Monetary

Highlights The Turkish economy is in disarray, ... : The lira's plunge has reminded some investors of the Thai baht's in 1997, but we do not foresee a replay of the Asian Crisis. ... highlighting emerging markets' vulnerability to external factors: EM economies may be on firmer footing than they were 20 years ago, but the vicissitudes of dollar-denominated debt remain their Achilles' heel. Fraught times around the world justify paring back portfolio risk, ... : Increased caution is appropriate in the face of potential EM distress. Multiples are elevated and spreads are tight, leaving stocks and bonds susceptible to a pickup in risk aversion. ... even if domestic data indicate that the U.S. expansion is alive and well: Global concerns did nothing to dim small businesses' rosy outlook, but the dirty little secret within the July NFIB survey is that rising cost pressures will keep the Fed from backing off of its tightening plans. Feature Dear Client, This is our final report for the month of August. We will resume our regular publication schedule the first week of September. We wish everyone an enjoyable rest of the summer. Best regards, Doug Peta, Chief U.S. Investment Strategist What a difference a year makes. If 2017 was all about synchronized global growth, 2018 has been a study in desynchronization. While the list of sputtering international economies grows longer with every passing month, the U.S. economy continues to gather steam. The fact that it is leaving the laggards choking on its exhaust as it speeds by, trampling the conventions of the postwar international order the U.S. itself established, and tightening the screws on dollar borrowers, is bruising feelings from Ankara and Beijing to Ottawa and Brussels. There is nothing on the horizon to indicate that the desynchronization trend is about to end. Surreal as it may be for baby boomers and other pre-millennials, trade barriers are an essential plank in the Republicans' midterm election platform. Our geopolitical strategists caution that there is little reason to expect the anti-trade rhetoric out of Washington to die down before November. The associated headwinds for multinational corporations and economies more reliant on global trade are likely to persist for at least a few more months. The other global policy irritant comes from the Fed. Although it is not blind to the impact of its policies on other economies, its America First mandate is firmly entrenched. Confronted with a domestic economy that is being force-fed stimulus when it is already showing signs of bumping up against supply constraints, the Fed has very little room to relax its vigilance. Investors counting on an "EM put" to alter the course of rate hikes should recognize that that put is way out of the money: it will take a great deal of EM pain for the Fed to back away from its projected course. Turkey's Tenuous Model Before the Asian Crisis, the growth of the Asian Tiger economies was the envy of the world. The formula was simple and effective: take ample supplies of cheap labor, mix with developed-world capital to finance a buildup of manufacturing capacity, and watch eye-popping growth ensue. All was well until too much excitement led to hard-currency-debt-financed investment in overcapacity. When exchange-rate pegs fell, domestic borrowers became unable to meet their obligations and the Asian Miracle imploded. The Turkish lira's plunge has put many investors in mind of the Thai baht's 1997 collapse that set the Asian Crisis in motion. The EM contagion eventually found its way to Russia in the summer of 1998, felling hedge fund titan Long-Term Capital Management (LTCM) and thoroughly rattling several of its Wall Street enablers. Investors would be foolish to ignore the problems in Turkey, which could well ripple out into other EM economies and the developed world. However, our current base-case scenario does not call for anything on the order of the Asian Crisis. Chart of the WeekTurkey Is A Clear Outlier Today ... Chart 2... But It Would Have Been In The Thick Of Things In 1997 Turkey's dependency on external capital flows is reminiscent of the Asian Tigers', but it is an outlier in today's more conservative context (Chart of the Week). On the eve of the Asian Crisis, Turkey's external financing profile, on both a flow (current-account balance as a share of GDP) and a stock (external private debt as a share of GDP) basis, would have placed it squarely within the smart set (Chart 2). In retrospect, the Asian Miracle template of the early and mid '90s was an accident waiting to happen. Currency pegs are seen as a naïve relic, and exporters assiduously build up reserve war chests to prevent currency panics from taking root. Chart 3U.S. Banks Have Modest EM Exposure The key issue for U.S. investors is the potential for contagion to the U.S. banking system and its markets. It is almost impossible to identify an LTCM in advance, but the fact that the banking system is on a much tighter leash following the crisis means that it is far less vulnerable than it was in the late '90s. As our f/x strategists point out,1 European banks (especially Spain's BBVA) have considerably more exposure to Turkey and other fragile EM economies (Chart 3). Sentiment is the most likely transmission mechanism, and U.S. assets would seem to be last in line for multiple de-rating and spread widening, given the strength of the U.S. economy and its comparative remove from the rest of the world. Bottom Line: The magnitude of Turkey's financing excesses is not representative of the entire EM complex. U.S. investors should operate with a heightened sense of caution, but they should not panic. Emerging Markets' Achilles' Heel The magnitude of Turkey's reliance on external financing is unusual, but the direction is common. The vast bulk of the world's wealth is held in developed economies, and EM projects necessarily source capital from DM investors. Over 90% of all EM corporate debt is denominated in hard currency, of which the vast majority is denominated in U.S. dollars. For EM corporates with mainly domestic revenues, moves in the dollar exchange rate exert disproportionate influence over how comfortably they can service their debt. Exchange rates are determined by many factors, but real interest rate differentials are among the most prominent drivers. When the Fed hikes the fed funds rate while other central banks are easing policy or standing pat, the dollar tends to appreciate. A rising dollar pressures EM corporate borrowers, and hasn't been good for EM stock prices, either (Chart 4). If the Fed were to lift the fed funds rate all the way to 3.5% by the end of 2019, as we expect, several EM borrowers could find themselves in the crosshairs. Chart 4Tighter Fed Policy Squeezes EM Equities, Too Meaningful Chinese stimulus could go a long way to offsetting Fed tightening pressures. A more robust Chinese economy would trade more and consume more natural resources. Increased export volumes and higher commodity prices would boost EM exports and commodity prices, helping to support exchange rates. Unfortunately for Asian and Latin American EMs, the jury is still out as to whether or not the Chinese cavalry will ride to the rescue. Our China strategists have observed that a sizable stimulus injection would run counter to policy makers' commitment to reining in shadow banking excesses and cooling off the property market. If the trade war with the U.S. really starts to bite, however, reform may become a lesser priority. The powers that be have been circumspect with stimulus so far (Chart 5), weakening the currency to defend exports (Chart 6) rather than attempting to boost domestic activity via government spending. We will keep a close eye on Chinese policy developments as they unfold. Chart 5Instead Of Helping The EM Bloc With Reflation,... Chart 6...China Has Been Exporting Deflation Bottom Line: Chinese stimulus could help cushion the blow from a stronger dollar, but policy makers have yet to show their hand. Stay tuned. The View From Main Street Despite the global challenges, the July NFIB survey underlined the point that the U.S. economy is flying high. The headline Optimism Index is a single tick below its all-time high (Chart 7, top panel), the Hiring Plans (Chart 7, second panel) and Job Openings components (Chart 7, third panel) are at or near all-time highs, and the Good Time to Expand component is just off the high it set in May (Chart 7, bottom panel). All in all, the view from Main Street is the best it's ever been over the survey's 44-year history. All of the readings in Chart 7 are so good (two-plus standard deviations above the mean), that there is little scope for improvement. Mean reversion may well begin to assert itself, but it is likely to be a slow process. Overall optimism peaks well ahead of downturns, and tends to take its time deteriorating. It lends support to the message from our recession indicator2 that the expansion has at least another year to run. All good things come to an end, however, and the downside to the gangbusters survey results is that they foreshadow the expansion's eventual demise. Respondents' reports of price changes and future intentions to raise them correlate closely with PCE inflation (Chart 8). Record strength in job openings and hiring intentions indicates the labor market is tight enough to squeak, suggesting that firms will soon have to bid up wages to attract new employees. Taken together, the inflation-related measures imply that the Fed will not be able to let up, supporting the house view that the fed funds rate will surprise to the upside. Chart 7A Roaring Economy... Chart 8...Carries The Seeds Of Its Own Demise Bottom Line: The end of the expansion is not at hand, but its strength will eventually compel the Fed to step in to cut it off. Investment Implications Fiscal stimulus and monetary policy still support the expansion and the bull markets in equities and corporate debt, but they will not do so indefinitely. Stimulus is not sustainable from a budgetary standpoint, and gathering inflationary pressures will eventually inspire the Fed to wield its policy tools to bring the curtain down on the business cycle. The shift to restrictive policy will mark an inflection point in risk-asset performance, and investors should pursue more defensive portfolio positioning when it arrives. Although the cyclical inflection point is not yet upon us, the uncertain outcome of trade tensions and emerging market vulnerabilities merit dialing back portfolio risk in the near term. In line with the BCA house view, we recommend overweighting cash and underweighting bonds, while maintaining benchmark positioning in equities. Treasuries will likely outperform if the EM rumblings turn into something more serious, but we would view any decline in yields as a temporary respite from a Treasury bear market that has already been in place for two years. Depending on when, or if, the current global pressures abate, the equity bull market may still have some juice, and we are keeping an open mind about moving stocks back to overweight for the final push. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 17, 2018 Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers," available at fes.bcaresearch.com. 2 Please see the August 13, 2018 U.S. Investment Strategy Special Report, "How Much Longer Can The Bull Market Last?" available at usis.bcaresearch.com.

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Dear client, Our publishing schedule will be shifting over the next two weeks. Next Friday, we will publish a Special Report aggregating various pieces from our colleague Matt Gertken of BCA's Geopolitical Strategy detailing the reforms taking place in China and their past and future evolution, and the economic and investment implications for China and the rest of the world. Matt argues that Chinese reforms are in place and here to stay, which should deepen the malaise in EM and support the dollar. We will not publish any report on August 31st. We will resume our regular publishing schedule on September 7. I hope you enjoy the rest of your summer. Best regards, Mathieu Savary Highlights The 1997 Asian Crisis was a deflationary event, causing commodity prices, commodity currencies and the yen to fall against the dollar, but it had a limited impact on the euro. When Russia collapsed in 1998, the LTCM crisis hit the U.S. banking system, with fears of solvency dragging Treasury yields lower, hurting the dollar against the yen and the euro. Today is not 1997, but the tightness of the U.S. economy suggests the Federal Reserve will need a large shock before abandoning its current pace of a hike per quarter; additionally, global liquidity conditions are tightening and China is slowing. The EM crisis is therefore not over, and vulnerable Brazil, Chile, Mexico, Colombia and South Africa could still experience significant pain. Unlike in 1998, the hot potato is not hiding in the U.S. but in Europe. A contagion event is therefore more likely to hurt the euro than 20 years ago; meanwhile, the yen stands to benefit. DXY could hit 100, and commodity currencies still have ample downside, the AUD in particular. Continue to monitor our China Play Index to gauge if Chinese stimulus could delay the day of reckoning for EM; this index can also be employed as a hedge for investors long the dollar or short EM plays. Feature "Misfortune tests the sincerity of friends." - Aesop This summer is oddly reminiscent of that of 1997. The Federal Reserve is tightening policy because the U.S. economy is not only at full employment but is also growing strongly and generating increasing domestic inflationary pressures. But the most familiar echoes come from outside the U.S. Specifically, emerging market trepidations are once again front page news as the Turkish lira, which had already fallen by 24% between January 2018 and July 31st, dropped by an additional 28% at its worst in a mere two weeks. Consequently, investors are now fretting about the risks of contagion across EM markets, one that could reverberate among G10 economies as well. We too worry that the echoes of 1997 are becoming increasingly louder. EM economies have built up large stocks of debt, and have financed themselves heavily by tapping foreign investors. However, these investors can be rather fickle friends, and we are set to test their sincerity. In this piece, we review how the events of 1997-'98 unfolded, what it meant for G10 currencies, and whether the same lessons can be applied today. We find that in 2018, an EM crisis could ultimately be more supportive for the dollar versus the euro, as unlike in 1998, where the hot potatoes were held by U.S. hedge funds, this time the mess sits squarely in Europe. Tom Yum Goong Goes Viral Initiated in the second half of the 1980s, the peg of the Thai baht seemed like a very successful experiment. The stability created by this institutional setup not only contributed to keeping Thai inflation at manageable levels, but by incentivizing capital inflows in the country it also helped Thailand build up its capital stock. At the time, this yielded a large growth dividend, with real GDP growth averaging 9% from 1985 to 1996. However, the economic boost generated by this cheap financing had a dark side. The Thai current account balance ballooned to a deficit of 8% of GDP in 1995-'96. As Herb Stein famously expressed, if something cannot go on forever, it will stop. Like in Aesop's fable where one of two travelers climbed up a tree to avoid a bear, leaving his friend to fend off the bear on his own, foreign investors abandoned Thailand, which was left on its own to finance its large current account deficit. While the Bank of Thailand was able to fend off the attacks for a few weeks, on July 2nd, 1997, it abandoned its efforts. The THB was left to float freely and dropped 56% against the USD over the subsequent six months. Other EM countries including Malaysia, Brazil and Korea, to name a few, had implemented similar U.S. dollar pegs. They too enjoyed stable inflation, growing money inflows and improved growth, but also experienced growing current account deficits and foreign currency debt loads. It did not take long for investors to extrapolate Thailand's woes to other countries. The Malaysian ringgit and the Indonesian rupiah began falling soon after the THB, while the Korean won began its own steep descent four months later (Chart 1). The economic pain was felt globally. The collapse in EM Asian exchange rates and the deep recessions experienced in these countries caused their export prices to collapse, which created a global deflationary shock (Chart 2). This shock was compounded by a fall in commodity prices that materialized as market participants realized that demand for commodities from the crisis-stricken countries was set to evaporate (Chart 2, bottom panel). Chart 1How The Thai Crisis Morphed Into An Asian Crisis Chart 2The Asian Crisis Was A Deflationary Shock Not only did this deflationary shock lift the USD against EM currencies and commodity currencies, it also caused inflation breakevens in the U.S. to fall significantly (Chart 3). However, because the U.S. economy remained robust through the second half of 1997 and in the early days of 1998, real rates did not respond much (Chart 3, bottom panel). Markets where not very concerned that this shock would force the Fed to cut rates, as it did not seem to affect the outlook for U.S. growth and employment. However, this combination of stable real rates in the face of weaker growth in EM, as well as the collapse in commodity prices ended up having large second-round effects. Russia defaulted in August 1998, prompting a collapse in the ruble. To patch up its finances, Russia began pumping ever more oil out of the ground, causing oil prices to fall below US$10/bbl in December 1998, deepening the malaise in commodity prices. This caused the Brazilian real to collapse in 1999, and the Argentinian peso to follow in 2002 (Chart 4). Chart 31997: Falling Breakevens, Stable Real Yields Chart 4Asian Crisis Goes Global Among these contagions, the Russian default was the event with the greatest systemic impact. This was because it was a direct hit to the U.S. banking system. Long Term Capital Management, a large Connecticut-based hedge fund, had accumulated massive bets on Russia. The country's default plunged the fund into the abyss. However, LTCM had liabilities to banks to the tune of US$125 billion. The exposure was perceived as an existential threat to the banking sector, and the market began to anticipate a repeat of the 1907 panic.1 Junk bond spreads jumped, the S&P 500 fell by 18%, and U.S. government bond yields collapsed by 120 basis points (Chart 5). The Fed was forced to respond, coming out of hibernation and cutting rates by 75 basis points between September and November of 1998. As the Fed forcefully responded to this shock and 10-year Treasury yields fell, the dollar, which had managed to stay somewhat stable against the synthetic euro from July 1997 to August 1998, fell 11%. Within the same one-year window starting in July 1997, the yen dropped 23%, dragged lower by the competitive pressures created by weaker Asian currencies. However, as soon as U.S. bond yields collapsed, the yen began to surge, rising by 36% from August 1998 to January 1999 (Chart 6). Only once the Fed started increasing rates anew did the euro and the yen level off. Chart 5The Russian Default Was The Real Shock For The U.S. Chart 6The Dollar Buckled After LTCM In aggregate, the dollar's performance through the 1997-1998 period was very mixed. The trade-weighted dollar managed to rise from July 1997 to August 1998. Nevertheless, this was a complex picture. During this timeframe the dollar rose against EM currencies - against the CAD, the AUD, the NZD and the JPY - but was flat against the euro. The USD then fell against everything from August 1998 to the first half of 1999. Only once the Fed started hiking again in the summer 1999, was the greenback able to resuming its broad ascent, one that lasted all the way until late 2001. Bottom Line: In 1997, the first domino to fall was Thailand. Since many East Asian economies suffered the same ills - current account deficits, foreign currency debt loads and falling foreign exchange reserves - Asian currencies followed, dragging the yen lower in the process. This generated a deflationary shock that hurt commodity prices and commodity currencies, leading to the infamous Russian default of 1998. The associated LTCM bankruptcy threatened the survival of the U.S. banking system, forcing bond yields much lower as the Fed cut rates three times. The dollar suffered because of this policy move, especially against the yen. However, once the Fed resumed its hiking campaign, the dollar recovered across the board, making new highs all the way to late 2001 and early 2002. Is 2018: 1997, 1998, Or 2018? In one key regard, today is not the late 1990s: Dollar pegs are few and far between. However, in many respects, similarities abound. First and most obviously, EM foreign currency debt loads, as measured against exports, GDP or reserves, are at similar levels to those prevailing in the late 1990s (Chart 7). This means that EM economies suffer when the dollar rises, as it represents an increase in their cost of capital, and thus a tightening in financial conditions. Second, the Fed has been increasing interest rates. Most importantly, the Fed is growingly concerned that domestic inflationary pressures in the U.S. are intensifying, courtesy of strong growth - at least relative to potential; a high degree of capacity utilization, especially in the labor market (Chart 8); and, unique to today, the U.S. has received a large degree of unneeded fiscal stimulus. Chart 7EM Dollar Debt Is High EM Have More ##br##Foreign-Currency Debt Than In The 1990s Chart 8The Foreign Pain Threshold For The Fed Is Much Higher ##br##Now Than In 2015 or 2016 This means it will take a lot of pain to derail the Fed from its desire to hike rates once a quarter. This also makes the current environment very different from 2015, the most recent episode of EM tumult. In 2015-2016, the Fed easily abandoned its hiking campaign. When it hiked rates in December 2015, the Fed anticipated increasing rates four times over the following 12 months. It delivered only one hike in December 2016. The reason was straightforward: Unlike today, the U.S. economy was still replete with slack (Chart 8) and was not on the receiving end of a large fiscal stimulus program, suggesting the Fed could not tolerate the deflationary impact of tightening financial conditions. Third, global liquidity is tightening, which is hurting the global growth outlook. Today, global excess money, as defined by the growth of broad money supply above that of loan growth in the U.S., the euro area and Japan, is contracting. Today, as in 1997, this indicator forebodes important weaknesses in global industrial production (Chart 9). U.S. liquidity is particularly important. Not only is dollar-based liquidity crucial to financing the large stock of dollar-denominated foreign debt, but the U.S. is also driving the fall in global excess money. The pick-up in U.S. economic activity is sucking liquidity from both the rest world and from the financial system to finance U.S. loan growth (Chart 10). This phenomenon was also at play in 1997. Chart 9Excess Money Is Contracting Global Excess ##br##Money Contracting, Just Like In Early 1997 Chart 10The U.S. Economy Is ##br##Sucking In Liquidity Why does this matter? Simply put, U.S. financial liquidity; built as a composite of 3-month T-bills, total bank deposits minus bank loans, bank investments, and M2 money supply; is a wonderful leading indicator. The current collapse in financial liquidity suggests that the global economy is about to hit a rough patch. As Chart 11 illustrates, the weakness of this indicator points to declines in our Global Leading Economic Indicators and in global commodity prices. This suggests the indicator is foretelling that a deflationary scare could materialize, an event normally also associated with a stronger dollar and downside in EM export prices (Chart 12). In a logically consistent fashion, the liquidity indicator is also warning that the AUD, CAD and NZD have substantial downside, while EM equity prices could also suffer more (Chart 13). Finally, it also highlights that even the U.S. stock market may not be immune to upcoming troubles (Chart 14). Chart 11U.S. Financial Liquidity Points To Weaker Growth... Chart 12...And A Stronger Dollar But Weaker EM Export Prices... Chart 13...Falling EM Stocks And Commodity Currencies... Chart 14...And Maybe Even A Correction In U.S. Stock Prices Fourth, gold is sending a similar signal as in the late 1990. As we have argued in the past, gold is a very good gauge of global liquidity conditions. During the Asian Crisis and the Russia/LTCM fiasco, industrial commodity prices only experienced a serious decline after the Thai baht had dragged down Asia into a tailspin. However, gold had been falling since 1996, a move predating the fall in Asian currencies (Chart 15). The precious metal was confirming that global liquidity was tightening and being sucked back into the booming U.S. economy. Today, gold prices are sending an ominous signal. After forming a large tapering wedge from 2011 to 2018, gold prices have broken down below the major upward-sloping trend line that had defined the bull market that began in 2001 (Chart 16). This indicates that gold may be starting another leg of a major bear market. Moreover, as the bottom panel of Chart 16 illustrates, it is true that net speculative positions in the yellow metal have plunged, but they remain far above the large net short positions that prevailed in the late 1990s. If gold is indeed entering another major down leg, this would confirm that tightening liquidity will further hurt EM asset prices, commodity prices and non-U.S. economic activity. Chart 15As Early As 1996, Gold Warned Of Upcoming Problems In Asia Chart 16Is A Secular Bear Market In Gold Beginning? Finally, adding insult to injury is China. The current communist party leadership is hell-bent on reforming the Chinese economy, moving it away from its dependence on capex and leverage. Consequently, China is in the midst of a major deleveraging campaign concentrated in the shadow banking sector, which has already caused money growth and total social financing to plumb to new lows (Chart 17). This is deflationary for the global economy as weaker Chinese credit weighs on capex, which in turns weighs on Chinese imports, as 69% of China's intake from the rest of the world are commodities and intermediate as well as industrial goods. Chart 17Chinese Monetary And Credit Conditions Remain ##br##Tight China Deleveraging Is Biting Chart 18No Capitulation ##br##Yet Moreover, the recent wave of renminbi weakness is exacerbating these deflationary pressures. The 9% fall in the yuan versus the dollar since April 11th represents a competitive devaluation that will hurt many EM countries. It also implies downside in China's import volumes, as it increases the prices paid by Chinese economic agents for foreign-sourced industrial goods and commodities.2 All these forces suggest that the pain that started in Argentina and Turkey could continue to spread across other vulnerable EM economies. It is doubtful that economies with large debt loads, large upcoming debt rollovers and other underlying economic problems will find it easy to receive financing in an environment of declining global liquidity, a strong dollar, budding deflationary pressures and a slowing China. Making this worry even more real, EM investors have not capitulated, as bottom-fishing has prompted massive inflows into Turkey in recent days (Chart 18). 2018 may not be 1997 or 1998, but it is likely to be a year to remember. Bottom Line: EM currency pegs to the dollar may not be as prevalent as they were back in the 1990s, but enough risks are present that contagion from Argentina and Turkey to other EM economies is a very real risk. Specifically, the domestic economic situation in the U.S. warrants higher interest rates, which suggests the Fed is unlikely to be fazed by EM market routs unless they become deep enough to present a threat to U.S. growth itself. Moreover, global liquidity conditions are tightening as the U.S.'s economic strength is sucking in capital from around the world. This combination means that EM countries with large dollar debt loads are likely to find debt refinancing a very onerous exercise. Finally, China is slowing and letting the RMB fall, which is exerting a deflationary impact on the world. Investment implications An environment of slower global economic activity, tightening global liquidity conditions and a potential deflationary scare is positive for the dollar. But 1998 shows that if the hot potato hides in the U.S. and the Fed is forced to ease aggressively, the dollar could nonetheless suffer. In order to get a sense as to whether the dollar can continue to strengthen or not, it is important to get a sense of where the exposure to an EM accident may lie. To begin this exercise, we need to first assess which EM countries are most vulnerable to catching the "Turkish Flu." To do so, we collaborated with our colleague Peter Berezin and his team at BCA's Global Investment Strategy to build a heat map of vulnerable EM economies. This heat map is based on the following factors: current account balance, net international investment position, external debt, external debt service obligation, external funding requirements, private sector savings/investment balance, private sector debt, government budget balance, government debt, foreign ownership of local currency bonds, and inflation. This method shows that after Turkey and Argentina, the next six most vulnerable countries are Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia in this order (Chart 19). Chart 19Vulnerability Heat Map For Key EM Markets While our long-term valuation models show that the Colombian peso is already trading at a significant discount to its fair value, the BRL, the CLP, the ZAR, and the MXN are not (Chart 20). This highlights that these markets could provide serious fireworks in the coming months. Moreover, they all have their own idiosyncrasies that accentuate these risks. Brazil will soon undergo elections that will likely not result in a market-friendly outcome.3 Chile has an extremely large dollar-debt load, copper prices are tanking and the CLP is very pricey. Finally, South Africa is contemplating the kind of land expropriations reminiscent of those that plunged Zimbabwe into chaos - not a good optic for a still-expensive currency. So, who is most exposed to this potential mess? The answer is the euro area, most specifically, Spain. As Chart 21 shows, the exposure of Spanish banks to the most vulnerable EM markets totals nearly 170% of the banking system's capital and reserves. This means that 30% of the capital and reserves of the banking systems in the euro area's five largest economies is exposed to these markets. Making the risk even more acute, French banks have large exposure to Spain, and German banks to France. This combined exposure dwarfs the exposure of the U.K., Japan or the U.S. to the most vulnerable EM economies. To be fair to Spain, Spanish banks often have set up their foreign affiliates as separate legal entities. This means that the impact on the balance sheets of the Spanish banking system of defaults in vulnerable EM countries may be more limited than seems at face value. Yet, this is far from certain. Chart 20BRL, CLP, ZAR, And MXN Are Too Expensive##br## In Light Of Their Vulnerabilities Chart 21Who Has More Exposure To EM? As a result, we would not be surprised if the European Central Bank is forced by an EM accident to back away from its desire to abandon its extraordinary accommodative stance. The ECB would first use forward guidance to message that a hike will be delayed ever further in the future. The ECB may even be forced to resume government and corporate bonds purchases past 2018. This is a potential nightmare scenario for the euro. In fact, as Chart 22 illustrates, a euro at parity may not be a far stretch. Historically, the euro bottoms when it trades 10% below our fair value model, based on real short rate differentials, relative yield curve slopes and the ratio of copper to lumber prices. Such a discount would correspond to EUR/USD at parity. Because under such circumstances the Fed could be forced to pause its own hiking cycle for a quarter or two, a move to EUR/USD between 1.10 and 1.05 seems more likely than a collapse to parity right now. This also means that in conjunction with BCA's Geopolitical Strategy team, we recommend our clients close overweight positions in Spanish assets. Chart 22The Euro Still Has Downside If EM Go Bust What about the yen? In the late 1990s, the yen fell against the U.S. dollar as Asian currencies were collapsing, but surged once the Fed backtracked and bond yields tanked in 1998. This time could follow a different road map. Japan does not compete against Brazil, Colombia, Mexico, Chile and South Africa in the same way as it was competing against industrial companies in countries like Taiwan, Singapore or South Korea. This means that Japan is unlikely to need to competitively devalue to remain afloat if the BRL, COP, MXN, CLP and ZAR collapse further. However, since an EM shock is likely to prove to be a deflationary event, this means that bond yields could experience downside, especially as positioning in the U.S. bond market is massively crowded to the short side (Chart 23). A countertrend bull market in bonds would greatly flatter the yen. As a result, we are maintaining our short EUR/JPY bias over the coming months. The G10 commodity currency complex is also at risk. Not only does tightening dollar liquidity imply further weakness in this group of currencies, so does slowing EM activity and a deflationary scare. Additionally, the CAD and the NZD are not trading at much of a discount to their fair value, and the AUD trades at a premium (Chart 24). This means we would anticipate these currencies to suffer more in the coming quarters, led by the AUD, which is not only the most expensive of the group, but also the most geared to EM economic activity. Being short AUD/CAD still makes sense. Chart 23A Bond Rally Would ##br##Support The Yen Chart 24TDollar-Bloc Currencies Offer Limited Cushion##br## In The Event of An EM Selloff Finally, the pound is its own animal. GBP/USD is now quite cheap, but the U.K.'s large current account deficit of 3.9% of GDP, which is not funded through FDIs anymore, means that Great Britain remains vulnerable to tightening global liquidity conditions. Moreover, Brexit negotiations will heat up in the fall, as the March 2019 deadline for reaching a deal with the EU looms large. This means that political tumult in the U.K. will remain a large source of risk for the pound. We will explore the outlook for the pound in an upcoming report this September. Currently, our long DXY trade is posting an 8.5% profit, with a target at 98. The above picture suggests that the dollar could move well past 98, especially as the momentum factor that is so important to the greenback still plays in favor of the USD.4 As a result, we are upgrading our target on the dollar to 100. However, we are also tightening our stop loss to 94.88. We will update our stop loss to 97 if the DXY hits 98 in the coming weeks, in order to protect gains while still being exposed to the dollar's potential upside. Bottom Line: Beyond Turkey and Argentina, the EMs most vulnerable to tightening global liquidity conditions are Brazil, Colombia, Mexico, Chile and South Africa. Spanish banks have outsized exposure to these markets, which means the euro area is at risk if the "Turkish Flu" becomes contagious. As such, the ECB could be forced to remain easier than it wants to. The euro is still at risk. The yen could strengthen if global bond yields suffer. Hence, it still makes sense to be short EUR/JPY. While the CAD, AUD and NZD are also all vulnerable to a deflationary scare, the Aussie is the worst positioned of the three. Shorting AUD/CAD still makes sense. The DXY is likely to experience significant upside from here, with a move to 100 becoming an increasingly probable scenario. Risks To Our View Chart 25A Gauge And A Hedge Against Chinese Stimulus The biggest risk to our view is China. In 2016, a vicious EM selloff was staunched by a large wave of stimulus that put a floor under Chinese economic activity, and caused China to re-lever. The impact was felt around the world, lifting commodity prices and EM assets while plunging the dollar into a vicious selloff in 2017. It is conceivable that such an outcome materializes anew, especially as China is, in fact, injecting stimulus into its economy. However, as we wrote two weeks ago, the current stimulus still pales in comparison to what took place in 2015. Moreover, reforms and deleveraging have much greater primacy now than they did back then.5 BCA believes that the current wave of stimulus is not designed to cause growth to surge again, as was the case in 2015, but is instead aimed at limiting the negative impact of the ongoing trade war with the U.S. Yet, we cannot be dogmatic. Not only is it hard to gauge the actual degree of stimulus currently applied to the Chinese economy, there is a heightened risk that the flow of policy announcements causes a shift in the dominant narrative among market participants. Such a shift in attitudes could easily cause a mass buying of EM assets and commodities, delaying the day of reckoning for vulnerable EM. As a result, we continue to promulgate that investors track the behavior of our China Play Index, introduced two weeks ago (Chart 25).6 Not only does this index provide a live read on how traders are pricing in Chinese developments, but it also provides a great hedge for investors long the dollar, short EM, or short the commodity complex. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 In the panic of 1907, the Knickerbocker Trust Company went bankrupt, threatening the health of the U.S. banking system. The stock market crashed, money markets went into paralysis, and a consortium of bankers led by J.P. Morgan himself ended up acting as a lender of last resort, staunching the crisis. As a consequence of this panic, the Federal Reserve System was born in 1913. 2 For a more detailed discussion of the deflationary risk created by the RMB, please see Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report, "Brazil: Faceoff Time", dated July 27, 2018, available at ems.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com 6 Ibid. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.

Highlights Duration: The market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace. Maintain below-benchmark portfolio duration. The Neutral Rate: Our indicators of the neutral (or equilibrium) fed funds rate are sending conflicting signals. The economic data suggest that the neutral rate might be above 3%, but this is contradicted by weakness in the price of gold. TIPS: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Remain overweight TIPS versus nominal Treasuries. Feature In February we published a report that outlined how we expect the cyclical bear market in bonds to evolve. Essentially, we view the bear market as consisting of two stages.1 The first stage is characterized by the re-anchoring of inflation expectations and the second stage deals with determining the neutral (or equilibrium) federal funds rate. In this week's report we track how the two-stage Treasury bear market has progressed since February and consider the implications for portfolio strategy. The First Stage Is Nearly Complete Long-maturity TIPS breakeven inflation rates are slightly higher than when we published our February report, but they are still not at levels we would consider "well anchored". We showed in our February report that prior periods when core inflation was close to the Fed's 2% target coincided with both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5%. At present, the 10-year TIPS breakeven inflation rate is 2.10% and the 5-year/5-year forward is 2.19%. As long as TIPS breakeven inflation rates remain below the 2.3% - 2.5% target range, nominal Treasury yields have further cyclical upside due to the re-anchoring of inflation expectations. This re-anchoring will play out as the core inflation data are released and investors come to realize that inflation is no longer consistently undershooting the Fed's target. When that re-anchoring occurs and both the 10-year and 5-year/5-year forward breakevens cross above 2.3%, the first stage of the bond bear market will be complete. One recent development is that TIPS breakevens have risen even as commodity prices have declined (Chart 1). In fact, while breakevens are somewhat higher than when we published our February report, commodity prices - as measured by the CRB Raw Industrials index - are lower. While this shift in correlation is so far only tentative, it could signal that TIPS investors are increasingly influenced by the actual core inflation data and not swings in the global growth outlook. We would not be surprised to see this correlation continue to weaken going forward, especially considering that core inflation looks more and more consistent with the Fed's 2% target. Core CPI for July came in at 2.33% on both a trailing 12-month and 3-month basis, annualized (Chart 2). This is more or less consistent with the pre-crisis period when the Fed's preferred PCE inflation measure was close to the 2% target. Alternative measures of CPI send a similar message (Chart 2, panel 2) and our diffusion index shows that more individual items have accelerated in price than have decelerated in each of the past three months (Chart 2, bottom panel). Taken together, the signals point to further near-term price acceleration. Chart 1Inflation Date Sinking In Chart 2Inflation Picking Up Steam Digging deeper, we see that the outlook for higher inflation pervades each of the main components of core CPI (Chart 3). The reading from our shelter inflation model has stabilized, core goods inflation continues to track non-oil import prices higher, and the rebound in core services inflation is consistent with rising wage growth. Eventually, we would expect the strengthening dollar to exert a drag on import prices (Chart 4), but it will be some time before this is reflected in the CPI data. Another important development is that, after appearing to have turned a corner in 2016, the residential vacancy rate has dipped back down (Chart 4, bottom panel). Such a low vacancy rate will continue to support strong shelter inflation. Chart 3The Components Of Core CPI Chart 4A Headwind And A Tailwind For Inflation Bottom Line: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Nominal Treasury yields have further upside at least until both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We also continue to recommend an overweight position in TIPS relative to nominal Treasury securities. We will remove this recommendation when breakeven rates reach our target range and stage one of the bond bear market is complete. Stage 2 Update: Conflicting Evidence On The Neutral Rate Once inflation expectations are well-anchored at levels consistent with the Fed's target, the cyclical bond bear market will transition into its second stage. How much further Treasury yields rise during this stage will depend on how high the Fed is able to lift interest rates before the economy starts to slow. In other words, the cyclical peak in Treasury yields will be determined by the neutral (or equilibrium) fed funds rate - the level of interest rates where monetary policy is neither accommodative nor restrictive, and which is also consistent with stable inflation near the Fed's 2% target. Unfortunately, the neutral rate can only be known with certainty in hindsight. But in a recent report we presented three factors that investors can track in real time that have forewarned of the shift from accommodative to restrictive monetary policy in the past.2 We review the recent trends in each of these signals below. Signal 1: Nominal GDP Growth Vs The Fed Funds Rate Chart 5The Message From Nominal GDP Growth A fed funds rate that is above the year-over-year growth rate in nominal GDP is typically a signal (though often a lagging one) that monetary policy has turned restrictive (Chart 5). An intuition that is confirmed by the fact that the spread between nominal GDP growth and the fed funds rate correlates positively with the slope of the yield curve. But while the flattening yield curve has caused some to worry that the Fed is tightening too quickly, the message from nominal GDP growth is that monetary policy is actually becoming more accommodative (Chart 5, bottom panel). If the Fed continues to lift rates at its current pace of 25 basis points per quarter, the fed funds rate will be between 3.25% and 3.5% by the end of 2019. Nominal GDP would have to decelerate fairly substantially from its current 5.4% growth rate to signal restrictive monetary policy by then. Signal 2: Cyclical Spending Another indicator that has historically coincided with restrictive monetary policy and the cyclical peak in bond yields is when growth in the most interest-rate sensitive sectors of the economy (aka the cyclical sectors) slows as a proportion of overall growth (Chart 6). This is especially true for consumer spending on durable goods. Not only is it well below pre-crisis levels as a percent of GDP, but recent data revisions revealed that the personal savings rate is much higher than previously thought. The savings rate looks especially elevated relative to household wealth, which leaves room for spending to accelerate as it falls to more normal levels (Chart 7). Extremely high consumer confidence supports the view that the savings rate will decline (Chart 7, panel 2), and despite recent increases in interest rates and the price of gasoline, consumer spending on essentials is not yet excessive relative to income (Chart 7, bottom panel). Chart 6Signal 2: Cyclical Spending Chart 7The Outlook For Consumer Spending Cyclical spending - which includes consumer spending on durable goods, residential investment and nonresidential investment in equipment & software - is currently rising only slowly as a proportion of GDP, but it remains well below average historical levels. This suggests that further catch-up is likely. Much like consumer spending, residential investment also has a lot of room to play catch-up relative to pre-crisis levels (Chart 6, panel 3). However, growth in residential investment has waned in recent months (Chart 8). The slowdown is likely the result of the housing market coming to grips with higher mortgage rates. But while higher rates have definitely impaired affordability, housing remains quite cheap compared to history (Chart 8, panel 2). A further support for housing is that homebuilders are extraordinarily confident in the outlook (Chart 8, panel 3). This is for good reason. The outstanding housing supply is historically low and continues to contract relative to demand as increases in building permits fail to keep pace with household formation (Chart 8, bottom panel). Unlike consumer spending on durables and residential investment, nonresidential investment in equipment & software is roughly consistent with its average historical level as a proportion of GDP (Chart 6, bottom panel). But so far leading indicators are not pointing to a slowdown. On the contrary, surveys of new orders, capital expenditure plans and CEO confidence suggest that investment growth will stay strong for the next few quarters (Chart 9). At some point, given its higher level relative to GDP, investment could be the cyclical sector that first shows some evidence of weakness. But so far this is not the case. Chart 8The Outlook For Residential Investment Chart 9The Outlook For Non-Residential Investment Signal 3: Gold Chart 10Signal 3: Gold The final signal of restrictive monetary policy we consider is the price of gold. The widely accepted perception of gold as a long-run store of value makes it the ideal "anti-central bank" asset. In other words, gold tends to perform well when monetary policy is perceived to be turning more accommodative relative to its neutral level, and it tends to sell off when policy is perceived to be turning restrictive. Gold is also a useful addition to our suite of indicators because it is a price that is set in financial markets. Compared to our other two indicators which are based on economic data, financial market indicators can provide more of a leading signal. The trade-off, however, is that false signals are far more frequent. Most interestingly, we observe that fluctuations in the price of gold have preceded revisions to the Fed's estimate of the neutral fed funds rate in the post-crisis period (Chart 10). This seems entirely logical. The falling gold price in 2014/15 suggested that the market viewed Fed policy as becoming increasingly restrictive, but market expectations for the near-term path of rate hikes were roughly flat during this period (Chart 10, bottom panel). The only explanation is that investors were revising down their estimates of the neutral fed funds rate during this time, resulting in a de-facto policy tightening. Similarly, around the same time that gold put in a bottom in early 2016, neutral rate estimates from both investors and the Fed started to level-off around the 3% level, where they remain today. Going forward, the implication is that if gold were to break out of its trading range to the upside, it would send a strong signal that the Fed is perceived to be falling behind the curve. Such a price movement would make upward revisions to the neutral fed funds rate, and a higher cyclical peak in Treasury yields, more likely. Conversely, if gold continues its recent slide, it could signal that policy is turning restrictive more quickly than many expect. Bottom Line: Trends in our neutral rate indicators since February are sending conflicting signals. The economic data - nominal GDP growth and cyclical spending - have improved and suggest that we should think about a neutral fed funds rate above the current market consensus of 3%. On the other hand, the weakness in the price of gold suggests that investors view monetary policy as becoming increasingly restrictive. Investment Strategy How best to square these conflicting signals when formulating a portfolio strategy? For the time being we strongly advise investors to maintain below-benchmark duration on a cyclical (6-12 month) horizon. For one thing, the bond bear market remains in its first stage and the market is still not fully convinced that inflation will re-anchor itself around the Fed's 2% target. This alone argues for maintaining below-benchmark duration and an overweight allocation to TIPS versus nominal Treasuries, at least until long-dated TIPS breakevens reach our target range. Beyond that, while the true neutral fed funds rate remains uncertain, the market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace, and is consistent with a neutral rate that is well below 3% (Chart 11). Chart 11The Market Not Buying Into The Fed's Current Rate Hike Pace In other words, current market pricing tilts the risk/reward trade-off firmly in favor of below-benchmark duration, but we will keep a close eye on our neutral rate signals in the coming quarters to see if a more consistent message emerges. Stay tuned. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights If the U.S. Treasury intervenes to push the greenback lower, it would only have a temporary impact. Ultimately, interventions work if they are matched with easy monetary policy. However, U.S. monetary policy will only be tightened going forward. Because inflation expectations have stabilized since the late-1980s, the dollar can influence the slope of the Phillips Curve. However, the combination of a tight labor market and untimely fiscal stimulus is likely to cause a sharp steepening of the Phillips Curve, with lower unemployment and higher inflation. Unlike in the late 1960s and early 1970s, but as in the mid-1980s, the Federal Reserve is unlikely to abide by these inflationary pressures. Thus, if the Phillips Curve steepens significantly, the Fed is likely to end up raising rates much more aggressively than what is currently priced in, in turn leading to a much stronger dollar. Feature In recent days we have heard speculation that U.S. President Donald Trump may be considering ordering the U.S. Treasury to sell dollars, in order to limit the greenback's strength. We have no preconception of whether this is indeed likely to happen or not, but the mere discussion of this risk forces us to ask questions regarding our view that the dollar can keep rallying in 2018. We think that this kind of policy, if implemented, could have a short-lived negative impact on the dollar, but that ultimately the path for the dollar will be conditional on the path taken by the Fed and global growth, not President Trump's whims. As such, we remain firmly focused on charting the most likely path for these two factors, and currently they continue to favor the USD. As a result, we recommend investors either buy into any corrective action in the dollar in the coming weeks, or, hedge them away. It is not the time to abandon our view that the dollar will end 2018 above current levels. Trump Vs The Trinity One of the bedrocks of international economics is called the Impossible Trinity. It is the simple idea that a country has to make a choice. A nation cannot target the level of its exchange rate and have an independent monetary policy while also having an open capital account. A country can pick two of these nodes at any point in time, but not all three simultaneously (Chart I-1). Chart I-1The Impossible Trinity Essentially, if Country A has an open capital account and decides to fix its exchange rate with Country B, it needs to follow a very similar monetary policy that the nation it is pegging its currency against follows. If risk-adjusted interest rates in Country A are lower than those in Country B, money will leave country A, creating downward pressures on its FX reserves, and ultimately forcing a downward adjustment in the exchange rate. The exact opposite will happen if Country A's risk-adjusted interest rates rise above those prevailing in Country B. As a result, if Country A wants to peg its currency to Country B and maintain monetary policy that is independent of that conducted in Country B, Country A has to close its capital account. Or, as was the case when the world was under the gold standard, if Country A wants to maintain an open capital account and still have a pegged currency, then it has to relinquish control over its monetary policy. Finally, countries can also follow the strategy currently in place across most advanced economies, and have both an open capital account and an independent monetary policy, but relinquish control over their exchange rate. Since the U.S. capital account is open, the idea that President Trump could target a lower USD by forcing the Treasury to sell greenbacks in the open market ultimately flies in the face of this impossible trinity, as long as the Fed maintains its independence.1 This last clause is crucial. For example, the Japanese Ministry of Finance conducted successful interventions between 1999 and 2000, when it managed to limit upside in the yen. However, the yen only really weakened once the Bank of Japan joined the game, as it was making sure that Japanese interest rates were falling relative to the U.S. (Chart I-2). The same occurred in 1985 around the Plaza Accord. From August 1984 to August 1986, the effective fed funds rate was declining, which buttressed the U.S. Treasury's verbal efforts of seeing a lower dollar (Chart I-3). Coordination with the rest of the G7 also helped. Chart I-2MoF Interventions Worked, Once Japanese##br## Rates Fell Vs. The U.S. Chart I-3The Plaza Accord Worked Because The##br## Fed Moved In The Same Direction This means that for interventions to have any durable impact on the U.S. dollar, the Fed needs to be easing monetary policy relative to the rest of the world as well. Otherwise, any decline in the dollar caused by interventions is likely to prove transitory as the higher interest rates offered by the U.S. will likely result in inflows into the dollar. Thus, the outlook for the Fed still holds primacy. On this front, the future does not look good for President Trump's desire to see a weaker dollar. Bottom Line: Because the U.S. has an independent monetary policy and an open capital account, the U.S. Treasury cannot unilaterally target a lower exchange rate. It needs the help of either foreign nations or a compliant Fed that eases policy. Right now, foreign nations have little incentive to follow the example of the 1985 Plaza Accord, and the U.S. economic backdrop points toward higher U.S. interest rates, not lower ones. Thus, any negative impact on the dollar from open market operations by the U.S. Treasury should have a limited lifespan. A Filip From The Phillips Curve? If the Treasury selling dollars can only drag the greenback lower on a durable basis only as long as the Fed eases policy as well, the Fed remains a much more important factor in determining the dollar's outlook. At the center of the Fed's reaction function lies a concept called the Phillips Curve, which normally shows a negative relationship between the unemployment rate and the inflation rate. Logically, we would anticipate that the more strongly inflation and the unemployment rate move in opposite directions, the stronger the link with the dollar should be. If inflation surges in response to small declines in unemployment rates, this forces the Fed to respond with greater assertiveness to capacity pressures. As a result, this should lift the dollar higher. If unemployment increases and inflation plunges, the Fed eases and the dollar weakens. However, the reality is very different. As Chart I-4 illustrates, the relationship between the slope of the Phillips Curve and the dollar evolves over time. When inflation expectations were unanchored to the upside, as was the case in the 1970s, the Phillips Curve became inverted - i.e. a rising unemployment rate was associated with rising inflation. Inflation was in the driver's seat. In this environment, the higher inflation and the unemployment rate got, the weaker the dollar became. The Fed was in a bind and remained behind the curve. Consequently, real rates kept falling and the dollar suffered. Chart I-4The Strange Dance Of The Phillips Curve And The Dollar After 1981 something interesting happened. The Phillips Curve moved back to its normal slope - i.e. negative. During that period, the dollar rallied. The slope of the Phillips Curve normalized because then-Fed Chair Paul Volcker drove up interest rates so high that inflation expectations collapsed, and ex-ante real rates rebounded as a result. This lifted the dollar. Since the second half of the 1980s, something even stranger has been happening. The dollar now moves upward when the Phillips Curve flattens or becomes inverted. The dollar also depreciates when the Phillips curve normalizes. In other words, the dollar today appreciates when the inflation rate and the unemployment rate move in unison, not in opposition. This is strange; very strange. However, this relationship can be understood if we flip the causation around. Essentially, the dollar may be driving the slope of the Phillips Curve. We have long argued that a strong dollar is not very negative for the U.S. economy, but it remains very negative for inflation.2 This can be seen in Chart I-5, which highlights that a strong dollar is associated with a falling unemployment rate, but also falling inflation. When the dollar is strengthening, it supports consumption as the price of imported goods decreases, increasing the purchasing power of households (Chart I-6). Since household consumption accounts for roughly 70% of GDP, what is good for households ends up being good for U.S. growth. However, a strong dollar dampens inflation by curtailing the price of imported goods, by weighing on the price of commodities, and by tightening EM financial conditions, which decreases EM demand and therefore further undermines global prices. This means that a strong dollar is associated with both a lower unemployment rate and lower inflationary pressures, thus a positively sloped Phillips Curve. These dynamics might explain why this cycle, the Fed has faced very limited inflationary pressures, despite facing an unemployment rate well below equilibrium: The dollar was very strong from 2014 to late 2016, and inflation fell as the unemployment rate also declined. Chart I-5A Strong Dollar Is Neutral For The##br## Unemployment Rate But Deflationary Chart I-6A Strong Dollar ##br##Helps Households How is this situation likely to evolve going forward? Will the dollar remain the likely driver of the Phillips Curve, or will the Phillips Curve drive the dollar? We opine that the Phillips Curve is likely to once again become the leading partner in this tango. This could help the dollar. Essentially, today's environment is unlike anything we have seen since the current relationship between the dollar and the Phillips Curve emerged in the second half of the 1980s. Not only is the economy at full employment, but also the U.S. government is engaging in massively expansionary fiscal policy. The obvious parallel is with the late 1960s. Back then, the unemployment rate was low, hitting 3.4% in 1969, yet in response to the Vietnam War and former President Lyndon Johnson's Great Society program, the U.S. budget deficit blew up. This generated the kind of excess demand that culminated in high inflation, and down the road, an unmooring of inflation expectations to the upside. This unmooring was crucial in causing the abnormal Phillips Curve slope discussed earlier, and the collapse in the dollar. This policy sowed the seeds of stagflation. However, forgotten in that parallel is the Fed's behavior at the time. As we highlighted two weeks ago, in the late 1960s and early 1970s, the Fed was much more focused on keeping the U.S. at full employment than it was focused on combatting inflation (Chart I-7). The Fed maintained too easy monetary policy, letting the U.S. economy become a pressure cooker.3 After 1977 and the Federal Reserve Reform act, inflation fighting became an official component of the Fed's mandate - one that took preeminence once Paul Volcker took the helm of the central bank. We are still in this regime. Chart I-7Trump's Fed Is Not Nixon's Fed As a result, while the current environment has echoes of the late 1960s, it also resonates with the first half of the 1980s, because the Fed is now more focused on inflation than it was in the 1960s. In the first half of the 1980s, Volcker was working on keeping inflation expectations at bay (Chart I-8). However, former President Ronald Reagan wanted to increase military spending and cut taxes. He got his wish. While the U.S. budget balance normally moves in line with the employment rate, as Chart I-9 illustrates, from 1984 to 1986 employment rose but the budget balance did not improve. This could have caused inflation expectations to increase because it represented a period of unwarranted fiscal expansion and excess demand. Yet inflation expectations did not move up. Instead, the Fed let real interest rates move higher, tightening monetary conditions. The dollar surged in response to a violent normalizing of the Phillips Curve. Chart I-8Inflation Expectations ##br##Are Crucial Chart I-9Investors Anticipating The Reagan / Volcker ##br##Battle Lifted The Dollar Today, the Fed will continue to fight the inflationary impact of Trump's policies. Moreover, we anticipate that the Phillips Curve is likely to become much more negatively sloped as the business cycle progresses. As Chart I-10 illustrates, not only is the unemployment rate very low, the broader U-6 measure is finally consistent with full employment. In fact, the gap between the two unemployment measures also indicates there is no more hidden labor market slack in the U.S. Additionally, while the employment-to-population ratio remains low in the context of the past 30 years, the employment-to-population ratio for prime age workers has normalized (Chart I-11). Moreover, as the bottom panel of Chart I-11 illustrates, the true culprit behind the dichotomy between the employment rate of prime-age workers and that of the rest of the population is the low employment rate of young workers. Essentially, younger Americans are getting more educated, which is keeping them out of the labor force for longer. As a result, the participation age for the population at large is likely to remain below levels that prevailed before the financial crisis. This also mean that since the participation rate for prime age workers has already normalized, additional employment gains are likely to result in additional wage gains and inflationary pressures. Chart I-10The Labor Market Points To##br## A Normalizing Phillips Curve Chart I-11Participation Is Low Because ##br##Millenials Stay In School Longer Another symptom highlighting that the labor market is very tight is the fact that the unemployment rate among individuals 25 years and older but without a high school diploma has collapsed to record lows (Chart I-12). Moreover, wage growth among this cohort has skyrocketed, normally a symptom of budding inflationary pressures (Chart I-12, bottom panel). As a result, the combination of evident pressures in the labor market and untimely fiscal stimulus is likely to realize the inflationary pressures suggested by the NFIB small business survey. When companies are much more worried about finding qualified employees than they are about finding demand for their products and services, core CPI hooks up. This time will not be different (Chart I-13). Chart I-12A Clear Sign Of Tightening Chart I-13Inflation Set To Pick Up All these dynamics raise the risk that after years of dormancy, the Phillips curve could suddenly become much steeper and more negative. The Fed is likely to use rising inflation and a steeper Phillips curve as a justification to suggest that r-star is rising. As a result, it will use this logic to push both nominal and real interest rate higher. This, in our view, will push the dollar higher. Why? As we have shown in the past, when the U.S. has the highest interest rates among the G-10, the dollar performs well (Chart I-14). However, as the top panel of Chart I-15 shows, U.S. rates are the determinant of this ranking - i.e. when the fed funds rate increases, so does the ranking of U.S. rates within the G-10. This also means the ranking of U.S. rates relative to other G-10 rates follows the U.S. business cycle. Moreover, as the bottom two panels of Chart I-15 illustrate, the current level of aggregate unemployment and of unemployment among the less-educated confirms that the U.S. should have the highest interest rates among G-10 nations. Trump's stimulus will only add fuel to the fire. Chart I-14Supported By The Highest Rates In The G10, ##br##The Dollar Can Rise Further Chart I-15The Ranking Of U.S. Rates Depends ##br##On The U.S. Business Cycle In fact, the combination of a tight labor market, high U.S. rates relative to the rest of the world and a quickly steepening normal (i.e. inverse relationship) Phillips Curve could result in a supercharged rally in the U.S. dollar. Such a rally, if it were to materialize, would likely cause very serious pain on EM economies and assets. As a result, we recommend investors closely watch the slope of the Phillips Curve in coming quarters, as it will hold the key to the dollar's path. Bottom Line: The slope of the Phillips Curve moves around significantly over time, but more interestingly, its relationship with the dollar does as well. Today's environment of a tight labor market accompanied by fiscal stimulus could result in a large steepening of the Phillips Curve. Since now the Fed is much more independent and much more focused on inflation than it was in the 1960s and early 1970s, such a shift in the Phillips Curve could supercharge the dollar's strength. Increasing this likelihood, the Fed is already at the top of the interest rate distribution among the G-10, which means the dollar remains under upward pressure. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 And we believe that the Fed will continue to conduct its monetary policy independently from the desires of the White House. Please see Foreign Exchange Strategy Weekly Report, "Rhetoric Is Not Always Policy", dated July 27, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "Rhetoric Is Not Always Policy", dated July 27, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been negative: Both average hourly earnings yearly growth and the unemployment rate came in line with expectations, at 2.7% and 3.9% respectively. However, non-farm payrolls underperformed expectations, coming in at 157 thousand. Nonetheless, the high upward revisions to the June and May numbers mitigated the blow. Moreover, the participation rate also surprised negatively, coming in at 62.9%. Finally, both Markit Services and Markit Composite PMI underperformed expectations, coming in at 56 and 55.7 respectively. DXY has been flat this week. While we recognize that the dollar could have some tactical downside, it is unlikely to be very playable. Thus, investors should stay long the green back, as the combination of tightening in both China and the U.S. will create an environment of slowing global growth where the dollar benefits. However, because a countertrend correction can always be more painful than anticipated, we have bought some hedges against our long dollar call, sell USD/CAD as a form of protection. Report Links: The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Time To Pause And Breathe - July 6, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area has been negative: Markit Services PMI underperformed expectations, coming in at 54.2. Moreover, retail sales yearly growth also surprised negatively, coming in at 1.2%. This measure also decreased relative to last month. German factory orders yearly growth also surprised to the downside, showing a contraction of 0.8%. Finally, German industrial production yearly growth also underperformed, coming in at 2.5%. EUR/USD has been relatively flat this week. The euro is likely to have downside for the rest of the year, as tight labor market in the U.S. and powerful inflationary pressures will push the fed to raise rates more than what is priced into the OIS curve. Meanwhile, the ECB will have to stay put, as deaccelerating global growth will weigh on its export-oriented economy. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Markit Services PMI underperformed expectations, coming in at 51.3. Moreover, the leading economic index also surprised to the downside, coming in at 105.2. However, overall household spending yearly growth surprised positively, coming in at -1.2%. This measure also increased relative to last month's number. Finally, labor cash earnings yearly growth also surprised to the upside, coming in at 3.6%. USD/JPY has gone down by nearly 0.7% this week. We are bullish on the yen versus commodity and European currencies on a 6 month basis, as slowing global growth coupled with trade tensions should generate rising volatility and help safe havens like the yen. Report Links: Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Market Services PMI underperformed expectations, coming in at 53.5. This measure also decreased from last month's number. Moreover, BRC Like-for-like retail sales yearly growth also underperformed expectations, coming in at 0.5%. This measure also decreased from 1.1% last month. However, Halifax house prices yearly growth outperformed expectations, coming in at 3.3%. This measure also increased form 1.8% the previous month. GBP/USD has fallen by 1% this week, as Brexit fears continue to put downward pressure on this cross. Cable will likely continue to fall until the end of the year, as rising U.S. rates will give a boost to the dollar. That being said, as the currency continues to depreciate it is important to keep an eye on whether inflation starts perking up a, as a buying opportunity might emerge. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Home loans growth underperformed expectations, coming in at -1.1%. This measure also decreased relatively to last month's number. However, retail sales month-on-month growth outperformed expectations, coming in at 0.4%. AUD/USD has rallied by nearly 1% this week, as investors have started to price in Chinese stimulus. Overall, we believe that any relief in tightening from the Chinese authorities will be temporary, which means that the rally in the AUD will likely be short lived. That being said, tactical investors who wish to take a position on Chinese stimulus can buy our designed "China Play Index", a risk adjusted portfolio comprised of AUD/JPY, Brazilian equities, Swedish industrials equities, iron ore and EM high yield debt. Report Links: What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 On Thursday, the RBNZ left its policy rate unchanged at 1.75%. NZD/USD fell by 1% following the decision. The monetary policy statement stroke a dovish tone, as the RBNZ stated that they expected "to keep the OCR (Official Cash rate) at this level through 2019 and into 2020", longer than originally projected in their May statement. Moreover, the RBNZ highlighted that the probability of rate cut, while still not its central scenario, has risen. We believe, that growth in the kiwi economy could be at risk as tightening by both the Fed and the PBoC as well as trade tensions will likely prove to be a toxic cocktail for this small open economy very levered to global trade. This means that NZD/USD is likely to continue to go down as we approach2019. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: The Ivey Purchasing Manager's Index underperformed expectations, coming in at 61.8. This measure also decreased from last month's number. Moreover, Building permit month-on-month growth also surprised negatively, coming in at -2.3%. However, International merchandise trade outperformed expectations, coming in at -0.63 billion. USD/CAD has been flat this week. We continue to hold a tactical bearish bias on this cross, as the excessive short positioning in the CAD has yet to be purged. That being said, we are bullish on this cross on a 6-12 month basis, as the Fed will likely keep raising interest rates, hurting EM economies, and consequently commodity producers like Canada. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data In Switzerland has been neutral: Headline inflation came in line with expectations, at 1.2%. This measure also increased relatively to last month's number. The unemployment rate also came in line with expectations at 2.6%. EUR/CHF has declined by roughly 0.6% this week. We believe this cross could continue to have downside on a 6 to 12 month basis if trade tensions and Chinese tightening continue to make for a risk off environment. That being said, on a longer term basis, the franc is not likely to have much upside, given that the SNB will keep ultra-dovish monetary policy in order to help bring back inflation to Switzerland. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has been relatively flat this week. We are bullish on this cross on a 6 to 12 month basis, given that widening interest rate differentials between the U.S. and Norway will likely boost this cross. It is important to remember that while oil prices are an important driver of USD/NOK, our research has shown that interest rate differentials have a stronger correlation. Thus, USD/NOK could rise even amid rising oil prices. With this in mind, we are bullish on the NOK within the commodity complex, as oil should outperform base metals thanks to the supply cuts by OPEC. Strong oil prices should also help the NOK versus the EUR. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 USD/SEK has risen by more than 1% this week. We are bearish on this cross on a 6-12 month basis, as our research has shown that the krona is the most sensitive currency to the dollar in the G10. This is likely due to the fact that Sweden is a small very open economy which sits early in the global supply chain, exporting a large proportion of intermediate goods. When the dollar rises and curtails Emerging market demand, Sweden producers are the first to feel the pain from the slowdown. On a longer term basis we are more bullish on the krona, given that inflation continues to be very strong in Sweden, and the Riksbank will eventually have to adjust monetary policy accordingly. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

特別レポート

Dear Client, This is the first of a two-part Special Report dealing with the question of whether a significant pickup in global inflation may be lurking around the corner. In this week's report, we look back at the causes of the Great Inflation of the 1970s to see if they are still relevant today. While there are plenty of differences, there are also a number of important similarities. In a forthcoming report, we will challenge the often-heard arguments that globalization, automation, e-commerce, aging populations, excessive indebtedness, and the declining role of trade unions all limit the ability of inflation to rise. Best regards, Peter Berezin, Chief Global Strategist Highlights The likelihood of a significant increase in inflation over the coming years is greater than the market believes. Just as in the 1960s, policymakers are coming around to the idea that there may be an exploitable trade-off between higher inflation and lower unemployment. Despite abundant evidence that inflation is a highly lagging indicator, the pressure to keep monetary policy accommodative until the "whites of inflation's eyes" are visible will remain strong. Political influence over the conduct of monetary policy is likely to increase, as already evidenced by Trump's tweets lambasting Jay Powell, suggestions that the Bank of Japan explicitly monetize government debt, Jeremy Corbyn's call for a "People's QE," and the ongoing need for the ECB to keep rates low in order to forestall a sovereign debt crisis in Italy. Feature Chart 1Back To Full Employment In The USA... The U.S. Labor Market Keeps Tightening The U.S. labor market continues to tighten. Nonfarm payrolls increased by 157,000 in July. While this was below consensus expectations of a 193,000 rise, much of the shortfall appears to have been due to a sharp drop in employment among sporting goods and hobby retailers, a category that includes the now-defunct Toys 'R' Us. Revisions to past months pushed up the three-month average payroll gain to 224,000, more than double the additional 100,000 jobs that are needed every month to keep up with population growth. The U-6 unemployment rate - a broad measure of joblessness that includes marginally-attached workers and part-time workers who desire full-time employment - fell by 0.3 percentage points to a fresh cycle low of 7.5%. There are currently more job openings than unemployed workers. A record 75% of labor market entrants have been able to find a job within one month. Business surveys show that companies are struggling to find qualified workers (Chart 1). Inflation: Dead Or Dormant? Despite the increasingly tight labor market, wage growth has been slow to accelerate (Chart 2). Wages of production and non-supervisory employees barely rose in July. The year-over-year change in the Employment Cost Index for private-sector workers edged up to 2.9% in the second quarter, but remains well below its pre-recession peak. The Atlanta Fed Wage Growth Tracker has actually been trending lower since mid-2016. The core PCE deflator rose by 1.9% year-over-year in June, shy of expectations of a 2.0% increase. Most other measures of core inflation remain reasonably well contained (Chart 3). The failure of wage and price inflation to take off in the face of diminished spare capacity has led many observers to conclude that inflation is unlikely to move materially higher. Both market expectations and household surveys reflect this sentiment. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below their pre-Great Recession average (Chart 4). Long-term inflation expectations in the University of Michigan survey are near record lows. Breaking down the University of Michigan survey, one can see that most of the decline in inflation expectations in recent years has stemmed from a smaller share of respondents expecting very high inflation. Chart 2...But Wage Growth Has Been Slow To Accelerate Chart 3Core Inflation Measures Remain Contained Chart 4Long-Term Inflation Expectations Are Subdued Fears of a 1970-style inflation episode continue to recede. But could most observers turn out to be wrong? Could a major bout of inflation be lurking around the corner? No one knows for sure, but we would attach a much larger probability to such an outcome than the market is currently assigning. On a risk-adjusted basis, this justifies a cautious view towards long-term bonds. Causes Of The Great Inflation To understand why we think a repeat of the 1970s is a greater risk than is generally accepted, it is useful to ask what caused inflation to spiral out of control during that decade. Much of the academic debate has focused on two competing explanations: call it the "bad luck" view versus the "bad ideas" view. We side with the latter. The "bad luck" view blames rising inflation on a series of unforeseen and unforeseeable shocks. These include the OPEC oil embargoes, the collapse of the Bretton Woods system of fixed exchange rates, and the deceleration in productivity growth that occurred during the 1970s. One major problem with the "bad luck" view is timing. As Chart 5 shows, inflation in the U.S. began to spiral out of control starting in 1966, five years before Bretton Woods collapsed and seven years before the first oil shock. Inflation also initially accelerated during a period when productivity growth was still strong. Chart 5AInflation Started To Pick Up Before##br## 'Bad Luck' Hit The U.S. Economy Chart 5BInflation Started To Pick Up Before ##br##'Bad Luck' Hit The U.S. Economy Reverse Causality Chart 6Oil Lagged Other Commodities ##br##Between 1971 And 1973 Rather than causing inflation to rise, it is quite possible that all three of the shocks listed above were, to some extent, the result of higher inflation. This certainly seems the case for the collapse of the Bretton Woods system, whose existence helped provide a critical nominal anchor for the money supply and, by extension, the price level. At its core, the system functioned like a quasi-gold standard, with the price of U.S. dollars set at $35 per ounce and all other currencies being pegged to the dollar. Inflationary policies in the U.S. and many other countries in the late 1960s made gold cheap relative to regular goods and services, leading to a shortage of bullion. As the largest holder of gold, the U.S. found itself in a position where other countries were swapping their currencies into dollars and then redeeming those dollars for gold. In a desperate bid to stem gold outflows, the U.S. devalued the dollar, which forced foreigners to sacrifice more local currency to get the same amount of gold. When that was not enough, President Nixon ordered the closure of the gold window in August 1971 and imposed a temporary 10% surcharge on imports. The delinking of the price of gold from the dollar ignited a bull market in bullion that ultimately saw the price of the yellow metal reach $850 per ounce in January 1980. The prices of other metals jumped, as did food prices. Farmland entered a speculative bubble. OPEC was initially slow to react to the seismic changes sweeping the globe (Chart 6). The price of oil barely rose between 1971 and 1973, even as other commodity prices soared. The Yom Kippur war shook the cartel out of its slumber. Within the span of four months, the price of oil more than doubled, marking the first of a series of oil shocks. It is hard to know if OPEC would have reacted differently in an environment where the Bretton Woods system did not collapse and the value of the dollar did not tumble. However, it is certainly plausible that excessively easy monetary conditions in the years leading up to the 1973 oil shock created an environment in which the price of crude ended up rising more than it would have otherwise. The dislocations caused by runaway inflation in the 1970s probably had some role in the productivity slowdown during that decade. In general, the economic literature has found that high and volatile inflation has an adverse effect on productivity.1 The fact that policymakers reacted to rising inflation in the 1970s with price controls and trade restrictions only exacerbated the problem. Bad Ideas The temporary imposition of price and wage controls in 1971 was just one of a series of policy blunders that occurred during that era, starting with the failure to quell inflationary pressures in the late 1960s. Three bad ideas enabled inflation to get out of hand: First, policymakers mistakenly believed that high unemployment reflected inadequate demand rather than festering labor market rigidities. Second, they incorrectly assumed that there was a permanent trade-off between lower unemployment and higher inflation. Finally, and perhaps most damaging, they increasingly came to see monetary tightening as an ineffective tool in the fight against inflation. Let's examine each bad idea in turn. How Much Slack? Athanasios Orphanides and others have shown that policymakers in the U.S. and elsewhere systemically overestimated the magnitude of slack in their economies (Chart 7). This occurred mainly because they failed to recognize the upward shift in the natural rate of unemployment that took place during this period. Economists continue to debate the reasons why the natural rate of unemployment rose in the second half of the 1960s. Demographics probably played a role. Young people tend to switch jobs more often, and so the mass entry of baby boomers into the labor market probably pushed up frictional unemployment. Lyndon Johnson's Great Society program also led to a massive increase in government entitlement spending (Chart 8). Not only did this supercharge demand, but it also arguably reduced the incentive to work by creating an increasingly elaborate welfare state. Chart 7The Tendency To Overestimate The Level Of Slack Chart 8Entitlement Spending Rose Rapidly In The 1960s Whatever the reasons, policymakers were slow to recognize that structural unemployment had risen. This led them to press down on the economic accelerator when they should have been stepping on the brake. Illusory Trade-Offs Once it became clear that rising demand was pushing up prices by more than it was boosting production, the Federal Reserve should have moved quickly to tighten monetary policy. While the Fed did begrudgingly hike rates in 1968-69, it backed off as the economy began to slow. By February 1970, inflation had reached 6.4%. One key reason why the Fed adopted such a lackadaisical attitude towards inflation is that it saw higher inflation as a small price to pay for keeping unemployment low. This conviction stemmed from the false belief that there was a permanent trade-off between inflation and unemployment. Not everyone shared this view. Milton Friedman and Edmund Phelps argued that central banks could only stimulate the economy if they delivered more inflation than people were anticipating. Higher-than-expected inflation would push down real interest rates, leading to more spending. However, once people caught on to what was happening, the apparent trade-off between higher inflation and lower unemployment would evaporate: lenders would increase nominal borrowing rates and workers would demand higher wages. Inflation would rise, but output would not be any greater than before. History ultimately proved Friedman and Phelps correct, but by then the damage had been done. A Dereliction Of Duty Of all the mistakes that central banks made during that period, perhaps the most egregious was their contention that rising inflation had little to do with the way they conducted monetary policy. The June 8th 1971 FOMC minutes noted that Fed Chairman Arthur Burns believed that "monetary policy could do very little to arrest an inflation that rested so heavily on wage-cost pressures. In his judgment a much higher rate of unemployment produced by monetary policy would not moderate such pressures appreciably." 2 This sentiment was echoed by the Council of Economic Advisors, which argued in 1978 that "Recent experience has demonstrated that the inflation we have inherited from the past cannot be cured by policies that slow growth and keep unemployment high." 3 If central banks could not do much to reduce inflation, it stood to reason that the onus had to fall on politicians and their underlings. By shunning their obligation to maintain price stability, central banks opened the door to all sorts of political meddling. And meddle they did. In his exhaustive study of the Nixon tapes, Burton Abrams documented how Richard Nixon sought, and Burns obligingly delivered, an expansionary monetary policy and faster growth in the lead-up to the 1972 election.4 Relevance For The Present Day President Trump's complaints over Twitter about Chair Powell's inclination to keep raising rates is hardly on par with the politicization of monetary policy that occurred during Nixon's presidency. Nevertheless, we may be slowly moving down that slippery slope. And it's not just the Fed. Suggestions that the Bank of Japan explicitly monetize government debt, Jeremy Corbyn's call for a "People's QE," and the ongoing pressure that the ECB will face to keep rates low in order to forestall a sovereign debt crisis in Italy all foreshadow growing political influence over the conduct of monetary policy. History clearly shows that inflation tends to be higher in countries which lack independent central banks (Chart 9). What about the broader question of whether the sort of mistakes that many central banks made in the 1960s and 70s could resurface, perhaps in a different guise? Here is where things get tricky. Today, few economists would question the notion that central banks can reduce inflation if they raise rates by enough to slow growth meaningfully. The Volcker disinflation, as well as the more vigilant approach that the Bundesbank and the Swiss National Bank took towards tackling inflation in the 1970s, are testaments to that (Chart 10). Chart 9Inflation Is Higher In Countries Lacking Independent Central Banks Chart 10The Great Inflation Around The World The problem is that most economists also recognize that central banks lack effective tools in bringing up inflation when confronted with the zero lower-bound on short-term interest rates. This has prompted many prominent economists to argue that central banks should raise their inflation targets above the current standard of two percent. The evidence is mixed about whether a higher inflation target of, say, three or four percent would unmoor inflation expectations by enough to generate an inflationary spiral. Our suspicion is probably not, but we would not dismiss the possibility altogether. Return Of The Paleo-Phillips Curve? Perhaps more relevant at the current juncture is that many influential economists once again see evidence for an exploitable trade-off between inflation and unemployment. One prominent advocate for this view is Paul Krugman. It is well worth quoting Krugman at length: "From the mid-1970s until just the other day, the overwhelming view in macroeconomics was that there is no long-run trade-off between unemployment and inflation, that any attempt to hold unemployment below some level determined by structural factors would lead to ever-accelerating inflation. But the data haven't supported that view for a while... Looking forward, the risks of being too loose versus too tight are hugely asymmetric: letting the economy slump again will impose big costs that are never made up, while running it hot won't store up any meaningful trouble for the future." 5 We have some sympathy for Krugman's position, as well as Larry Summers' view that policymakers should not raise rates until they see "the whites of inflation's eyes." Still, one cannot help but notice that these arguments bear some resemblance to the views that pervaded economic circles in the 1960s. Inflation is a highly lagging indicator. It typically does not peak until after a recession has begun and does not bottom until the recovery is well underway (Chart 11). The Federal Reserve has cut its estimate of the natural rate of unemployment from 5.6% in 2012 to 4.45% at present. It has also reduced its estimate of the appropriate long-term level of the nominal federal funds rate from 4.25% to 2.875% over this period (Chart 12). Perhaps these new NAIRU estimates will turn out to be correct; perhaps they won't. The IMF reckons that the U.S. economy is currently operating at 1.2% of GDP above potential. Chart 13 shows that the IMF has consistently overestimated slack in the U.S. and other G7 economies during the past twenty years. It is entirely possible that the U.S. economy is already operating well beyond its full potential, but we will not know this until the lagged effects of diminished slack appear in the inflation data. Chart 11Inflation Is A Lagging Indicator Chart 12Estimates Of NAIRU And R* Have Fallen Chart 13The IMF Has Tended To Overestimate Slack In The G7 As we discussed several weeks ago, fiscal stimulus, faster credit growth, higher asset prices, and a rising labor share of total income have probably pushed up the neutral rate quite a bit over the past few years.6 This lifts the odds that the Fed will find itself behind the curve, causing inflation to rise more than the market is anticipating. Many commentators have argued that excess capacity in the rest of the world will not permit inflation to rise much from current levels, even if the Fed is slow to raise rates. In addition, they contend that automation, e-commerce, and other deflationary technologies, as well as population aging, high debt levels, and the declining influence of trade unions will keep inflation at bay. We will examine these arguments in a forthcoming report. To preview our conclusions, we think they are much weaker than they first appear. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Stanley Fischer, "The Role of Macroeconomic Factors in Growth," NBER Working Paper (December 1993); and Robert J. Barro, "Inflation and Economic Growth," NBER Working Paper (October 1995). 2 Please see "Federal Open Market Committee, Memorandum Of Discussion," Federal Reserve (June 8, 1971). 3 Please see "Economic Report Of The President (Transmitted To The Congress January 1978)," Frasier, Federal Reserve Bank Of St. Louis (January 1978). 4 Burton A. Abrams, "How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes," Journal of Economic Perspectives, 20 (4): 177-188. 5 Paul Krugman, "Unnatural Economics (Wonkish)," The New York Times, May 6, 2018. 6 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic and political polarization. Until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Extremely loose monetary policy is inappropriate for Germany and France and ineffective for Italy. If Italy's banking system does recover to full functionality, the best long-term investment play will be Italy's real estate market. The equity play is Covivio. Feature The European Monetary Union is a contradiction because European monetary policy is not united; it is fragmented. Granted, the euro area has one policy interest rate, and one currency. But monetary policy works principally through accelerations and decelerations in the broad money supply, whose main component is bank credit. It follows that when the banking system is fragmented, a genuine monetary union is elusive. Italy Is 'Yin', The Rest Of Europe Is 'Yang' Economist Richard Koo distinguishes two distinct phases of an economy, a 'yin' phase and a 'yang' phase, with the key difference being the financial health of the private sector including the all-important banking system. In a yang economy, the private sector and the banks are solvent and functional. In such an economy, the smaller and less intrusive the government, the better. Fiscal policy is ineffective because it crowds out private investment. But monetary policy is highly effective because a forward-looking private sector generates a demand for bank credit which will accelerate or decelerate according to the policy interest rate. In a yin economy, the opposite is true. The private sector and/or the banks are insolvent and dysfunctional. In such an economy, monetary policy is ineffective. No amount of depressing interest rates, central bank liquidity injections, or bond buying is able to stimulate bank lending. This is because impaired balance sheets prevent the private sector from borrowing and/or the banks from lending. But in a yin economy, fiscal policy is highly effective. Because the private sector is single-mindedly paying down debt, the government can borrow and spend these private sector debt repayments and excess savings with no danger of crowding out. Indeed in a yin economy, if the government consistently applies an appropriately sized fiscal stimulus, the economy can continue to grow at a healthy pace. Chart I-1-Chart I-6 should make it crystal clear that while Germany and France have a yang economy, Italy has a yin economy. Chart I-1Italy Has A 'Yin' Economy: ##br##Monetary Policy Is Not Effective... Chart I-2...But Fiscal Policy##br## Is Effective Chart I-3France Has A 'Yang' Economy: ##br##Monetary Policy Is Effective... Chart I-4...But Fiscal Policy##br## Is Not Effective Chart I-5Germany Has A 'Yang' Economy:##br## Monetary Policy Is Effective... Chart I-6...But Fiscal Policy ##br##Is Not Effective A Monetary Union Needs A Banking Union In Germany and France, bank credit has surged in response to the ECB's ultra-accommodative monetary policy. But in Italy, bank credit growth is almost non-existent. Through the past ten years, no amount of depressing interest rates, central bank liquidity injections, or bond buying has been able to stimulate Italy's money supply (Chart I-7 and Chart I-8). Chart I-7Italian Banks Are ##br##Not Lending... Chart I-8...Because The Italian Banking System Has##br## Been Left Undercapitalised For A Decade Furthermore, when the ECB bought Italian government bonds from investors, where did Italian investors deposit the hundreds of billions of euros they received? Not in the local Italian banks, but in German banks, which they deemed to be much safer. Italian banks are not lending, and their depositors are still very wary, because the Italian banking system has been left undercapitalized for a decade. The irony is that the ECB's bond-buying was supposed to help Italy the most, but has probably helped it the least (Chart I-9). Chart I-9The ECB's Bond-Buying Has Exacerbated##br## The Target2 Imbalances Europe's full-fledged banking union is still years away. Europe has established a single supervisor for its 130 largest banks. It has also set up a single resolution fund (SRF) to wind down failing banks in an orderly fashion. Unfortunately, the SRF's coffers will not be full for another six years.1 Until then, the SRF will not be credible to the financial markets without a backstop. A candidate to provide such a backstop would be the European Stability Mechanism (ESM), but this is work in progress. Europe also lacks a common deposit insurance scheme. Knowing that the buck stops with the national government makes depositors wary, as has been the case recently in Italy. The large international banks are keen to implement a pan-European deposit insurance scheme. But this requires a clean-up of bank balance sheets in certain countries, notably Italy. Otherwise, the prudent banks will balk at the prospect of paying for the past mistakes of their less prudent competitors. Again, this is work in progress which may take several years to complete. A Fragmented Monetary Policy Requires A Fragmented Fiscal Policy If the entire euro area economy enters a yin phase, the constituent governments are allowed to use fiscal policy to support growth. For example, when the whole euro area went into a yin phase during the debt crisis, the European Commission relaxed the normal 3% cap on government deficits, and this fiscal stimulus helped the most troubled countries to weather the storm. But what if one country enters a yin phase, while the others are still in a yang phase? For example, a 'no-deal' Brexit would hit Ireland much harder than other euro area economies. The EU budget can help to an extent but, at just 1% of Europe's GDP compared to almost 20% in the U.S., the budget is small. This might still be sufficient to help Ireland, but it is insufficient for a large economy like Italy. The ESM can also help, but the assistance arrives too late - when the troubled country has already lost market access, and thereby is in, or close to, a recession. The unfortunate truth is that without a true banking union it is impossible to have a true monetary union. The result is a fragmented monetary policy, as is the case right now. A fragmented monetary policy with an inflexibly rigid fiscal policy is a recipe for economic polarization and thereby, political polarization. Therefore, until the banking union is complete, policymakers must permit a more fragmented fiscal policy as a crucial economic counterbalance. Because ultimately, a less economically polarized euro area will be a more successful and united euro area. An important test to this thesis has now arrived, as the new government in Italy prepares next year's budget. The government must agree its fiscal plan by September and present a draft to the European Commission by mid-October. Italy was projected to reduce its structural deficit by about 0.8 percent. But given that Italy will have one of the world's lowest structural deficits in the coming years, this reduction seems unnecessarily drastic (Table I-1). Because an increase in the deficit might unnerve the markets, the optimal outcome would be to leave the structural deficit close to its current level. Table 1Italy Will Have One Of The World's Lowest Structural Deficits We end with two brief thoughts for investors. The evidence clearly shows that the ECB's extremely loose monetary policy is wholly inappropriate for the euro area's mostly yang economy and largely ineffective for Italy's yin economy. On this premise, expect a multi-year narrowing in core euro area long bond yield spreads versus their counterparts in the U.K. and U.S. Finally, if Italy's banking system does gradually recover to full health and functionality, the best long-term investment play will be Italy's real estate market, in which prices have been bid down to depressed levels due to a lack of a lack of bank financing. On this premise, the long-term equity play is Covivio. Please note that I am taking a brief summer break, so the next weekly report will come out on August 23. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The SRF will be gradually built up during 2016-2023 and shall reach the target level of at least 1% of the amount of covered deposits of all credit institutions within the Banking Union by December 31 2023. Fractal Trading Model* We have seven open positions, so we are not adding any new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations

Highlights China is turning moderately reflationary, but Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. Fiscal spending, rather than a sharp acceleration in credit growth, will dominate China's reflationary efforts, and even a strong fiscal response would involve more "soft infrastructure" than in the past. Consequently, expectations that Chinese reflation will dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy are not likely to be met. The goal of policymakers is merely to prevent a substantial, uncontrolled downturn in domestic demand. Convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy would cause us to advocate a more pro-cyclical investment stance. There is a small chance this may occur, but it is far from our base case view. For now, stay neutrally positioned towards Chinese stocks within a global equity portfolio, and favor low-beta sectors within the Chinese investable universe. Feature Today's Weekly Report is abridged, as we are sending you part 1 of a 2-part report written by my colleague Matt Gertken, Associate Vice President of BCA's Geopolitical Strategy (GPS) service. Last year our geopolitical team made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk. This view has played out quite well, and today's report presents an assessment of the likely impact of China's recent stimulus announcements along with the implications for investors. Matt's report concludes that China is turning moderately reflationary: a substantial boost to fiscal thrust, and possibly a smaller boost to credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy, as China will not entirely abandon the "Reform Reboot" that began last October. This will be discussed next week in the second-part of the two-part series. Today's GPS report is quite timely, as the intensity of China's reflationary efforts is at the forefront of investor attention. BCA's China Investment Strategy (CIS) argued in our July 26 Weekly Report that China is taking its foot off of the brake rather than pressing the accelerator,1 meaning that so far the stimulus announced has fallen short of a substantially reflationary response that would dramatically reverse both the looming export shock as well as the underlying slowdown in China's old economy. Chart 1 shows that market signals are so far consistent with this view, at least in terms of fiscal and/or infrastructure spending. The chart shows how domestic infrastructure stocks are outperforming the broad domestic market (in response to news two weeks ago of stepped up infrastructure spending), but that their performance remains anemic relative to global stocks. Presumably, "big bang" fiscal spending in China would cause the earnings outlook for domestic infrastructure stocks to brighten considerably relative to the global average. Matt notes in today's joint report that even a strong fiscal response would involve more "soft infrastructure" than in the past, and for now investors do not seem to be betting on an intense, "hard infrastructure" boom. Chart 1The Performance Of Infrastructure Stocks Does Not Herald "Big Bang" Stimulus Chart 2At First Blush, This Implies Maximum Reflationary Efforts However, one development that is not consistent with CIS' "foot off the brake" view is the extraordinary decline in interbank interest rates that has occurred over the past month. Chart 2 shows that the 3-month interbank repo rate (China's "de-facto" policy rate) has collapsed even further than it had when we published our July 26 report which, at first blush, suggests that the PBOC has turned the policy dial to maximum reflation. Chart 3 presents a stylized view of the possible PBOC reactions to the imposition of U.S. tariff imposition against China. In scenario 1, the PBOC eases policy in a way that is proportional to the tariff-induced deterioration in the growth outlook, which would stabilize the economy but not result in an acceleration in growth from conditions in place prior to the impact of tariffs on exports. In scenario 2, the PBOC stimulates disproportionately, giving investors license to expect that monetary easing will result in a growth outcome that is net positive. Chart 3A Proportional Monetary Response To A Deceleration In Growth Isn't A Net Positive For The World As Matt notes in his report, the decline in interbank interest rates may not feed through into significantly stronger credit growth if banks are afraid to lend, which could occur as long as the Xi administration remains even partially committed to its crackdown on the financial sector. The decline in the repo rate may not reflect the PBOC's intention to forcefully stimulate credit growth via lower borrowing rates, but rather is a necessary consequence of substantially increasing liquidity in the banking system to avoid any financial system instability stemming from a major shock to exports. We agree that the collapse in the 3-month repo rate is more consistent with scenario 2 than scenario 1, although there are two important counterpoints to consider: Chart 4Possibly Due To Rising NIMs, Rather Than A Significant Acceleration In Credit Growth On the second point, the crackdown on shadow banking over the past 18 months has substantially (negatively) impacted small Chinese banks, and it is conceivable that the PBOC has acted to prevent a liquidity problem from become an outright solvency problem for some financial institutions. If true, this suggests that the extent of the decline in the repo rate may be temporary, or that policymakers will employ other tools to limit the feedthrough from lower interbank borrowing costs to lending rates in the real economy in order to limit the resulting pickup in credit growth. The latter option would, in effect, purposely engineer an expansion in bank net interest margins, a scenario that could explain the recent uptick in domestic bank relative performance without resorting to a forecast of surging credit growth (Chart 4). What does this all mean for investors? Were we to see convincing signs that China is likely to end up overstimulating in a way that results in a net positive for the global economy, we would recommend a more pro-cyclical investment stance. This could likely include the constituent assets of the China Play Index presented by my colleague Mathieu Savary, Vice President of BCA's Foreign Exchange Strategy service in his last Weekly Report,2 and we plan on employing the index as a gauge of investors' stimulus expectations. But for now, we are comfortable with our existing recommendations: investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. We will be monitoring the upcoming export shock as well as further policymaker responses continually over the coming weeks and months, and invite investors to come along for the ride. Stay tuned! Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Research's China Investment Strategy Special Report "China Is Easing Up On The Brake, Not Pressing The Accelerator," published July 26, 2018. Available at cis.bcaresearch.com. 2 Please see BCA Research's Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus," published August 3, 2018. Available at fes.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

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Highlights Xi Jinping is trying to do two things at once: ease policy while cracking down on systemic financial risk; The trade war with the U.S. is a genuine crisis for China and is eliciting fiscal stimulus; Credit growth is far more likely to "hold the line" than it is to explode upward or collapse downward; The 30% chance of a policy mistake from financial tightening has fallen to 20% only, as bad loan recognition is underway and a critical risk to monitor; Hedge against the risk of a stimulus overshoot. Feature "We have upheld the underlying principle of pursuing progress while ensuring stability." - Xi Jinping, General Secretary of the Communist Party of China, October 18, 2017 "Any form of external pressure can eventually be transformed into impetus for growth, and objectively speaking will accelerate supply-side structural reforms." - Guo Shuqing, Secretary of the China Banking and Insurance Regulatory Commission, July 5 Last year we made the case that China's General Secretary Xi Jinping would double down on his reform agenda in 2018, specifically the bid to control financial risk, and that this would bring negative surprises to global financial markets as policymakers demonstrated a higher pain threshold.1 This view has largely played out, with economic policy uncertainty spiking and a bear market in equities developing alongside an increase in corporate and even sovereign credit default risk (Chart 1). We also argued, however, that Xi's "deleveraging campaign" would be constrained by the Communist Party's need for overall stability. Trade tensions with the U.S., and Beijing's perennial fear of unemployment, would impose limits on how much pain Beijing would ultimately tolerate: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again.2 Over the past month, China has clearly reached its pain threshold: authorities have announced a series of easing measures in the face of a slowing economy, a trade war, and a still-negative broad money impulse (Chart 2). Chart 1Policy Uncertainty Up, Stocks Down Chart 2PMI Falling, Money Impulse Still Negative How stimulating is the stimulus? Will it lead to a material reacceleration of the Chinese economy? What will it mean for global and China-dedicated investors? We expect policy to be modestly reflationary. A substantial boost to fiscal thrust, and at least stable credit growth, is in the works. Yet Xi's reform agenda will remain a drag on the economy. While this new stimulus will not have as dramatic an effect as the stimulus in 2015-16, it will have a positive impact relative to expectations based on China's performance in the first half of the year. We advise hedging our negative EM view against a rally in China plays and upgrading expectations for Chinese growth in 2019. The policy headwind is receding for now. Xi Jinping's "Three Tough Battles" Xi will not entirely abandon the "Reform Reboot" that began last October. From the moment he came to power in 2012-13, he pursued relatively tight monetary and fiscal policy. Total government spending growth has dropped substantially under his administration, while private credit growth has been capped at around 12% (Chart 3). Chart 3Xi Jinping Caps Government Spending And Credit Xi partly inherited these trends, as China's credit growth and nominal GDP growth dropped after the massive 2008 stimulus. But he also embraced tighter policy as a way of rebalancing the economy away from debt-fueled, resource-intensive, investment-led growth. A comparison of government spending priorities between Xi and his predecessor makes Xi's policy preferences crystal clear: the Xi administration has increased spending on financial and environmental regulation, while minimizing subsidies for housing and railways to nowhere (Table 1 and 2). Table 1Central Government Spending Preferences (Under Leader's Immediate Control) Table 2Total Government Spending Preferences (Under Leader's General Control) These policies are "correct" insofar as they are driven not merely by Xi's preferences but by long-term constraints: The middle class: Pollution and environmental degradation threaten the living standards of the country's middle class. Broadly defined, this group has grown to almost 51% of the population, a level that EM politicians ignore only at their peril (Chart 4). Asset bubbles: The rapid increase in China's gross debt-to-GDP ratio since 2008 is a major financial imbalance that threatens to undermine economic stability and productivity as well as Beijing's global aspirations (Chart 5). The constraint is clear when one observes that "debt servicing" is the third-fastest category of fiscal spending growth since Xi came to power (Table 2). Chart 4Emerging Middle Class A Latent Political Risk Chart 5The Rise And Plateau Of Macro Leverage The problem is that Xi also faces a different, shorter-term set of constraints arising from China's declining potential GDP, "the Middle-Income Trap," and the threat of unemployment.3 The interplay of these short- and long-term constraints has forced Xi to vacillate in his policies. In 2015, the threat of an economic "hard landing," ahead of the all-important mid-term party congress in 2017, forced him to stimulate the "old" industrial economy and sideline his reforms. Only when he had consolidated power over the Communist Party in 2016-17 could he resume pushing the reform agenda.4 In July 2017, Xi announced the so-called "Three Critical Battles" against systemic financial risk, pollution, and poverty. The three battles are interdependent: continuing on the capital-intensive economic model will overwhelm any efforts to cut excessive debt or pollution (Chart 6), yet sudden deleveraging could derail the Communist Party's basic claim to legitimacy through improving the lot of poor Chinese. The macroeconomic impact of the three battles is broadly deflationary, as credit growth falls and industries restructure. The first battle - the financial battle - will determine the outcome of the other two battles as well as the growth rate of China's investment-driven economy, Chinese import volumes, and emerging market stability (Chart 7). Chart 6Credit Stimulus Correlates With Pollution Chart 7Credit Determines Growth And Imports On July 31, in the midst of worldwide speculation about China's willingness to stimulate, Xi reaffirmed this "Three Battles" framework. Remarkably, despite a general slowdown, a sharp drop in the foreign exchange rate, the revival of capital flight, and a bear market, he announced that the battle against systemic financial risk would continue in the second half of 2018. However, he also admitted that domestic demand needed a boost in the short term. Hence there should be no doubt in investors' minds about the overarching policy framework or Xi Jinping's intentions in the long run. The question driving the markets today is what China will do in the short term and whether it will initiate a material reacceleration in economic activity. Bottom Line: Xi Jinping remains committed to the reform agenda that he has pursued since coming to power in 2012. But he is forced by circumstances to vary the pace and intensity. At the top of the agenda is the control of systemic financial risk. This is a policy driven by the belief that China's economic and financial imbalances threaten to undermine its overall stability and global rise. Why The Shift Toward Easier Policy? The gist of the July 31 Politburo statement was that policy will get more dovish in the short term. It mentioned "stability" five times. The Politburo pledged to make fiscal policy "more proactive" and to find a better balance between preventing financial risks and "serving the real economy." This direct promise from Xi Jinping of more demand-side support gives weight to the State Council's similar statement on July 23 and will have reflationary consequences above and beyond the central bank's marginal liquidity easing thus far. What is motivating this shift in policy, which apparently flies in the face of Xi's high-profile deleveraging campaign? If we had to name a single trigger for China's change of tack, it is not the economic slowdown so much as the trade war with the United States. The war began when the U.S. imposed sanctions on Chinese firm ZTE in April and China depreciated the RMB, but it escalated dramatically when the U.S. posted the Section 301 tariff list in June (Chart 8).5 This is a sea change in American policy that is extremely menacing to China. China runs a large trade surplus and has benefited more than any other country from the past three decades of U.S.-led globalization. Its embrace of globalization is what enabled the Communist Party to survive the fall of global communism! Chart 8More Than Market Dynamics At Work Chart 9China Is Less Export-Dependent True, China has already seen its export dependency decline (Chart 9). But Beijing has so far managed this transition gradually and carefully, whereas a not-unlikely 25% tariff on $250-$500 billion of Chinese exports will hasten the restructuring beyond its control (Chart 10). A very large share of China's population is employed in manufacturing (Chart 11). To the extent that the tariffs actually succeed in reducing external demand for Chinese goods, these jobs will be affected. Chart 10Tariffs Will Add More Pain To Factory Workers Chart 11Manufacturing Unemployment A Huge Threat Unemployment is anathema to the Communist Party. And China is simply not as experienced as the U.S. in dealing with large fluctuations in unemployment (Chart 12). While Chinese workers will blame "foreign imperialists" and rally around the flag, the pain of unemployment will eventually cause trouble for the regime. Domestic demand as well as exports will suffer. It is even possible that worker protests could evolve into anti-government protests. Chart 12China Not Experienced With Layoffs Given that Chinese and global growth are already slowing, it is no surprise that the Politburo statement prioritized employment.6 China's leaders will prepare for social instability as the worst possible outcome of the showdown with America - and that will push them toward stimulus. In addition, there will be no short-term political cost to Xi Jinping for erring on the side of stimulus, as there is no opposition party and the public is not demanding fiscal and monetary austerity. Moreover, the main macro implication of Xi's decision last year to remove term limits - enabling himself to be "president for life" in China - is that his reforms do not have to be achieved by any set date. They can be continually procrastinated on the basis that he will return to them later when conditions are better.7 The policy response to tariffs from the Trump administration also signals another policy preference: perseverance. Xi would not be straying from his reform priorities if not for a desire to counter American protectionism. China is not interested in kowtowing but would rather gird itself for a trade war. Still, our baseline view is that the Xi administration will stimulate without abandoning the crackdown on shadow lending or launching a massive "irrigation-style" credit surge that exacerbates systemic risk.8 Policy will be mixed, as Xi is trying to do two things at once. Bottom Line: China's slowdown and the outbreak of a real trade war with the United States is forcing Xi Jinping to ease policy and downgrade the urgency of his attempt to tackle systemic financial risk this year. Can Fiscal Easing Overshoot? Yes. How far will China's policy easing go? China has a low level of public debt, and fiscal policy has been tight, so we fully expect fiscal thrust to surprise to the upside in the second half of the year, easily by 1%-2% of GDP, possibly by 4% of GDP. A remarkable thing happened this summer when researchers at the People's Bank of China and the Ministry of Finance began debating fiscal policy openly. Such debates usually occur during times of abnormal stress. The root of the debate lay in the national budget blueprint laid out in March at the National People's Congress. There, without changing official rhetoric about "proactive fiscal policy," the authorities revealed that they would tighten policy this year, with the aim of shrinking the budget deficit from 3% of GDP target in 2017 to 2.6% in 2018. The IMF, which publishes a more realistic "augmented" deficit, estimates that the deficit will contract from 13.4% of GDP to 13% (Chart 13). This fiscal tightening coincided with Xi's battle against systemic financial risk. Hence both monetary and fiscal policy were set to tighten this year, along with tougher regulatory and anti-corruption enforcement.9 Thus it made sense on May 8 when the Ministry of Finance revealed that the quota for net new local government bond issuance this year would increase by 34% to 2.18 trillion RMB. This quota governs new bonds that go to brand new spending (i.e. it is not to be confused with the local government debt swap program, which eases repayment burdens but does not involve a net expansion of debt). Local government spending is the key because it makes up the vast majority (85%) of total government spending, which itself is about the same size as new private credit each year. Chart 13Fiscal Tightening Was The Plan For 2018 Table 3Local Government Bond Issuance And Quota In June, local governments took full advantage of this opportunity, issuing 316 billion RMB in brand new bonds (up from a mere 17 billion in May - an 11.8% increase year-on-year) (Table 3). This spike in issuance is later than in previous years. Combined with the Politburo and State Council pledging to boost fiscal policy and domestic demand, it suggests that net new issuance will pick up sharply in H2 2018 (Chart 14).10 Chart 14Local Government Debt Can Surprise In H2 Chart 15June Issuance Surged, Special Bonds To Pick Up At the same time, the risk that special infrastructure spending will fall short this year is receding. About 1.4 trillion RMB of the year's new bond allowance consists of special purpose bonds to fund projects. The State Council said on July 23 it would accelerate the issuance of these bonds, since, at most, only 27% of the quota was issued in the first half of the year (Chart 15). The risk of a shortfall - due to stricter government regulations over the quality of projects - is thereby reduced. What is the overall impact of these moves? The Chinese government provides an annual "debt limit" that applies to the grand total of explicit, on-balance-sheet, local government debt. The limit increased by 11.6% for 2018, to 21 trillion RMB (Table 4), which, theoretically, enables local governments to splurge on a 4.5 trillion RMB debt blowout. Should that occur, 2.6 trillion RMB of that amount, or 3% of GDP, would be completely unexpected new government spending in 2018 (creating a positive fiscal thrust).11 Table 4Local Government Debt Quota Is Not A Constraint Such a blowout may not be likely, but it is legally allowed - and the political constraints on new issuance have fallen with the central government's change of stance. This means that local governments' net new bond issuance can move up toward this number. More feasibly, local governments could increase their explicit debt to 19.3 trillion RMB, a 920 billion RMB increase on what is expected, which would imply 1% of GDP in new spending or "stimulus" in 2018.12 The above only considers explicit, on-balance-sheet debt. Local governments also notoriously borrow and spend off the balance sheet. The total of such borrowing was 8.6 trillion RMB at the end of 2014, but there is no recent data and the stock and flow are completely opaque.13 The battle against systemic risk is supposed to curtail such activity this year. But the newly relaxed supervision from Beijing will result in less deleveraging at minimum, and possibly re-leveraging. Similarly, the government has said it is willing to help local governments issue refinancing bonds to deal with the spike in bonds maturing this year.14 This frees them up to actually spend or invest the money they raise from brand new bonds. In short, our constraints-based methodology suggests that the risk lies to the upside for local government debt in 2018, given that it is legal for debt to increase by as much as 2.5 trillion RMB, 3% of GDP, over the 1.9 trillion RMB increase that is already expected in the IMF's budget deficit projections for 2018. What about the central government? Its policy stance has clearly shifted. The central government could quite reasonably expand the official budget deficit beyond the 2.6% target. Indeed, that target is already outdated given that new individual tax cuts have been proposed, which would decrease revenues (add to the deficit) by, we estimate, a minimum of 0.44% of GDP over a 12-month period starting in October.15 Other fiscal boosts have also been proposed that would add an uncertain sum to this amount.16 The total of these measures can quite easily add up to 1% of GDP, albeit with the impact mostly in 2019. Finally, the strongest reason to err on the side of an upward fiscal surprise is that an expansion of fiscal policy will allow the Xi administration to boost demand without entirely relying on credit growth. First, local governments are actually flush with revenues due to strong land sales (Chart 16), which comprise around a third of their revenues. This enables them to increase spending even before they tap the larger debt allowance. Second, China's primary concern about financial risk is due to excessive corporate (and some household) leverage, particularly by state-owned enterprises (SOEs) and shadow banking. It is not due to public debt per se. It is entirely sensible that China would boost public debt as it attempts to limit leverage. In fact, this would be the Zhu Rongji playbook from 1998-2001. This was the last time that China announced a momentous three-year plan to crack down on profligate lending, hidden debts, and credit misallocation. The authorities deliberately expanded fiscal policy to compensate for the anticipate credit crunch and its drag on GDP growth (Chart 17).17 Chart 16Land Sales Enable Non-Debt Fiscal Spending Chart 17China Boosted Fiscal During Last Bad Debt Purge As for the impact on the economy, the money multiplier will be meaningful because the economy is slowing and fiscal policy has been tight. But fiscal spending does operate with a six-to-ten month lag, meaning that China/EM-linked risk assets will move long before the economic data fully shows the impact. Our sense, judging by the unenthusiastic response of copper prices thus far, is that the market does not anticipate the fiscal overshoot that we now do. Bottom Line: The political constraints on local government spending have fallen. Fiscal policy could add as much as 1%-3% of GDP to the budget deficit in H2 2018, namely if local government spending is unleashed by the recently announced policy shift. This is comparable to the 4% of GDP fiscal boost in 2008-09 and 3% in 2015-16. Can Monetary Easing Overshoot? Yes, But Less Likely. Credit is China's primary means of stimulating the economy, especially during crisis moments, and it has a much shorter lag period than fiscal spending (about three months). But Xi's agenda makes the use of rapid, credit-fueled stimulus more problematic. Based on the sharp drop in the interbank rate - in particular, the three-month interbank repo rate that BCA's Emerging Markets Strategy and China Investment Strategy use as a proxy for China's benchmark rate - it is entirely possible that credit growth will increase to some degree in H2 2018. Interbank rates have now fallen almost to 2016 levels, while the central bank never hiked the official 1-year policy rate during the recent upswing (Chart 18). In other words, the monetary setting has now almost entirely reversed the financial crackdown that began in 2017. The sharp drop in the interbank rate is partly a consequence of the three cuts to required reserve ratios (RRRs) this year, which amounts to 2.8 trillion RMB in new base money from which banks can lend.18 One or two more RRR cuts are expected in H2 2018, which could free up another roughly 800 billion-to-1.6 trillion RMB in new base money. With China accumulating forex reserves at a slower pace than in the past, and facing a future of economic rebalancing away from exports and growing trade protectionism, RRRs can continue to decline over the long run (Chart 19). China will not need to sterilize as large of inflows of foreign exchange.19 Chart 18Monetary Settings Back To Easy Levels Chart 19RRR Cuts Can Continue If China's banks and borrowers respond as they have almost always done, then credit growth should rise. The risk to this assumption is that the banks may be afraid to lend as long as the Xi administration remains even partially committed to its financial crackdown. Moreover, the anti-corruption campaign is continuing to probe the financial sector. While this has only produced a handful of anecdotes so far, they are significant and may have helped cause the decline in loan approvals since early 2017. Critically, China has begun the process of recognizing non-performing loans (NPLs), by requiring that "special mention loans" be reclassified as NPLs, thus implying that NPL ratios will spike, especially among small and regional lenders (Chart 20). This is part of the deleveraging process we expect to continue, but it can take on a life of its own and will almost certainly weigh on credit growth to some extent for as long as it continues. Chart 20NPL Recognition Underway (!) Chart 21Three Scenarios For Private Credit In H2 2018 What will be the prevailing trend: monetary easing or the financial crackdown? In Chart 21 we consider three scenarios for the path of overall private credit growth (total social financing, ex-equity) for the rest of the year, with our subjective probabilities: In Scenario A, 10% probability, we present an extreme case in which Beijing panics over the trade war and the banks engage in a 2009-style lending extravaganza. Credit skyrockets up to the 2010-17 average growth rate. This would mark a massive 11.9 trillion RMB or 13.8% of GDP increase in excess of the amount implied by the H1 2018 data. This size of credit spike would be comparable to the huge spikes that occurred during past crises, such as the 22% of GDP increase in 2008-09 or the 9% of GDP increase in 2015-16. Needless to say, this is not our baseline case, but it could materialize if the trade war causes a global panic. In Scenario B, 70% probability, we assume, more reasonably, that traditional yuan bank loans are allowed to rise toward their average 2010-17 growth rate as a result of policy easing, yet Xi maintains the crackdown on non-bank credit in accordance with this "Three Battles" framework. Credit growth would still decelerate in year-on-year terms, but only just: it would fall from 12.3% in 2017 to 11.5% in 2018. Additional policy measures could easily bump this up to a modest year-on-year acceleration, of course. This scenario would result in a credit increase worth 2.9 trillion RMB or 3.4% of GDP on top of the level implied by H1 2018. In Scenario C, 20% probability, we assume that the 2018 YTD status quo persists: bank credit and non-bank credit continue growing at the bleak H1 2018 rate. The administration's attempt to maintain the crackdown on financial risk could frighten banks out of lending. This would mean no credit increase in 2018 beyond what is naturally extrapolated from the H1 2018 data. Credit growth would slow from 12.3% to 10.7% in 2018. This scenario would be surprising, but not entirely implausible given that the Politburo is insisting on continuing the Three Battles. The collapse in interbank rates and the easing measures already undertaken - such as reports that the Macro-Prudential Assessments will lighten up, and that the People's Bank is explicitly softening banks' annual loan quotas20 - lead us to believe that Scenario B is most likely, and possibly too conservative. This is the scenario most consistent with the latest Politburo statement: that authorities will continue the campaign against systemic risk, namely through the policy of "opening the front door" (traditional bank loans go up) and "closing the back door" (shadow lending goes down), which began in January. The Chinese government has always considered control of financial intermediation to be essential. The only way to reinforce the dominance of the state-controlled banks, while preventing a sharp drop in aggregate demand, is to allow them to grow their loan books while regulators tie the hands of their shadow-bank rivals (Chart 22). Chart 22Opening The Front Door, Closing The Back One factor that could evolve beyond authorities' control is the velocity of money. Money velocity is essentially a gauge of animal spirits. If a single yuan changes hands multiple times, it will drive more economic activity, but if it is deposited away for a rainy day, then the bear spirit is in full force. Thus, if credit growth accelerates, but money in circulation changes hands more slowly, then nominal GDP can still decelerate - and vice versa.21 China's money velocity suffered a sharp drop during the tumult of 2015, recovered along with the policy stimulus in 2016, and has tapered a bit in 2018 in the face of Xi's deleveraging campaign. Yet it remains elevated relative to 2012-16 and clearly responds at least somewhat to policy easing. The implication is that money velocity should remain elevated or even pick up in H2. Again, the risk to this view is that Xi's ongoing battle against financial risk, and anti-corruption campaign in the financial sector, could suppress money velocity as well as credit growth. Bottom Line: We see a subjective 70% chance that the drop in credit growth will be halted or reversed in H2 as a result of the central bank's liquidity easing and the Politburo's willingness to let traditional bank lending grow while it discourages shadow lending. Our baseline case says the impact could amount to new credit worth 3.4% of GDP in H2 2018 that markets do not yet expect. Investment Conclusions Beijing's shift in policy suggests that our subjective probability of a policy mistake this year, leading to a sharp economic deceleration, should be reduced from 30% to 20% (Credit Scenario C above).22 Why is this dire scenario still carrying one-to-five odds? Because we fear that the financial crackdown and rising NPLs could take on a life of their own. Meanwhile the risk of aggressive re-leveraging has risen from 0% to 10% (Credit Scenario A above). Summing up, Table 5 provides a simple, back-of-the-envelope estimate of the size of both fiscal and monetary policy measures as a share of GDP. Table 5Potential Magnitude Of Easing/Stimulus Our bias is to expect a strong fiscal response combined with a weak-to-moderate credit response. This would reflect the Xi administration's desire to prevent asset bubbles while supporting growth. A more proactive fiscal policy harkens back to China's handling of its last financial purge in 1998-2001. If banks prove unable or unwilling to lend sufficiently, additional fiscal expansion will pick up the slack. New local government debt can surprise by 1% of GDP or more, while formal bank lending amidst an ongoing crackdown on shadow lending could add new credit of around 3.4% of GDP and hence mitigate or halt the slowdown in credit growth. The combined effect would be an unexpected boost to demand worth 4.4% of GDP in H2 2018, which would exert an unknown, but positive, multiplier effect. We are replacing our "Reform Reboot" checklist, which has seen every item checked off, with a new "Stimulus Checklist" that we will monitor going forward (Appendix). Chart 23How To Monitor The Stimulus Impact Neither the size of this stimulus, nor the composition of fiscal spending, will be quite as positive for EM/commodities as were past stimulus efforts. China's investment profile is changing as the reform agenda seeks to reduce industrial overcapacity and build the foundations for stronger household demand and a consumer society. Increases in fiscal spending today will involve more "soft infrastructure" than in the past. We recommend reinstituting our long China / short EM equity trade, using MSCI China ex-tech equities. We also recommend reinitiating our long China Big Five Banks / short other banks trade, to capture the disparity of the financial crackdown's impact. To capture the new upside risk for global risk assets, our colleague Mathieu Savary at BCA's Foreign Exchange Strategy has devised a "China Play" index that is highly sensitive to Chinese growth - it includes iron ore prices, Swedish industrial stocks, Brazilian stocks, and EM junk bonds (all in USD terms), as well as the Aussie dollar-Japanese yen cross. BCA Geopolitical Strategy also recommends this trade as a portfolio hedge to our negative EM view (Chart 23).23 A major risk to the "modest reflation" argument in this report will materialize if the RMB depreciates excessively in response to the escalating trade war (Trump will likely post a new tariff list on $200 billion worth of goods in September).24 This could result in renewed capital outflows breaking through China's capital controls, the PBC appearing to lose control, EM currencies and capital markets getting roiled, EM financial conditions tightening sharply, and global trade and growth slowing sharply. China would ultimately have to stimulate more (moving in the direction of Credit Scenario A above), but a market selloff would occur first and much economic damage would be done. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com Yushu Ma, Contributing Editor yushum@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 3 Please see The Bank Credit Analyst Special Report, "A Long View Of China," dated December 28, 2017, available at bca.bcaresearch.com. 4 The fact that he began tightening financial policy in late 2016 and early 2017 was especially significant because only a very self-assured leader would attempt something so risky ahead of a midterm party congress. 5 Please see BCA Geopolitical Strategy Weekly Reports, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, and "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 6 The statement declared in its first paragraph that China would "maintain the stability of employment," with employment being the first item in a list. A similar emphasis on employment has not been seen in Politburo statements since the troubled year of 2015, and it has not been mentioned substantively in 11 key meetings since the nineteenth National Party Congress last October. 7 Please see footnote 2 above. 8 After the State Council meetings on July 23 and 26, Vice-Minister of Finance Liu Wei elaborated on the government's thinking: "These [measures] further add weight to the overall broad logic at the start of the year ... It isn't at all that the macro-economy has undergone any major volatility, and we are not undertaking any irrigation-style, shock-style measures." Please see "Beijing Sheds Light On Plans For More Active Fiscal Policy," China Banking News, July 27, 2018, available at www.chinabankingnews.com. 9 Our colleagues in BCA's Emerging Markets Strategy service have dubbed this policy "triple tightening." Please see BCA Emerging Markets Strategy Weekly Report, "EM And China: A Deleveraging Update," dated November 8, 2017, available at gps.bcaresearch.com. 10 This spike in net new issuance in the single month of June is equivalent to 19.8% of the total net new issuance in 2017. It is also much higher than the average monthly issuance in 2014-17 or in 2017 alone. However, since June and July have typically seen the largest spikes in new issuance, it will be critical to see if new issuance in 2018 remains elevated after July. Notably, local government bond issuance is currently divided between brand new bonds, debt swap bonds, and refinancing bonds, but the debt swap program will expire in August, and the refinancing bonds are separate, meaning that a larger share of the allowed new issuance will involve new spending. 11 The IMF expects the change in local government explicit debt this year to be 1.9 trillion RMB. That is, a rise from 16.5 trillion existing to 18.4 trillion estimated. 12 This number is derived by assuming that total debt reaches 92.2% of the debt limit in 2018, which is the share it reached in 2015 (since 2015 the share has fallen to 87.5% in 2017). However, 2015 was a year of fiscal easing, so it is not unreasonable to apply this ratio to 2018 as an upper estimate, now that the government's easing signal is clear. One reason that local governments have been increasing debt more slowly than allowed was that the central government was tightening investment restrictions, for instance on urban rail investment. Many new subway projects of second-tier cities have been suspended, and after raising the qualifications for subway and light rail, the majority of third- and fourth-tier cities were not qualified to build urban rail at all. As a result, local governments' investment intentions were dropping. Now this may change. 13 This estimate comes from the Ministry of Finance. The previous estimate was from the National Accounting Office and stood at 7 trillion RMB as of June 2013. 14 Maturities will spike in the coming years, so this policy signal suggests that further support for refinancing will be forthcoming. There are even unconfirmed rumors of a second phase of the local government debt swap program, which would cover "hidden debt." 15 We say "minimum" because we do not include projections of the impact of tax deductions, lacking details. We only estimate the headline savings to household incomes - loss to government revenues - based on the increase of the individual income tax eligibility threshold and the reduction in tax rates for different income brackets. 16 Additional fiscal measures include corporate tax cuts, R&D expense credits, VAT rebates, and reductions in various fees. 17 Please see BCA Geopolitical Strategy Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 18 In fact it is more like 1.9 trillion due to strings attached, but a fourth or even fifth RRR cut could push it 3.5 trillion for the year, assuming the average 800 billion cut. 19 Ultimately this trend will result in tightening liquidity conditions in China, but for now forex reserves are not draining massively, while the RRR cuts are easing domestic liquidity. 20 Please see "China Said To Ease Bank Capital Rule To Free Up More Lending," Bloomberg, July 25, and "China's Central Bank Steps Up Effort To Boost Lending," August 1, 2018, available at www.bloomberg.com. 21 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 22 Please see BCA Research Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2017, available at bca.bcaresearch.com. 23 Please see BCA Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus," dated August 3, 2018, available at fes.bcaresearch.com. 24 Please see BCA Global Investment Strategy Weekly Report, "Three Macro Paradoxes Are About To Come True," dated August 3, 2018, available at gis.bcaresearch.com. Appendix

Highlights Real Rate "Targeting": Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. U.K.: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Japan: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Feature Chart Of The WeekA 'New, New Normal' Of Higher Real Rates? Three major central banks met last week and, surprisingly, the most important message did not come from the Federal Reserve. The Bank of England (BoE) and Bank of Japan (BoJ) both delivered policy decisions that appeared more hawkish on the surface, even though the underlying message was far more mixed. The BoE hiked rates by 25bps, while the BoJ tweaked its yield curve control policy by raising the allowable ceiling for the 10-year Japanese Government Bond (JGB) to 0.2%. Yet both central banks signaled - through published research, commentary and outright forward guidance - that the timing of the next policy move is uncertain. This contrasts with the Fed, who continues to signal a slow-but-steady path of U.S. rate hikes over at least the next year. The BoE and BoJ are dealing with the same issues that all the major developed market central banks are facing now - how to reconcile low unemployment and an apparent dearth of spare economic capacity with only modest upward inflation momentum and real interest rates that appear too low (Chart of the Week). Against that backdrop, the communication of central banker strategies to the public, and to the financial markets, is critical to their success, defined by keeping inflation stable around target levels. The Fed has been a leader in introducing nuance into the execution, and communication, of post-crisis policymaking. First, by focusing more on underutilized capacity in the U.S. labor market to justify keeping the funds rate low despite the headline unemployment rate falling below its estimate of "full" employment. Later, by focusing attention on real interest rates and the possibility that the neutral level of that rate (a.k.a. "r-star") can vary cyclically from levels that would previously have been considered consistent with full employment and stable inflation. In both cases, the Fed has provided a framework that allows some wiggle room as it continues to normalize away from crisis-era policy settings. Passionate advocates of the concept like current New York Fed President John Williams have led the Fed's growing focus on r-star. Yet in its latest Inflation Report published last week, the BoE dedicated five full pages to the topic of estimating r-star in the U.K.1 Other central banks have discussed their own estimates of r-star over the past year, as well.2 This is an important point for global bond markets. If other central banks begin to follow the lead of the Fed and elevate the importance of "real rate targeting" into their inflation targeting frameworks, then real bond yields could have significant upside with policy rates still not above realized inflation in the major developed economies. This will especially be true if factors that have kept r-star cyclically depressed in many countries in the post-crisis era - weak productivity growth, fiscal consolidation, excess capacity in labor markets, household deleveraging, among others - continue to slowly dissipate. At the moment, the most important themes for global financial markets relate to the ongoing Fed tightening cycle, the potential for policy stimulus in China in response to slowing domestic growth, and the slowing growth of central bank balance sheets (Chart 2). All three are bond bearish. We could add a fourth item to that list - U.S. protectionism, which can lead to slowing global through diminished trade activity. While there is evidence from many countries that a more uncertain outlook for global trade has negatively affected business confidence, there is also some tentative evidence that the deceleration in global trade activity may be in the process of stabilizing (Chart 3). Yet even if the U.S. - China trade tensions worsen and industrial activity slows further, tariffs and trade barriers represent a supply shock that could result in higher global inflation and prevent a meaningful decline in bond yields. Summing it all up for our government bond investment strategy, we continue to recommend: a below-benchmark overall portfolio duration stance country allocation (Chart 4) with underweight exposure to countries where central banks can credibly raise interest rates (U.S., Canada) and overweight exposure where rate hikes will be more difficult to deliver (U.K., Japan, Australia) Bottom Line: Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. Chart 2The Biggest Market Risks Are Bond Bearish Chart 3Tentative Signs Of Global Trade Stabilization? Chart 4Underweight Countries That Can Credibly ##br##Raise Rates (And Vice Versa) Stay Overweight U.K. Gilts, Even After The BoE Rate Hike The BoE delivered a 25bp rate hike last week, bringing its Bank Rate to 0.75%. The growth and inflation forecasts for the next three years were essentially unchanged, however. The hike was described by BoE Governor Mark Carney as a sign of growing confidence by the Monetary Policy Committee (MPC) in its forecast. Thus, another step towards normalizing the Bank Rate from accommodative levels was appropriate. In the press conference following the MPC meeting, Carney noted that the recent pickup in U.K. wage growth was an important development. Carney said that with the economy at full employment,3 the BoE's job is to "manage demand" to control inflation while nominal wage growth expands. Real wage growth has crept back into positive territory in recent months (Chart 5). Numerous indicators were presented in the August 2018 Inflation Report to suggest that U.K. labor markets are growing increasingly tight - including faster wage growth for those switching jobs than those staying in jobs (bottom panel) and survey data showing greater pay increases in sectors facing recruitment and retention difficulties. The BoE did downplay the recent cooling of realized U.K. inflation, which has been more a product of the stability of the pound than an easing of domestic inflation pressures. While this is true, market-based measures of inflation expectation like CPI swaps have also been following the path of the pound, rather than typical forces like oil prices, since the collapse in the pound after the 2016 Brexit vote (Chart 6). On the margin, however, the more stable pound means that U.K. inflation will be more influenced by domestic factors, like tight labor markets and wage pressures. Chart 5Mixed Signals From The U.K. Labor Market Chart 6U.K. Inflation Following The Pound, Not The Labor Market As discussed earlier, the BoE did devote a significant section of the latest Inflation Report to the topic of the neutral real rate or r-star. The BoE noted that there was a longer-term and shorter-term r-star, and that the latter had to be deeply negative in recent years given the shocks from the 2008 Financial Crisis and recession to the 2016 Brexit vote to the fiscal austerity of recent Conservative governments. As the impacts of those shocks fades, the shorter-term r-star increases, requiring faster BoE rate hikes. Or as it was described in the Inflation Report: "The expected rise in r* over coming years, combined with the absorption of spare capacity over the forecast period, means that - even as inflation is projected to fall back toward 2% - the Bank Rate is likely to need to rise gradually to keep inflation at the target. But the persistence of the fall in the trend real rate means that any rises in the Bank Rate are expected to be limited, and interest rates are likely to need to remain low by historical standards for some time to come." That sounds like the BoE wanting to have its cake and eat it too, talking up rate hikes while making the case for rates to stay low for longer. The longer-run r-star estimates shown in the Inflation Report (between 0.5% and 1.5%) when added to the 2% BoE inflation target, suggests that the neutral nominal Bank Rate is between 2.5% and 3.5%. That does imply that there is a lot of scope for additional BoE rate hikes without even reaching a level that could be considered "'neutral' from a longer-term perspective" (Chart 7). It will be difficult for the BoE to deliver on any additional rate hikes, however, while both the economy and inflation are decelerating. The current pricing in the U.K. Overnight Index Swap (OIS) curve shows that there are only 42bps of hikes discounted by the end of 2020. That represents a very low hurdle to overcome, even if the U.K. economy remains sluggish and the Brexit outcome turns ugly. From a strategy perspective, we think that Gilt yields can rise above the current shallow path of the forward curve over the next 6-12 months, suggesting that a below-benchmark duration stance in the U.K. is appropriate. Yet with U.K. growth slowing and leading indicators suggesting more of that is to come, and with still no resolution to the Brexit negotiations with the March 29, 2019 "Brexit Day" looming in the distance, Gilt yields are likely to stay relatively subdued versus global peers. We continue to recommend an overweight stance on Gilts in hedged global bond portfolios (Chart 8). Chart 7U.K. Real Rates Are WAY Below Longer-Run R-Star Chart 8Stay Overweight U.K. Gilts Bottom Line: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Bank of Japan: Zero Pressure On The 0% Target Global bond yields got a bit of a jolt recently from the most unlikely of sources - Japan, the place where bond volatility goes to die. Amid media speculation that the Bank of Japan (BoJ) was considering an upward adjustment to its JGB yield target, the 10-year JGB took several runs at breaching the BoJ's implied pain threshold of 0.10%, resulting in the BoJ intervening with offers of "unlimited" purchases to quell the selloff. Yet at the monetary policy meeting last week, the BoJ only delivered modest changes: The allowable range for the 10-year JGB yield was widened to -0.20% to +0.20% New forward guidance was introduced indicating no rate hikes until at least 2020 A shift in the BoJ's equity ETF purchases to favor ETF's that target a broader index We were not surprised by the outcome, given that there was absolutely no reason why the BoJ should have even considered a change in policy settings. Back in February, we outlined the three things that we believed must ALL occur before the BoJ could plausibly raise its yield target for the 10-year Japanese government bond (JGB).4 Five months later, none of those conditions has been met (Chart 9): 1) The USD/JPY exchange rate must at least get back to the 115-120 range. USD/JPY has struggled to reach even the bottom end of our target range, only getting to an intraday high of 113.17 on July 19th. The starting point for the yen must be weaker than that before the BoJ can deliver any sort of more hawkish policy that would likely send the yen roaring higher. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5%. The extremely tight Japanese labor market (Chart 10) has finally begun to put upward pressure on wage growth, which now sits at 2.2% on a year-over-year basis. There has been no follow through into core inflation, however, which only got as high at 0.5% in March before sliding back to 0.2% in June. Chart 9None Of Our Conditions For A BoJ Hike Have Been Met Chart 10How Does This Job Market Not Produce Inflation? 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries. We judge this by looking at the residual from a fundamental model of the 10-year JGB yield published by the BoJ. The model includes both the 10-year U.S. Treasury yield as the proxy for global yields, and the share of outstanding JGBs owned by the central bank to measure the impact of BoJ buying (Table 1). That model suggests that current JGB yields are only at fair value, and that U.S. Treasury yields have to rise by a lot more (to at least 3.5%) to make the current level of JGB yields look "expensive", thus justifying a higher BoJ yield target (USD/JPY would likely be in the 115-120 range if that happened, as well). Yet despite all these factors arguing against any change in the BoJ's policy settings, the topic was seriously discussed at last week's policy meeting, according to Reuters.5 The renewed weakness of Japanese inflation scuttled any chance that a serious policy change could be delivered. The decision to widen the allowable yield range for the 10-year JGB yield not associated with any signaled change to the 0% yield target. Investors got the hint, and yields have calmed down after the late July turbulence. The BoJ is increasingly backed into a corner with its hyper-easy monetary policy. There is no spare capacity in the economy, with the unemployment rate at a 25-year low of 2.4% and the BoJ estimating that the output gap is closed. Our own Japan Central Bank Monitor is no longer in negative territory, indicating that the next policy move should be a tightening (Chart 11). The BoJ has indeed been "tightening", but only by reducing the pace of its bond buying. BoJ purchases now only matches the pace of new JGB - a far cry from when the BoJ was buying more than all new JGBs issued between 2013 and 2017 (bottom two panels). Table 1JGB Yield Model Chart 11BoJ Has Been Quantitatively Tightening There is a reported disagreement within the BoJ over the impact of the negative interest rate and yield curve control policies on Japanese bank profitability and lending capacity. Yet any sort of rate hike, at either end of the yield curve, would result in a sharp increase in the yen. To have that happen now would harm Japanese exporters' competitiveness at the worst possible time. Economic growth is decelerating in two of Japan's major trading partners, China and South Korea. At the same time, U.S. protectionism risks trade wars that would slow global trade at a time when Japanese export growth, and business confidence, may already be peaking (Chart 12). We continue to recommend an overweight position in Japanese government debt within hedged global government bond portfolios. Admittedly, the idea of overweighting a market where nearly half of all bonds still have a negative yield does not sound like a path to riches. Yet the BoJ stands out as the one major central bank that has virtually no chance at credibly talking about, much less delivering, any sort of monetary tightening with core inflation close to 0%. If non-Japanese yields continue to rise over the next 6-12 months, as we expect, then JGBs will once again be a relative outperformer in a global bond bear market (Chart 13). Chart 12Japan Is Vulnerable To A Global Trade War Chart 13Stay Overweight JGBs In Hedged Global Bond Portfolios Bottom Line: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The r-star discussion can be found on pages 39-43 of the August 2018 BoE Inflation Report, which can be found here https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2018/august/inflation-report-august-2018.pdf 2 For example, the BoJ's estimates of Japan's r-star can be found here, https://www.boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e06.pdf, while the Bank of Canada's estimates for Canadian r-star can be found here https://www.bankofcanada.ca/wp-content/uploads/2017/11/boc-review-autumn2017-dorich.pdf 3 The BoE estimates full employment to be around the current unemployment rate of 4.25%, which is well below the OECD's estimate of 5.5% shown in the top panel of Chart 5. 4 Please see BCA Global Fixed Income Strategy Special Report "What Would It Take For The Bank Of Japan To Raise Its Yield Target?" dated February 13, 2018, available at gfis.bcaresearch.com 5 https://www.reuters.com/article/us-japan-economy-boj-policy-insight/bojs-architect-of-shock-and-awe-plots-retreat-from-stimulus-idUSKBN1KR0TA Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns