often argued that the problem with today's labor market is that much of the job creation is happening in low-skilled positions. This is true, but historically, low-skilled jobs have tended to experience the most upward pressures when the job market tightens significantly. Instead, the key anchor on average hourly earnings has been the hidden labor market slack. However, today, the U-6 unemployment rate is finally ticking at 8.6%, levels where in previous cycles wage growth accelerated (Chart I-11). A rebound in GDP growth, as highlighted by the Atlanta Fed growth forecast of 4.1% in Q2, would accentuate pressures on the labor market and help realized the underlying wage pressures resulting from the current readings of the U6 unemployment rate. Chart I-10The Phillips Curve: It's Alive Chart I-11U.S. Wages Will Pick Up What could support growth? Let's begin with the credit dynamics. As we have argued, credit growth is a lagging indicator of economic activity. The improvement in the ISM through 2016 and early 2017 continues to point to a rebound in C&I loans in the U.S. (Chart I-12). Moreover, aggregate bank credit in the U.S. is already re-accelerating, suggesting that credit will once again add to economic activity, and will stop subtracting from it (Chart I-13). Chart I-12Credit Lags, And It Will Pick Up Chart I-13Momentum In U.S. Loans Is Turning Up Another positive for the U.S. economy has been the substantial easing in financial conditions resulting from the fall in the dollar and bond yields since the beginning of 2017. This easing should help economic activity over the course of the next quarters (Chart I-14). In its most recent minutes, the Fed has alluded to these forces. The fall in the dollar is already showing signs of helping. The ISM export orders index is currently ticking near 60, suggesting that the fall in the USD has had a stimulative impact on the U.S economy (Chart I-15). This is especially salient when contrasted with the euro area industrial production dynamics described above. Chart I-14U.S. Financial Conditions Will Help Growth Chart I-15The Dollar's Easing Is Evident Finally, when it comes to fiscal policy, our Geopolitical Strategy team remains adamant that tax cuts will materialize in the coming quarters. It is becoming imperative for congressional Republicans to achieve this as Trump's popularity remains dismal at the national level, which could prompt a serious electoral rout in the 2018 mid-term elections (Chart I-16). This means that fiscal easing is likely to come through, which should have an impact on asset prices and the dollar: The DXY is back to pre-election levels and the relative performance of stocks most sensitive to changes in tax policy is back to January 2016 levels. These price trends indicate that investors have massively curtailed their expectations for governmental support to growth. Chart I-16If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 Moreover, the current format of the AHCA is unlikely to make it through the more moderate U.S. Senate. The loss of coverage and the insurance premia increases implied by the current plan are likely to be electoral poison in 2018, something well understood by key GOP policymakers. An AHCA still up in the air does not preclude tax cuts either. The budget deficit hole created by unfunded tax cuts will likely be patched through aggressive growth assumptions, the magic of dynamic scoring. The recently revealed Trump budget proposal itself is also unlikely to see the light of day in its current form and will evolve toward something more supportive of growth as time and negotiations pass. Bottom Line: Investors have massively curtailed their expectations of Fed tightening over the next two years. This view has been based on the lack of wage acceleration in the U.S., the poor credit growth numbers, and the uncertainty surrounding fiscal policy. These are still important risks to our bullish stance. However, we remain optimist because wage growth is only set to increase now, credit is a lagging indicator that looks about to pick up anew, financial conditions should help future U.S. economic activity, and the potential for tax cuts is far from dead. Stay long DXY. Norway's Passing Inflation Problem It was not long ago when the Norges Bank was facing the daunting task of kick starting a Norwegian economy ravaged by the collapse in oil prices while trying to contain the high inflation brought upon by the sell-off in the krone. However, following the stabilization of the NOK, this dilemma has dissipated as multiple measures of inflation have plunged. The Norges Bank is now free to maintain its dovish bias as the economy remains tired and will require easy monetary to recover going forward. Based on the effect of currency moves, inflation might reach a bottom at the beginning of next year, but it will likely stay below the central bank's target of 2.5 % for the foreseeable future (Chart I-17). Indeed, in spite of the rebound in oil prices, employment is contracting, the output gap is large, and wage growth remains deeply negative (Chart I-18). The Norges Bank is sympathetic to this view, acknowledging in its most recent monetary policy statement that inflation will hover in a 1-2% range in the coming years. Chart I-17A Stable NOK Will Keep Inflation Subdued Chart I-18No Domestic Inflationary Pressures In Norway Lastly, Norway's bubbly real estate market, the last obstacle to the Norges Bank dovish bias, is finally slowing down. Thanks to changes in regulation on residential mortgage lending at the start of the year, banks are tightening lending standards to households, a precursor to a cooling housing market (Chart I-19). With a Fed looking to increase rates, the real rate differential between the U.S. and Norway should move in favor of USD/NOK. Yet, could rising oil prices deepen the USD/NOK weakness? This seems doubtful as USD/NOK continues to be more correlated with real rate differentials than with the price of oil (Chart I-20). Nevertheless, the outlook of the krone against the AUD and the NZD is much more promising: Chart I-19No Need To Raise Rates To Curb Housing Prices Chart I-20Real Rates Matter More Than Oil Yesterday, OPEC Russia agreed to maintain their production cuts in place for the next nine months. This deal should keep the oil market in a deficit, pushing oil prices up and providing a tailwind to the NOK against non-oil commodity currencies. Chart I-21CAD/NOK: A Call On The U.S. Dollar On the other hand, the outlook for industrial metals and other commodities, which are more sensitive to the Chinese economy, continues to be worrying. Monetary conditions are still tightening in China and multiple economic activity indicators have disappointed to the downside. While base metals have already fallen considerably, we believe that additional weakness in the Chinese economy will trigger a selloff in EM assets, bringing the NZD and the AUD down with them. Finally, it may be time to sell the NOK against the CAD. The Bank of Canada struck a hawkish tone on Wednesday, stating that the Canadian economy's adjustment to lower oil prices is largely complete and that consumer spending should be supported by an improving labor market. This change in rhetoric should set the stage for a rally in CAD/NOK. Moreover, our Intermediate-Term Timing Model shows that this cross is 7% cheap, and our bullish USD view implies an outperformance of the loonie versus the krone given the tight correlation between CAD/NOK and the DXY (Chart I-21). Bottom Line: Outperformance of oil in the commodity space will help the krone outpace non-oil commodity currencies. However, the Norges Bank is likely to keep a dovish bias, which should make it difficult for the NOK to rally durably against a cheap U.S. dollar. Go long CAD/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "The Achilles Heel Of Commodity Currencies", dated May 5, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback suffered some losses following the release of Fed minutes. Puzzlingly, the rhetoric was not dovish, as markets and news outlets confirmed the prospect for a June rate hike. The result was a dollar selloff and a drop in yields. This easing in financial conditions created an additional fillip for the S&P as it traded at a record high, the opposite of what is expected with a looming rate hike. As new home sales contracted on a monthly basis and the manufacturing PMI disappointed, the U.S. soft patch continues. Nevertheless, our base case remains on par with the Fed's: the weakness in data is temporary and the Fed will hike more than the markets expect. We are already seeing this as continuing and initial jobless claims beat expectations at 1.923 million, and 234,000 respectively, and the greenback has found a footing at the 97.1 level. As this scenario further unfolds, gold will retreat as real returns increase, and the greenback will gain upward momentum. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro area continues to surprise with better than expected data: German IFO: Overall Business Climate came in at 114.6 - levels last seen in 1970; Expectations came in better than expected at 106.5; and the Current Assessment also beat expectations of 121.2, coming in at 123.2. Euro area Manufacturing PMI is at 57 for May, beating expectations of 56.5, and the Composite measure also recorded an outperformance, coming in at 56.8. On the consumer side, German Gfk Consumer Confidence Survey came in at 10.4, beating expectations of 10.2. While the euro to be overvalued on short-term metrics, and the euro area is structurally weaker than the U.S., weaker data needs to be seen for the markets to see a correction. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has been negative in Japan: Manufacturing PMI decreased to 52 in May from 52.7 in April. Exports growth decreased to 7.5%, from 12% the month before and underperforming expectations. Japan's all industry activity Index also underperformed expectations, contracting by 0.6% MoM. We continue to believe that Japanese economic activity will ultimately be determined by the exchange rate. The yen has appreciated since this the start of the year, therefore it is understandable that inflation and economic activity have been subdued. Taking this into account, the BoJ will continue to target a yield of 0% in JGB's, and thus the yen should suffer on a cyclical basis given that real rates differentials with the U.S. will continue to widen. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent British data has been mixed: GDP growth underperformed, coming in at 2%, decreasing from last quarter and underperforming expectations, mostly reflecting poor trade numbers. Meanwhile total business investment grew by 0.8%, outperforming expectations. We are not positive on the pound against the dollar, given that near 1.3 the pound is no longer a bargain tactically. On the other hand we expect more upside against the euro. Powerful inflationary pressures are building in the U.K., and governor Carney, previously concerned about the effects of Brexit in the economy, might be more inclined now to deal with inflation as the U.K. has proved resilient. This will put upward pressure in British rates vis-à-vis European rates. Additionally EUR/GBP has reached overbought levels, indicating it might be a good time to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 As the greenback's descent slowed down, so did the Aussie's ascent. The underlying motives for strength in the antipodean currency are misplaced. As data remains unpromising, this week followed through with further disappointments as overall construction work done contracted by 7.2% on an annual basis, with the engineering component contracting by 13%. Research by the RBA illustrates that construction work has a very close relationship with the national accounts of Australia. This could result in a slowdown in the economy - something which the RBA cannot afford amidst flailing inflationary pressures. On a more optimistic note, the commodity selloff is taking a breather. Most crucially for the AUD, iron ore futures have remained flat for almost a month after a 30% depreciation, and natural gas has been flat for almost a month. These developments have limited the AUD's downside for now. However, looming EM risks and the potential resumption of the dollar bull market represent very real risks for the AUD going forward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has appreciated by about 1.5% against the dollar this week. Additionally, recent data has been positive: Visitor Arrivals yearly growth skyrocketed to 21.5% on April. The trade balance outperformed expectations coming in at -3.48 Billion The kiwi economy continues to surge, with 7% growth in nominal GDP and retail sales growth at decade-highs. Additionally, dairy prices continue to surge, and are now growing at a 60% YoY pace. For this reason we are bearish on AUD/NZD, as the Australian economy is not only in a more precarious state, but is also more sensitive to the Chinese industrial cycle. Meanwhile, we continue to be bearish on NZD/USD, as a negative view on EM assets necessarily entails a bearish view on the kiwi. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Following on from the dollar's weakness, the CAD displayed further strength after the BoC's decision statement. While keeping rates unchanged, the bank highlighted that "recent economic data have been encouraging" and that "consumer spending and the housing sector continue to be robust on the back of an improving labor market". Furthermore, the Bank more or less expects these supports to growth to "strengthen and broaden over the projection horizon". While wholesale sales increased by less than expected at 0.9%, the BoC also expects that the "very strong growth in the first quarter will be followed by some moderation in the second quarter". This is likely to keep market expectations anchored and the CAD's value intact. Additionally, oil should pare recent weaknesses as OPEC follows through on its cuts. The CAD is therefore likely to see some strength against other commodity currencies. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has continued to depreciate after coming close to reaching 1.1. We continue to be negative on this cross, as the Euro is likely to have limited upside from current levels. The ECB is unlikely to hike rates any time soon, as wage pressures outside of Germany continue to be muted. Furthermore, this is not likely to change any time soon, as the labor market of the periphery continues to be very rigid. Meanwhile, the SNB is likely to take off the floor from this cross next year, as core inflation and retail sales growth have both returned to positive territory. We will continue to monitor the rhetoric by the SNB to have a more clear understanding of when the removal of the floor might occur. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone has rallied this week, thanks to the rise in oil prices. However real rate differentials should continue to move in favor of USD/NOK. While the fed is likely to hike more than what is currently anticipated in the OIS curve, the Norges Bank will stay dovish, given that the Norwegian economy is still too weak to sustain a rise in interest rates. Furthermore, macro prudential measures seem to be helping the Norges bank to slow down the housing market. The NOK is also likely to have downside against the CAD. The dollar bull market should help this cross rally, given the tight correlation between CAD/NOK and the DXY. Furthermore the BoC has struck a more hawkish tone as of late, which should further increase the difference between interest rate expectations in these two countries. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Positive data emerged from Sweden this week as consumer confidence picked up to 105.9 from 103.7, beating expectation of a decline to 103.6. The seasonally-adjusted unemployment rate remains on a structural downtrend, coming in at 6.6% according to Statistics Sweden. In terms of crosses, USD/SEK continues to weaken due to the greenback's instability. EUR/SEK has topped out and is also showing some weakness. Against commodity currencies, the movement is mixed. The SEK has shown the most strength against the AUD, while CAD/SEK and NZD/SEK have been flat, and NOK/SEK has seen considerable strength on the back of robust oil prices. We can see the SEK being weak against oil-based currencies as we expect OPEC to remain focused on cutting global oil inventories, while AUD/SEK could see further downside due to poor fundamentals in Australia. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Fiscal policy is likely to be eased modestly in most advanced economies over the next two years. The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has proposed. Ironically, fiscal stimulus is coming to America just when the economy has reached full employment. The market is pricing in too little Fed tightening over the remainder of the year. The dollar's swoon is ending. Go short EUR/USD with a target of parity by the end of the year. Feature Fiscal Thrust Around The World In its latest Fiscal Monitor, the IMF estimated that advanced economies eased fiscal policy by 0.2% of GDP in 2016, reversing a five-year streak of fiscal tightening (Chart 1). The Fund expects a further 0.1% of GDP of easing in 2017, followed by a neutral stance in 2018. In the EM universe, the IMF foresees a fiscal thrust1 of -0.2% of GDP in 2017 and -0.4% of GDP in 2018. Chart 1IMF Expects Modest Fiscal Easing In Advanced Economies, Further Tightening In EM Averages can disguise a lot of variation across countries (Charts 2). Comparing 2018 with 2016, the IMF expects Canada and the U.S. to experience a positive fiscal thrust of 0.7% of GDP and 0.4% of GDP, respectively. The fiscal thrust is projected to be -0.2% of GDP in the euro area, -1% of GDP in the U.K., and -0.5% of GDP in Japan. Among the larger advanced economies, Australia is expected to experience the largest degree of fiscal tightening, with a fiscal thrust of -1.2% of GDP. Across the EM universe, most of the fiscal tightening is projected to occur among oil producers. The IMF expects oil-exporting economies to collectively reduce their fiscal deficits by US$150 billion between 2016 and 2018. Political considerations require that the IMF give considerable weight to the stated objectives of governments when formulating fiscal projections. In reality, governments often struggle to meet their budget targets. Consequently, the Fund has typically overestimated the degree of fiscal consolidation that ends up happening (Chart 3). As such, our own projections foresee somewhat less fiscal tightening - and in some countries, a fair bit of fiscal easing - than the IMF projects. In particular: Chart 2Countries Will Follow Different Fiscal Paths Chart 3IMF Forecasts Tend To Overestimate Extent Of Fiscal Consolidation We do not expect much more incremental fiscal tightening out of the euro area. Thanks to a slew of austerity measures, the euro area's structural primary budget balance went from a deficit of 2.6% of GDP in 2010 to a surplus of 1.0% of GDP in 2014. It has remained close to those levels ever since. Now that a primary surplus has already been achieved and interest rates and bond spreads have fallen to exceptionally low levels, the need for further belt tightening has abated. That's the good news. The bad news is that high government debt levels in many European economies rule out any major new stimulus programs (Chart 4). The U.K. will slow the pace of fiscal consolidation. The U.K.'s structural primary budget deficit fell from a peak of 7.1% of GDP in 2009 to 1.3% of GDP in 2016. The IMF expects the primary balance to move into a surplus of 0.6% of GDP in 2019. We think that's unlikely. The Conservatives are under intense pressure to keep the economy afloat during Brexit negotiations. Prime Minister Theresa May has indicated she will delay eradicating the budget deficit until the middle of the next decade, having previously promised a 2020 target date. Japan has limited scope to further tighten fiscal policy. Japan's structural primary budget deficit reached 6.9% of GDP in 2010. The IMF expects it to reach 3.7% this year and fall further to 2% in 2020, provided the government goes forward with raising the VAT from 8% to 10%. We are skeptical that Japan's economy will be strong enough to allow the government to raise taxes. However, even if it is, this will only be because the Bank of Japan gooses growth by keeping long-term yields pinned to zero, thereby allowing the yen to depreciate further. China is making a structural transition to large budget deficits. The IMF estimates that China's structural primary budget balance deteriorated from a surplus of 0.1% of GDP in 2014 to a deficit of 2.8% of GDP in 2016. The increase in the fiscal deficit cannot be explained by the reclassification of off-budget spending as on-budget, since the IMF's "augmented" fiscal balance - which attempts to control for such statistical issues - deteriorated by roughly the same amount (Chart 5). Part of the erosion in China's fiscal balance stemmed from the global manufacturing slowdown in 2015-2016, which hit tax receipts and necessitated a healthy dose of fiscal stimulus. However, there is more to the story than that. As we controversially argued in "China Needs More Debt," now that China is no longer in a position to run gargantuan current account surpluses, large fiscal deficits will be necessary to absorb excess private-sector savings.2 The government's desire to rein in credit growth will only add to the impetus to find new sources of aggregate demand. The era of red ink has begun. Chart 4Government Debt Levels Outside Of Germany Are Still High Chart 5China's Fiscal Deficit Has Been Increasing The U.S. Congress will ultimately cut taxes, although the size of the cuts will be far smaller than what President Trump has ambitiously proposed. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 6). We think this pessimism is overdone. Donald Trump desperately needs a "win," and cutting taxes is one key area where the President and Congress both see eye to eye. Trump's falling poll numbers have heightened the risk that the Republicans will lose control of the House of Representatives next November (Chart 7). This makes passing a tax bill before the midterm elections all the more urgent. The main questions surround the scale and scope of any tax cuts, and just as critically, how they are paid for. We discuss these issues next. Chart 6Markets Have Priced Out Meaningful Fiscal Stimulus Chart 7Challenging Outlook For Republicans In 2018 Trump's Budget Proposal: Fake Math Chart 8Trump In Wonderland? If the definition of a good leader is one who underpromises and overdelivers, then President Trump's budget proposal left much to be desired. Trump's plan assumes that U.S. growth will reach 3% over the next ten years. Even in the unlikely event that the economy manages to avert a recession over this period, such a growth rate would be a remarkable feat. After all, growth has averaged only 2.1% since 2009. And keep in mind that the unemployment rate has fallen from 10% to 4.4% over this interval, consistent with potential GDP growth of only 1.4%. The slow pace of capital accumulation following the Great Recession undoubtedly hurt the supply side of the economy, but it would take a phenomenal - and rather implausible - acceleration in potential GDP growth to justify Trump's 3% target. Many of the other assumptions in Trump's blueprint are no less dubious (Chart 8). Despite projecting much slower growth, the Federal Reserve expects short-term rates to rise to 3% in 2019. In contrast, the Trump administration sees rates increasing to only 2.4%, an assumption that perhaps not coincidentally helps reduce projected debt-servicing costs. Most flagrantly, the plan assumes no decline in the revenue-to-GDP ratio, even though the basis for faster growth largely rests on the assumption of steep tax cuts. When pressed on the issue, officials from the Office of Management and Budget sheepishly noted that there would be offsetting limits on tax deductions, which would have the effect of broadening the tax base. However, no specific information was given on what these would entail. Many theories have been offered as to why Trump offered such an outlandish budget plan. Was he trying to appease conservatives in Congress? Perhaps this was just a sly attempt to gain leverage in future budget negotiations? Our theory is simpler: Trump promised an economic boom during the election campaign, while assuring voters that his tax cuts would more than pay for themselves. Hell would need to freeze over before he released a plan that did not share these assumptions. Congress Will Decide So where do we go from here? The specifics of Trump's plan are irrelevant. Congress will rewrite the budget from scratch. Major spending cuts will be scrapped. So will the onerous cuts to insurance subsidies and Medicaid in the House version of the health care bill. The Senate will ditch those. In contrast, Trump's tax cuts will be preserved, albeit on a smaller scale than envisioned in his budget proposal. Granted, congressional leaders have said they want tax reform to be revenue neutral, meaning that any tax cuts would need to be offset by other revenue-raising measures. That is easier said than done, however. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - all face severe resistance from vested interests. In Washington, where there is a will there is usually a dishonest way. Budget forecasts are typically made over a 10-year window. Thus, it is possible to lower taxes upfront and promise spending cuts and ill-defined revenue raising measures in the tail end of the budget window. Such a strategy would generate a positive fiscal thrust early on, while leaving the door open for Congress to dump any future spending reduction or revenue measures before they are actually implemented. Add to that the tax revenue that is projected to pour in from supply-side reforms, and the stage is set for a dollop of fiscal easing starting in early 2018. How likely is it that Republicans will pursue such a strategy? Very likely. As evidence, look no further than the fact that White House budget director Mick Mulvaney floated the idea on Wednesday of extending the 10-year budget scoring window to 20 years. Investment Conclusions Chart 9Phillips Curve Is Alive And Well An obsessive focus on fiscal austerity hamstrung the recovery in many countries following the Great Recession. The irony is that fiscal stimulus is coming to America just when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year. Despite all the obituaries that have been written for the death of the Phillips curve, the data show that it is alive and well (Chart 9). Higher inflation will allow the Fed to raise rates once per quarter. The market is not prepared for this. Investors currently expect only 45 basis points in rate hikes over the coming 12 months. That is far too low. On the other side of the Atlantic, the ECB's months-to-hike measure has plummeted from 65 months in July 2016 to only 24 months today (Chart 10). Real rates are projected to be a mere 14 basis points higher in the U.S. than in the euro area in five years' time (Chart 11). Chart 10The Big Shift In Market Sentiment Towards ECB Policy Chart 11The Vanishing Transatlantic Bond Spread Poor demographics and high private-sector debt levels imply that the neutral rate of interest is lower in the euro area than in the U.S. And while the euro area may not be tightening fiscal policy any longer, the fact that its structural primary budget balance is 2.6% of GDP larger than America's means that the euro area's overall fiscal stance will contribute less to aggregate demand than in the U.S. This will force the ECB to keep rates lower for longer, causing the euro to weaken. Chart 12Widening Real Rate Differentials ##br##Support The Dollar Chart 13Speculators Are Long The Euro For ##br##The First Time In Three Years Incredibly, two-year real interest rate differentials between the euro area and the U.S. have widened by 41 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 12). We think this divergence has occurred because investors have been busy covering the euro hedges that they put on in the lead up to the French elections. However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will subside (Chart 13). With all this in mind, we are going short EUR/USD today with a year-end target of parity and a stop-loss of 1.14. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The fiscal thrust is defined as the change in the structural primary budget balance from one year to the next. As a convention, we define a positive thrust as loosening in fiscal policy (i.e., a lower fiscal balance). 2 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, and "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

特別レポート

Highlights Brazilian President Michel Temer has been accused of crimes much worse than what got his predecessor impeached; Further instability is likely, with low probability that Temer's impeachment would restart reforms; Only a technocratic government, or brand new election, could produce a market-friendly outcome. Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Stay put on Brazilian financial markets. Feature Investors cheered the impeachment of Brazil's President Dilma Rousseff, bidding up Brazilian assets for over a year despite the challenging macroeconomic context. BCA's Emerging Markets Strategy and Geopolitical Strategy services have repeatedly cautioned investors not to buy the hype. Brazil was already "priced for political perfection" on May 12, 2016 when Rousseff was removed from office to face trial by the senate over fiscal accounting irregularities.1 And yet, the political context has been far from perfect. As we wrote last May: "It is highly unlikely that the political dysfunction within Brazil's political class will end with a Temer administration, at least not anytime soon." The latest corruption revelations have directly implicated acting president Michel Temer of the Brazilian Democratic Movement Party (PMDB) as well as Senator Aecio Neves, the leader of centrist and investor-friendly Brazilian Social Democratic Party (PSDB) and a key Temer ally in Congress. The market has placed a massive bullish bet in the abilities of the tentative Temer-Neves (PMDB-PSDB) entente cordiale to push through largely unpopular fiscal reforms through Congress. These reforms, none of which have passed yet (!), are now likely to stall until either an early election is called (best case scenario) or until the current government's mandate expires in October 2018. We have expected Brazil's political rally to dissipate. As we argued in 2016, without a new election, the interim government has no mandate for painful structural reforms. We are sticking to this view today. What Is Going On In Brazil? According to revelations in the Brazilian press, President Temer was caught in an audio recording asking the chairman of JBS Group - the world's largest meatpacker - to continue making payments to the former President of the Chamber of Deputies Eduardo Cunha, who was jailed for corruption in 2016. Cunha, a former Temer ally and member of PMDB, was indicted in the large scale "Operation Car Wash" corruption scandal involving the state-owned oil company Petrobras. The payments by JBS were allegedly meant to ensure that Cunha did not spill the beans on his co-conspirators. Cunha had previously disclosed that he possessed compromising information about several senior politicians linked to the Petrobras scandal. JBS Chairman Joesley Batista, himself under investigation, recorded a conversation with Temer on March 7 as part of his plea bargain negotiations with law enforcement officials. According to press reports, Temer asked Batista to continue payments to ensure Cunha's silence. As part of the same investigation, Senator Aecio Neves - the darling of the Brazilian investment community who narrowly lost the presidential election to Rousseff in 2014 - was filmed soliciting two million reals ($638,000) from Batista. This is not his first brush with the law, Neves was also under corruption investigation when he was the governor of the state of Minas Gerais. Neves's apartment has since been raided by the police as the corruption probe against Brazilian politicians reaches a fever pitch. How serious are the charges against the Temer and his ruling coalition? They are deadly serious. As an aside, we have been puzzled that investors have never posed the following question: how was it possible that the entire political and especially congressional system is so corrupt but Temer - the long-serving head of the largest party in the congress and one of the most shrewd politicians in Brazil - has not been involved in this corruption scheme. President Dilma Rousseff, former leader of the left-wing Workers Party (PT) and successor to President Inácio "Lula" da Silva, was impeached and removed from power for a lot less. There was never any actual evidence that Rousseff was personally involved in Operation Car Wash, at least at the time of her impeachment. In fact, the strongest legal case against Rousseff was that she failed to uphold the so-called Fiscal Responsibility Law. Essentially, Rousseff was impeached and removed from power because she stimulated the economy for political gain. A charge that practically every president in Brazil's history has been guilty of (if not every leader in the world!). Temer and Neves are accused of much greater crimes. If the reporting of the Brazilian press is accurate, Neves personally profited and continues to profit from Operation Car Wash. And Temer is then directly involved, to this day, in obstruction of justice and witness intimidation. These are not crimes by association or mere technicalities resulting from politically charged fiscal profligacy. Rather, they are serious crimes that could end with lengthy jail terms, let alone removal from power. Rousseff claimed that her removal from power was a coup d'état. She was correct to characterize it as such. Unlike in the U.S., where a president removed from power is replaced with the vice president from the same party, in Brazil vice presidents are often appointed from a coalition partner. As such, Vice President Temer replaced Rousseff and proceeded to alter Brazilian policy in a dramatic fashion. He abandoned the PMDB legislative alliance with left-wing PT, turned to the centrist PSDB for votes in Congress and proceeded to enact orthodox, conservative, supply-side reforms. While these are absolutely the reforms that Brazil needs, we never accepted the view that they are reforms that Brazilians want. In fact, Rousseff won the 2014 election against Neves, with Temer as her running mate, by campaigning on a populist platform against precisely these types of supply-side reforms. Bottom Line: We hate to tell our clients "we told you so," but Temer's 180-degree turn in policy was never going to work. Not without an election that bolsters his political mandate to enact painful structural reforms. We also cautioned our clients that corruption in Brazilian Congress was endemic and severe and would therefore not magically disappear with Rousseff's removal from power. As such, "impeachment was no panacea,"2 especially not when many members of Congress voting against Dilma were under investigation for corruption themselves! The high level of corruption is not because of a moral failing particular to Brazilian mentality. Rather, corruption is a feature of Brazil's fractured and regionalized politics that depend on side-payments and pork barreling to grease the wheels of legislative process. Rousseff's crimes appear paltry when compared to the (yet unproven) allegations against Temer and Neves. J-Curve Of Structural Reforms Amidst the 2016 political crisis, we argued that the only positive outcome for Brazilian politics and markets in the long-term would be a new election (Figure I-1).3 Why? Because we understood how painful fiscal reforms would have to be to deal with Brazil's disastrous fiscal position (Chart I-1). Without a new election, the interim Temer administration would not have the political capital to enact painful reforms. Figure I-1Brazil: Our Take On Possible Political Scenarios ##br##Before Former President Rousseff Was Impeached Chart I-1Brazil's Fiscal Position The market has disagreed with us for a full year now. However, the rally based on political hopes was always unsustainable. First, investors have misunderstood the nature of political corruption in Brazilian politics and just how intrinsic the problem has been. In retrospect, Rousseff may have been the least corrupt major politician in Brazil! Second, investors have ignored the message of our J-Curve of structural reforms (Diagram I-1). Diagram I-1Structural Reforms Are Painful: ##br##Stylized Representation Reform is always and everywhere painful, otherwise it would be the form. Every government pursuing reforms has to get through the "danger zone" on our J-curve of structural reform. As reforms are passed and enacted, they begin to "bite." This is when the protests against reforms mount and the government loses its political capital. If the policymakers in charge of the reform effort are already starting with low political capital - as the Temer and his congressional coalition most certainly did in August 2016 - than the "danger zone" is essentially insurmountable. We have disagreed with the market as it has confused Rousseff's removal from power with widespread support for reforms that amount to economic austerity. As we often repeated in client meetings, "a vote for impeachment is not a vote for austerity." With general election only roughly one year away in October 2018, we doubted that the Temer administration would have the political capital to push through such reforms. After all, every government wants to be reelected and pursuing painful reforms ahead of the elections is not feasible election winning strategy. What has the Temer coalition managed to do thus far? It must have done a lot, given the positive market performance over the past 12 months? False. The market has rallied despite remarkably shoddy evidence of actual reforms. As we predicted in our analyses throughout 2016, the post-Rousseff Brazilian policymakers have been dogged by lack of political capital. Out of five major reform efforts, only two have passed - oil-auction legislation (Production Sharing Agreement Bill) and a fiscal-spending cap. We do not wish to claim that the latter is insignificant but as we discuss below they are insufficient to stabilize Brazil's public debt load. The main three reform efforts that would have significant long-term effect on Brazil's fiscal sustainability - social security reform, labor reform, and tax reform - have stalled and are now likely to fail (Table I-1). Table I-1President Temer's Proposed Structural Reforms & Their Status Brazilian Senator Ricardo Ferraço, of the centrist PSDB, in charge of drafting the labor reform report for the Senate, has already canceled the work on the proposal. Ferraço issued a statement that said, "the institutional crisis we are facing is devastating and we need to prioritize finding a solution. Everything else is secondary now." This is a major blow against labor reforms, which already passed the lower house in April. We suspect that it will largely be impossible to restart and, more importantly, pass the reforms without an election that gives a new government a political mandate. Alternatively, a technocratic government led by technocrats without political ambitions, could try to enact reforms until the next election. Without a new election or a technocratic government, members of centrist PSDB and center-left PMDB will start to distance themselves from the allegedly corrupt Temer administration. It makes no political sense for Congressmen like Ferraço to sacrifice their own political capital on the cross of austerity just a year from the start of the electoral campaign in the summer of 2018. Bottom Line: The results made clear by Figure I-1 are not surprising and were eminently forecastable. However, the market ignored the structural realities of Brazilian politics, as well as the theoretical foundation of successful structural reforms, and charged ahead regardless. Without fiscal reforms outlined in Table I-1, however, Brazil will likely end up in a debt trap very soon. A Perilous Fiscal Situation Brazil's fiscal position and public debt remain on an unsustainable trajectory. In fact, there has been limited fiscal improvement compared to what financial markets have priced in. In particular: The constitutional amendment by Brazilian President Michel Temer's government that introduced a cap on government spending was a dilution of the Fiscal Responsibility Law adopted in 2000 which stipulated that the government had to run primary fiscal surpluses. Capping government expenditure growth to the inflation rate de facto represents a relaxation of structural fiscal policy. Under the new fiscal rules, the government is targeting not the primary fiscal deficit (and, by extension, public debt), but only government expenditures. This implies that in a case where government revenues fall short of projections, the government is not obliged to rein in spending. On the whole, Temer's government has relaxed rather than tightened structural fiscal rules. While this makes sense because the economy is in a depression and needs fiscal relief, it has been bad news for government creditors. As a final point, the former President Dilma Rousseff was impeached for violating this exact same law that the current government has now relaxed. The fiscal balance has stabilized around 9% of GDP in the past year, but this has been due to one-off temporary measures. With nominal GDP growth at around 5%, the bulk of the 16% rise in collected income taxes from a year ago came from one-off measures such as the repayment of funds by the Brazilian Development Bank (BNDES) to the government, taxes on foreign asset repatriation and other temporary actions (Chart I-2). In short, Temer's government has resorted to one-off measures to improve the country's fiscal position. Unless the economy and tax collection recover strongly in the next 12 months, Brazil's fiscal position will worsen substantially, and public debt servicing will become unsustainable. Furthermore, the federal government's transfers to states have surged as the latter are facing their own fiscal crises due to revenue shortfalls. Local governments are reluctant to curb spending amid the ongoing depression, and will continue to pressure the federal government for more transfers. This will worsen public debt dynamics. Importantly, the social security deficit, presently at 2.4% of GDP, will continue to escalate without meaningful reforms (Chart I-3). According to IMF estimates,4 the social security deficit will reach 14% of GDP by 2021 if no reforms are implemented. This is assuming robust economic recovery this year and solid growth in the years ahead. Given social security reforms are unlikely to occur and economic growth will continue to underwhelm amid heightened political uncertainty, odds are that the impact of the social security deficit on the public debt dynamics will be worse than the IMF projections suggest. Moreover, the gap between local currency interest rates and nominal GDP growth remains extremely wide (Chart I-4). To offset this, the government has to run primary surpluses. The primary deficit is currently 2.3% of GDP. Chart I-2Income Tax Collection Has Been ##br##Boosted By One-Off Measures Chart I-3Brazil's Social Security System ##br##Is On Unsustainable Track Chart I-4An Untenable Gap That said, tightening fiscal policy amid the ongoing economic depression is politically suicidal. Finally, our public debt simulation suggests that unless economic growth recovers strongly, Brazil's public debt-to-GDP ratio will rise above 90% of GDP by the end of 2019 - in both our baseline and most pessimistic scenarios. Notably, our baseline scenario assumes nominal GDP growth of 5.5% in 2017, and 7% in both 2018 and 2019 (Table I-2). These are not bearish assumptions, but and could prove optimistic given the escalating political crisis. This debt simulation assumes that interest rates will stay above 10%, but it also assumes no bailout for public banks and state-owned companies, or a rise in transfers to state governments. Table I-2Brazil: Public Debt Sustainability Scenarios 2017-2019 Bottom Line: Odds are that Brazil's public debt load will continue to escalate, and that in two years or so the debt-to-GDP ratio will spiral out of control. The Economy, Corporate Profits And Markets There has been no recovery in either the economy or corporate profits (excluding commodities companies). Brazilian share prices have rallied massively in the past 17 months, yet profits in companies leveraged to the domestic business cycle have continued to shrink. Specifically, EPS for consumer staples companies and banks have dropped a lot in local currency terms, despite the equity market rally (Chart I-5). It is normal that share prices lead profits by six to 12 months, but the current rally in Brazil is already 16 months old. In short, the discrepancy between share prices and EPS is unprecedented and unsustainable. Ongoing profit weakness is consistent with a lack of recovery in domestic demand, which is corroborated by the macro data: retail sales volumes, manufacturing production and capital goods imports have not grown at all; their pace of contraction has simply moderated (Chart I-6). Chart I-5No Recovery In Corporate Profits ##br##In Non-Commodities Sectors Chart I-6No Recovery In Economy In Brazil, key to its financial markets is the exchange rate. If and when the currency appreciates, interest rates will decline and share prices will rally and the economy will eventually revive - and vice versa. In turn, the exchange rate is driven not by the interest rate differential versus the U.S., as shown in Chart I-7, but by commodities prices, with which it strongly correlates (Chart I-8). Chart I-7Interest Rate Differential And ##br##Exchange Rate: No Correlation Chart I-8BRL Is Sensitive To Commodities Prices BCA's Emerging Markets Strategy team believes commodities prices have peaked and will decline in the months ahead. This, along with renewed political turmoil, warrants a bearish stance on the Brazilian currency. While the central bank has large foreign currency reserves and could sell U.S. dollars to support the real, this cannot preclude a selloff in the nation's financial markets. Selling foreign currency by a central bank entails withdrawing local currency from the banking system, tighter local liquidity and higher interest rates. Hence, a central bank can defend the exchange rate from depreciation if it tolerates higher interbank rates. Higher interest rates will, however, be devastating for Brazil. If the central bank of Brazil, having used its international reserves to defend the currency, decides to inject local currency liquidity into the system to bring down local rates, the outcome will be currency depreciation. In a nutshell, a central bank cannot control both the exchange rate and local interest rates if the nation has an open capital account structure. Remarkably, Chart I-9 contends that in Brazil, the exchange rate correlates with central bank lending to commercial banks. If the central bank lends to commercial banks, the currency depreciates, and vice versa. Facing the choice between currency depreciation and higher local rates, the Brazilian central bank will choose the former because of its perilous public debt situation as well as the imperative of a revival in credit growth. Hence, the Brazilian central bank is unlikely to defend the currency on a sustainable basis. If the currency depreciates, local bonds, sovereign and corporate U.S. dollar credit and share prices will sell off too. Bottom Line: Without structural reforms and higher commodities prices, Brazilian financial markets are looking into the abyss. Investment Recommendations Politics has fueled the rally in Brazilian assets since early 2016, and now politics taketh away. With the political tailwinds reversing, investors will have nothing left to base their decisions on but the terrible macroeconomic picture. We maintain our bearish stance on Brazilian financial markets: We continue to short the BRL versus both the U.S. dollar and the Mexican peso. The real is not cheap at all while the peso offers good value (Chart I-10). Chart I-9Central Bank's Liquidity Provision ##br##To Banks Vs. Exchange Rate Chart I-10BRL Is Not Cheap, MXN Is Dedicated EM equity and credit investors should continue underweighting Brazil in their respective portfolios. Finally, local rates will be under upward pressure as the currency depreciates. We remain offside this market. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Santiago E. Gomez, Consulting Editor santiago@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Brazil: Priced For Political Perfection," dated May 12, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Client Note, "Brazil: Impeachment Is No Panacea," dated April 26, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Brazil's Political Honeymoon Is Over," dated August 18, 2016, available at gps.bcaresearch.com. 4 Cuevas et al., IMF Working Paper: Fiscal Challenges of Population Aging in Brazil, March 2017

Highlights U.S. fiscal stimulus will be priced back into markets; Northeast Asia is consumed with domestic politics for now; China's financial crackdown raises risks, but so far looks contained; South Korea's relief rally will lead to buyer's remorse; Japan's constitutional reforms portend more reflation. Feature The market has lost faith in U.S. fiscal stimulus. The bond market has given back all of the expectations of faster growth and higher inflation (Chart 1). Hopes of populist, budget-busting tax cuts appear to have been dashed by the Putin-gate scandal and alleged White House obstruction of justice. As a result, the DXY has fallen to pre-election levels, while the Goldman Sachs high tax-rate basket of equities has fallen to its lowest level relative to the S&P 500 since February 2016 (Chart 2). We continue to believe that tax reform, or just tax cuts, will happen this year or early next year and that the market will have to re-price fiscal stimulus and budget profligacy at some point this year.1 As such, we are not ready to close our tactical recommendations of going long the high-tax rate basket relative to S&P 500 (down 1.62% since April 5) or playing the 2-year / 30-year Treasury curve steepener (down 11.4 bps since November 1). Republicans in Congress will push through tax reforms or cuts for the sake of remaining competitive in the upcoming midterm elections. And we doubt their commitment to budget discipline. That said, it is not clear that the equity market needs tax reforms to continue its upward trajectory. The Atlanta Fed's GDPNow model is predicting growth of 4.1% in the second quarter while the NY Fed's Nowcast is forecasting 2.3%. BCA U.S. Equity Strategy's earnings model continues to predict continued healthy profit growth for the remainder of the year both in the U.S. and abroad (Chart 3).2 In fact, if expectations of stimulus in the U.S. fully dissipate, the USD will take a breather - giving global stocks a boost - and the Fed will be able to take it easy on tightening U.S. rates, easing global monetary conditions. Chart 1Market No Longer##br## Believes In Trump Stimulus... Chart 2...Or Trump ##br##Tax Cuts Chart 3Corporate Profit ##br##Outlook Still Strong Perhaps far more important for global and U.S. risk assets is global growth. And the fulcrum of global growth has been China's economic performance. As the only country willing to run pro-cyclical monetary and fiscal policy, China has had a disproportionate impact on global growth since 2008. As such, we turn this week to the geopolitics and politics of Northeast Asia. China: How Far Will Deleveraging Go? Chinese financial policy tightening caught the market by surprise this year. The running assumption was that policy would be fully accommodative in order to ensure stability ahead of the all-important nineteenth National Party Congress in October or November.3 However, it is possible that the assumption is flawed. First, as we have pointed out in the past, China does not have a record of proactive economic stimulus ahead of party congresses (Chart 4). Second, President Xi Jinping may be far more secure in his position than is understood. Chart 4Not Much Evidence Of Aggressive Stimulus Ahead Of Mid-Term Party Congresses In China The crackdown on the financial sector in recent months suggests that Xi's administration has a greater appetite for risk ahead of the party congress than is generally believed: The administration is continuing to tamp down on the property sector. The PBoC has drained liquidity and allowed interbank rates to rise (Chart 5). The China Banking Regulatory Commission (CBRC) has launched inspections and new regulations on wealth management products and the shadow lending sector. The China Insurance Regulatory Commission (CIRC) has imposed new restrictions, including preventing insurers from selling new policies. One can make a good case that these measures will be limited so as not to cause excessive disruption in the financial system. All of the key Communist Party statements, from Premier Li Keqiang's recent comments to those made by the economic leadership in December, at the beginning of this tightening cycle, have emphasized that stability remains the priority.4 The PBoC's measures have been marginal; other measures have mostly to do with supervision. Notable personnel changes affecting the top economic and financial government positions fall under preparations for the party congress and do not necessarily suggest a new ambitious policy initiative is under way.5 Moreover, the government has already stepped back a bit in the face of the liquidity squeeze. One of the signs of the PBoC's tighter stance was its discontinuation of its Medium-Term Lending Facility in January, but this has since been reinstated.6 And throughout May the PBoC has injected increasing amounts of liquidity into the interbank system, marking an apparent tactical shift (Chart 6). Furthermore, government spending is already growing again after a brief contraction. Chart 5People's Bank Tightens Marginally... Chart 6...But Keeps Interbank Rates On A Leash In light of these decisions, it seems policy tightening is intended not to be stringent but merely to keep the financial sector - especially the shadow banking sector - in check during a year in which the assumption is that regulators' hands are tied. After all, an unchecked expansion of leverage throughout the year could interfere with the stability imperative. There are two major risks to this view. First, there is the danger of unintended consequences: China is overleveraged: The fundamental problem for China is that there is too much leverage in the system and there has not been a bout of deleveraging for several years (Chart 7). Much of the leverage is off-balance sheet as a result of the rapid growth in shadow lending. There are complex and opaque webs of counterparty risk. When authorities crack down, they cannot be certain that their actions will not spiral out of control. Recently, heightened scrutiny of "mutual guarantees," a type of shadow lending between corporations, led to the default of a company in Shandong that prompted a local government bailout, and more such credit events have occured.7 Policymakers are human: It is a fallacy to assume that Chinese policymakers are omnipotent. The mishaps of 2015-16 put a point on this. A state-backed newspaper has recently reiterated that its "deleveraging" campaign is not finished - the government could accidentally push too far.8 The rise in bond yields has already inverted the yield curve, causing the five-year bond yield to rise higher than the ten-year (Chart 8). This is a red flag and warrants caution.9 Quick fixes have negative side-effects: China escaped the last round of financial jitters, in 2015-16, by using its time-tried technique of credit and fiscal spending to boost the property market and build infrastructure, while imposing draconian capital controls. The growth rebound came at the expense of more debt, less economic rebalancing, and less financial openness. Chart 7China Is Massively Overleveraged Chart 8China's Yield Curve Has Inverted Second, there is the risk that Xi Jinping's calculus ahead of the party congress is not knowable. It may well be the case that Xi's position in the party is strengthened by a disruptive financial crackdown. The party congress is already under way: The party congress runs all year; it is not merely a one-off event this fall. Senior party officials will come up with a list of candidates for promotion in June or July. Then the PSC and former PSC members will likely meet behind the scenes to hash out their final list, which the Central Committee will ratify in the fall. If financial jitters were supposed to be strictly avoided for the party congress, then the current crackdown would never have begun. The outcomes are uncertain: The negotiations for the Politburo and PSC are not a foregone conclusion no matter how well positioned Xi appears to be as the "core" of the Communist Party. A simple assessment of the current Politburo suggests that the factions are evenly balanced when it comes to the current Politburo members capable of filling the five positions on the new PSC. Two of these positions should go to President Xi's and Premier Li Keqiang's successors, likely to be of opposing factions, while there will probably be three remaining slots that will have to be divvied up among an equal number of candidates from the two main factions (Table 1). Xi may still need to win some battles for influence behind the scenes in order to stack the Central Committee, Politburo, and PSC with his people for 2017 and beyond.10 His anti-corruption campaign has slowed down but is not over (Chart 9). This is all the more imperative for him since his retirement could be rattled by future enemies, given that he has removed the longstanding impunity of former PSC members. Table 1Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced Despite these risks, we still tend to think that for China, as for the world, political risks are overstated in 2017 and understated in 2018.11 If Xi deliberately courts instability this year, as opposed to merely staying vigilant over the financial sector, then it will mark a major break from the norms of Chinese politics. The true risk to China's stability - aside from the unintended consequences discussed above - arises after the party congress, when Xi's political capital is replenished and he can attempt to reboot his policy agenda. Previous presidents Hu Jintao and Jiang Zemin both launched reform pushes after their midterm congresses in 2007 and 1997, respectively. Hu's reform drive was cut short by the global financial crisis, while Jiang's was large-scale and disruptive and paved the way for a decade of higher potential GDP. Having consolidated power in the party, bureaucracy, and military, and tightened controls over the media, Xi Jinping will be in a position in 2018 to launch sweeping reforms should he choose to do so. Presumably these reforms would follow along the lines of those he outlined in the Third Plenum of the Eighteenth Central Committee back in 2013 - they would be pro-market reforms focused on raising productivity by transferring more wealth to households and SMEs at the expense of state-owned enterprises and local governments.12 To illustrate the process of structural reform, we have often used the notion of the "J-Curve" in Diagram 1. This shows that painful reforms deplete political capital, creating a "danger zone" for political leaders in which they lose popularity as economic pain hurts the public. Xi's work over the past five years to fight corruption and rebuild the party's public image have given him the ability to start the J-Curve process from a higher point than otherwise would have been the case. He will start at point D in the diagram, instead of point A, which means that the low point E may not embroil him as deeply in the danger zone of serious political instability as point B. Chart 9Embers Still Burning In ##br##Anti-Corruption Campaign Diagram 1The J-curve Of##br## Structural Reform But there is still no guarantee that he intends to expend his political capital in this way. The current round of financial tightening could be preliminaries for bigger moves next year - or it could be just another mini-cycle in the ongoing process of "managing" China's massive leverage. If China decides to execute a major deleveraging campaign, either now or next year, it will have a negative effect on global commodity demand (particularly base metals), on commodity exporters, on emerging markets in general, and ultimately on global growth. It would be beneficial for Chinese growth in the long run but negative in the short run, and in terms of Chinese domestic risk assets would open up opportunities for investors to favor "new (innovative) China" versus "old (industrial) China." Bottom Line: We remain long Chinese equities versus Taiwanese and Hong Kong equities for now, but are wary of any sign of doubling down on policy tightening in the face of more frequent and intense credit events. That would indicate that the Chinese leadership has a higher risk appetite than anyone expects and may be willing to induce serious financial disruption before the party congress. Korea: Drunk On Moonshine The Korean election is over and with it much of the heightened uncertainty that accompanied the impeachment and removal from office of President Park Geun-hye over the past year. The new president, Moon Jae-in of the Democratic Party, performed right around the polled expectations at 41% of the vote (Table 2). His competitor on the right wing, Hong Jun-pyo, outperformed expectations, though he still trailed well behind at 24%, giving Moon a large margin of victory by Korean standards that will help provide him with political capital (Chart 10). Table 2South Korean Presidential Election Results Chart 10Moon Will Have A Honeymoon Moon's election will bring relief to markets on both the domestic and geopolitical front. On the domestic front, he is proposing a series of policies that will cumulatively boost fiscal thrust and growth. On the geopolitical front, he will revive the "Sunshine Policy" (now "Moonshine Policy") of engagement with North Korea, reducing the appearance that the peninsula is slipping into war.13 The power vacuum in South Korea was a key driver of North Korea's belligerence in 2016, as the lead-up to South Korean elections has been in the past (Chart 11). South Korean presidents typically enjoy a substantial honeymoon period in which they are able to drive policy. The fact that the election occurred seven months early, as a result of the impeachment, gives Moon a notable boost to this period - he has seven months longer than he would have had before he faces any potential check from voters in the 2020 legislative elections. That is not to say that Moon has free rein. Ahn Cheol-soo's People's Party holds 40 seats in the National Assembly and is therefore in a "kingmaker" position - able to provide either the ruling Democratic Party or the fractured right-wing opposition with a majority of seats (Diagram 2). The People's Party is already criticizing Moon's call for increasing government spending by around 0.7% of GDP to fulfill his campaign pledges. True, the People's Party leans to the left and rose to power as a result of the median voter's shift to the left in the 2016's legislative elections. This may limit its ability to obstruct Moon's agenda at first. Nevertheless, it poses a substantial constraint on Moon's agenda through 2020. Chart 11Bull Market For##br## North Korean Threats Diagram 2Center-Left People's Party##br## Is The Korean Kingmaker Markets are relieved but not ebullient. The impeachment rally is over and eventually markets will realize that while Moon's agenda is pro-growth, it is not necessarily pro-corporate profits (Chart 12). He is promising to introduce a higher minimum wage, to convert temporary labor contracts into permanent ones, to increase social spending, and to toughen up labor and environmental regulation (Table 3). He has also appointed the so-called "chaebol sniper" as his point man in leading the reform of the country's chaebol industrial giants. On one hand, South Korea definitely needs corporate governance reform; on the other, the process will add uncertainty and Moon's approach may not be market-positive.14 Chart 12Relief Rally Likely To Disappoint Table 3South Korean President's Campaign Proposals To get an indication of what kind of impact Moon's economic agenda may have, it is helpful to compare that of his mentor, Roh Moo-hyun, president from 2002-7. Roh gave a boost to consumption, both government and private, and saw a relative drop off in fixed capital accumulation, which fits with the broad agenda of supporting workers and households and removing privileges for Korea's traditional export-oriented industrial complex (Chart 13). Roh proved very beneficial for the financial sector, wholesale and retail trade, and health and social work. Education and public administration received some support but were flat overall (Chart 14 A & B). If Moon follows in Roh's footsteps, he will be beneficial for the domestic-oriented economy. Chart 13South Korea's Left Wing##br## Boosts Domestic Consumption Chart 14ASouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (I) Chart 14BSouth Korea's Left Wing Boosts Finance,##br## Domestic Trade, And Health Care (II) Abroad, the Moonshine Policy is likely to have some success, at least in the medium term. The Trump administration is pursuing a strategy comparable to the U.S.'s nuclear negotiations with Iran from 2011-15, in which it tries to rally a coalition to impose tougher sanctions on the rogue state with the purpose of entering into a new round of negotiations that will actually generate concrete results. The "arc of diplomacy" will take time to get going and could last several years - it is essentially a last-ditch effort to convince North Korea to pause its nuclear and missile advances. The tail risk of conflict on the Korean peninsula will be moved out to the end of this effort, perhaps around the end of Trump's term.15 Meanwhile, Moon is already patching up trade relations with China, according to reports, after the latter imposed sanctions on Korea for deploying the U.S. THAAD missile defense system (Chart 15). He will also seek joint infrastructure projects with China and Russia to connect the peninsula. China has a vested interest in Moon's success because it is attempting to demonstrate to the Trump administration that it is cooperating on North Korean security. Chart 15China Likely To Ease##br## Sanctions On South Korea Chart 16South Korean Inflation##br## And Credit Impulse Weak The geopolitical risk to markets is, first, that North Korea miscalculates the threshold of other nations' patience, continues with provocations, and eventually causes an incident that derails the new negotiations. This is possible given the North's record of belligerent acts and the fact that both the Trump administration and the Abe administration could cut diplomacy short in the face of a truly disruptive provocation for domestic political reasons. Second, there is a risk that Trump decides to escalate North Korean tensions again, whether to distract from domestic scandals or to reinforce the military deterrent in the event that China and South Korea appear to be giving North Korea a free pass in another round of useless talks. If Moon pursues a unilateral détente with North Korea, without adequate coordination with the U.S., and pushes for the removal of THAAD missiles, then the U.S. and South Korea are headed for a period of higher-than-normal alliance tensions that could become market-relevant.16 Bottom Line: We remain short KRW/THB. Core inflation and domestic demand remain weak in Korea, which reinforces the central bank's recent decision to stick to an accommodative monetary policy. Credit growth is cyclically weak, which reinforces the fact that rate cuts are still on the table (including the possibility of a surprise rate cut like in mid-2016) (Chart 16). Finally, the KRW has been relatively strong compared to the currencies of Korea's competitors (Chart 17). Chart 17South Korean Won Has Outpaced The Yuan And Yen In terms of equities, the top six chaebol have come under scrutiny, but Samsung has rallied despite lying at the center of the corruption scandal. The others have not performed well amid the economic slowdown. We see no opportunity at present to short the chaebol in relation to the broader market. Broadly, however, Moon's policies will add burdens to large internationally competitive industrials while boosting small and medium-sized enterprises. We also remain short the Korean ten-year government bond versus the two-year (see Chart 12, panel three, above). Moon's policy bent will subtract from a 1% budget surplus (2016) and worsen the long-term trajectory of the country's relatively low public debt (39% of GDP). Insofar as his foreign policy succeeds, it entails a larger future debt burden as a result of efforts to integrate with North Korea, which is relevant to long-term bonds well before reunification appears anywhere on the horizon. At bottom, we are structurally bearish South Korea because of rising headwinds both to U.S.-China relations and to the broader globalization process that has benefited South Korea so much in the recent past. Japan: Is Militarism The Final Act Of Abenomics? Japan has reached peak political capital under Shinzo Abe. The ruling Liberal Democratic Party, with its New Komeito coalition partner, continues to play in a totally different league from its competitors - there is no political alternative at the moment (Chart 18). The ruling party has a de facto two-thirds supermajority in both houses of the Diet. Abe himself is more popular than any recent prime minister, and has retained that popularity over a longer period of time (Chart 19). He has secured permission from his party to stay on as its president until 2021, though he faces general elections in December 2018 to stay on as prime minister. Chart 18Japan: Liberal Democrats Still Supreme Chart 19Shinzo Abe Remains The Man Of The Hour Political capital is a fleeting thing, so Abe must use it or lose it. This is why we have insisted that he would press forward rapidly with attempts to revise Japan's constitution, his ultimate policy goal, which he has now confirmed he will do. His proposed deadline is July 2020 for the new provisions coming into force.17 Constitutional revision is not only about enshrining the Japanese Self-Defense Forces (JSDF) so as to normalize the country's defense policy. It is also about Japan becoming an independent nation again, capable of forging its own destiny outside of the one foreseen by the American framers of the post-WWII constitution. Though Abe has specific constitutional aims, any change to the constitution will demonstrate that change is possible and break a taboo, advancing Abe's broader goal of nudging the Japanese public toward active rather than passive policies.18 Hence Japanese politics are about to heat up in a big way. Abe has already done a trial run in his passage of a new national security law in September 2015. This law allowed the government to reinterpret the constitution so as to achieve many of his chief military-strategic aims (e.g. allowing the JSDF to come to the aid of allies in "collective self-defense"). Over the course of that year, Abe's popularity flagged, as public opinion punished him for shifting attention away from the economic reflation agenda that got him elected so as to focus on his more controversial, hawkish security agenda (Chart 20). Nevertheless, Abe stuck to the security agenda, in the face of some of the largest protests in Japan's post-Occupation history, and managed to shift back to the economy in time to notch another big victory in the upper house elections of 2016. We expect a similar process to unfold this time, though with bigger stakes and far less of a chance that Abe can "pivot" again. Under no circumstances do we see him reversing the constitutional drive now that he has the rare gift of supermajorities in the Diet; rather, he is going to spend his political capital. After all, there is no telling what could happen in the 2018 election. What are the market implications of this agenda? There may be some hiccups in consumer and business sentiment as a result of the rise in activism, political opposition, and controversy that is already beginning and will intensify as the process gets under way. Abe will be accused of putting the economy on the backburner. Abenomics is already of questionable success (Chart 21) and it will come under greater criticism as Abe shifts attention elsewhere, especially if global headwinds gain strength. Chart 20Abe Loses Support When He Talks##br## Security Instead Of Economy Chart 21Abenomics: ##br##Progress Is Gradual However, we recommend investors fade this narrative and buy Japan. Abe's constitutional changes must receive a simple majority in a nationwide popular referendum in order to pass - and Abe does not clearly have what he needs at the moment (Chart 22). This means that he cannot, in reality, afford to put Abenomics on the back burner, but instead must err on the side of monetary dovishness, fiscal stimulus, and reflation in order to win support for the non-economic agenda. There has been virtually no talk of fiscal stimulus this year, yet the policy setting is conducive to increasing spending as necessary. The Bank of Japan has explicitly embraced a monetary regime designed to allow for greater "coordination" with fiscal policy (Chart 23).19 There is no reason whatsoever to believe Abe is backing away from this stance. (Incidentally, the next consumption tax hike is not slated until October 2019, and could be delayed again.) Geopolitics are also fairly supportive of the Abe administration. First, the Korean situation is currently alarming enough to help justify the constitutional changes yet not alarming enough to provoke outright conflict. Abe is also making headway toward a historic improvement of relations with Russia, allowing Japan's military to pivot from the north to the south and west (i.e. China and North Korea). The chief risk for Abe is if North Korea surprises on the dovish side and new international diplomatic efforts appear so fruitful as to reduce domestic support for remilitarization. China, South Korea, and possibly North Korea will encourage the latter dynamic, while drumming up global criticism of Japan for warmongering. Meanwhile Japan will try to remind the domestic public and the U.S. that North Korea remains a clear and present danger and tends to take advantage of negotiations. Given the relatively positive geopolitical backdrop for Abe, the biggest risk to his agenda is an exogenous economic shock. Even then, if that shock stems from China and causes Beijing to rattle-sabers as a domestic distraction, then it will benefit Abe's remilitarization agenda. What would hurt Abe is if global growth sags but China and North Korea lay low. It is too soon to say that they will do this, but it is unlikely. Trump is also a wild card whose threats of "tough" policy toward China and North Korea may reemerge in 2018, in time to help Japan make constitutional changes that the U.S. generally supports. Bottom Line: Go long Japan. While there is no correlation between Japan's defense-exposed equity sector performance and the current government's remilitarization efforts, there is a clear case to be made that nominal GDP and defense spending will both be going up as a result of constitutional and economic policies (Chart 24). Abe will double down on reflation for at least as long as is necessary to maintain popular approval of his government ahead of a historic constitutional referendum. Chart 22Revise The Constitution? Yes.##br## End Pacifism? Maybe. Chart 23Japanese Reflation ##br##Will Continue Chart 24Expect Higher Nominal##br## Growth And Defense Spending Housekeeping: Play Pound Strength Through USD, Not EUR We are closing our short EUR/GBP position, open since January 25, for a loss of 1.77%. This trade has largely been flat. We put it on as a way to articulate our view that Brexit political risks are overstated and that the pound bottomed on January 16. The political call was right, but the pound has largely moved sideways versus the euro since then. We maintain our short USD/GBP, which is up 4.63% since March 29, as a way to articulate the same view that Brexit (and the upcoming U.K. elections) are not a risk. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Weekly Report, "Trump Thumps The Markets," dated May 19, 2017, available at gis.bcaresearch.com. 3 The party congress, which occurs every five years and marks the "midterm" of President Xi Jinping's administration, will see a sweeping rotation of Communist Party officials, including on the Central Committee, the Politburo, and the Politburo Standing Committee (PSC). 4 Please see "China able to keep its financial markets stable, Premier Li says," Reuters, May 14, 2017, available at www.reuters.com. For the December meeting, see "China's monetary policy to be prudent, neutral in 2017," Xinhua, December 16, 2016, available at www.chinadaily.com. 5 Finance Minister Xiao Jie, Commerce Minister Zhong Shan, NDRC Chairman He Lifeng, and China Banking Regulatory Commission Chairman Guo Shuqing have all recently been appointed, but they replaced leaders due to retire as part of the party congress reshuffle. Only the new China Insurance Regulatory Commission Chairman Xiang Junbo and the new Director o f the National Bureau of Statistics Wang Baoan were replaced for reasons other than retirement, having been stung by the anti-corruption campaign. By March 2018 the world should have a better sense of Xi's economic and financial "team" for 2018-22. 6 Please see BCA China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 7 Zouping government, in Shandong, intervened into the case of Qixing aluminum company's insolvency in order to transfer control to Xiwang, a corn oil and steel producer that had given a mutual guarantee to Qixing. The Zouping authorities arrested the son of Qixing's chairman to force the transfer. Please see "Bond Buyers Blacklist Some Chinese Provinces After Run Of Defaults," Bloomberg, April 26, 2017, available at www.bloomberg.com. 8 Please see "China Deleveraging To Continue As Goals Not Yet Achieved: State Paper," Reuters, May 17, 2017, available at www.reuters.com. 9 Please see BCA Emerging Markets Strategy Weekly Report, "Signs Of An EM/China Growth Reversal," dated April 12, 2017, available at ems.bcaresearch.com, and Global Investment Strategy Special Report, "The Signal From Commodities," dated May 19, 2017, available at gis.bcaresearch.com. 10 Xi may yet go after another big "tiger," Zeng Qinghong, the right-hand man of former President Jiang Zemin. 11 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated in 2018," dated April 12, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "Reflections On China's Reforms," dated December 11, 2013, and "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com, and China Investment Strategy Special Report, "Tracking The Reform Progress," dated October 22, 2014, available at cis.bcaresearch.com. 13 "Moonshine Policy" is a phrase we regrettably did not coin, but we discussed its coming in BCA Geopolitical Strategy Weekly Report, "What About Emerging Markets?" dated May 3, 2017, and "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 14 Moon has nominated Kim Sang-jo, a professor of economics at Hansung University in Seoul, to head his Fair Trade Commission. Kim is a long-time advocate for shareholders against the family-controlled chaebol and led a prominent law suit against Samsung. Past efforts at reforming the chaebol led by Presidents Kim Dae-jung and Roh Moo-hyun focused on improving balance sheets, protecting minority shareholders' rights, limiting the total amount of investment, and improving corporate management and accountability. It remains to be seen how Moon (and Kim Sang-jo, assuming his nomination is confirmed) will proceed, but the effort will bring domestic challenges to the top industrial conglomerates' operating environment at least initially. 15 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 16 South Korea's special envoy Hong Seok-hyun claims that Trump told him at the White House that he will work closely with Moon and is willing to try engagement with Pyongyang, conditions permitting, though he is not interested in talks for the sake of talks. This fits with our view that the U.S. saber-rattling this year was designed to make the military option more credible before pursuing a new round of diplomacy. 17 Please see BCA Geopolitical Strategy "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 18 So, for instance, if it should happen that, over the course of the coming debates, Abe is forced to drop his proposed revisions to the pacifist Article 9, he may still achieve changes to the amendment-making procedure in Article 96. The latter would be even more important for Japan's future, since it would make it easier for Japan to change the constitution for whatever reason in the coming decades. 19 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com.

Highlights China's recent growth moderation is due to marginally tighter monetary conditions. There is no case for severe policy tightening that could lead to a material growth relapse. There are plenty of signs the economy could continue to run hotter on almost all fronts. The downside risk in the economy remains fairly low, even if annual growth rates of various macro variables do not continue to accelerate. Feature Chart 1Tighter Monetary Conditions ##br##Led To Growth Moderation Our team was in China over the past two weeks, talking to investors and exchanging views with our local contacts for some on-the-ground reconnaissance. Investors appeared more upbeat on China's cyclical outlook than during our recent past trips, but generally speaking conviction remained low, and concern on some structural issues - particularly credit and the housing market - remained deeply rooted. Investors' more upbeat sentiment on growth reflected China's cyclical recovery since early last year, but the rapidly-emerging consensus appeared to be that the growth acceleration peaked in the first quarter, and the economy is facing growing downward pressure, even though few investors seem worried about a chaotic "hard landing" at the moment. Collectively, investors appeared largely preoccupied with downside risks and mindful of negative surprises, while the upside risks were not really discussed. China's latest PMI numbers released this week seemed to validate the consensus view of an imminent growth top. Most major components of the PMI surveys in both the manufacturing and service sectors had setbacks, which were also reflected in softer commodities prices (Chart 1).1 A key reason for the growth moderation is likely the performance of the RMB. We have long argued that the RMB's depreciation has been a key reflationary force for China, which boosted producer prices, enhanced profit margins and reduced the real cost of funding.2 By the same token, the pace of RMB depreciation has moderated in recent months, removing some reflationary impulses within the economy. However, it is important to note that China's worsening growth deterioration in previous years was in part attributable to sharp RMB appreciation, a replay of which is highly unlikely going forward (Chart 2). The RMB appreciated by almost 30% between 2012 and 2015, a massive deflationary shock to the economy. Currently, the trade-weighted RMB is still depreciating, albeit at a slower pace, and real interest rates deflated by PPI are still negative. In other words, although tighter on the margin, monetary conditions are still fairly stimulative, which should continue to help the economy improve. On the fiscal front, the government significantly reduced fiscal stimulus toward the end of last year, but quickly reversed course (Chart 3).3 Both direct fiscal spending and infrastructure investment have picked up notably, and its impact will continue to ripple through the broader economy. Moreover, China's fiscal spending tends to be pro-cyclical: growth recovery typically boosts fiscal revenues, which gives the government more financial resources for fiscal expenditures, and vice versa. Unless the government steps on the brakes, there is no case for a sudden retrenchment in fiscal stimulus soon. Chart 2China: But Monetary Conditions ##br##Remain Fairly Stimulative Chart 3... Meets Waning Fiscal Stimulus China: ##br##Fiscal Retrenchment Has Been Reversed In short, China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Chart 4China: More Upside In Exports? Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant. In fact, there are plenty of signs the economy could continue to run hotter on almost all fronts: Exports are likely to continue to accelerate, according to our model, barring disruptions from major external shocks such as election surprises in Europe and /or broad protectionist measures from the Trump administration (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output.4 The upturn in the profit cycle will likely boost investment, particularly among private industrial enterprises (Chart 5). Rising profits and higher output prices indicate tighter capacity utilization, which would in turn encourage capital spending. The prolonged downturn in China's capital spending cycle has likely come to an end. Domestic consumption may further benefit from improvement in the labor market, which is lifting both income and confidence. This is particularly important for large-ticket consumer durable goods such as automobiles and household appliances. Housing construction will likely continue to improve, driven by strong demand. The most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the last quarter, underscoring a massive increase in pent-up demand (Chart 6). Developers are also warming to increasing supply - and land purchases have resumed positive growth in recent months after a prolonged slump. Tighter housing policies in major cities will prevent a massive boom, but will not short-circuit the recovery. Chart 5China: Private Capex Should Have Bottomed Chart 6China: A Sharp Recovery In Housing Demand All in all, we reiterate our view that the downside risk in the Chinese economy is low from a cyclical perspective, even if annual growth rates of various macro variables do not continue to accelerate. Growth figures to be released in the coming weeks will become noisy, but we lean against being overly bearish. Overall, business activity will remain fairly robust, and a major relapse in growth is unlikely. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead" dated April 6, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming" dated January 6, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening" dated February 16, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit" dated April 13, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart I-4U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4½% in February on a year-over-year basis (Chart I-7). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession that was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart I-8). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little 'dry power' left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Highlights Markets will survive late spring and summer unscathed; Macron will win the French election; Trump's agenda is not going down in flames; U.K. snap polls support our sanguine view on Brexit; Fade the rally in Treasuries and bet against unwinding of Trump reflation; Stay tactically long EUR/USD, long the pound, and long French industrials vs. German. Feature One of the oldest adages of Wall Street is to "sell in May and go away." Data reinforce the conventional wisdom, with a strategy of staying on the sidelines during the summer months clearly outperforming the alternative of staying long every month (Chart 1). Chart 1Sell In May And Go Away Should investors adopt the same approach in 2017? Certainly the risks are skewed to the downside due to investor complacency and a busy political schedule: Complacency: Investor complacency has been spectacularly elevated ahead of Q2 this year. Our colleague Anastasios Avgeriou of BCA's Global Alpha Sector Strategy, who has been flagging warning signs since early February, lists four measures of complacency that peaked in April (Chart 2).1 The SKEW index, controlled for by the VIX, rose above 12 early in April, warning that at least a tactical pullback is at hand. The Yale U.S. one year institutional confidence index hit an all-time high of 98.68% in February. Similarly, the Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 dropped to below 10%, a level last seen during the peak of the previous bull market in 2007 (bottom panel).2 Political Schedule: April and May have an unusually high number of high-profile deadlines, meetings, and elections packed into a tight space: April 26: U.S. President Donald Trump is expected to announce key details of his long-awaited tax reform plan; April 28: The U.S. government's stopgap funding measure, the continuing resolution, will expire - leading to a government shutdown if no replacement is passed; April 29: The EU Council will hold its "Brexit Summit" to either approve, amend, or reject Council President Donald Tusk's proposed negotiation guidelines;3 May 7: The second round of the French presidential election will be held; May 9: An extraordinary presidential election will take place in South Korea; Mid-May: U.S. President Donald Trump will present his full budget proposal, including tax plans, spending cuts, and growth projections; May 19: Iran holds its presidential election; May 25: The OPEC meeting in Vienna will determine whether to extend the current production-cut agreement. In this Weekly Report, we focus on the three most immediate risks to the markets: the second-round of French presidential election, U.S. domestic politics, and the upcoming election in the U.K. We will also address downside risk to oil prices in an upcoming joint report, to publish tomorrow, with BCA's Commodity & Energy Strategy. Our conclusion is that while risks are indeed skewed to the downside by the mere combination of investor complacency and volume of potential tail-risks, the market will likely emerge from the summer doldrums unscathed. As such, any market downturns are an opportunity to buy on dips. As we recently warned, however, the real risks will emerge in 2018.4 France: Fin? Centrist Emmanuel Macron has won the first round of the French presidential election with a narrow victory over nationalist Marine Le Pen (Table 1). As expected, the two will now contest the second round on May 7. France will subsequently hold a two-round legislative election on June 11 and 18. Chart 2Complacency At A Peak Table 1France: First-Round Election Results Investors learned three things from the first round of the French presidential election: Polls are right: Repeat after us: polls are not wrong, pundits are.5 Neither the Brexit referendum nor the U.S. presidential election came as a huge surprise to those who read polls objectively. In both cases, the outcome was inside the margin of error. Hopefully, the first round of the French presidential election will set aside the notion that all polls are useless and therefore investors are better off interpreting chicken entrails for election forecasting. In fact, polls in France have not significantly underestimated Marine Le Pen's nationalist party - Front National - since the 2002 election (Chart 3). Le Pen has no momentum: Le Pen consistently polled in the high 20s throughout late 2016 and 2017, but ended with only 21.43% of the vote on April 23 (Chart 4). In fact, she only narrowly improved on her 2012 performance of 17.9%, which is astounding considering everything that has happened in France since then (terrorist attacks in particular). Macron has meanwhile nearly doubled his polling from late 2016. French voters are angry: Protest and anti-establishment candidates came away with 49.62% of the vote (Chart 5). Chart 3FN Rarely Outperforms Its Polling Chart 4Le Pen's Momentum Is Gone Chart 5French Voters Are Angry... What to make of these three lessons? First, if lessons A and B are correct, then Le Pen is toast on May 7 (Chart 6).6 According to a poll conducted from April 17 to 21, Le Pen will struggle to get any voters from Mélenchon and Socialist candidate Benoît Hamon (Chart 7). This should not be surprising to anyone who knows France and its history: the left and the right just do not get along. We construct a "Le Pen best case scenario" out of the data by giving her all the voters who said they would abstain in the second round. Let's say that they were lying and are secret Le Pen supporters. She still loses (Chart 8)! Chart 6...But Not That Angry Chart 7Most Voters Will Swing To Macron Chart 8The No-Shows Can't Win It For Le Pen But surely a major terrorist attack could turn it around for Le Pen, right? Wrong. Macron is not pro-terrorist. Why would the French turn to a Russian-financed nationalist with no clear plan on how to prevent terrorism or stop refugee flows into Europe other than to close French borders?7 (And that description is not fake news!)8 They wouldn't. And there is empirical evidence to prove that French voters see through Le Pen's empty rhetoric. We highly recommend our clients read our February report titled "The French Revolution" where we conducted a careful study of the 2015 December regional elections.9 These elections occurred only 23 days following the November 2015 terrorist attacks in Paris and at the height of that year's migration crisis. It was as if the fates conspired with Le Pen's Front National (FN) to create a perfect storm. And yet the election was a crushing loss for the nationalists who came away with nothing in the second round. Chart 9French Public Supports The EU And Euro But hold on a minute. Are the French really about to elect a former investment banker for president even though 50% of them are "angry," as suggested by our lesson C? Well, yes. The "anger" is complicated. Mélenchon received a lot of the disgruntled Socialist Party voters who jumped the Hamon ship after it sunk during the latter's woefully uninspiring debate performances. These are not hard-core Euroskeptic voters. In fact, both Mélenchon and Le Pen moderated their Euroskepticism in the run up to this election to broaden their base of support. Le Pen promised that she would abide by the results of a referendum on the EU even if it went against her will, as polls currently suggest it would (Chart 9). And Mélenchon suggested that exiting the EU would only be his "Plan B," in case his plan to renegotiate the Treaty of the EU failed. What should investors expect of a Macron presidency? While the "French Thatcherite" François Fillon may have been more welcome to the markets than Macron, we think that a combination of President Macron and right-leaning National Assembly could accomplish some reforms. Polling for the legislative elections in June is scarce, but Le Pen's party is highly unlikely to outperform Le Pen herself. Judging by the December 2015 regional elections and Fillon's pre-scandal polling, the center-right Les Républicains are likely to win at least a plurality of seats in the legislative elections. Several prominent center right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister.10 This is highly positive for the markets as it means that French economic policy will be run by the center right, with an ultra-Europhile as president. Bottom Line: Nothing is over until it is over. Le Pen obviously still has a chance to win given that she is one of the two people running in the French election. However, given current polling, Macron is highly likely to become the next president of France. Hold tactical long EUR/USD and strategic long French industrial equities / short German industrial equities. But start thinking about closing long euro positions. The U.S.: From Math To Magic There are three reasons for global investors to worry about U.S. politics at the moment: Government shutdown: The U.S. government will face a shutdown on April 28 if the continuing resolution (CR) is not extended (via another CR) or if an omnibus funding bill is not passed. The risk for investors is that Senate Democrats could filibuster an omnibus bill that contains a conservative "poison pill" such as funding the wall on the border with Mexico or defunding Planned Parenthood. This would result in a partial government shutdown. Our view is that there is no time to find a long-term solution and the Republicans will have to extend current spending levels via short-term CRs, possibly until the end of the fiscal year on October 1. Given that the government has already been funded for half of the current fiscal year via short-term CRs, it may be the only way that Republicans can avoid a showdown with Democrats in the Senate. Obamacare repeal and replacement: The Senate and the House passed a budget resolution on January 13 that included "reconciliation instructions" allowing for the repeal of Obamacare in an eventual reconciliation bill.11 The reconciliation procedure allows measures that impact government spending and revenue - budgetary matters - to pass through Congress with a simple majority, i.e. without the need for 60 votes to defeat a filibuster in the Senate.12 These instructions are believed to "expire" at the end of May or thereabouts, giving Republicans one more month to replace Obamacare without causing greater traffic jams down the road.13 There are two hurdles to this process. First, the Tea Party-linked "Freedom Caucus" opposed the original Obamacare proposal and needs to be placated with provisions that may put off centrist Republicans in the Senate. Second, both the original Paul Ryan plan and the soon-to-be-revealed alternative are likely to be challenged by the Democrats under the reconciliation rules.14 Trump at first appeared willing to walk away from repealing Obamacare - which seemed to make sense given that the bill he endorsed imposes a roughly $700 billion burden on U.S. households (Chart 10). However, he has since decided that he needs the bill's roughly $320 billion in savings over ten years in order to pay for the "hyuge" tax cuts he has promised.15 Tax reform: Also coming into focus in April and May is tax reform. The White House is set to release key tax-reform details as we go to publication. Further, Trump has to deliver his full FY2018 budget in mid-May. Unlike the budget Trump released in mid-March, the May edition will include the tax proposals, measures on "mandatory" or entitlement spending, and growth projections. Concurrently, Congress has to start working on its budget resolution for FY2018, which, as mentioned, will enable using reconciliation to pass the tax bill with a mere 51 votes in the Senate. Again, the Freedom Caucus is a potential hurdle. Investors fear they will demand that any tax bill be strictly revenue neutral and thus foul up the legislative process. Chart 10Obamacare Repeal Hits Households Confused yet? You are not alone! We have noticed from client meetings and the financial media a growing obsession with details of upcoming reforms and the arcane congressional rules that will govern the legislative process. This is a mistake. Investors should step back and focus on the big picture: Trump is an economic populist who wants to see a higher rate of nominal GDP growth; Republicans are a party that favors tax cuts; Legislative rules are meant to be broken. As such, the key question is whether President Trump can bend the will of the Freedom Caucus, which plays the role of the antagonist in his efforts to clear all three hurdles listed above. We have no reason to believe that he cannot. In fact, all signs are pointing to the Freedom Caucus playing ball with the White House: Rhetoric has changed: Mark Meadows (R- North Carolina), Chairman of the Freedom Caucus, has confirmed that he is not demanding revenue-neutral tax reform plan and that he is open to a compromise on Obamacare. The Freedom Caucus is reportedly getting closer to accepting a health-care bill that passes the deadly issues to the states, allowing state legislatures to make their own decision on whether to remove the most popular regulatory requirements of Obamacare. Politically, this is a brilliant move. It allows both the Tea Party and moderate Republicans to declare victory by claiming that they upheld "state rights" - a core conservative principle - while giving conservative governors and state legislatures the option of eroding Obamacare at a state level. Moderates in the Senate, the theory goes, will not have to shoot down the new health bill for fear of a popular backlash since they presumably reside in states that will opt to keep the Obamacare measures in question (essential health benefits, community ratings, etc). The bill is by no means guaranteed to pass, but the point is that the Freedom Caucus has changed its tune after having been blamed for failing to repeal Obamacare, when repeal was one of the main reasons they were elected in the first place. Trump retains political capital: President Trump's polling with Republican voters has improved since the strike against Syria (Chart 11). He retains political capital with GOP voters and is therefore still a threat to the Freedom Caucus if he should campaign against them in the 2018 midterm primaries. The electoral threat is real: The Tea Party-favored candidate in Georgia's special election on June 20, Bob Gray, came in third place with just over 10% of the vote.16 Notably, a Trump-linked super PAC fielded campaign ads against Gray, helping propel the moderate candidate - Karen Handel - to the run-off against the Democratic challenger. While the media has obsessed about the surprise performance by Jon Ossoff, the first Democrat to make the district competitive since 1978, we are certain that House Freedom Caucus members have taken notice of Gray's fate. The message from the White House is clear: don't mess with Donald Trump. Trump will use carrots as well as sticks with the Freedom Caucus. To that end, we wish to remind our clients of "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue loss of tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, consequences that actually add to revenues. In other words, "tax cuts pay for themselves." Republican legislators have been using dynamic scoring to justify deficit-busting tax cuts for decades. And there is some truth to their claim that tax cuts generate revenue. For instance, while it is true that President Bush's White house vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 12). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 13). And we are being conservative in those numbers. Chart 11Trump In Line With##br## GOP Predecessors Chart 12Bush Was Right,##br## CBO Was Wrong! Chart 13Dynamic Scoring Will Offset About 10% ##br##Of Revenues Lost To Tax Cuts Treasury Secretary Steven Mnuchin was anything but conservative when he explicitly told investors to expect a tax reform plan paid for largely by dynamic scoring. Speaking on the sidelines of the IMF and World Bank spring meetings in Washington, Mnuchin said, Some of the lowering in (tax) rates is going to be offset by less deductions and simpler taxes, but the majority of it will be made up by what we believe is fundamentally growth and dynamic scoring. We have been arguing since November that investors should expect tax cuts that rely on dynamic scoring to justify their deficit-busting effects.17 Mnuchin's comments, after several hints from other legislators, confirm that this is indeed the plan. For the Freedom Caucus, dynamic scoring provides a defense against the accusation that their tax cuts increase the budget deficit. That said, data clearly shows that voters care less about deficits - their concerns have subsided with the deficits themselves (Chart 14).18 It remains to be seen whether Trump's team expects for dynamic scoring to do all the heavy lifting in justifying tax cuts or whether real tax reforms are still on the agenda. Even assuming Trump rejects the House GOP's border adjustment tax (which is apparently hanging onto life by a thread), he can offset revenue losses by repatriating companies' foreign earnings, moderating tax cuts for high-income earners, and closing loopholes. These offsets would add to whatever he saves from repealing Obamacare and cutting regulations.19 Chart 14Americans Not So Worried About Deficits Now Chart 15Trump Lags Average Predecessor Ultimately, Republicans of all stripes know that if they fail to produce some legislative "wins" then they will be left with nothing to campaign on in the midterm elections except for their affiliation with President Trump's very poor nationwide approval rating (Chart 15). The current polling foreshadows a 36-seat slaughter in the upcoming midterm elections for the Republicans in the House (Chart 16). This would give Democrats a majority. Several clients have asked us if this makes tax reform less likely. We do not think so. It simply means that Republicans have 18 months to pass their most treasured policies - and much less time if they want the economic growth spurt to help them get reelected. They may not have an opportunity like this for decades. Bottom Line: Investors should step back and focus on the big picture: Trump remains popular with GOP voters, the Freedom Caucus understands this threat, and - to quote Pink Floyd - magic makes the world go round. Investors should fade the rally in Treasurys, as our colleague Peter Berezin of BCA's Global Investment Strategy recently recommended. We are sticking with our "Trump reflation" 2-year/30-year Treasury curve steepener and initiating a recommendation that clients go short the January 2018 fed funds futures contract (Chart 17).20 Chart 16Republicans Heading For Huge Defeat In 2018 Chart 17Short Jan '18 Fed Funds Futures Brexit: Early Elections Reinforce Our GBP Call British Prime Minister Theresa May's decision to hold early elections vindicates our view that the political risks of Brexit peaked - and GBP bottomed - in mid-January when May declared that her country would leave the EU's common market (Chart 18).21 At that time, May frontloaded the worst expectations of negotiations while simultaneously removing the most contentious issue: common market access. With the U.K. decisively "out," i.e. not trying to take the EU's market while rejecting its people, the EU had less of a reason to make an example of the U.K. to other countries whose Euroskeptics might think they could pick and choose what they want from the bloc. Now May and the Tories are on track for a big electoral win that will not only confirm her government's strategy but also give her more maneuverability to handle the negotiations: May's Personal Mandate: May is a "takeover" prime minister - she emerged as leader in the party reshuffle after her predecessor David Cameron's resignation following the "Leave" outcome of the referendum. Takeover prime ministers are historically weaker than "elected" prime ministers and do not last as long in office - on average they rule for 3.3 years, as opposed to six for their elected peers (Chart 19). In other words, May's position was tenuous. This was especially likely to be the case as the country entered the rocky period of formal exit in 2019 and general elections in 2020. Her struggles in turn could have threatened the Brexit deal or her party's control. At the same time, May has received a bigger "bounce" in popular opinion after assuming office than other takeover prime ministers have done (Chart 20), partly as a result of the rally-around-the-flag effect after the referendum shock. Thus, it was eminently sensible to seek public approval of her leadership at this time. Chart 18GBP Bottomed When U.K. ##br##Forswore Common Market Chart 19Theresa May Faced##br## A Short Tenure Chart 20May Received ##br##A Brexit Boost A Thin Majority: The Conservative Party has also rallied post-referendum, especially in contrast with the divided Labour Party, under Jeremy Corbyn, that will hit its lowest point since 1918 if it performs according to current polling (Chart 21). Yet the government has a thin majority in parliament of only 17 seats, among the thinnest majorities in recent decades (Chart 22). This is a liability heading into the parliamentary vote on the final exit deal with the EU in 2019, raising the menace of a "Brexit cliff" in which the U.K.'s two-year negotiating period could expire without any EU deal at all. That would be an unmitigated disaster. With a greater majority, May will be able to cow the other parties further and whip her own party's backbenchers into shape. There was also a festering scandal about the Conservative Party's 2015 fundraising that could trigger a number of by-elections jeopardizing the thin majority.22 2022 is better than 2020: The Tories also faced the prospect of running for re-election in 2020, one year after Brexit actually occurs. By that time negative economic effects (not to mention any cyclical downturn) are more likely to be felt by the public than today. The Tories would also have to face the public immediately after any embarrassing compromises in the EU negotiations. Although Labour is currently in free fall - as illustrated by the astounding loss to the Tories in the by-election in Copeland in February23 - the next two years provide opportunities for revival. The negotiations may be messy, the economy will suffer as reality sets in,24 and the union itself may come under threat from a second Scottish referendum.25 Hence the new election timeline will suit the Tories better than the old, giving them till 2022 to cement Brexit itself and address some of the effects of the aftermath before facing voters. Chart 21Labour In The Doldrums Chart 22Tories Want A Bigger Majority To Manage Brexit Few doubt that May's timing is impeccable. There can be backlash from election opportunism and voter fatigue, but May's popular approval and the national atmosphere do not suggest it will be significant. Pollsters project from current opinion polls that she will secure a 100-seat majority or greater, and since 1997 party-preference polling has become more, not less, predictive of parliamentary seats after elections. Moreover our extremely conservative estimate based exclusively on opportunities that the Tories have to snatch seats from rivals at odds with the Brexit referendum suggests that they cannot do worse than to add 11 seats to their majority (Table 2). Table 2Minimal Scenario Gives Tories 11 New Seats For Their Majority In turn, a bigger majority more securely linked to Theresa May's leadership will bring greater maneuverability in the EU talks and assurance that she can get her final deal through parliament - even if it is an ugly one. How do the elections affect the EU? Contrary to the posturing on both sides, the early election will send a further electoral confirmation to the EU that the U.K. is dead-set on leaving and that the EU cannot deliberately negotiate a bad deal in hopes that the U.K. will change its mind. It could hardly hope to overturn domestic politics and elicit a reversal on Brexit after a third national electoral outcome in favor of leaving the union. Yet the EU saw the writing on the wall already. EU Council President Tusk's negotiating guidelines are not vindictive.26 The EU is opening the possibility of a multi-year transition period after the formal 2019 exit date and acknowledging the need under Article 50 of the Lisbon Treaty to take account of the future relationship, i.e. to provide a framework for a trade deal. The City of London stands to lose the most, but the guidelines are so far fairly tame outside of the financial sector. Moreover, we do not expect a harder line to emerge from the EU Council meeting on April 29. Already the Dutch, Irish, and Danish have called for negotiations on a trade agreement to begin promptly, essentially agreeing with Britain's urgent timeline.27 True, the probability that Macron will be the next French president - along with a likely shift toward a more outspoken Europhile stance in Germany after elections in September - presents the prospect of a "clash" with May's triumphant Tories. Macron has called for a "strict approach" to negotiations, has threatened to model his pro-market reforms in France in such a way as to steal "banks, talents, researchers, academics" from the U.K., and has suggested that the U.K. can at best hope for a deal comparable to Canada's Free Trade Agreement with the EU. That would set a low bar for the U.K.'s all-important services exports (Chart 23). However, Macron is an establishment player who will not significantly change France's position in the negotiations from what it would have been otherwise. (A Le Pen presidency obviously would mark a change by throwing the EU into chaos, but it is highly unlikely.) France is going to demand with the rest of the EU that the U.K. pay its dues (namely a 60 billion-euro budget contribution), but it is not in the interest of France or the EU to impose, effectively, a British recession - not while they seek to cultivate their own economic recoveries. Moreover, wreaking vengeance would not necessarily discourage Euroskeptics on the continent. With Le Pen mortally wounded, the significant Euroskeptic threat lies in Italy, where an imperious approach to Brexit from Germany and France may not be well received (Chart 24). Chart 23Services Are Key For The U.K. Chart 24Punishing The U.K. May Not Dissuade Italy Bottom Line: May's early election helps remove additional political risk by giving her party more maneuverability in negotiations and a greater ability to "make do" with what the Europeans give. Though this is highly unlikely to lead to a "soft Brexit" (common market access, customs union membership, subordination to the European Court of Justice), it is much more likely to prevent Britain from sailing off into a "no deal" abyss. To be clear, we can still see scenarios in which a reversal of Brexit is possible, as discussed previously,28 but they are very low probability. The snap election enables May's government to be flexible in the negotiations and accept some difficult truths in the final deal, which will reinforce the existing tendency of the EU to avoid causing a destabilizing "punitive" break. Both sides of the Channel are positioning for a relatively market-friendly outcome. We maintain our view that the pound has bottomed. Our short USD/GBP recommendation is up 2.85% since March 29 and short EUR/GBP is up 0.14% since January 25. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Alpha Sector Strategy Weekly Report, "Eerie Calm," dated February 10, 2017, available at gss.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Caveat Emptor," dated March 24, 2017, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 6 French toast in fact... we'll be here all night folks! 7 The reason this plan does not make sense is because most perpetrators of terrorist attacks in France have been French or European citizens. Le Pen's plan amounts to closing the barn door after the horse has bolted. 8 Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at bloomberg.com. 9 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 10 Former conservative prime ministers Jean-Pierre Raffarin and Alain Juppé, as well as other prominent members of Les Républicains have already announced that they would support Macron in the second round. 11 Please see "S. Con. Res. 3 - A concurrent resolution setting forth the congressional budget for the United States Government for fiscal year 2017," United States Congress, available at www.congress.gov. 12 For a great summary of the arcane procedure, please see "Introduction to Budget 'Reconciliation,'" dated November 9, 2016, available at cbpp.org. 13 If Republicans choose to delay beyond May, they will have to delay producing the fiscal year 2018 budget resolution. This is possible but introduces problems for next year's budget appropriations and the tax reform measures which will depend on the yet-to-be-written FY2018 budget resolution's reconciliation instructions. "The reconciliation legislation that the GOP is using to partially repeal and replace the ACA has a half-life. It will expire when Congress begins drafting the fiscal 2018 budget blueprint, which will likely be sometime in May. So if Republicans want to resurrect the AHCA and avoid the need for bipartisan votes in the Senate, they will have to vote on the bill within the next several weeks." Please see Baker and Hostetler LLP, "GOP Struggles To Revive Health Bill," Lexology, April 7, 2017, available at www.lexology.com. 14 In short, reconciliation can only be used to pass bills that impact spending and revenue. As such, any changes to Obamacare that do not impact fiscal matters could be found inadmissible by the Senate parliamentarian and thus could defeat the entire bill. There is of course always the "nuclear option" of simply ignoring the ruling of the Senate parliamentarian, but it is not clear whether the Senate GOP would want to go "Kim Jong-Un" twice in the same year! 15 Please see Congressional Budget Office, "American Health Care Act," March 13, 2017, available at www.cbo.gov. 16 Georgia's sixth congressional district is holding this special election to fill the seat left vacant by Tom Price, the new Secretary of Health and Human Services, as appointed by Trump. 17 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 18 Wouldn't dynamic scoring fail to pass the "smell test" with the CBO? Yes, it would. The CBO will likely ignore Republican "magic" and apply actual "math" to the tax proposal. However, this is not an impediment to passing tax reform as the reconciliation rules can still be used as long as the legislation expires after ten years. This is how President George W. Bush passed tax cuts in 2001. 19 A study by the conservative American Action Forum suggests that Trump's regulatory cuts may save $260 billion over ten years. This is a likely source of savings to justify tax cuts, and Trump is only getting warmed up when it comes to deregulation! For the study, please see Sam Batkins, "Fiscal Benefits Of The CRA, Regulatory Reform," April 20, 2017, available at www.americanactionforum.org. 20 Please see BCA Global Investment Strategy Weekly Report, "Fade The Rally In Treasurys," dated April 21, 2017, available at gis.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see "Conservatives fined £70,000 over expenses by election watchdog," Channel 4 News, March 16, 2017, available at www.channel4.com. 23 The Conservatives won the Copeland seat for the first time since 1982 after the Labour MP Jamie Reed's resignation there. 24 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 27 Please see "Brexit Shouldn't Delay Trade Talks Too Long, Say Leaders," Bloomberg, April 21, 2017, available at www.bloomberg.com. 28 See note 26 above. Geopolitical Calendar

Highlights The earnings rebound underway in Corporate America is being driven by more than just higher oil prices. S&P 500 profit margins have stabilized recently, but remain in secular decline. We remain bullish on the dollar and the other "Trump Trades" have legs as well. Uncertainty around tax policy may be restraining business capital spending and C&I loan growth. Feature Chart 1Excluding Energy Earnings Rebounding The so-called "Trump trades" have either stalled or partially reversed. The failure to reform Obamacare has dented hopes that the Administration and GOP will get a tax reform package done this year. The S&P 500 is not far off its all time high, but Treasury yields have returned to the bottom of the trading range and the dollar has weakened (although it has risen over the past 3 weeks). We still believe that the Republicans will at least push through tax cuts and some infrastructure spending this year, which will be stimulative for the economy. However, the 12-month outlook for the stock-to-bond ratio does not hinge solely on U.S. fiscal policy. As we have highlighted in the past, the underlying fundamentals for equities are positive, despite the fact that we see more dollar upside (see below). First quarter earnings season is about to kick off, and it should be another good one. Before we discuss the outlook for profits, let's review the fourth quarter of 2016. S&P 500 firms posted profit growth of 6% on a 4-quarter moving total year-over-year basis. The Q4 reading beat consensus bottom-up expectations at the start of earning season but were roughly in line with expectations at the start of Q4 2016 itself. The fourth quarter increase was the best year-over-year EPS gain since Q3 2014 - just after the oil price peak- and the first year-over-year increase in the 4-quarter sum since Q3 2015. Energy sector earnings posted a 6% advance in Q4, as oil prices averaged close to $49 per barrel in Q4 2016, up 17% from Q4 2015. It was the first time that oil prices posted a year-over-year increase in a quarter since Q2 2014. Part of the acceleration in earnings reflects the rise in oil prices from the Q1 2016 bottom, but higher energy prices are not the only factor driving the turnaround (Chart 1). Overall, 9 of the 11 S&P 500 sectors saw positive year-over-year profit gains in Q4 2016, led by technology (13%), financials (12%) and utilities (10%). In addition, Consumer Discretionary, Financials and Health Care all posted solid earnings figures in the last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is also benefiting from favorable comparisons. Eighty-eight percent of technology firms posted Q4 results that beat expectations, as did 80% of health care companies and 75% of financials, so the market was caught somewhat off guard by the pace of the upturn in earnings outside of energy. While earnings grew at 6% year-over-year in Q4 2016, revenues grew just 4% due to low nominal GDP growth last year (although the latter rebounded late in the year). Ten of 11 sectors posted year-over-year revenue increases in Q4, but the revenue gain just matched consensus estimates with only half of firms posting revenues that exceeded already low expectations. In short, the market didn't expect much and didn't get much from revenues in Q4. The Marginal Way: A Top Down View Looking ahead, a secular downtrend in margins will be a headwind for earnings growth in the coming years, as we highlighted in the February 27, 2017 Weekly Report. A "mean reversion" process for margins is underway, as a tight labor market pushes up wages but firms have difficulty passing along the cost pressure in a poor environment for pricing power. For large cap U.S. companies, global GDP is a better proxy for revenue than U.S. GDP. Nominal global GDP growth fell 6% year-over-year in 2015, but rebounded to a 2%+ increase in 2016 and the World Bank expects global GDP to accelerate rapidly to a 6% increase here in 2017. Thus, there is scope for U.S. corporate revenue growth to pick up after a long period of deceleration. Indeed, the risks for global growth are to the upside of consensus estimates in our view (Chart 2). For those industries and sectors with mainly domestic sales (utilities, telecom), U.S. GDP is a better proxy for top line sales. At just 3.0%, U.S. nominal GDP growth was disappointing in 2016, running 340 basis points below its long-term average (6.4%) and nearly a full percentage point shy of the 2010-2014 (post Great Recession but pre-oil price decline) average of 3.8%. We expect nominal GDP growth to accelerate this year, even absent potentially growth-enhancing legislation from Congress on tax cuts, tax reform and infrastructure. Compensation costs represent two thirds of business costs, and various measures of wage gains are slowly climbing as the U.S. economy approaches full employment. Average hourly earnings rose 2.7% in March 2017 versus a year ago, up from a low of 1.5% hit in 2012. The Employment Cost Index is accelerating as well. The Atlanta Fed's Wage tracker has been trending higher for 7 years, not coincidentally, along with service sector inflation. The Atlanta Fed wage tracker shows the same pattern for both job stayers and job seekers (Chart 3). Chart 2Global Growth Accelerating Chart 3Wage Pressures Building The quit rate from the BLS's JOLTs data has hit a new cycle high and is within striking distance of an all-time high. This is significant because a high quit rate means that job prospects are favorable and that employees are jumping to new jobs in search of higher wages. In addition, mentions of wages, skilled labor, and shortages in the Fed's Beige Book have been on the upswing for four years (Chart 4). Labor costs are rising faster than selling prices in the non-financial corporate sector, as highlighted by the downtrend in BCA's Profit Margin Proxy (Chart 5, Panel 1). The mean reversion process will continue, but that does not preclude periods of margin expansion. Indeed, margins rose in the third and fourth quarters on a four quarter moving total basis according to S&P data and we would not be surprised to see this continue early in 2017 as nominal GDP growth recovers from last year's depressed pace (Chart 5, Panel 2). Chart 4"Inflation Words" On The Rise Chart 5Bullish Profit Model What about the dollar? As we discuss below, BCA believes that the dollar bull market still has legs. A stronger dollar is both a blessing and a curse for margins. All else equal, a stronger dollar lowers the cost of imported goods and thereby boosts margins for import-intensive firms. On the other hand, a strong dollar undermines profits earned overseas. The net impact of dollar strength is negative for overall corporate profits. However, our quantitative work highlights that it does not take much in the way of stronger growth to offset the negative impact on profits from a rise in the dollar. Investors are also concerned about the impact of higher interest rates on corporate income statements, especially given all the corporate debt that has been accumulated. While we agree with the conventional wisdom that interest costs as a percent of sales have likely bottomed for the cycle, and will undermine margins if yields rise, research by the monthly Bank Credit Analyst revealed that it will require a large increase in interest rates to 'move the dial' on interest payments.1 This is because of a long maturity distribution and the fact that the average yield-to-maturity is still so far below the average coupon in the corporate debt indices that average coupons will continue to erode as debt rolls over in the coming years. Chart 6 shows that interest payments as a fraction of GDP will be roughly flat even if the yield curve shifts up by another 100 basis points in the near term. It would require a 200-300 basis point rise in yields to see a meaningful impact on interest payments over the next 1-2 years. The implication is that rising interest costs won't be a key driver of profit margins in our investment horizon. Chart 6U.S. Corporate Sector Interest Payment Projection Despite our secular view on profit margins, we remain upbeat for EPS growth this year. Our profit model remains constructive. Indeed, EPS growth for the year may not trail (perennially overly optimistic) bottom-up estimates for the year, currently at 10%. In short, we see a potential for upside surprise on earnings this year, although growth will not be as high as our short-term profit model suggests (Chart 5, Panel 3). Bottom Line: We certainly would not rule out a pullback in the S&P 500 on disappointment surrounding a lack of follow-through by Congress and the Trump Administration on a tax cut, tax reform and an infrastructure package. However, fears around margin contraction, the sustainability of the earnings rebound and valuations are overdone. Earnings estimates almost always come down over the course of the year. Moreover, while above-average valuations suggest below average-returns over the next decade, valuation tells us little about returns over the next 12 months. We continue to favor stocks over bonds in 2017. Is The Dollar Bull Over? The dollar has firmed over the past couple of weeks but it remains below the December high in trade-weighted terms. Is this just a consolidation phase? Or has the dollar peaked for this cycle because the maximum policy divergence between the Fed and the other major central banks is now in the price? Indeed, the global growth outlook outside of the U.S. has brightened at a time when some of the so-called "hard" U.S. economic data have disappointed and the promised Trump fiscal stimulus appears to be on the ropes. The European Central Bank (ECB) has already tapered its asset purchase program once and is expected to do so again early in 2018. Some are even speculating that the ECB will lift rates in the not-to-distant future. This raises the possibility that the bund yield curve begins to converge with the Treasury curve, placing upward pressure on the euro versus the dollar. The Eurozone economic data have certainly been stellar so far this year. The PMIs for manufacturing and services both pulled back a bit in March, but remain at levels consistent with continued above-trend growth. The uptrend in capital goods orders bodes well for investment spending over the coming months (Chart 7). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. The Eurozone unemployment rate is falling fast and there is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases in 2013 (Chart 8). Chart 7Solid Eurozone##br## Economic Data Chart 8Less Spare Capacity In Europe Now ##br##Vs. Pre-Taper Tantrum U.S. Nonetheless, the calm readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Our diffusion index for the components of the CPI points to some upside for core inflation in the coming months, but it fell back to 0.7% in March according to the flash estimate. The ECB will probably not feel comfortable announcing the next tapering until September of this year. But even then, policymakers will apply a heavy dose of "forward guidance" on the outlook for short-term rates in order to avoid an outsized impact on Eurozone bond yields. Some tapering is presumably already discounted in rates and the euro. Chart 9Market Is Reassessing The FOMC It will be much longer before the Bank of Japan is in any position to begin removing monetary accommodation. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year, and probably much longer. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well. This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese nominal interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. On the U.S. side, we believe that the market has over-reacted when the FOMC signaled last month that it was not yet prepared to adjust the 'dot plot.' The market is discounting only two rate hikes over the next 12 months, down by about 10 basis points since the FOMC meeting (Chart 9). The market view is too complacent for three reasons. First, we expect the U.S. "hard" to catch up with the more robust "soft" data readings in the coming months. Second, the FOMC did not signal a more dovish mindset last month. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. The poor (weather-related) March payroll report does not change the Fed outlook. The important point is that the market appears to be at full employment based on FOMC committee projections. In fact at 4.5% in March (the lowest since May 2007) the rate is below the median and midpoint of the FOMC's long-run forecast, of respectively 4.7% and 4.85%. Finally, the market is underestimating the prospects for stimulative tax cuts and infrastructure spending. The Republican's desire to cut taxes will dominate fears of blowing out the budget deficit. The resulting stimulus will add pressure on the FOMC to tighten monetary conditions. Bottom Line: Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms as yield spreads move further in favor of the greenback, but a move of that magnitude wouldn't be a major headwind for U.S. corporate earnings growth and would pale in comparison to the hit earnings took from the 20-25% gain in the dollar in late 2014 through early 2016. Our view remains that the U.S. bond bear phase is not yet over. Revisiting "Weak" U.S. CAPEX The BCA Model for business investment tracks broad capex swings and has been trending down for several months now. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Comments from management during the recent Q4 2016 earnings reporting season were upbeat, but cautious, and there is some evidence (the recent rollover in C&I) loans that businesses may be delaying some portion of capital spending until after tax cuts and or tax reform is enacted by Congress. Part of the macroeconomic narrative for many investors over the past several years is that U.S. growth has been slow this cycle because private investment has been weak. The prolonged nature of "weak" U.S. investment during this economic recovery has been offered as evidence of deep-seated structural problems by many market participants, and arguably remains a factor driving the continued prevalence of the secular stagnation narrative. Two elements of the "weak investment" narrative are undeniably true. First, overall investment has indeed grown at a sluggish pace over the past eight years relative to previous economic expansions. Second, residential investment has certainly been weak by any measure, which is to be expected given that housing was at the epicenter of the subprime financial crisis. However, Chart 10 presents a different perspective about the "weakness" of investment by examining the trend in non-residential fixed asset investment (i.e., capex). The chart shows that, relative to GDP, capex has not been weak at all this cycle: it experienced a V-shaped recovery over the past several years, and has risen either back to its post-1980 average (in nominal terms) or to a new high (in real terms). This highlights that growth in investment, abstracting from the housing effect, has been weak in absolute terms because consumption has been weak, rather than because of some other unexplained structural force. Chart 10Investment Has Not Been Weak Relative To GDP More recently, Chart 10 shows that there has been a decline in the capex-to-GDP ratio, which has been a concerning sign for some investors that U.S. growth may be faltering. Until the beginning of last year, this deceleration could have been simply blamed on a collapse in resource investment following the sharp decline in the price of oil that began in mid-2014. But Chart 11 shows that this ceased to be the case through to the fourth quarter, as real capex excluding mining structures has also decelerated sharply. The slowdown in capex last year is echoed by a sharp recent slowdown in U.S. bank lending, and a detailed analysis suggests they may both be (at least somewhat) related to the same cause. Chart 12 presents the 3-month annualized rate of change in commercial & industrial (C&I) loans, along with the U.S. Economic Policy Uncertainty Index. The recent spikes in the latter correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November, and the chart clearly shows a close correlation between these spikes and the deceleration in C&I loan growth. Indeed, C&I lending had begun to pick up again following the Brexit vote, only to decelerate again after November. Chart 11Oil Accounts For Some, But Not All, ##br##Of Recently Weak CAPEX Chart 12Tax Rule Certainty May Spur Bank##br## Lending And Investment Uncertainty over Brexit represented legitimate CEO concern about a potential global macro shock, but our view is that the recent uncertainty following the U.S. election has not been driven by fear. This is a crucial distinction with implications for the economic outlook: if the recent uptick has been driven by a dearth of information about how business-friendly fiscal policy will become as a result of the election, then investors are more likely observing uncertainty over how much and when to invest rather than whether to invest. If true, this suggests that weak bank lending and growth in non-resource capex in Q4 has merely been deferred until rule clarity emerges and firms are confident that they will benefit from any investment-related changes to the tax code. In short, far from being a bearish signal about economic activity, recent trends in C&I lending and non-resource capex may actually indicate that firms plan on responding positively to corporate tax relief, suggesting that overall economic growth may improve once the details of the plan are known. Bottom Line: A detailed analysis of recent weakness in C&I lending and non-resource capex points to policy-related uncertainty as the culprit, rather than impending economic weakness or a broad-based contraction in activity. This argues that some capex spending is pent up, and that economic growth will improve following the establishment of tax rule certainty by the Trump administration and/or congressional leadership. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports Jonathanl@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report "Global Debt Titanic Collides With Fed Iceberg?", dated February, 2017, available at bca.bcaresearch.com

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... Chart 2...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades