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Highlights Merkel is not revolutionizing but reaffirming Germany's Europhile policy; An earlier date for the Italian election would bring market jitters forward from Q1 2018; Yet a new German-style electoral law would decrease the risks of a populist win; The Tories will retain their majority in U.K. elections. Fiscal policy will ease regardless of the outcome; Close long Chinese equities versus Hong Kong/Taiwan; remain overweight Euro Area equities. Feature Possible early elections in Italy and a narrowing lead for Theresa May in the June 8 U.K. election has unsettled investors over the past week. The former threatens to rekindle the flames of the Euro Area conflagration and has weighed on Euro Area equities (Chart 1). The latter threatens Prime Minister May's mandate and political capital, suggesting that the U.K.-EU Brexit negotiations could be acrimonious later this year. This report deals with both issues. Yes, Italy is a major risk to the Euro Area, and despite general awareness of the election, it is not clear to us that investors realize the depth of the risk. As such, Euro Area equities may outperform developed market peers right until the election. As for the U.K. election, we think its impact on global risk assets is non-existent and its impact on U.K. assets is likely to be fleeting. The bigger threat to global markets remains China. In a March report, we suggested that Chinese policymakers may be testing the waters for broad-based financial and industrial sector reform akin to their late 1990s efforts.1 These reforms could be deflationary in cyclical terms and thus a risk for global growth. We argued that the timeline for these efforts would have to wait for the conclusion of the nineteenth National Party Congress this fall and thus Beijing's policy represented a potential problem for 2018.2 Chart 1Italy Weighs On European Risk Assets Italy Weighs On European Risk Assets Italy Weighs On European Risk Assets Chart 2China: Monetary Tightening Takes A Toll China: Monetary Tightening Takes A Toll China: Monetary Tightening Takes A Toll Then again, President Xi Jinping may flout the rule of thumb in Chinese politics that aggressive policy actions should wait until after the five-year party congresses. Monetary tightening - which could be the first salvo of broader financial-sector reform - has already had negative effects on the real economy (Chart 2). The economic surprise index has corrected, as have China's PMI and LEI. Further Chinese tightening would invariably hurt Chinese demand for imports (Chart 3), which would have negative knock-on effects for EM economies, whose growth momentum appears to have already rolled over (Chart 4). Investors should carefully monitor China over the summer. Any signaling from policymakers that they are willing to move away from the "Socialist Put" and towards genuine deleveraging (not to mention their promised free-market reforms) would have negative global implications. Our colleague Mathieu Savary, of BCA's Foreign Exchange Strategy, has pointed out that Europe's economic outperformance relative to the U.S. is highly leveraged to Chinese liquidity (Chart 5).3 As such, decisions made by policymakers in Beijing will likely be more important for European asset performance than who sits in Rome's Palazzo Chigi. Chart 3Tighter Credit Impulse##br## Will Drag Down Imports Tighter Credit Impulse Will Drag Down Imports Tighter Credit Impulse Will Drag Down Imports Chart 4A Chinese Import ##br##Drag Will Hurt EM A Chinese Import Drag Will Hurt EM A Chinese Import Drag Will Hurt EM Chart 5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity Euro/U.S. Growth Differentials And Chinese Liquidity Euro/U.S. Growth Differentials And Chinese Liquidity We are closing our long Chinese equities / short Taiwanese and Hong Kong equities trade for a gain of 3.45%. While policymakers are already backpedaling a bit, financial tightening inherently raises risks in an excessively leveraged economy. Europe Über Alles? Many clients are asking about German Chancellor Angela Merkel's recent comments on European unity. On the heels of the G7 summit, during which Merkel locked horns with U.S. President Donald Trump, Merkel delivered the most Europhile speech of her career: The era in which we could fully rely on others is over ... That's what I experienced over the past several days ... We Europeans truly have to take our fate into our own hands ... But we have to know that we Europeans must fight for our own future and destiny. To many in the media and financial industry the speech seemed like a massive departure from Merkel's cautious and reticent approach to European policymaking. We could not disagree more. European integration imperatives are intrinsically geopolitical, as we have argued since 2011.4 Members of the Euro Area are integrating not because of liberal idealism or misguided dogmatism on monetary union. Rather, they are engaged in a cold, calculated, and deeply realist political project to remain relevant in the twenty-first century. This net assessment has guided our analysis of various Euro Area crises. We supported our top-down theoretical view with bottom-up data showing that European voters were not revolting against integration. Integration may be elite-driven, but it has broad popular support. Support for the common currency has never dipped below 50% (Chart 6), despite a once-in-a-generation economic crisis, and most European states are pessimistic about their separate futures outside the EU (Chart 7). Chart 6Voters Approve Of The Euro Voters Approve Of The Euro Voters Approve Of The Euro Chart 7EU Exits: Not On Horizon EU Exits: Not On Horizon EU Exits: Not On Horizon German policymakers have operated within these geopolitical confines since the Euro Area sovereign debt crisis began in the waning days of 2009. At every turn of the crisis, whenever one or another German policymaker issued a "red line" regarding what "Berlin cannot accept," the correct view was to bet against that policymaker, i.e. against any Euroskeptic outcome. Since 2010, we have seen: Numerous direct bailouts of member states; A dove appointed to lead the ECB, with Berlin's blessing; Direct ECB purchases of government bonds; Deeper fiscal and banking integration of the Euro Area, albeit at a slow pace; Expansion - not contraction - of Euro Area membership; The reversal of fiscal austerity. We were able to forecast these turns because our constraint-based methodology gave us a high-conviction view that German policymakers would ultimately be forced down the integrationist, Europhile road. The German population did not revolt against these constraints. Germans are not Euroskeptic. We have no idea why many investors think they are: there is no evidence of it in data or history. German history is replete with failed efforts to unify (and lead) the European continent by hook or by crook. The country is cursed with just enough economic prowess to be threatening to its peers and yet not enough to dominate them by force. As such, it is a German national security imperative to ensure that it does not see the rest of Europe coalesce into an economic or military alliance against it. The EU and its institutions, which allow Germany to be prosperous without the threat of an enemy coalition, are therefore worth preserving, even at a steep cost. True, the costs of bailing out Greece, Ireland, Portugal, and Spain tested German enthusiasm for European integration. However, German support for the common currency never dipped below 60% amidst the sovereign debt crisis and has since rebounded to a record high of 81% (Chart 8). Only 20% of Germans are confident of a future outside the EU (Chart 9). Chart 8Rise Of The Europhile Germany Rise Of The Europhile Germany Rise Of The Europhile Germany Chart 9Germany: No Life After EU Death Germany: No Life After EU Death Germany: No Life After EU Death As such, Merkel's statement following the G7 summit is only surprising because it is explicit. Indeed, the reason Merkel made this statement now is not because she suddenly had a grand geopolitical realization, nor because Trump suddenly disabused her of a naïve belief in the benevolence of the United States. Merkel has understood Europe's imperatives for at least a decade. The real reason for her statement is domestic politics. Martin Schulz, Merkel's opponent in general elections to be held on September 24, has tapped into the rising Europhile sentiment among Germans. The Social Democratic Party (SPD) sprang back to life this year following Schulz's appointment as SPD chancellor-candidate. Despite a recent relapse for the SPD in the polls, Merkel wants to ensure that she is not vulnerable on her left flank to the more Europhile Social Democrats. In the face of this renewed threat from the SPD, the venue of Merkel's speech was highly symbolic: a summit of the Christian Social Union (CSU), the Bavarian sister party to Merkel's Christian Democratic Union (CDU), held in a beer hall no less! Bavaria is the most conservative and Euroskeptic part of Germany. Over the past two years, the CSU has flirted with abandoning its post-war electoral alliance with the CDU due to Berlin's various Europhile turns. This development threatened to undermine Merkel and her base of power from within. Merkel's speech, to the most Euroskeptic part of Germany, was designed to prepare her conservative base for a further deepening of European integration. It was not a policy shift but rather a statement that brought her rhetoric more in line with her policy actions. It was also a reminder to her core allies that they must continue on the current policy path unless they would rather have Schulz's SPD force them into even deeper European integration, and faster. What does this mean going forward? We think that the dirty word of European politics - "Eurobonds" - will come into play again. As if on cue, the European Commission has published a report that proposes bundling the debt of Euro Area sovereigns.5 The proposal is not exactly calling for Eurobonds, but rather for securitizing existing bonds into new instruments. As usual, a German finance ministry spokesperson opposed the plan. However, the path of least resistance will be towards more integration that may include such securitization. In fact, Eurobonds already exist. Europe's fiscal backstop mechanisms - formerly the European Financial Stability Facility (EFSF) and now the European Stability Mechanism (ESM) - have both issued bonds to finance sovereign bailout efforts. So has the European Investment Bank (EIB). Their bonds trade largely in line with French sovereign debt, with a 37 basis point premium over German 10-year Bunds (Chart 10). Chart 10 Most importantly, the European Commission - the executive arm of the EU - already has authority to issue bonds and even tap member states for funds in case it needs to fill a gap. As the European Commission cites in its pitch-book to bond investors (yes, you read that correctly), "should the funds available from the EU budget be insufficient, the Commission may directly draw on the Member States, without any extra decision making being required."6 Currently, EU treaties forbid bond issuance that would directly finance the budget of a member state. However, Article 143 lays down the possibility of granting mutual assistance to an EU country facing a balance-of-payments crisis, which the EU Commission handles via its €50 billion balance-of-payments assistance program. In the future, the Commission could issue bonds to finance joint, EU-wide projects for areas like defense or infrastructure. It does not appear that such a decision would require a change to EU treaties. Over the long term, the integration imperative will remain strong in Europe. Ironically, Donald Trump is probably the best thing that has happened to European unity, at least since President Vladimir Putin. However, we think media commentators may be overstating President Trump's impact. The U.S. was already growing aloof toward Europe under President Obama, who overtly tilted his foreign policy towards Asia, and President Bush, whose administration clashed with "old Europe" and merely flirted with "new Europe." With the prospect of the U.S. withdrawing its security blanket, Europeans are being forced to integrate. Otherwise they would have to deal with the full range of global crises - from debt to terrorism to migration to war - as separate, and weak, individual states. And the U.S. is unlikely to return to its post-World War II level of concern regarding European affairs anytime soon. We doubt that even a recession would greatly impede the integrationist impulse on the continent. The Great Financial Crisis was a once-in-a-generation economic crisis and yet it has deepened, not decreased, support for integration. That said, risks remain. While the median voter in Europe appears to support the elite-driven integrationist effort, the median voter in Italy is on the fence. Bottom Line: Merkel's Europhile speech in Bavaria was meant to reinforce the ongoing integrationist path to her domestic audience in an election year. We suspect that Germany under Merkel, along with France under recently elected President Emmanuel Macron, will continue down the same path. At some point in the not-so-distant future, this may include the issuance of Eurobonds for specific projects. Our long-held geopolitical view supports overweighting Euro Area risk assets, given economic momentum and valuations. However, near-term political risks in Italy are substantial and pose the main risk to our strategic view. Italy's Divine Comedy - Coming Soon To A Theater Near You? Early Italian elections - in September 2017, instead of February-May 2018 - have become a real possibility. Matteo Renzi, leader of the ruling Democratic Party (PD) and former prime minister, recently signaled that he would be willing to compromise on a new electoral law, and that it could pass as early as July, given a tentative agreement with the Forza Italia party of former prime minister Silvio Berlusconi. This would satisfy the condition of President Sergio Mattarella that a new electoral law be passed before elections can proceed. What does this development mean for markets? Italian political elites share the same integrationist goals of their European peers. There is no logic in Italian independence from the EU. Rome's ability to patrol its coastline for smugglers bringing in migrants would not improve with independence, nor would its ability to negotiate a low price for Russian natural gas. Italy is, as much as any European country, in terminal decline as a geopolitical power. Membership in the EU is therefore a natural, and realist, response to its weakness. In addition, exiting the monetary union would be fraught with risks that would overwhelm any benefits that Italian exports may gain from devaluation. It is highly unlikely that Germany, France, Spain, and the Netherlands would allow Italy - the Euro Area's third largest economy - to set a precedent of using massive currency devaluation while maintaining access to the Common Market. Rome would in fact break its Maastricht Treaty obligations. These stipulate that every member state, save for Denmark and the U.K., must become a member of the EMU. It would likely be evicted from both the EU and the Common Market. Furthermore, as we discussed in our September net assessment of Italy, the country's 19th nineteenth century unification has never made much sense.7 We would go so far as to argue that Euro Area amalgamation makes more sense than the unification of Italy. Northern Italy remains as much part of "core Europe" as London, the Rhineland, or the Netherlands, whereas the south - the Mezzogiorno - might as well be in the Balkans. We do not see how Rome would afford the Mezzogiorno on its own without access to both the EU's markets and ECB-induced low financing costs. All that said, the median Italian voter is not buying the Euro Area at the moment. Unlike their European peers, Italians seem to be flirting with overt Euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 50% (Chart 11). Similarly, a plurality of Italians appears to be confident in the country's future outside the EU (Chart 12). Chart 11Italy A Clear Outlier On The Euro Italy A Clear Outlier On The Euro Italy A Clear Outlier On The Euro Chart 12Italians Willing To Go Solo? Italians Willing To Go Solo? Italians Willing To Go Solo? Of course, only about a third of Italians identify themselves as only "Italians," largely in line with the Euro Area average and nowhere near the trend in Britain, where the share of the public that feels exclusively British has generally ranged from half to two-thirds (Chart 13). Nevertheless, the Euroskeptic trend in Italy is real and jeopardizes European integration. Our high-conviction view that European politics would be a "red herring" in 2017 was originally based on data that showed that voters in the Netherlands, France, and Germany increasingly supported European integration. This allowed us to dismiss polls that suggested that Euroskeptic politicians - such as Geert Wilders or Marine Le Pen - would do well in this year's elections. Even if they did perform well, the median voter's stance on European integration would force such policymakers to modify their Euroskepticism. This process has already happened in Spain (Podemos), Finland (The Finns, formerly known as the True Finns), and Greece (SYRIZA). In Italy, however, the median voter's Euroskepticism has not abated. As such, parties such as the Five Star Movement (M5S) and Lega Norde (LN) have no political incentive to modify their Euroskepticism. In fact, LN has done the opposite, evolving from a liberal and pro-EU regional sovereignty movement into a far-right, anti-immigrant, Euroskeptic, and nationalist Italian party -- a full brand overhaul. The timing of the upcoming election is difficult to forecast. Nonetheless, Renzi's compromise on changing electoral rules has now increased the probability that the election be held in Q4 2017, instead of Q1 2018. Renzi reportedly favors the same date as the German election, September 24. To accomplish this timetable, the new electoral law would have to be rushed through Italy's bicameral Parliament. The Chamber of Deputies - the lower house - is expected to vote on the compromise law in the first week of June, with the Senate passing the law by July 7. Given that the top four parties all seem to agree with adopting a German-style electoral system - proportional representation, with parties required to gain at least 5% of the vote to gain any seats - this ambitious timeline is possible. However, there are still some minor outstanding issues, which could drag out the process until the fall. In addition, local elections scheduled for June 11 (with a second-round run-off on June 25) could change the calculus of the ruling PD. If Renzi's party underperforms, he may back away from early elections, although the message would be that a strong populist performance in early 2018 is more likely. Polls have not budged much for the past 18 months, although Renzi's PD lost support around the time of its failed December 2016 constitutional referendum (Chart 14). The market may find solace in the fact that the revised electoral law would grant no "majority-bonus" to the winner, virtually ensuring that the Euroskeptic M5S cannot govern on its own. Chart 13Majority Of Italians Are Also Europeans Majority Of Italians Are Also Europeans Majority Of Italians Are Also Europeans Chart 14Ruling Party And Populist M5S Neck-In-Neck Ruling Party And Populist M5S Neck-In-Neck Ruling Party And Populist M5S Neck-In-Neck The risk to the market, however, is that M5S outperforms and then creates a limited coalition with right-wing Euroskeptics. Such a coalition could have the singular goal of calling a "non-binding, consultative" referendum on Italy's Euro Area membership. The official M5S line is that it would call such a referendum "if fiscal policies of the Euro Area did not change." Either way, the Italian constitution forbids referendums on international treaties, but a consultative referendum would give impetus to Euroskeptic parties to start negotiating a Euro Area exit for the country. There are two reasons why such an outcome is possible, if not our base scenario. First, a German-style 5% threshold will eliminate the votes cast for a number of minor parties from the overall calculation. These currently combine to make up about 18% of the total vote. This means that the parties that meet the 5% minimum will gain a larger share of seats in the parliament than they gained of the overall popular vote (82% of the vote will hold 100% of the seats), as is the case in Germany. There is a chance that both the PD and M5S get a considerable seat boost in the final tally that puts them close an overall majority. Second, much will hinge on whether the right wing - and Euroskeptic - Fratelli d'Italia (FdI) enter parliament. They are currently polling at about 5% of the vote. If they gain seats, it would significantly increase the percentage of total seats held by Euroskeptic parties. There is no evidence at the moment that M5S, which is on the left of the policy spectrum, would contemplate such an electoral alliance with LN and FdI. The party remains opposed to any coalitions and we suspect that it would not break its pledge to pursue the highly risky strategy of calling a referendum on the Euro Area. The M5S stands for a lot of different things: anti-corruption, anti-establishment, youth empowerment, etc. Euroskepticism is one of its pillars, not a singular objective. In fact, party leader Beppe Grillo recently attempted to abandon the Euroskeptic alliance with UKIP at the European Parliament to join the ultra-liberal, and Europhile, Alliance of Liberals and Democrats for Europe. Various factions vying for control of the movement oscillate between overt Euroskepticism, aloofness toward Europe, and open support for European integration. In addition, Italian voters may adjust ahead of the election by switching their support away from the various minor parties currently polling below 5% and toward the four major parties. This will likely benefit the ruling PD more than any other party. Out of the four parties highly unlikely to cross the 5% threshold - Campo Progressista (CP), Movimento Democratica e Progressista (MDP), Alternativa Popolare (MP), and Sinistra Italiana (SI) - three are centrist or aligned with the PD. One (Sinistra Italiana) would likely see its voters split between the PD and M5S (Chart 15). Such vote migration would clearly benefit the center-left PD, which Renzi is likely counting on in accepting the German-style proportional electoral system.8 Chart 15Most Minor Party Votes ##br##Would Help Ruling Democrats Most Minor Party Votes Would Help Ruling Democrats Most Minor Party Votes Would Help Ruling Democrats Bottom Line: Investors trying to make sense of the Italian election will find relief in the new electoral law. A purely German-style system - given the current level of factionalism in Italian politics - is unlikely to produce a populist government in Italy. In fact, the center-left PD could see a boost in support as voters switch away from minor parties. The tentative compromise on the electoral law has both increased risks by making an earlier election more likely and decreased risks by reducing the probability of an anti-market result. That said, there is still a possibility that M5S crosses the ideological aisle to form an alliance with right-wing Euroskeptics to try to take Italy out of the Euro Area. We doubt that they will do so. Nonetheless, it will be appropriate to hedge such a risk in currency markets closer to the date of the election, once the date is known. We therefore closed our long EUR/USD recommendation last week for a gain of 3.48%. Whatever the outcome of the election, Italian political risks will remain the main threat to European integration (and assets) going forward. We therefore expect the ECB to keep one eye on Italy, forcing it to be less hawkish than it otherwise would be. We will explore Italian politics and economy further in an upcoming report with our colleagues at BCA's Foreign Exchange Strategy. U.K.: The Election Is About G The latest polling averages show that Prime Minister Theresa May's Conservative Party maintains a 5% lead over Jeremy Corbyn's Labour Party, despite Labour's remarkable rally since early elections were called on April 18 (Chart 16). One projection of actual parliamentary seats that takes into account the crucial factor of voter turnout suggest that the Tories could add from 15 to 34 seats to their 2015 take of 330 seats - and this roughly matches our back-of-the-envelope calculation that the Tories could pick up 11 seats on account of the Brexit referendum (Table 1).9 Chart 16Labour Revives On Snap Election Labour Revives On Snap Election Labour Revives On Snap Election Table 1Referendum Results Offer Some Simple Gains For Tories Has Europe Switched From Reward To Risk? Has Europe Switched From Reward To Risk? There have been only two other cases in recent memory in which Britain's incumbent party led by double digits two months ahead of an election: 1983 and 2001. In the first case, Margaret Thatcher followed up the hugely successful Falklands campaign by expanding her popular support in the final two weeks to win a huge 144-seat majority. In the second case, Tony Blair lost some of his lead but still won the election handily.10 There has not been a case in recent memory where a double-digit lead dropped into single digits as quickly as it did this past month. Moreover, looking at the latest individual polls, it is too soon to say that Labour's rally has ended. Indeed, YouGov's model even shows the Conservatives losing their majority.11 Snap elections are always a gamble, as we have stressed throughout this campaign.12 There is no question that Labour has the momentum and May is feeling the heat. Yet the Tories have a fairly solid foundation of support at the moment. First, they are still polling above 40% support, almost 10% higher than before the referendum, reflecting the rally-around-the-flag effect after voters' surprising decision to leave the EU. They even poll above 40% among working-class voters, the original base of Labour, and the country's aging demographic profile also heavily favors them. (Youth turnout would have to surprise upward to upset the Tories.) Second, the Tory strategy of gobbling up supporters of the U.K. Independence Party (UKIP) has succeeded (Chart 17). UKIP has no raison d'être after achieving its foundational goal of Brexit. The Conservative Party's decision to hold a referendum on the EU was, in fact, driven by this rivalry from the right flank. UKIP posed the chief threat to the Tories through its ability to dilute their vote share in Britain's first-past-the-post electoral system. Now, almost all conservative voters will vote for the Conservative Party, while Labour must still compete with the Liberal Democrats, Greens, Scottish National Party, and Welsh Plaid Cymru in various constituencies (Chart 18). Chart 17Tories Keep Devouring UKIP Tories Keep Devouring UKIP Tories Keep Devouring UKIP Chart 18Labour Has Rivals, Tories Do Not Labour Has Rivals, Tories Do Not Labour Has Rivals, Tories Do Not Third, while May's popularity is merely converging with her party's still-buoyant level, Corbyn is less popular than both May and his own party (Chart 19). Corbyn still has a net negative favorability and is seen as less "decisive" and less "in touch" with voters than May. Fourth, voters still see Brexit as the most important issue of the election (Chart 20) and May as the best candidate to manage the tricky exit negotiations ahead. Because Brexit is the driver, the benefit of the doubt goes to the Tories. The 2015 elections, the EU referendum, the polls since the referendum, and the parliamentary votes (driven by popular pressure) enshrining the referendum result all suggest a great deal of public momentum on this key issue. The only truly historic development that could have broken this momentum, given that the economy is holding up, is the Tory decision to seek a "hard Brexit," i.e. exit from the EU's Common Market. Yet opinion polls show that Brexit still has the support of a majority of likely voters; moreover, 55% of voters would rather have "no exit deal" than "a bad exit deal."13 If voters still see this as the defining issue, then the Tories still have a key advantage. On the other hand, perceptions of Jeremy Corbyn and Labour have improved rapidly and May's simultaneous popularity slump is especially important in this election. She is a "takeover prime minister" (having initially gained the office when Cameron resigned rather than leading her party into an election as the presumed prime minister) and thus highly vulnerable. This election is largely about her need for a "personal mandate."14 Her political missteps (both real and perceived) are very much at issue in this particular election. Chart 19May Lifts Tories, Corbyn Drags Labour May Lifts Tories, Corbyn Drags Labour May Lifts Tories, Corbyn Drags Labour Chart 20 If polls continue to narrow, the election could produce a "hung parliament," in which no single party holds the 326 seats necessary for a majority in the House of Commons. What should investors expect in that scenario? First, May would have the chance to rule a minority government or form a coalition. A minority government would be weak, vulnerable to collapse under pressure, and would have a harder time controlling the Brexit negotiations. As for a coalition, there is very little chance that the other major parties would cooperate with her - the Liberal Democrats would not reprise their role as coalition partner from 2010-15. But there is a slim chance that the Democratic Unionist Party (DUP) of Northern Ireland could unite with the Tories to obtain a majority. The DUP has not exercised real power in a century, literally, and several of its members do not normally even take their seats in Westminster. However, the party is Euroskeptic and could provide just enough support to accomplish the single goal of a Tory-led Brexit. Suffice it to say that this outcome is not impossible - the Tories have been courting the DUP for months and the existence of a historic "common cause" changes the usual parliamentary dynamic. Still, this arrangement would be highly unusual, causing a massive uproar, and would lead to all kinds of uncertainties about parliament's ability to pass a final Brexit deal in 2019. Second, assuming May fails, the Labour Party would have to rule in the minority or form a coalition (if informal) with the Scottish National Party, LibDems, Plaid Cymru, Greens, and others. Here are the most likely outcomes of such an arrangement, in broad brush strokes: Brexit will in all likelihood proceed, given that all parties have professed respect for the referendum outcome. Since the new government would likely not seek to curtail immigration as strictly, it could seek to retain membership in the Common Market. However, a la carte membership in the Common Market remains the greatest difficulty with the EU member states, and therefore it is possible that even Labour would have to accept the logic of exiting the Common Market. In fact, we could see Labour's insistence on access to the Common Market producing more acrimony with the EU than the Tory clean-break strategy. Nevertheless, the odds of a "Brexit cliff" in which the U.K. exits without a trade deal would fall from their already low level, given Labour's unwillingness to let that happen. Despite moving ahead with Brexit, a Labour-led government would increase the relatively low probability of an eventual reversal of the decision, given that it would be more inclined to accept or encourage such an outcome in the face of a bad exit deal, a recession, or other challenges that cause public opinion to shift. The Scottish National Party would probably sideline its demands for a second Scottish independence referendum - especially given that polls supporting a second referendum have floundered for the time being - though not permanently.15 Fiscal spending would increase as a result of Labour's and the SNP's campaign promises and greater focus on domestic social issues. Even if May avoids squandering her party's majority (our baseline case), there are several important takeaways from her drop in the polls: Chart 21Dementia Tax' Gaffe Added To Tory Woes Dementia Tax' Gaffe Added To Tory Woes Dementia Tax' Gaffe Added To Tory Woes The median voter wants government support: The Labour Party's rally began as soon as elections were called, with left-leaning voters switching away from the LibDems once they saw a chance to challenge the ruling party. But the Tories took a hit from May's unprecedented (and publicly awkward) reversal on a party manifesto pledge only days after publishing it (Chart 21). The pledge, now infamous as the "dementia tax," was an attempt at fiscal tightening by which the government would include the value of an elderly person's home in the assessment of their financial means when it came to government support for social care. By contrast, Labour has rallied on the back of a party manifesto that promises fiscal expansion in various categories, including £7.7 billion additional funds for health care, social care, and nursing. More broadly, National Health Service funding, rent caps, and a higher "living wage" are the top four campaign pledges that gain above 60% popular support. As we elucidated last year, the two economies that most enthusiastically embraced a laissez-faire model - the U.S. and the U.K. - are now experiencing the most effective swing to the left.16 The U.K. campaign confirms that, with the Tories minimizing cuts and Labour offering greater spending. Brexit means Brexit: 69% of the public claims that government should follow the referendum outcome, and 52% favor Theresa May's proposed Brexit strategy. The opposition parties are not openly opposing the referendum outcome, as mentioned. Moreover, Labour's pledge to prevent the U.K. leaving the bloc without a trade deal is one of the least popular campaign pledges (only 31% approve), while the Liberal Democrats' pledge to hold a second nationwide referendum on the outcome of the exit talks is also unpopular (34% approve) (Chart 22). Labour is recovering support by focusing on its bread-and-butter, left-wing, social platform. Terrorism is not driving voters: The tragic terrorist attacks at parliament, Manchester, and London Bridge have hardly given May and the Tories any additional support despite being the party viewed as stronger on security. Amid a bull market in terrorism, British voters, like European peers, are becoming somewhat inured to periodic attacks against "soft" targets.17 Health is a bigger concern than immigration: A large majority of Britons think immigration has been too high in recent years, but only about 25% think it is a major issue facing the country, compared with 43% who cite health care as a major issue (see Chart 20 above). These are not completely independent issues because many people believe that immigrants are putting pressure on scarce health care resources. Immigration is closely tied to Brexit and will remain a burning issue if the government does not convince voters that it is more vigilant. But the Labour Party's greater support on health care (as well as education and other social issues) is a growing liability to the Tories as Brexit becomes more settled. If Brexit was a revolt against the elites, it is not necessarily the only manifestation of that revolt. The elitist Tories should be careful that they do not rest on their laurels having been on the right side of that particular issue. The key takeaway is that, aside from Brexit, fiscal policy is the driving issue in British politics. Brexit was not only a vote about sovereignty and immigration, it was also a demand from the lower and middle classes for an end to second-class status. That is why May highlighted the need for government to moderate the forces of globalization and capitalism and make the economy "work for everyone" in her October 2016 speech at the Conservative Party conference and in her rhetoric since then.18 Chart 22 That is also why the ruling party has already eased fiscal policy. In his first Autumn Statement, Chancellor Philip Hammond abandoned his predecessor George Osborne's promise to eliminate the budget deficit by 2019, pushing the timeline to beyond 2022 (Chart 23). The latest budget projections by the Office for Budget Responsibility show that the current government is projecting more spending than its predecessor (Chart 24). Chart 23 Chart 24 The Tories are also claiming that they will reboot the country's industrial strategy to improve productivity, which will become all the more imperative if they even partially follow through on their pledge to cut immigration numbers from the current annual ~250,000 to under 100,000, which will necessarily reduce labor force growth and thus also potential GDP growth.19 The National Productivity Investment Fund will need a projected £23 billion just to get on its feet. Given that Labour is proposing even more ambitious spending increases (£49 billion additional spending through 2022), the direction of U.K. politics - away from austerity - is clear regardless of the election outcome. Finally, our colleagues at BCA's Global Fixed Income Strategy expect the Bank of England to maintain loose monetary policy for the foreseeable future, being unable to turn more hawkish against inflation in the context of continued risks and uncertainties related to Brexit.20 Thus monetary and fiscal conditions are both accommodative for the short and medium term. Given that we do not expect the European Union to exact crippling measures on the Brits for leaving, as we have outlined in previous reports,21 the result is a relatively benign environment for the U.K., at least until the business cycle turns, the effects of Brexit begin to bite, and/or global growth slows down. The combination of fiscal stimulus and easy monetary policy, however, could weigh on the pound regardless of the election outcome. As such, we closed our short USD/GBP last week for a gain of 3.34%. Bottom Line: We do not expect a hung parliament; most signs suggest that the Tories will retain at least a weak majority. However, a hung parliament that produces a Labour-SNP alliance would not likely reverse Brexit (though it would make a reversal more conceivable). Such an alliance could eventually result in an exit deal that is both less politically logical than the Tory deal (because London would pay to stay in the Common Market yet have less say in how it is managed) and more favorable to the British economy in the long run (because retaining the benefits of Common Market access). But this is not a foregone conclusion. We maintain our view that Brexit itself has largely ceased to have concrete market-relevant impacts other than a decline in Britain's long-term potential GDP growth. There are two reasons for this. First, May has ruled out membership in the Common Market and thus has removed a potential source of acrimony with Brussels over any "special treatment." Second, the EU does not want to precipitate a crisis in the U.K. that could reverberate back onto the continental economy. Investment Implications We remain strategically overweight European equities relative to their U.S. peers, a trade that has returned 7.39% thus far. We would remind clients that we closed our long GBP/USD and long EUR/USD tactical trades last week for 3.34% and 3.48% gains, respectively. We are also booking a 3.45% profit on our "One China Policy" strategic trade (long Chinese equities as against their Taiwanese and Hong Kong peers). We still think policymakers will do everything they can to keep China's economic growth stable ahead of the party congress this fall, but, as we discussed in our May 24 missive,22 the decision to tighten financial regulation is risky and threatens to cause unintended consequences. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, “China Down, India Up?” dated March 15, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, “Political Risks Are Understated In 2018,” dated April 12, 2017, available at gps.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, “ECB: All About China?” dated April 7, 2017, available at fes.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, “Europe’s Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011; and “Europe: The Euro And (Geo)politics,” dated February 11, 2015, available at gps.bcaresearch.com. 5 Please see European Commission, “Reflection paper on the deepening of the economic and monetary union,” May 31, 2017, available at ec.europa.eu. 6 Please see European Commission, “EU Investor Presentation,” April 7, 2017, available at ec.europa.eu. 7 Please see BCA Geopolitical Strategy Special Report, “Europe’s Divine Comedy: Italian Inferno,” dated September 14, 2016, available at gps.bcaresearch.com. 8 The only minor party that is Euroskeptic, FdI, is just close enough to the 5% threshold that its voters are unlikely to abandon it. They will not likely give the Euroskeptic Lega Norde and M5S much of a boost. 9 Please see Lord Ashcroft Polls, “2017 Seat Estimates: Overall,” May 2017, available at lordashcroftpolls.com. 10 In the 1997 election, Tony Blair and Labour led by double digits, but they were in the opposition. Their lead in the polls shrank slightly before Blair won a 178-seat majority, even larger than Thatcher’s 144 seats in 1983 and Clement Attlee’s 147 seats in 1945. 11 Please see YouGov, “2017 UK General Election Model,” accessed June 6, 2017, available at yougov.co.uk. 12 Please see BCA Geopolitical Strategy Weekly Report, “Buy In May And Enjoy Your Day!” dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see Anthony Wells, “Attitudes to Brexit: Everything We Know So Far,” March 29, 2017, available at yougov.co.uk. 14 Please see footnote 12 above. 15 Please see The Bank Credit Analyst and Geopolitical Strategy Special Report, “Will Scotland Scotch Brexit?” dated March 30, 2017, available at bca.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, “Brexit Update: Does Brexit Really Mean Brexit?” dated July 15, 2016, and “Brexit Update: Red Dawn Over Britain” in Geopolitical Strategy Monthly Report, “King Dollar: The Agent Of Righteous Redistribution,” dated October 12, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, “With Or Without You: The U.K. And The EU,” dated March 17, 2016, available at gps.bcaresearch.com. 20 Please see BCA Global Fixed Income Strategy Weekly Report, “Adventures In Fence-Sitting,” dated May 16, 2017, available at gfis.bcaresearch.com. 21 Please see “Brexit: A Brave New World” in BCA Geopolitical Strategy Weekly Report, “The ‘What Can You Do For Me’ World?” dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, “Northeast Asia: Moonshine, Militarism, And Markets,” dated May 24, 2017, available at gps.bcaresearch.com.

Highlights Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. Several measures of equity markets have reached or are close to their previous structural peaks. In the second half of 1990s, booming U.S. and European growth as well as the tech mania, did not preclude a bear market in commodities and EM financial markets. Overall, EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Falling commodities prices will weigh on Indonesia's terms of trade. Equity investors should maintain an underweight position in this market and currency traders should continue shorting the rupiah. Feature A New Era? Money has been flowing into EM financial markets, irrespective of the evolution of many economic and financial variables that have in the past shaped markets dynamics. Indeed, EM share prices and currencies have refused rolling over despite a relapse in a number of variables they have historically been correlated with. EM share prices have continued to surge, even though the aggregate EM manufacturing PMI has rolled over (Chart I-1). Chart I-1Unsustainable Decoupling Unsustainable Decoupling Unsustainable Decoupling The recent relapse in the EM manufacturing PMI has not hurt EM currencies either (Chart I-2, top panel). In addition, EM currencies have diverged from commodities prices, an unprecedented historical occurrence (Chart I-2, bottom panel). The same applies to EM versus DM relative equity performance. Chart I-3 demonstrates that EM share prices have outperformed their DM counterparts year to date, even though the EM manufacturing PMI considerably underperformed DM's. Chart I-2Untenable Divergence Untenable Divergence Untenable Divergence Chart I-3Relative Share Prices And Relative PMIs Relative Share Prices And Relative PMIs Relative Share Prices And Relative PMIs Notably, EM stock prices have even defied the recent setback in EM net earnings revisions (Chart I-4). Typically, the latter correlate with swings in share prices, but this time both variables have diverged. Finally, it is important to note that this phenomena of decoupling cannot be explained by the performance of technology stocks. EM share prices excluding technology companies have still rallied, albeit much less, despite the decline in EM net earnings revisions and the EM manufacturing PMI. Remarkably, China's H shares - the index that does not include U.S.-listed Chinese internet/social media companies and is instead "heavy" in banks and "old economy" stocks - have still ignored both the drop in China's manufacturing PMI and rising local interest rates (Chart I-5). Chart I-4Even Analysts' Net EPS ##br##Revisions Have Rolled Over Even Analysts' Net EPS Revisions Have Rolled Over Even Analysts' Net EPS Revisions Have Rolled Over Chart I-5Puzzling... Puzzling... Puzzling... One could argue that the dominant macro drivers of EM in recent months have been the U.S. dollar and U.S. bond yields, both of which have downshifted since mid-December 2016. If the greenback and expectations of Federal Reserve policy continue to shape EM performance, the outlook is not much better. The basis is that the Fed will likely continue to hike interest rates if global stocks continue to rally. Notably, U.S. corporate bond yields/spreads are very low, the dollar is already down quite a bit, U.S. asset prices are reflating and U.S. economic growth is decent. If the Fed does not normalize interest rates now, when and under what conditions will it? Similarly, investor sentiment on the U.S. dollar is no longer bullish, and the market expects only 44 basis points in Fed rate hikes over the next 12 months. The latter is a low bar. We maintain that the dollar's selloff - even though it has lasted longer than we previously expected - is late, especially versus EM currencies. Bottom Line: Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. As and when this happens - our hunch is that it is a matter of weeks not months - EM risk assets will sell off materially and underperform their DM counterparts. Signs Of A Top? Or Is This Time Different? The EM equity rally has been facilitated by the tech mania occurring worldwide as well as by falling financial market volatility and risk premia - leading investors to bet on EM carry trades. A relevant question is whether these trends are close to the end or have much further to go. We have the following observations: EM share prices in local currency terms, as well as the KOSPI and Taiwanese TSE indexes in U.S. dollar terms, all are testing their previous highs which they have never broken out from (Chart I-6). The question we would ask is: Why should this time be different, or why would these indexes break out this time around? In our opinion, EM fundamentals, including the outlook for EPS growth, remain poor. We have elaborated on this issue at length in previous reports1 and stand by our assessment. On many metrics, the U.S. equity market is expensive, and the rally is overstretched (Chart I-7). Chart I-6Facing A Major ##br##Technical Resistance Facing A Major Technical Resistance Facing A Major Technical Resistance Chart I-7U.S. Stocks Are Expensive ##br##And Overstretched U.S. Stocks Are Expensive And Overstretched U.S. Stocks Are Expensive And Overstretched These charts do not provide clues for the timing of a reversal, but when all these ratios reach their previous secular tops, investors should be critically examining the investment outlook. Our take is as follows: Without a broad-based U.S. corporate profit recession, a major bear market in the S&P 500 is not likely, but share prices could soon hit a major resistance and correct meaningfully from the current expensive and overbought levels. While EM stocks are not expensive, the outlook for their share prices is negative because we expect EM earnings to shrink again by early next year1. Finally, not only is U.S. equity market volatility extremely muted but EM equity as well as U.S. bond market volatility are testing their previous lows (Chart I-8). When implied volatility reached these low levels in the past, it marked a major market reversal. Bottom Line: Several measures of equity market performance have reached or are close to their previous structural peaks and financial markets volatility is at record lows. While one can make the case that this time is different and this EM equity rally will persist, we continue to err on the side of caution. Tech Mania And EM In The 1990s A recent narrative in the marketplace has been as follows: given the share of tech stocks' market cap has risen to 26%, and commodities sectors presently account for only 14% of the EM MSCI benchmark, it makes sense that EM equities have decoupled from commodities prices and have become correlated with tech stocks and DM growth. In this respect, it is instrumental to revisit what happened in the second half of the 1990s, when global tech/internet and telecom stocks were in the midst of a mania like social media/tech stocks nowadays. We have the following observations on this matter: EM share prices, currencies, and bonds plunged in the second half of the 1990s, even though U.S. and European real GDP growth was extremely strong - 4.5% and 3% on average, respectively (Chart I-9, top panel) - and the S&P 500 was in a full-fledged bull market. Chart I-8Volatility: As Low As It Gets Volatility: As Low As It Gets Volatility: As Low As It Gets Chart I-9EM Stocks And DM Growth In The 1990s EM Stocks And DM Growth In The 1990s EM Stocks And DM Growth In The 1990s EM share prices collapsed in 1997-'98, even though U.S. and European import volumes were expanding at a double-digit rates (Chart I-9, middle panel). Furthermore, the crises originated in emerging Asian countries such as Thailand, Korea and Malaysia that were large exporters to advanced economies. Besides, the share and importance of the U.S. and European economies was much larger 20 years ago than it is now. Back then, China was negligible in terms of its impact on EM in general and commodities in particular. The question is, if an economic boom in the U.S., and Europe in the second half of the 1990s did not preclude crises in export-oriented economies in East Asia, why would moderate DM growth today - as well as their much smaller share of global trade - boost EM share prices from already elevated levels. Twenty years ago, EM share prices fell along with declining U.S. bond yields (Chart I-10). The Fed hiked rates only once by 25 basis points in March 1997. In the past 18 months, the Fed has already hiked 3 times. In fact, the U.S. dollar was in a bull market in the second half of the 1990s, despite falling U.S. bond yields during that period. EM stocks collapsed along with falling commodities prices in 1997-'98 (Chart I-11, top panel) even though the S&P 500 was in the midst of a major bull market (Chart I-11, bottom panel). Chart I-10The 1990s: EM Bear Market ##br##Was Not Due To Rising U.S. Bond Yields The 1990s: EM Bear Market Was Not Due To Rising U.S. Bond Yields The 1990s: EM Bear Market Was Not Due To Rising U.S. Bond Yields Chart I-11EM Stocks, Commodities And The S&P 500 EM Stocks, Commodities And The S&P 500 EM Stocks, Commodities And The S&P 500 Importantly, the mania sectors of the late 1990s - technology and telecom - accounted for approximately 33% of EM market cap in January 2000. Presently, following an exponential rally and outperformance, technology and social media/internet stocks make up 27% of the EM MSCI benchmark. In addition, the market cap of energy and materials companies stood at 19% of the MSCI EM equity benchmark in January 2000, compared with 14% presently (Chart I-12). Hence, the market cap of commodities sectors was not substantially larger in the late 1990s than today. Chart I-12 Finally, Korean and Taiwanese bourses have historically had a high positive correlation with both oil and industrial metals prices (Chart I-13). The reason for this relationship is that both economies are leveraged to the global business cycle, and commodities prices are often driven by global trade cycles. Chart I-13Asian Bourses And Commodities Prices Asian Bourses And Commodities Prices Asian Bourses And Commodities Prices Bottom Line: In the late 1990s, EM crises/bear markets occurred despite booming U.S. and European growth, and at a time when these economies were much more important to EM than they are today. The EM bear market also occurred amid the S&P 500 bull market and falling U.S. bond yields. To be sure, we are not suggesting that everything is identical between today and the 1990s, but all the above suggests to us that EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Profits, China And Commodities Redux", dated May 31, 2017, link available on page 16. Indonesia: Facing Commodities Headwinds (Again) Decelerating Chinese growth and falling commodities prices will weigh on Indonesia's exchange rate (Chart II-1). In turn, not only will the currency depreciation undermine foreign currency returns to investors in stocks and local bonds, but it will also exert upward pressure on local rates. The latter will extend the credit downturn and weigh on domestic demand. Chinese imports of Indonesian coal have begun falling in volume terms (Chart II-2). Consistently, Chinese thermal coal prices - the type of coal that China buys from Indonesia - have also rolled over decisively after rallying sharply in 2016. Chart II-1Indonesia Currency ##br##And Commodities Prices Indonesia Currency And Commodities Prices Indonesia Currency And Commodities Prices Chart II-2Indonesia's Coal Exports ##br##To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Indonesia's exports of base metals and oil/gas to China are also declining in U.S. dollar terms. Commodities exports account for around 30% of Indonesia's total exports. As such, falling commodities prices will lead to negative terms of trade for this nation. On the domestic front, consumer demand remains sluggish. Although auto sales have revived, motorcycles sales are still declining for a fourth consecutive year (Chart II-3). Meanwhile, capital expenditures are tame. Capital goods imports are no longer contracting, but there has been no recovery so far (Chart II-4). Chart II-3Consumer Spending: ##br##Auto And Motorcycle Sales Consumer Spending: Auto And Motorcycle Sales Consumer Spending: Auto And Motorcycle Sales Chart II-4Indonesia: Capex Is Sluggish Indonesia: Capex Is Sluggish Indonesia: Capex Is Sluggish Bank loan growth has not recovered much (Chart II-5) despite low interest rates and a benign external backdrop since early 2016, specifically the revival in commodities prices and large foreign portfolio inflows. NPLs on banks' balance sheet will rise further due to weak growth and lower commodities prices. That, in turn, will dent banks' willingness to grow their loan book. In regard to the credit cycle, Indonesia might be following India's example with a several year lag. In India's banking system, high NPLs have curtailed public banks' desire to lend and, consequently, capital spending has been in disarray. Similarly, Indonesia's credit-sensitive consumer spending and investment expenditure growth will disappoint in the next 12 months as credit growth slows anew. Finally, at a trailing price-earnings ratio of 19.6, equity valuations are not attractive. The poor growth outlook that we foresee does not justify such high multiples. Besides, relative performance of this bourse versus the overall EM equity benchmark is stuck between technical support and resistance (Chart II-6). We are biased to believe that it will relapse from the current juncture. Chart II-5Indonesia's Credit Cycle Is Not Out Of The Woods Indonesia's Credit Cycle Is Not Out Of The Woods Indonesia's Credit Cycle Is Not Out Of The Woods Chart II-6Indonesian Equity Relative Performance Indonesian Equity Relative Performance Indonesian Equity Relative Performance Bottom Line: Weaker commodities prices emanating from slower Chinese growth will hurt Indonesia's currency. We recommend equity investors to keep an underweight position in this bourse. Also, we remain short IDR versus the U.S. dollar and underweight local currency bonds within the EM universe. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The global economy remains awash in massive amounts of oversupply, reflecting extraordinary levels of capex in emerging markets. This will weigh on global inflation. Thanks to a tighter labor market, the U.S. is likely to suffer less from this force than the euro area or commodity producers. In this context, the tightening in Chinese and U.S. policy could represent a severe blow to the recent improvement in global trade. Continue to hold some yen and some dollars but stay short commodity and European currencies. Feature The U.S. is in its eighth year of recovery, yet core PCE is clocking in at a paltry 1.5% despite the headline unemployment rate standing 0.3% below its long-term equilibrium and despite incredibly low interest rates. The phenomenon is not unique to the U.S., euro area core CPI remains a meager 1% and even Germany, despite experiencing an unemployment at 26 year lows, is incapable of generating core inflation beyond 1.6%. Let us not even broach the topic of Japan... So what lies behind this low inflation environment? Not Enough Capex Or Too Much Capex? Capex in advanced economies has averaged 21% of GDP since 2008, compared to an average of 24% of GDP between 1980 and 2007, suggesting that the supply side of the economy is not expanding as fast as before (Chart I-1). Historically, countries plagued by low investment rates have tended to experience higher inflation. Simply put, these low investment rates mean these economies do not enjoy high labor productivity growth rates, causing severe bottlenecks. When these capacity constraints are hit, inflation emerges. This time around, the low investment rate in advanced economies is not yielding this development. Why? One reason is that demand has been hampered by the rise in savings preferences that emerged following the financial crisis (Chart I-2). But another phenomenon is also at play. Global capex has remained very elevated. Chart I-1Low Investment In DM ##br##Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Chart I-2Post 2008: ##br##Marked Preference For Savings Post 2008: Marked Preference For Savings Post 2008: Marked Preference For Savings As Chart I-3 illustrates, global capex has averaged 25.2% of world GDP since 2010, well above the international average from 1980 to 2009. This is simply a reflection of the massive amount of capacity expansion that continues to materialize in the EM space, where investment has equaled more than 30% of GDP for eight years in a row. This matters because since the 1990s, the world has experienced a massive outward shift in the aggregate supply curve, resulting in an extended period of falling inflation and then, low inflation, independent of the state of growth or of long-term inflation expectations (Chart I-4). Chart I-3Global Capex Is High Global Capex Is High Global Capex Is High Chart I-437 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance In the 1990s, this expansion of global production capacity reflected the addition of billions of potential workers to the international capitalist system, but this phenomenon slowed massively in the 2000s and is now over (Chart I-5). Instead, the driver of the expansion of the global supply curve has since become the rampant investment taking place in developing economies, which has resulted in a massive increase in the capital-to-GDP ratio for the entire planet (Chart I-6). Chart I-5 Chart I-62000s To Present: Capital Drives##br## The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion In the first decade of the millennium, this massive increase in the level of global capacity was still manageable. Global real GDP growth expressed in purchasing-power parity terms averaged 7% from 2000 to 2008 and was able to absorb some of the productive capacity being added to the world economy. As a result, core inflation average 2% in the OECD while short-term and long-term interest rates averaged 2.9% and 4.1%, respectively. However, since 2009, global GDP growth expressed in purchasing-power parity terms has only averaged 4.6%, despite a continued robust pace of investment globally, suggesting that now, supply growth is outstripping demand growth by a greater margin than in the previous cycle. This means that to achieve an average core inflation rate of 1.8% in the OECD, short-term and long-term interest rates have needed to average 0.7% and 2.4%, respectively. Going forward, the problem is that global excess capacity has not been expunged. With credit growth still limited in the G10 and in a downtrend in China (Chart I-7), deflationary tendencies are likely to remain a prevalent feature of the global economy for the rest of the business cycle. Thus, central banks the world over will find it very difficult to tighten monetary policy by much without re-invigorating downward spirals in inflation. While this problem applies to the Fed - a case cogently described by Lael Brainard this week - this is even truer for many other economies. The global trend in inflation is a function of this global expansion in supply, but domestic dynamics can still affect the dispersion of national inflation rates around this depressed global level. As Chart I-8 shows, countries with an unemployment rate substantially below equilibrium - a negative unemployment gap - do experience higher levels of inflation. Today, this puts the U.S. on a path toward higher inflation relative to the euro area. This suggests that there remains a valid case to expect a tightening of monetary conditions in the U.S. vis-à-vis the euro area. Chart I-7Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Chart I-8 In this vein, Japan is an interesting case. Japan does have one of the most negative unemployment gaps among major economies, yet it experiences one of the lowest inflation rates. Japan is such an outlier that if it were excluded from the chart above, the explanatory power of the employment gap on inflation would double. This is because Japan has to grapple with another, even more pernicious problem: chronically depressed inflation expectations. Hence, the BoJ has to commit to an "irresponsibly easy" monetary policy and keep the economy growing above its potential for an extended period of time to genuinely shock inflation expectations upwards if it ever wants to remotely approach its 2% inflation target. Thus, we should remain negative the yen on a cyclical basis, only buying the JPY when asset markets are at risk. Bottom Line: The global economy remains awash in excessive supply. In the 1980s and 1990s, much of the supply expansion reflected an increase in the global labor force; since the turn of the millennium, the global supply expansion has been a function of high investment rates in developing economies. Without credit growth, the global economy will be hostage to deflationary pressures, at least for the rest of this cycle. Despite this picture, among major economies, the U.S. needs the smallest amount of monetary accommodation, supporting a bullish dollar stance. Policy Mistake In The Making? In this context of global overcapacity, low growth and underlying deflationary pressures, deflationary policy mistakes are easy to come by, and the world economy may be facing two such shocks. In and of itself, the U.S. economy may be able to handle higher rates. Even if inflation is likely to remain low by historical standards, a rebound toward 2% could happen later this year. At the very least, our diffusion index of industrial sector activity suggests that the recent inflation deceleration in the U.S. may be over (Chart I-9). However, it remains to be seen if EM economies, which is where the true excess capacity still lies, can actually handle higher global real rates. The rollover in our global leading indicator diffusion index is perplexing and points to a deceleration in global growth, a potential warning sign about the frailty of the global economy (Chart I-10). Additionally, it is true that 1% CPI inflation in China does not necessitate much of a strong policy response by the PBoC. But the vast swathe of cumulative capital investment in China implies that this country could suffer from the greatest amount of excess capacity (Chart I-11). China required a massive amount of stimulus in 2015 and early 2016 to generate a small rebound in growth. Thus, the current tightening in Chinese monetary conditions, as small as it may be, could be enough to prompt another wave of weakness in that country. The recent softness in PMIs - with the Caixin gauge falling below 50 - could be a symptom of this problem. Chart I-9U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... Chart I-10...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating Chart I-11China Is Oversupplied China Is Oversupplied China Is Oversupplied Making the situation even more precarious is that China stands at the apex of the overcapacity problem, which makes it prone to develop virtuous and vicious cycles. Chinese corporate debt stands at 180% of GDP, heavily concentrated in state-owned enterprises and heavy industries. This means that swings in producer prices can have a deep impact on real rates. Based on a 10 percentage points swing in PPI, Chinese real rates were able to collapse from 10% to -1% in the matter of 12 months last year. The problem is that for this PPI rebound to happen, Chinese monetary conditions had to ease greatly (Chart I-12). Now that Chinese monetary conditions are tightening and now that commodity prices are weakening anew, PPI could once again fall toward 0%, lifting real rates to 4.4% in the process (Chart I-13). Chart I-12Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chart I-13Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up This means that the already emerging contraction in manufacturing and the recent deceleration in new capex projects could gather further momentum (Chart I-14). As credit flows dry up because of the increasing price of credit in a weakening and over-supplied economy, so will Chinese imports, which are so sensitive to the investment cycle and credit impulse (Chart I-15). This is a problem because the recent bright patch in the global economy was based on this rebound in Chinese demand. In the wake of the Chinese growth acceleration last year, global exports and export prices rebounded sharply (Chart I-16). However, now that China is facing a renewed slowdown, this improvement is likely to dissipate. Chart I-14Problems With Chinese Growth Problems With Chinese Growth Problems With Chinese Growth Chart I-15Slowing Chinese Credit Will Hurt Chinese Imports... bca.fes_wr_2017_06_02_s1_c15 bca.fes_wr_2017_06_02_s1_c15 Chart I-16...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade This is obviously negative for the commodity currency complex. Not only does this mean that the negative terms of trade shock that is affecting many commodity producers could deepen - for example iron ore futures continue to fall and are now down 39% since mid-march - but also, monetary policy could be eased relative to the U.S. Actually, our monetary stance gauge, based on real short rates and the slope of the yield curve, already highlights potential weaknesses for AUD/USD (Chart I-17). This development is also a problem for Europe. As we have highlighted before, European growth is three times more levered to EM dynamics than the U.S. economy is. Also, employment in the manufacturing sector in the euro area is still five percentage points above that of the U.S., underscoring the euro area's greater exposure to global manufacturing and global trade. This means that if Chinese troubles deepen, the closing of the European unemployment gap might slow, at least relative to the U.S. where the unemployment rate is already below equilibrium. Therefore, the high-time to bet on a tightening of European policy relative to the U.S. could be passing. Already, before the European economy has even been hit by a negative shock from EM, the euro looks vulnerable. Investors are very long the euro, but also EUR/USD has dissociated enough from interest rate fundamentals that it is now expensive on a short-term basis. The relative monetary stance gauge between the euro area and the U.S. is pointing toward trouble ahead (Chart I-18). This trend may be magnified if, as we expect, global goods prices weaken anew. Another problem for the euro is that now that the world has embraced president Macron with a firm handshake, political risk may be once again rearing its ugly head in Europe. The Italicum electoral reform in Italy is progressing and there may be a new prime minister sitting in the Palazzo Chigi in Rome this fall. The problem is that the Italian public remains much more euroskeptic than France and the euro is supported by barely more than 50% of the population (Chart I-19, top panel). With euroskeptic and pro-euro parties standing neck-and-neck in the polls, the risk of a referendum on the euro in the area's third largest economy is becoming increasingly real (Chart I-19, bottom panel). Chart I-17Relative Monetary Conditions ##br##Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Chart I-18Euro At ##br##Risk Euro At Risk Euro At Risk Chart I-19Italy Is Not ##br##France Italy Is Not France Italy Is Not France The yen could benefit if the combined impact of higher U.S. rates and tighter Chinese policy proves to be a mistake. Our composite indicator of global asset market volatility - based on implied volatility in bonds, global stocks, global commodities, and various exchange rates - is near record lows (Chart I-20). Hence, global risk assets - commodity and EM plays in particular - could suffer some damage in the face of a deeper than anticipated global growth slowdown led by China. The recent improvement in Japanese industrial production, which mirrors the improvement in EM trade, may be short-lived. This would depress Japanese inflation expectations and boost Japanese real rates, helping the yen in the process (Chart I-21). Shorting GBP/JPY may be one of the best ways to take advantages of these dynamics (Chart I-22). Chart I-20Global Cross-Asset ##br##Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Chart I-21If China And EM Slow, Japanese ##br##CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge Chart I-22New Downleg In ##br##GBP/JPY? New Downleg In GBP/JPY? New Downleg In GBP/JPY? Bottom Line: An oversupplied global economy could find it difficult to withstand the combined tightening emanating from China and the U.S. The improvement in global trade and global good prices is likely to dissipate in the coming month. The euro and commodity currencies could suffer from this development and the yen could benefit. Concluding Thoughts Global policy makers will ultimately not stand pat in the face of this problem. This may in fact deepen their well-entrenched dovish biases. As a result, while the scenario above sounds dire, it is likely to be transitory. The Chinese authorities will not let growth crater; European and Japanese policymakers will fight deflation; and even the Fed may be forced to leave policy easier than it would like. We will explore this topic in more detail in future publications. A Few Words On The RMB Chart I-23China Has Regained Control ##br##Of Its Capital Account China Has Regained Control Of Its Capital Account China Has Regained Control Of Its Capital Account This week, the RMB has been well bid as the PBoC announced that the currency will increasingly be used as a countercyclical tool. The market has interpreted this move as an attack on speculators betting on a falling RMB. The conditions had become very propitious for this kind of announcement to lift the CNY. On the back of a weaker dollar the trade-weighted RMB had in fact weakened for most of 2017 (Chart I-23, top panel), implying that the RMB has continued to help the Chinese economy. Additionally, capital flight out of China has slowed in response to the enforcement of capital controls, something made clear by the collapse in import over-invoicing (Chart I-23, bottom panel). Going forward, it is not clear whether this announcement is necessarily bullish or bearish. It all depends on the Chinese economy and its deflationary pressures. If we are correct that Chinese deflationary pressures are set to increase in the coming quarters, this could imply that Chinese authorities put downward pressure on the CNY later this year. That being said, we remain reluctant to short the yuan to play Chinese deflationary forces. The capital account is well controlled and the PBoC will continue to aggressively manage the exchange rate. This implies that currencies like the AUD or BRL, which exhibit strong correlations with Chinese imports, could remain the main vehicles to play a Chinese slowdown in the forex space. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback displayed further weakness as FOMC member Brainard shared her opinions questioning the future path of U.S. policy. We consider these remarks as temporary hurdles for the dollar, as fundamentals are still in favor of a stronger dollar, which is something the Fed recognizes. This week, some minor deflationary worries resurfaced as the ISM Prices Paid declined to 60.5 from the previous 68.5. While this is true, the labor market continues to tighten as the ADP survey come in very strong. Additionally, ISM Manufacturing PMI also paints a brighter picture for manufacturing, coming in at 54.9. We believe the Fed will hike this month, and will continue to highlight its tightening path going forward, which will provide a fillip for the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Europe delivered a more negative outlook this week with softer data: Services sentiment, economic sentiment indicator, industrial confidence and business climate all came in less than expected; German CPI disappointed with CPI increasing at a 1.5% rate, less than the expected 2% rate, and the harmonized index also underperformed at 1.4%; European CPI also disappointed at 1.4%, while core CPI also slowed; However, Italian unemployment improved to 11.1% from 11.5%. President Draghi also reiterated his dovish stance in a speech on Monday. While the euro is up this week, elevated short-term valuations warrant a lower euro in coming months. Furthermore, following Draghi's reiteration, rate differentials may continue to move in favor of the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Upbeat data from Japan has lifted the yen this week: Job/applicants ratio is at 1.48, a level last seen in 1974; Retail trade increased at a 3.2% annual pace, much more than the expected 2.3% rate; Industrial production increased at a 5.7% pace; Housing starts increased at 1 .9%. While data surprises to the upside in Japan, low inflation still remains entrenched in the economy. We believe the BoJ will remain dovish until inflation emerges, which will keep JPY's upside limited. That being said, risk-averse behavior can provide a temporary tailwind for the yen in the upcoming months. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The U.K.'s consumer sector remains mixed, showing a ray of sunshine after batches of poor numbers: Gfk Consumer Confidence came in at -5, better than the expected -8; Consumer credit came in at GBP 1.525 bn,; M4 Money Supply also increased at 8.2% yoy. Mortgage approvals, however, clicked in below estimates, while net lending to individuals was GBP 4.3 billion, less than expected and previously reported. Nevertheless, cable has been relatively strong this week, lifted by the euro. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was some negative data out of Australia this week: Building permits are still contracting, now at a 17.2% pace, less than the 19.9% pace last month; Private sector credit is expanding at a slower pace of 4.9%; AiG Performance of Manufacturing Index decreased to 54.8 from 59.2; AUD has been considerably softened recently, as commodity prices weakened. While the Chinese NBS manufacturing PMI marginally beat expectations, the Caixin Manufacturing PMI actually weakened from 50.3 to 49.6, and is now in contraction territory. As China continues to face structural issues, which are now front and center thanks to their most recent debt rating downgrade, AUD could suffer even more. In the G10 space, it is likely it will be one of the worst performing currencies this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD has seen a broad-based appreciation across the G10 space in the past 2 weeks due to stronger than expected trade balance and visitor arrivals. Dairy prices annual growth rate also remain robust at 56% this week. Further buoying the NZD was the release of the RNBZ Financial Stability Report, which was upbeat and states that financial risks have subsided in the past 6 months. The RBNZ also highlighted the slowdown in house price growth due to macroprudential measures. Most recently, NZD has been weak against European currencies, as upbeat data and a higher euro drove up these currencies. EUR/NZD is likely to trend downwards as growth differentials could further bifurcate central bank policies, and weigh on this cross. NZD/USD, itself, is unlikely to see much upside if the dollar bull market resumes and EM cracks deepen. However, AUD/NZD should weaken some more. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has seen downside recently as oil's gains receded after markets seemed disappointed by the OPEC deal. Data further corroborated this negative view, as both industrial and raw material prices increased by less than expected at 0.6% and 1.6% respectively. Additionally, the first quarter current account also faltered into a further deficit of CAD 14.05 bn. However, GDP growth was strong and could improve further. Investors are currently highly bearish on the CAD, with net speculative positions at the lowest level in 10 years, suggesting the bad news is well priced in. Going forward, the BoC continues to argue that the output gap is closing quicker than expected which will warrant higher rates, and help the CAD. While the CAD may not appreciate much against the USD, it will be one nonetheless one of the best performing currencies in the G10 space. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF continues to drift lower as lofty short-term valuations are hurting the euro. As the ECB is likely to remain accommodative, as per Draghi's recent remarks, the recent weakness may only be the beginning of a new trend. Recent data shows that there might be a slight deceleration in the Swiss economy as the KOF leading indicator has slowed down to 101.6. However, with Italian political risks growing faster than anticipated, the CHF could find additional support. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 As oil prices falter after the OPEC deal, the NOK displayed substantial downside against the USD, the EUR, and the CAD. Despite our Commodity and Energy team seeing additional upside for oil prices, the NOK will continue to be pulled down by low rates as the Norges Bank battles against deflationary prices, falling wages, and a weak labor market. Real rate differentials will prompt upside in USD/NOK, as well as CAD/NOK, as both the U.S. and Canada have adopted a hawkish and neutral bias, respectively. Regarding data, retail sales picked up from a meager 0.1% growth rate to a still unimpressive rate of 0.2%. At 5.1%, Norway's credit Indicator also grew less than expected and continues to slowdown. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data this week showed that last quarter, the economy did not perform as well as anticipated, with GDP increasing by 2.2%, lower than the expected 2.9%. However, more recent data shows a pickup in activity, with retail sales increasing at a 4.5% rate. USD/SEK has been weak recently due to the dollar's weakness, which we think is at its tail end. EUR/SEK's recent appreciation is likely to alleviate the Riksbank's deflationary worries. However, downside is possible as the euro may retract some of its gains. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In the near term, the PBoC is likely to set a stronger fixing rate against the dollar and dampen market expectations for further RMB declines. The PBoC hinted that the exchange rate can be used as a "countercyclical" policy tool, which could signal a major shift, as previously the central bank had mostly stressed maintaining exchange rate stability as its main policy target. Chinese growth remains reasonably buoyant. Listed firms' Q1 earnings improved significantly, confirming the profit cycle upturn. This bodes well for private sector capex, and supports our positive cyclical stance on H shares. Feature The People's Bank of China (PBoC) last week changed how it sets the RMB's official fixing rate against the dollar, making an already opaque mechanism even less transparent. With the latest tweak, it appears the PBoC intends to assert greater discretion over the RMB exchange rate, a notable departure from its recent moves toward a more market-driven system. Odds are high that the central bank will try to stabilize the trade-weighted RMB around current levels in the near term, unless the dollar takes a sudden sharp turn in either direction. Technical details aside, fundamental factors are no longer unanimously bearish for the RMB, as we discussed in a recent report.1 Meanwhile, most of Chinese-listed firms have reported first quarter earnings, which show strong improvement compared to a year ago. This buttresses our positive stance on Chinese H shares. It also bodes well for capital spending in the private sector as well as overall business activity. Why? And Does It Matter? Technically, the PBoC appears to be trying to correct a problem inherently built into its old exchange rate-setting formula. Up until the recent changes, the RMB official fixing rate was determined by the closing exchange rate of the previous trading day as well as the RMB's performance against a currency basket. As such, a lower onshore spot CNY against the dollar automatically led to a lower official fixing on the following day, which in turn anchored expectations for further RMB depreciation in the spot market - setting in motion a series of self-feeding mini-vicious circles. This became increasingly obvious in recent months (Chart 1). The dollar has depreciated broadly against other currencies since the beginning of the year, which should have led to a higher CNY/USD. In reality, the RMB official fixing rate has been essentially flat, and the onshore CNY spot rate has constantly traded below the official fixing rate, reflecting market expectations of further declines in the RMB. In the new formula, by adding in an unspecified "countercyclical" factor, the PBoC intends to reset market expectations and arrest the automatic extrapolation of the recent RMB trend into the future. More fundamentally, the PBoC hinted that the exchange rate can be used as a "countercyclical" policy tool. If true, this would signal a major shift, as previously the PBoC had mostly stressed maintaining exchange rate stability as its main policy target. In a press release accompanying the latest change, the PBoC argued that China's recent growth improvement suggests that a weaker RMB is no longer warranted, which fits the PBoC's broader policy stance. By the same token, it also suggests the PBoC will actively guide the RMB exchange rate lower at times of weakening growth to reflate the economy. Historically, the PBoC had mostly sat idle with the exchange rate at times of heightened volatility in the global currency market, which exposed the Chinese economy to sharp swings in the trade-weighted RMB (Chart 2). For example, the PBoC effectively pegged the RMB to the dollar during the global financial crisis between mid-2008 and early 2010 - despite the rollercoaster ride other Asian currencies experienced. Similarly, the central bank held the RMB largely steady against the dollar between 2013 and mid-2015 amid sharp declines in other currencies against the dollar, leading to sharp RMB appreciation in trade-weighted terms and creating relentless deflationary pressure for the Chinese economy. The slide of the RMB against the greenback since August 2015 has been a catch-up to its Asian neighbors to the downside. Chart 1The PBoC Wants A Stronger RMB Fixing? The PBoC Wants A Stronger RMB Fixing? The PBoC Wants A Stronger RMB Fixing? Chart 2The RMB: Moving Towards Dirty Float The RMB: Moving Towards Dirty Float The RMB: Moving Towards Dirty Float How the PBoC manages the exchange rate under the new mechanism remains to be seen, and it is too soon to draw definite conclusions just yet. In the near term, the PBoC is likely to set a stronger fixing rate against the dollar and dampen market expectations for further RMB declines. Longer term, if the central bank indeed intends to use the exchange rate as a countercyclical macro policy tool, it will have to more actively manage the trade-weighted RMB according to the cyclical profile of the Chinese economy. This will move the RMB closer to a true "dirty float" currency, which also means much greater volatility for the RMB cross rate with the dollar than in the past. The Earnings Scorecard The latest macro numbers confirm that the Chinese economy is losing some steam, but overall growth momentum remains largely stable . Both manufacturing and service PMI numbers released early this week remained in expansionary territory. and some key components such as export orders, orders backlog and employment showed a pick-up compared with the previous month. We expect the economy to remain fairly buoyant in the next two to three quarters, even if year-over-year growth numbers continue to moderate. As far as investors are concerned, the important development is that China's profit cycle upturn remains in place. Total profits of industrial firms increased by 24% in the first four months of 2017 compared with a year ago. In addition, most of domestic-listed firms have released first-quarter earnings, which show similar profit growth (Chart 3). A few observations can be made: Chart 3Profit Acceleration Profit Acceleration Profit Acceleration Table 1A-Share Companies' Earnings Scorecard The RMB's New Secret Formula, And The Chinese Earnings Scorecard The RMB's New Secret Formula, And The Chinese Earnings Scorecard All domestic-listed A-share firms reported a 23% increase in Q1 earnings compared with last year, or 34% if financials and energy companies are excluded. Profit acceleration was more pronounced in the materials and energy sectors, but was also fairly broad-based (Table 1). Top line revenue growth accelerated, a key factor behind rising profits (Chart 4, top panel). Excluding financials and energy, A share-listed firms' total revenue increased by almost 20% from 2016 according to our calculation, a marked acceleration compared with previous years. Profit margins also increased modestly, which helped boost profits (Chart 4, bottom panel). Net margins still pale in comparison to pre-crisis levels, though are now close to their long-term trend line. In short, China's profit cycle upturn reflects a pickup in both price increase and volume expansion in the overall economy, and defies the assertion by some that China's growth improvement since last year has been purely driven by credit. Looking forward, our model suggests that profit growth will likely begin to roll over (Chart 5), but there is no evidence that profits will contract anytime soon. Chart 4Improvement In Both Revenue And Margin Improvement In Both Revenue And Margin Improvement In Both Revenue And Margin Chart 5Profit Growth Is Rolling Over, But No Contraction Profit Growth Is Rolling Over, But No Contraction Profit Growth Is Rolling Over, But No Contraction What does this mean? First, profit growth in the industrial sector is good news for the banking system. Materials producers and energy companies, the major trouble spots in banks' asset quality in recent years, experienced the biggest increase in profit growth among the major sectors. This should reduce non-performing loans (NPL) from these industries. The pace of banks' NPL increase will likely continue to decelerate, and asset quality stress in the banking sector should ease. Second, profit recovery in the industrial sector bodes well for capital spending, which in turn will support overall business activity. Private enterprise investment is mostly profit-driven. Therefore, rising profits should lead to stronger incentive to expand capex. We maintain the view that the multi-year downshift in China's capital spending cycle will likely bottom up going forward (Chart 6). Finally, strong profit growth should also be good news for Chinese equities. Chinese H shares are trading at 32% and 24% discounts compared with the global benchmark, based on trailing and forward price-to-earnings ratios respectively (Chart 7). Without a major profit contraction in Chinese-listed companies, the large valuation gap between Chinese shares and global equities is unreasonable and unsustainable - and will eventually narrow. In short, we remain cyclically positive on H shares, and overweight China against global/EM benchmarks. Chart 6Profit Improvement Bodes Well For Capex Profit Improvement Bodes Well For Capex Profit Improvement Bodes Well For Capex Chart 7Mind The Gap Mind The Gap Mind The Gap Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Markets have gone too far in pricing out the Republican's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections. A bill that at least cuts taxes should be forming by year end. The risk is that continued political turbulence, now including the possibility of impeachment, distracts Congress and delays or completely derails tax reform plans. Fortunately for the major global equity markets, corporate profits are providing solid support. We expect U.S. EPS growth to accelerate further into year end, peaking at just under 20%. The projected profit acceleration is even more impressive in the Eurozone and Japan. Corporations are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end that will favor the latter two bourses in local currency terms. EPS growth will fall short of bottom-up estimates for 2017, but what is more important for equity indexes is the direction of 12-month forward EPS expectations, which remain in an uptrend. The positive earnings backdrop means that stocks will outperform bonds for the remainder of the year even if Congress fails to pass any market-friendly legislation. The FOMC is "looking through" the recent soft economic data and slower inflation, and remains on track to deliver two more rate hikes this year. The impact of the Fed's balance sheet runoff on the Treasury market will be limited by several factors, but a shrinking balance sheet and Fed rate hikes will force bond yields to rise faster than is currently discounted. Policy divergence will push the dollar higher. The traditional relationship between the euro/USD and short-term yield differentials should re-establish following the French election. The euro could reach parity before the next move is done. "Dr. Copper" is not signaling that global growth will soften significantly this year. Chinese growth has slowed but the authorities are easing policy, which will stabilize growth and support base metals. That said, we remain more upbeat on oil prices than base metals. Feature Investors have soured on the prospects for U.S. tax reform in recent weeks, but the latest travails in Washington inflicted only fleeting damage on U.S. and global bourses. The S&P 500 appears to have broken above the 2400 technical barrier as we go to press. Market expectations for a more tepid Fed rate hike cycle, lower Treasury yields and related dollar softness undoubtedly provided some support. But, more importantly, corporate profits are positively surprising in the major economies and this is not just an energy story. The good news on company earnings should continue to drive stock prices higher this year in absolute terms and relative to bond prices. It is a tougher call on the dollar and the direction of bond yields. We remain short duration and long the dollar, but much depends on the evolution of U.S. core inflation and fiscal policy. A Death Knell For U.S. Tax Reform? Chart I-1 highlights that the market now sees almost a zero chance that the Republicans will ever be able to deliver any meaningful tax cuts or infrastructure spending. Many believe that mushrooming political scandals encumbering President Trump will distract the GOP and delay or derail tax reform. Indeed, impeachment proceedings would be a major distraction, although this outcome would not necessarily lead to an equity bear market. The historical record shows that the economy is much more important than politics for financial markets. BCA's geopolitical strategists looked at three presidential impeachments, covering the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974) and the President Clinton's Lewinsky Affair (January 1998 to February 1999).1 Watergate was the only episode that coincided with a bear market, but it is difficult to pin the market downturn on Nixon's impeachment since the U.S. economy entered one of the worst post-war recessions in 1973 that was driven by tight Fed policy and an oil shock. Impeachment would require that Trump loses support among the Republican base, which so far has not happened. The President still commands the support of 84% of Republican voters (Chart I-2). Investors should monitor this support level as an indicator of the President's political capital and the risk of impeachment. Chart I-1Fading Hopes For Tax Reform Fading Hopes For Tax Reform Fading Hopes For Tax Reform Chart I-2 We believe that markets have gone too far in pricing out Trump's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans see eye to eye. The odds are good that an agreement to cut taxes will be formed by year end. Congressional leaders want tax reform to be revenue neutral, but finding sufficient areas to cut spending will be extremely difficult. They may simply require that tax cuts are paid for in a 10-year window. This makes it possible to lower taxes upfront and promise non-specific spending cuts and revenue raising measures down the road. Or, Congress may pass tax reform that is not revenue neutral through the reconciliation process, which would require that tax cuts sunset at some point in the future. Tax cuts would give stocks a temporary boost either way but, as we discuss below, it may be better for corporate profits in the medium term if Congress fails to deliver any fiscal stimulus. Profits, Beats And Misses While economists fret over the soft U.S. economic data so far this year, profit growth is quietly accelerating in the background (Chart I-3). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at about 18%, before moderating in 2018. Profit growth is accelerating outside of the energy sector. The projected acceleration in EPS growth is equally impressive in the Eurozone and Japan. The favorable profit picture in the major economies reflects two key factors. First, profits are rebounding from a poor showing in 2015/16, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart I-4). Our short-term forecasting models for real GDP, based on a mixture of hard data and surveys, continue to flag a pickup in economic growth in the major economies (Chart I-5). Chart I-3Top-Down Profit Projection Top-Down Profit Projection Top-Down Profit Projection Chart I-4EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production Chart I-5GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate The U.S. model's forecast paints an overly rosy picture, but it does support our view that Q1 softness in the hard data reflected temporary factors that will give way to a robust rebound in the second and third quarters. The Eurozone economy is really humming at the moment, as highlighted by our model and recent readings from the IFO and purchasing managers' surveys. Indeed, these indicators are consistent with real GDP growth of nearly 3%! Our GDP models are also constructive for Japan and the U.K., although not nearly as robust as in the U.S. and Eurozone. Chart I-6Profit Margins On The Rise Profit Margins On The Rise Profit Margins On The Rise Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row (Chart I-6). Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.2 The hiatus of wage pressure may not last long, and we expect the "mean reversion" in profit margins to resume next year. But for now, our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). Profit margins are also on the rise in Japan and the Eurozone. Margins in the latter appear to have the most upside potential of the three major markets, given the fact that current levels are still depressed by historical standards, and that there remains plenty of slack in the European labor market. We are not incorporating any margin expansion in Japan because they are already very high. Nonetheless, we do not expect any "mean reversion" in margins over the next year either, because the business sector is going to great lengths to avoid any increase in the wage bill despite an extremely tight labor market. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end: The U.S. is further ahead in the global profit mini recovery and year-ago EPS comparisons will become more difficult by the end of the year. The drag on corporate profits in 2017 from previous dollar strength will be larger than the currency drag in the Eurozone according to our models, assuming no change in trade-weighted exchange rates in the forecast period (Chart I-7). The pass-through of past yen movements will be a net boost to EPS growth for Japanese companies this year.3 Currency shifts would favor the Japanese and the Eurozone markets versus the U.S. even more if the dollar experiences another upleg. We expect the dollar to appreciate by 10% in trade-weighted terms. A 10% broad-based dollar appreciation would trim EPS growth by 2½ percentage points, although most of this would occur in 2018 due to lags (Chart I-8). Eurozone and Japanese EPS growth would receive a lift of 2 and ½ percentage points, respectively, as their currencies depreciate versus the dollar. Chart I-7Currency Impact On EPS Growth Currency Impact On EPS Growth Currency Impact On EPS Growth Chart I-8A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits Finally, the fact that profits in Japan and the Eurozone are more leveraged to overall economic growth than in the U.S. gives the former two markets the edge as global industrial production continues to recover this year and into 2018. Japanese and Eurozone equity market indexes also have a higher beta with respect to the global equity index. The implication is that we remain overweight these two markets relative to the U.S. on a currency hedged basis. Lofty Expectations Even though the message from our EPS models is upbeat, our forecasts still fall short of bottom-up estimates for 2017. Is this a risk for the equity market, especially in the U.S. where valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table I-1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in the recession. But even outside of 2008, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart I-9 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years since the Great Recession. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the trend in 12-month forward estimates (which remains up at the moment). Chart I- Chart I-9S&P 500 Follows ##br##12-month Forward EPS S&P 500 Follows 12-month Forward EPS S&P 500 Follows 12-month Forward EPS The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth U.S. expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. The Fed's Balance Sheet: It's Diet Time The minutes from the May FOMC meeting reiterated that policymakers plan to begin scaling back on reinvesting the proceeds of its maturing securities of Treasurys and MBS by the end of the year. The Fed is leaning toward a gradual tapering of reinvestment in order to avoid shocking the bond market. Still, investors are rightly concerned about the potential impact of the balance sheet runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. Chart I-10 Chart I-10 presents a forecast for the flow of Treasurys available to the private sector, taking into consideration the supply that is absorbed by foreign official institutions and by the Fed. The bottom panel shows a similar calculation for the aggregate supply of government bonds from the U.S., Japan, the Eurozone and the U.K. While the supply of Treasurys has been positive since 2012, the net flow has been negative for these four economies as a whole because of aggressive quantitative easing programs. This year will see the largest contraction in the supply of government bonds available to the private sector, at US$800 billion. The flow will become less negative in 2018 even if the Fed were to keep its balance sheet unchanged (mostly due to assumed ECB tapering). If the Fed goes ahead with its balance sheet reduction plan, the net supply of government bonds from the major economies will move slightly into positive territory for the first time since 2014. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" for the path of future short rates. Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables and the stock of assets held by the Fed as a share of GDP. Just for exposition purposes, let us take an extreme example and assume that the Fed simply terminates all re-investment as of January 2018 (i.e. the runoff is not tapered). In this case, the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a contraction of roughly 10 percentage points of GDP (Chart I-11). Applying the IMF interest rate model's coefficient of -0.09, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. Chart I-11Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario However, it is more complicated than that. The impact on yields is likely to be tempered by two factors: The balance sheet may never fully revert to historic norms relative to GDP. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).4 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. Fed Outlook: Mostly About Inflation The May FOMC minutes confirmed that the FOMC is "looking through" the soft economic data in the first quarter, chalking it up to temporary factors such as shifts in inventories. They are also inclined to believe that the moderation in core CPI inflation in recent months is temporary. The message is that policymakers remain on track to deliver two more rate hikes this year, in line with the 'dot plot' forecast. The market is pricing almost a 100% chance of a June rate hike. However, less than two full rate hikes are expected over the next year, which is far too benign in our view. Investors have been quick to conclude that recent economic data have convinced Fed officials to shift from a "gradual" pace of rate hikes to a "glacial" pace. Treasurys rallied on this shift in Fed expectations and a decline in long-term inflation expectations. The 10-year TIPS breakeven inflation rate has dropped to about 1.8%, the lowest level since before the U.S. election. This appears to us that the bond market over-reacted to the drop in core CPI inflation from 2.2% in February to 1.9% in April. The evolution of actual inflation will be critical to the outlook for the Fed and Treasury yields in the coming months. Our U.S. fixed-income strategists have simulated a traditional Phillips Curve model of inflation (Chart I-12).5 The model projects that core PCE inflation will reach 2.1% by December, even assuming no change in the unemployment rate or the trade-weighted dollar. Inflation ends the year not far below the 2% target even in an alternative scenario in which we assume that the dollar appreciates and that the full-employment level of unemployment is lower than the Fed currently assumes. Chart I-12U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% Thus, the trend in inflation should reinforce the FOMC's bias to keep tightening policy, forcing the bond market to reassess the pace of rate hikes discounted in the curve. That said, if we are wrong and inflation does not trend higher in the next 3-4 months, then it is the FOMC that will be forced to reassess and our short duration recommendation will probably not pan out on a six month horizon. Longer-term, last month's Special Report highlighted that we have reached an inflection point in some of the structural forces that have depressed bond yields. This month's Special Report, beginning on page 20, builds on that theme with a look at the impact of technological progress on equilibrium bond yields. With respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. Stay overweight corporate bonds within fixed income portfolios for now. While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten policy for an extended period, outside of removing negative short rates and tapering QE purchases a bit further in 2018. The euro has appreciated versus the dollar even as two-year real interest rate differentials have moved in favor of the dollar since the end of March. This divergence probably reflects euro short-covering following the market-friendly French election outcome. Next up are the two rounds of French legislative elections in June. Polls support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus. In the meantime, we do not see any risk factors emanating from the Eurozone that could upset the global equity applecart in the near term. Moreover, the traditional relationship between the euro/USD exchange rate and 2-year real yield differentials should now re-establish. The implication is that the euro could reach parity before the next move is done. Dr. Copper? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 25% on a year-ago basis, but has fallen by 5% since February (Chart I-13). From their respective peaks earlier this year, zinc and copper are down about 7-10%, nickel has dropped by 18% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Chart I-13What Are Commodities Telling Us? What Are Commodities Telling Us? What Are Commodities Telling Us? Some of our global leading economic indicators have edged lower this year, as we have discussed in previous reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart I-14). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over. Both the PMI and housing starts are correlated with commodity prices. The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: The authorities wish to slow credit growth, but there is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Both direct fiscal spending and infrastructure investment have picked up noticeably this year (Chart I-15). Finally, the PBoC re-started its Medium-Term Lending Facility and recently made the largest one-day cash injection into the financial system in nearly four months. Chart I-14China Is The Main Story ##br##For Base Metals Demand China Is The Main Story For Base Metals Demand China Is The Main Story For Base Metals Demand Chart I-15Direct Fiscal Spending And ##br##Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. Fading fears about a China meltdown may give commodities a lift later this year. Our commodity strategists are particularly positive on crude oil, as extended production cuts from OPEC and Russia outweigh the impact of surging shale production, allowing bloated inventories to moderate. In contrast, the backdrop is fairly benign for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Investment Conclusions: Accelerating corporate profit growth in the major advanced economies provides a healthy tailwind and suggests that stocks could perform well under a couple of different scenarios in the second half of 2017. If the rebound in U.S. economic growth from the poor first quarter is unimpressive and it appears that Congress will be sidetracked by political turmoil in the White House, then the S&P 500 should benefit from the 'goldilocks' combination of healthy profit growth, low bond yields, an accommodative Fed and a soft dollar. If, instead, U.S. growth rebounds strongly and Congress makes progress on the broad outline of a tax reform bill over the summer months, then stocks should benefit from the prospect of stronger growth in 2018. Rising bond yields and a firmer dollar would provide some offset for stocks, but would not derail the equity bull market as long as inflation remains below the Fed's target. Our model suggests that U.S. inflation will remain below-target for the next several months, but could be near 2% by year end. This scenario would set the stage for a more aggressive Fed in 2018, a surge in the dollar and possibly a bear market in risk assets next year. We are therefore comfortable in predicting that the stock-to-bond total return ratio will continue to rise for at least the remainder of this year. The tough part relates to bond yields and the dollar, since the above two scenarios have very different implications for these two asset classes. Our base case is closer to the second scenario, such that we remain below benchmark in duration and long the dollar. That said, much depends on the evolution of U.S. core inflation and U.S. politics. Both are particularly difficult to forecast. A failure for core PCE inflation to pick up in the next 3-4 months and/or continuing political scandals in Washington would force us to reconsider our asset allocation. Of course, there are other risks to consider, including growing mercantilism in the U.S., Sino-American tensions and North Korea. At the top of the list are China and Italy. (1) China China remains our geopolitical strategists' top pick as the catalyst most likely to scuttle our upbeat view on global risk assets in 2017.6 Our base case assumption is that policymakers will not enact wide-scale financial sector reform, which would entail a surge in realized non-performing loans and bankruptcies and defaults, ahead of the Fall Party Congress. The regulatory crackdown so far seems merely to keep the financial sector in check for a while. The government has already stepped back somewhat in the face of the liquidity squeeze, and fiscal policy has been loosened (as mentioned above). All of the key Communist Party statements have emphasized that stability remains a priority. Nonetheless, it may be difficult for the authorities to manage the deleveraging process given nose-bleed levels of private-sector leverage. Politicians could misjudge the fragility of the financial system and investors might front-run the reform process, sending asset prices down well in advance of policy implementation. (2) Italy We have flagged the next Italian election as a key risk for markets because of polls showing that voters have become disillusioned with the euro. It appeared that an election would not take place until 2018, and we have downplayed European elections as a risk factor for 2017. However, the 5-Star Movement has now backed a proportional electoral system, which raises the chances of an autumn election in Italy. This would obviously spark turbulence in financial markets in the months leading up to the event. Turning to emerging markets, the pickup in global growth and a modest bounce in commodity prices would support this asset class. However, our view that the dollar is headed higher on the back of Fed rate hikes keeps us from getting too excited about EM stocks, bonds or currencies. Our other recommendations include the following: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. on a currency-hedged basis. Overweight the dollar versus the other major currencies. Overweight small caps stocks versus large in the U.S. market. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2017 Next Report: June 29, 2017 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 7, 2017, available at gps.bcaresearch.com 2 Please see The Bank Credit Analyst, "Overview," April 017, available at bca.bcaresearch.com 3 Currency shifts affect earnings with a lag, which in captured by our models. 4 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets ," dated May 24, 2017, available at gps.bcaresearch.com II. Is Slow Productivity Growth Good Or Bad For Bonds? This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-3The Shift Towards Software ##br##Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Chart II-4 Chart II-5 Chart II-6 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8 Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14 Chart II-15Aging Will Reduce ##br##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17 Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-20 Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed ##br##Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The breakout in the S&P 500 above 2400 in May has further stretched valuation metrics. Measures such as the Shiller P/E and price/book are elevated relative to past equity cycles. The price/sales ratio is in a steep rise too. However, our U.S. Composite valuation metric, which takes into consideration 11 different measures of value, is still a little below the one sigma level that marks significant overvaluation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, these measures will not look as favorable when rates finally rise. Technically, the U.S. equity market has upward momentum. Our Equity Monetary Indicator has remained around the zero line, meaning that it is not particularly bullish or bearish at the moment. Our Speculation Index is high, pointing to froth in the market. The high level of our Composite Sentiment Index and low level of the VIX speaks to the level of investor complacency. The U.S. net revisions ratio jumped higher this month, and it is bullish that the earnings surprise index advanced again. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little "dry powder" left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking forward, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. It is disconcerting that our Europe WTP suffered a pull-back over the past month. Nonetheless, we believe that accelerating corporate profit growth in the major advanced economies provides a strong tailwind and suggests that stocks remain in a window in which they will outperform bonds. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as we have reached an inflection point in some of the structural forces that have depressed bond yields. We also believe that the combination of Fed balance sheet shrinkage and rate hikes will lead to higher bond yields than are currently discounted in the market. Technically, our composite indicator has touched the zero line, clearing the way for the next leg of the bond bear market. The dollar is very expensive on a PPP basis, although it is less so by other measures. Technically, the dollar has shifted down this year, crossing the 200-day moving average. That said, according to our dollar technical indicator, overbought conditions have been totally worked off, suggesting that the currency is clear to move higher if Fed rate expectations shift up as we expect. Moreover, we believe that policy divergence in the overall monetary policy stance between the U.S. on one side and the ECB and BoJ on the other will push the dollar higher. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS. BCA's Emerging Markets Strategy team has a more pessimistic outlook than the BCA house view, which is upbeat on the prospects for China's capex growth and commodity prices. The ongoing liquidity tightening in China amid lingering credit excesses is bound to produce major negative growth surprises. The authorities will reverse the ongoing monetary tightening only if the pain on the ground becomes visible or the economic data deteriorates significantly. Financial markets will sell off considerably in advance. In Chile, take profits on the receiving 3-year swap rate trade; stay neutral on this bourse within an EM equity portfolio. Feature EM Profit Recovery: How Enduring? EM equities have not only advanced in absolute terms but have also outperformed developed market (DM) share prices considerably since early this year. This outperformance has been rationalized by a recovery in EM earnings per share (EPS). Indeed, EM EPS has revived briskly in recent months (Chart I-1A). Chart I-1AEM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) Chart I-1BEM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) For this rally to continue, EM EPS would need to continue to expand further. We do not expect this. On the contrary, our bet is that EM EPS growth will slow considerably later this year and most likely contract in early 2018. Our basis is that the growth (first derivative) and impulse (second derivative) of EM & Chinese narrow money (M1) has in the past led their respective profit cycle (Chart I-1A and Chart I-1B). If these relationships hold and EM EPS growth dwindles later this year, EM share prices should begin to sense it now, and start falling back very soon. Interestingly, EM EPS net revisions have failed to rise above the zero line despite the recent rebound in profits (Chart I-2, top panel). This is in contrast to DM EPS net revisions, which have surged well above zero (Chart I-2, middle panel). As a result, recent EM relative outperformance against their DM peers has occurred despite the drop in relative net EPS revisions (Chart I-2, bottom panel). This presages EM equity analysts are not revising upward their forward estimates for EM EPS, despite the ongoing rally in share prices. This is extremely puzzling (and rare) and may be a reflection of recent weakness in commodities prices - or the fact that expectations for EM EPS growth were already elevated. We do not place much emphasis on analysts' EPS revisions because the latter swing with stock prices - they have zero forecasting power for share prices. We highlight this fact simply to counter the common market narrative that EM corporate earnings growth expectations are improving, driving EM bourses higher. Bottom Line: EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS nine months ahead. Importantly, EM equity prices relative to DM shares are at a major technical juncture (Chart I-3). A decisive breakout would be a very bullish technical signal, whereas a failure to break out would be an important warning sign. We continue to bet on the latter. Chart I-2EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM Chart I-3Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM China's Credit Cycle And Commodities Redux Our overarching theme has been and remains that China is tightening liquidity amid a lingering credit bubble. This cannot end well for financial markets that are exposed China's growth. Here we revisit our rationale for a credit slowdown in China and its impact on EM. Chinese interest rates have risen dramatically since last November across the entire yield curve. The 3-month interbank rate and AA- on-shore corporate bond yields both have risen by about 200 basis points since November 1, 2016. Monetary policy works with a time lag, and higher interest rates warrant a slowdown in credit growth (Chart I-4). In turn, it takes only a deceleration in credit growth for the credit impulse - the second derivative of outstanding credit - to turn negative. The falling credit and fiscal impulse will consequently lead to a relapse in Chinese import volumes and EM EPS (Chart 5), in turn weighing on commodity prices and non-commodity producing countries like Korea and partially Taiwan. Mainland import volumes contracted mildly in the second half of 2015, as demonstrated in Chart I-5. De facto, from the perspective of the rest of the world, China was in mild recession in late 2015. Not surprisingly, global risk assets in general, and particularly those exposed to China, tumbled. Chart I-4China: Higher Rates Point To##br## Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse Chart I-5China's Credit Impulse Heralds ##br##Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports We expect China import volumes to shrink again by the end of this year or early next. Some sort of replay of 2015 is a real possibility. The broad-based yet mild selloff in commodities since early this year (Chart I-6) amid weakness in the U.S. dollar exchange rate gives us confidence in our view. Chart I-6ABroad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Chart I-6BBroad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Our colleagues at BCA have attributed the selloff in commodities this year to deleveraging in China's shadow banking system, and to traders worldwide closing their long positions. They expect an improving commodities supply-demand balance to support prices going forward. It makes sense to us to explain the selloff in commodities as having been caused by deleveraging in China's shadow banking system. Yet to be consistent, we should also acknowledge that the rally in commodities last year was to a large extent driven by the same forces in reverse: non-commercial buyers (investors) buying commodities both in China and elsewhere. In short, this signifies there was little improvement in worldwide commodities demand last year. In 2016, rising commodities prices provided a significant boost to commodity-producing countries and underlying corporate profits - and ultimately EM risk assets. The drop in commodities prices this year, if sustained, should lead to the opposite dynamic: income/profits among commodities countries/companies will drop. As such, falling commodities prices amid diminishing investor demand for commodities is bearish for EM risk assets. Where we differ from the majority of our colleagues at BCA is that we expect Chinese credit growth to decelerate, thereby weighing on its capital spending and depressing demand for commodities (please refer to Chart I-5). We have written extensively1 on this topic and will not fully rehash our view that China's annual credit growth will decelerate from the current 12% to somewhere around 8% in the next 12-18 months. In short, China's corporate and household credit-to-GDP ratio cannot rise indefinitely from an already high level of 225% of GDP. Credit growth will likely downshift to a level of sustainable nominal GDP growth, which is probably around 8%. Our main disagreement with our colleagues on structural issues is as follows: we believe China's credit excesses are not a natural outcome of the nation's high savings rate but rather the outcome of a speculative credit boom driven by high-risk behavior among creditors and debtors.2 Tightening liquidity amid such speculative excesses creates a very bearish backdrop for risk assets exposed to China's credit cycle. The bullish camp on China has recently pointed to a strong recovery in mainland nominal GDP growth, which in their view suggests that double-digit credit growth in China is not excessive (Chart I-7). However, such a surge in nominal GDP growth has been due to the GDP deflator rising from zero in the fourth quarter of 2015 to 5% in the first quarter of this year. Importantly, the swings in the GDP deflator almost perfectly correlate with the fluctuation in commodities prices (Chart I-8). This proves how much China's economy is exposed to commodities cycles and how much of nominal GDP swings are stipulated by resource price swings. Chart I-7China: Credit And ##br##Nominal GDP Growth China: Credit And Nominal GDP Growth China: Credit And Nominal GDP Growth Chart I-8China's GDP Deflator Is Very Sensitive##br## To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices As commodities prices decline, China's GDP deflator, producer prices and nominal GDP growth will all dwindle. Thereby, China's underlying steady state nominal GDP growth is probably around 8% at best (5.5-6% real growth), with inflation of 2-2.5% (assuming flat commodities prices). If this is indeed the case, corporate and household credit growth of 12% entails a further build-up of leverage and an escalating non-public credit-to-GDP ratio, which already stands at 225% of GDP: corporate debt is 180% and household debt is at 45% of GDP. Bank loans account for 70%, while shadow (non-bank) funding channels (corporate bonds, trust products, entrusted loans, and banker's acceptance) constitute 30% of outstanding non-public credit or 65% of GDP. Both are growing at an annual rate of 11-12.5% (Chart I-9). On the whole, the share of shadow banking is non-trivial and its current growth pace is unsustainable amid ongoing regulatory tightening and rising interest rates. Furthermore, banks are themselves exposed to shadow banking as their claims on non-depository financial institutions have risen exponentially from RMB 3 trillion to RMB 27 trillion over the past five years. In regard to non-standard credit assets,3 our estimates are that banks' off-balance-sheet exposure is RMB 10 trillion compared with RMB 18.3 trillion of their balance-sheet non-standard credit assets. The off-balance-sheet credit exposure to non-standard credit assets is much larger for medium and small banks than the largest five (Table I-1). We discussed these issues in greater detail in our June 15, 2016 Special Report titled "Chinese Banks' Ominous Shadow". Chart I-9Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Chart I- With banks being forced by regulators to bring off-balance-sheet assets onto their balance sheets, their capital adequacy ratios will drop and their ability to sustain double-digit credit growth will be curtailed. Chart I-10Stay With Short Small / Long Large ##br##Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade The risks to medium and small banks is greater than to the large five banks. That is why we reiterate our recommendation from October 26, 2016 to short small banks versus large ones (Chart I-10). As a final note, we are often asked whether the government will provide a bail out if things deteriorate. Yes, we concur that policymakers will step in and backstop a financial system to preclude a systemic crisis. However, they are tightening now, and like the rest of us have little visibility. The authorities will meaningfully reverse the ongoing monetary tightening only if the pain on ground becomes visible or economic data deteriorate considerably. Financial markets will sell off materially in advance. Bottom Line: Investors should not be long China-plays, commodities and EM risk assets when mainland policy tightening is occurring amid lingering speculative credit excesses. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Strategy For Chilean Markets We recommended receiving 3-year swap rates on November 2, 2016 and this position has panned out with rates dropping by 30 basis points. We now recommend booking profits. The following has led us to conclude that the risk-reward profile of this position is no longer attractive: The improvement in narrow money (M1) growth points in a bottom in the economic activity indicator (Chart II-1). Mining production plunged amid the strikes in the world's largest copper producer Codelco (Chart II-2, top panel) and manufacturing production has also been contracting (Chart II-2, bottom panel). A period of improvement in mining and manufacturing output from a very low base is likely. Chart II-1Book Profits On Receiving ##br##3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Chart II-2Chile: Money And Economic##br## Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out This will ameliorate overall business conditions and cause the central bank, at least for the time being, to halt the easing cycle. The pace of expansion in employment, wage growth, and consumer credit remains decent (Chart II-3). This will put a floor under household spending growth for now. Odds are that copper prices will decline meaningfully in the next nine months or so, which will cause the Chilean peso to depreciate. Although a depreciating currency will not to lead to materially higher interest rates in Chile, it will limit downside in local rate expectations. Finally, local 3-year swap rates and their spread over U.S. 3-year bond yields are extremely low from a historical perspective (Chart II-4). At this point, there is little value left in Chilean local rates. Chart II-3Chile's Mining And Manufacturing ##br##A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chart II-4Chile: Consumer Spending##br## Is Holding Up Chile: Consumer Spending Is Holding Up Chile: Consumer Spending Is Holding Up Investment Conclusions Chart II-5Chilean Local Rates Spreads Over ##br##U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left We do not expect the central bank to hike but the downside in local rates is limited for the time being. Take profits on the receiving 3-year swap rate trade. As to equities, the outlook for relative performance is balanced; we continue recommending a benchmark weight in Chile for dedicated EM equity portfolios. For absolute return investors, the risk-reward profile is not attractive because our profit margin proxy points to a relapse in corporate earnings (Chart II-5). Unit labor costs are rising faster than the core inflation rate, producing a profit margin squeeze (Chart II-5, bottom panel). Finally, we continue shorting the peso versus the U.S. dollar as a bet on lower copper prices. 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports titled, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?", dated March 23, 2017, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, "Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 3 Non-standard credit assets are banks' claims on corporates that are not classified as loans. For more details please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominous Shadow", dated June 15, 2016, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Geopolitical risks remain overstated in 2017, but China and Italy could scuttle the party; June elections in France and the U.K. are not market-movers; But early Italian election is a risk that could prompt the ECB to stay easy, close long EUR/USD for a gain; U.S. budget reconciliation process may be arcane, but is vital to understand upcoming tax reform process; Investors should expect details of tax reform by Q4 2017, but legislation may only pass in Q1 2018. Feature We turned the traditional adage of "sell in May and go away" on its head last month in a report titled "Buy In May And Enjoy Your Day!"1 So far so good (Chart 1). The fundamental reasons behind the breakout is the narrowing of the global equity risk premium on the back of easy monetary policy and a recovering global economy (Chart 2) two trends that our colleagues at the Global Alpha Sector Strategy highlighted last September.2 Since then, geopolitical risks cited as likely to end the party have been largely overstated.3 We continue to worry about Chinese financial sector reforms, U.S. politics, Sino-American tensions, signs of growing U.S. mercantilism, prospects of early Italian elections, and especially the developments in North Korea. But these remain risks for 2018, rather than 2017.4 Chart 1Blow-Off Phase Has Resumed Blow-Off Phase Has Resumed Blow-Off Phase Has Resumed Chart 2Global ERP Has Room To Fall Global ERP Has Room To Fall Global ERP Has Room To Fall There are still some "loose ends" to tie up from the first quarter, including the upcoming French legislative and U.K. general elections. On the former, there is nothing to say other than that investors should indeed prepare for a "French Revolution," by which we mean a supply-side revolution.5 Current seat projections based on the latest polling have pro-market, centrist, Europhile parties controlling between 85-92% of the National Assembly following the two-round elections in mid-June (Diagram 1).6 Diagram 1French National Assembly Seat Projection Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep Yes. In France. Skeptical commentary will surely rain on the centrist parade by pointing out that anti-establishment presidential candidates won nearly 50% of the vote in the first round of the presidential election (true), that Marine Le Pen will be back even stronger in 2020 (false), or that the electoral system is designed to suppress the populist vote (yes, so what?). We are not as perceptive nor profound as the witty op-ed writers. Our far simpler conclusion is that the French National Assembly will elucidate the revealed preference of the French electorate, given the electoral rules that are quite familiar to all French voters. And that preference appears to be for pro-market, and quite possibly painful, structural reforms. We remain long French industrials relative to German ones, but our clients may find alternative ways to play the upcoming free-market revolution in France. On the British front, Tory PM Theresa May is facing her first genuine crisis. The impact of the Manchester terrorist attack on the election is difficult to forecast. However, May's "dementia tax" gaffe has clearly given Labour new life in the polls (Chart 3). What most commentators saw as a clear shoo-in for the Conservative Party has now become a competitive, if not exactly tight, race. Chart 3Labour Gains... Labour Gains... Labour Gains... Chart 4...But Tories Keep Devouring UKIP ...But Tories Keep Devouring UKIP ...But Tories Keep Devouring UKIP We would note that despite Labour's rise in the polls, May's strategy of suppressing the UKIP vote by campaigning from the nationalist right is paying off. As Chart 4 illustrates, UKIP voters appear to be switching to the Tories en masse: UKIP has gone from support of 20% in April 2016 to under 5% today. Given Britain's first-past-the-post electoral system, May's strategy of swallowing the UKIP whole is a savvy move. It will eliminate the probability that UKIP siphons votes away from the Tories in competitive constituencies. Our own, highly conservative, estimate gives the Tories a minimum of 11 gained seats (Table 1). This is based on constituencies that voted for Brexit but where Labour and the Liberal Democrats won by less than 5% in the last election. Table 1Minimal Scenario Gives Tories 11 New Seats For Their Majority Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep We do not think that the election will have much impact on the Brexit process. Political risks peaked in January when May announced that she planned to take the U.K. out of the EU Common Market. We pointed out at the time that this decision made it highly unlikely that the U.K. and EU negotiations would take an acrimonious turn.7 The market agreed with us, with the pound bottoming in mid-January. We continue to believe that the Brexit process will have no investment relevance for global assets. As for U.K. equities and the pound, a larger-than-expected seat grab by the Tories (375+) at the upcoming election would likely strengthen the pound further, which in turn could weigh on the FTSE 100 (with the FTSE 250 being less affected). A disappointing result, one where the Conservative Party fails to reach 350 seats, could create temporary headwinds for the pound. The one risk that remains on our horizon is faster-than-expected deleveraging in China. As we mentioned in our report last week, China's financial crackdown raises near-term risks (Chart 5).8 We do not think that policymakers are looking to enact wide scale financial sector reform, which would entail a surge in realized non-performing loans, bankruptcies, and defaults ahead of the Fall Party Congress. However, Chinese investors and businesses may already be looking ahead to 2018. Chart 5Policymakers Are Inducing Financial Risk... Policymakers Are Inducing Financial Risk... Policymakers Are Inducing Financial Risk... Chart 6...At A Time When Vulnerability Is Growing ...At A Time When Vulnerability Is Growing ...At A Time When Vulnerability Is Growing China's reserves-to-M2 ratio - an IMF-proposed measure that captures Chinese reserves of liquid assets against those that its residents could potentially liquefy as part of wide scale capital flight - has continued to decline (Chart 6). Measures of quarterly net portfolio flows and capital flight show that the Q4 2016 outflows accelerated sharply after a slowdown in outflows in the previous two quarters (Chart 7), although we have no information for Q1 2017. More recently, there has been a stunning surge in Bitcoin prices. The crypto-currency is up 65% since the start of May, which cannot be attributed to Euro Area fears given the victory of Europhile Emmanuel Macron in the French election. Could it be related to policy uncertainty in China? We think yes (Chart 8). China remains our pick for the risk that is most likely to scuttle our sanguine view on global risk assets in 2017. Chart 7Chinese Outflows Restarted In Q4 2016 Chinese Outflows Restarted In Q4 2016 Chinese Outflows Restarted In Q4 2016 Chart 8Chinese Uncertainty Is Bitcoin's Gain Chinese Uncertainty Is Bitcoin's Gain Chinese Uncertainty Is Bitcoin's Gain The final risk to investors that we have been tracking this year is inaction by U.S. Congress on the tax reform front. We have received many client questions regarding when investors should expect to see tax reform legislation and when (and how) it is expected to pass. We turn to this question in the rest of this report. Market Relevance Of The Budget Reconciliation Process The U.S. legislative process is complicated, arcane, and highly mutable. We have tried to spare our clients as much of the headache of U.S. congressional procedure as possible.9 However, the budget reconciliation process underpins current efforts to reform both the 2010 Affordable Care Act (Obamacare) and enact tax reform. To understand how, when, and whether the GOP-controlled Congress will pass these pieces of legislation, it is necessary for investors to learn the basics of the reconciliation process in particular, and the budget process more broadly. Budget reconciliation - or simply, reconciliation - simplifies the process of passing a budget and was introduced by the Congressional Budget Act of 1974.10 To understand why reconciliation matters, we first have to explain how the U.S. Congress sets the budget. The U.S. Budget Process The U.S. budget process (Diagram 2) begins with the U.S. president submitting the White House budget request to Congress. This is a largely ceremonial act as Congress has the power over the appropriations process. Diagram 2U.S. Budget Process: A Tentative Timeline Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep Congress takes into account the president's request as it formulates a budget resolution, which both houses of Congress pass but which is not presented to the president and does not actually constitute law. The resolution sets out the guidelines for the budget process, which is supposed to ultimately produce an appropriations bill. It is this bill, also referred to as a budget bill, which appropriates funding for the various federal government departments, agencies, and programs. Under a revised timetable in effect since 1987, the annual budget resolution is supposed to be adopted by both chambers of Congress by April 15, giving legislators sufficient time to then pass a budget bill by the start of the fiscal year on October 1. However, there is no obligation to do so. In fact, Congress failed to pass a budget resolution for most of President Obama's two terms in office due to a high degree of polarization between the Democrats and Republicans. As such, the government was funded via "continuing resolutions," which merely extended pre-existing appropriations at the same levels as the previous fiscal year. Reconciliation Process Where does the reconciliation process fit? It was originally introduced to simplify the process of changing the law on the books in order to bring revenue and spending levels into line with the budget resolution. The crucial feature of the process, and the reason we are focusing so much on it, is that it limits the debate in the Senate to 20 hours, thus automatically preventing any Senator from filibustering the ultimate legislation that emerges from the reconciliation process. No filibuster, no need to reach 60 Senate votes to invoke cloture, an act that ends the debate in the chamber. In the current context, where the Republican Party controls 52 seats, this means that the Republicans can use the reconciliation process to pass legislation that would otherwise be "filibustered" in the Senate. The reconciliation procedure is a very powerful legislative tool by which Congress can pass controversial legislation, as long as such legislation has an impact on government revenues or spending levels. Tax legislation, obviously, would impact government revenues. George W. Bush used the reconciliation procedure to lower taxes in 2001 and 2003. His father, George H. W. Bush used reconciliation to raise taxes in 1990 (and thus roll back some of the Ronald Reagan 1986 tax reform). The 1996 welfare reform - the Personal Responsibility and Work Opportunity Reconciliation Act of 1996 - was also passed via the reconciliation process. Obamacare was not passed via the reconciliation procedure. The main portion of the bill - including almost all of its key provisions - was passed at the beginning of the 111th Congress in 2009 when the Democrats held 58 seats in the Senate following the momentous 2008 election.11 It was the subsequent amendments to the original bill that required the reconciliation process due to the death of Massachusetts Senator Ted Kennedy, particularly several crucial funding provisions. The one unifying feature of all reconciliation bills is that they must have an impact on the budget, essentially by changing the revenue or spending levels of the federal government. If the bill introduces extraneous provisions that deviate from the budgetary requirement, then these can be struck out by invoking the so-called "Byrd rule." Waiving the Byrd rule requires an affirmative vote of three-fifths of the Senate, which is 60 votes. As such, it essentially requires the 60-seat majority needed to also invoke cloture, making the entire reconciliation process redundant. Bottom Line: The budget reconciliation process allows U.S. Congress to pass legislation without the a 60-seat Senate majority. However, procedural rules require the provisions of a reconciliation bill to deal exclusively with legislation that impact government revenue or spending levels. Timing Since the introduction of the procedure in 1974, there have been 24 reconciliation bills, three of which were vetoed by the president. The reconciliation process begins with the passing of the budget resolution, which sets out the "reconciliation instructions." However, since the procedure was introduced, it has rarely progressed along the intended timeline. The very first reconciliation act in 1980 was introduced in a budget resolution that passed well after the April 15 deadline, in mid-June. And the ultimate appropriations bill, the Omnibus Reconciliation Act of 1980, was only signed into law in early December 1980, so essentially two months after the start of FY1981 on October 1. Investors should therefore understand that the U.S. budget process has no real firm deadlines. The schedule is highly malleable. A reconciliation bill also does not have to be passed with the actual budget. Despite being initiated by the budget resolution, reconciliation runs parallel to the budget process. For example, Congress has already set appropriations for FY2017, but the reconciliation bill on Obamacare - set by the FY2017 budget resolution - is still in negotiations. Diagram 3 illustrates that half of all reconciliation bills were passed after the start of the fiscal year for which they were introduced in a budget resolution. And five reconciliation bills were passed in the calendar year of the fiscal year for which they were supposed to reconcile the budget, basically mid way through the fiscal year. Diagram 3Timing Of Reconciliation Procedures Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep This is important in the current context because investors are waiting for tax reform legislation which is supposed to be passed via the budget reconciliation process for FY2018. However, the GOP-controlled Congress has not even finished the budget process for FY2017. In fact, the budget resolution for FY2017 only passed the House on January 13, 2017. As we learned above, U.S. budget process guidelines call for the budget resolution to have been passed by April 15, 2016. As such, the Obamacare repeal and replace bill, if it were to ultimately pass the Senate, would certainly be the most delayed reconciliation bill ever. In fact, we could see the current Congress passing the FY2017 reconciliation bill in the waning days of FY2017! Congressional rules only allow one budget resolution to be active at any one time. In fact, as soon as a new budget resolution is passed, the old reconciliation instructions are made void. As such, investors have to wait for the Republicans to decide what they plan to do with the Obamacare reconciliation bill before they begin contemplating tax reform. Bottom Line: Republicans in Congress decided to issue reconciliation instructions as part of the FY2017 budget resolution, which passed in January. As such, investors have to wait until that process ends - with either Obamacare repeal or failure of the bill - before Congress can produce a FY2018 budget resolution with reconciliation instructions for tax reform. We suspect that the FY2018 budget resolution will be passed sometime between the end of the August Congressional recess, on September 5, and December. But that is just a guess (Diagram 4). It could happen earlier, in July, if Obamacare is dealt with over the next month. Diagram 4Tentative U.S. Political Timeline Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation And The Markets - Warning: This Report May Put You To Sleep Reconciliation Rules And Tax Reform Changing America's complex tax laws is precisely the sort of legislative action that reconciliation was designed to facilitate. That said, investors are still not sure whether the Trump administration and Congress will be able to agree on comprehensive tax reform that includes lowering top rates for corporations, or whether they will merely agree to cut household taxes on households. Some clarity will emerge once the Republican-controlled Congress passes the FY2018 budget resolution, which will contain reconciliation instructions for either comprehensive tax reform (most likely) or merely household tax reform (unlikely). At that point, the length of the reconciliation process will depend on how much agreement there is surrounding tax reform. Diagram 3 shows that tax cuts - such as those in 2001 and 2003 - take relatively little time to pass. Tax reform, on the other hand, could take a while longer given multiple competing interests. If comprehensive, we would expect tax reform to be passed by the end of Q1 2018. Would that mean that tax cuts would only be effective from January 1, 2018? Or, even less bullish, from the start of FY2019? No. The GOP would have the option of making tax cuts retroactive and thus can avoid a huge market disappointment if tax cuts come later in the next year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.12 Can reconciliation be used to pass budget-busting tax reform, as we have argued investors should expect? You bet! From 1980 to the 1990s the reconciliation procedure was primarily used - and in fact designed - to reduce the deficit through reductions in mandatory spending, revenue increases, or both. It has since become a tool to expand deficits. This was most famously done by the Bush era reconciliation bills in 2001 and 2003, which introduced large tax cuts. The aforementioned Byrd rule forces any provision of a bill that increases the deficit beyond the years covered by the reconciliation bill to "sunset." In the case of the 2001 and 2003 bills, this meant that Bush-era tax cuts expired in 2011 (estate tax) and 2013 (which investors will remember as the "fiscal cliff"). The sunset period does not have to be ten years, it could conceivably be a lot longer, in effect making tax reform permanent, as far as most investors' time horizons are concerned. Following the Democratic Party sweep in the 2006 midterm elections, the Democrat-controlled Senate changed reconciliation rules to prohibit any deficit-increasing measures, regardless of the sunset clause loophole. However, the Republicans changed the rules back in 2015, after they re-took the Senate in the 2014 midterm election. This is crucial for two reasons: first, it means that the current procedural rules on the books allow deficits to be blown out via the reconciliation procedure and second, it establishes that the current cohort of Republicans in Congress is fiscally profligate, despite media punditry to the contrary. Bottom Line: The reconciliation process was designed to facilitate precisely the type of legislation that Republicans will try to pass via tax reform. According to the current procedural rules, such legislation can increase the budget deficit, as long as it sunsets at the conclusion of the budgetary period set out by the legislation (normally 10-years, but it could be longer). We suspect that tax reform will take until Q1 2018 to pass, but Republicans will be able to make its effects retroactive to January 1, 2017. The Big Picture - What Does It All Mean For Fiscal Policy? We expect the Republican-held Congress to attempt to pass comprehensive tax reform over the next four quarters. If the GOP fail to agree on "revenue offsets" for corporate tax cuts, we could see the Republican Congress electing to pass simple tax cuts for households, as the Bush-era tax cuts of 2001 and 2003 did. To facilitate such legislation politically, the Republicans will rely on "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue lost through tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, factors that actually add to revenues. In other words, "tax cuts pay for themselves." It is true that the Congressional Budget Office (CBO) will balk at dynamic scoring. But we doubt that "egghead, socialist economists" will stand in the way of tax reforms. As we discussed above, the CBO's score will ultimately only force the Republicans to "sunset" tax reform legislation, not scuttle it. The market disagrees with us. After a wave of euphoria following the presidential election, the market has largely priced out meaningful fiscal stimulus. This can be seen in the flagging relative performance of infrastructure stocks and highly-taxed companies, as well as in the sharp decline in inflation expectations (Chart 9). Chart 9Market Has Voted: No Fiscal Stimulus Market Has Voted: No Fiscal Stimulus Market Has Voted: No Fiscal Stimulus We think the market is making a serious mistake by taking the Republican mantra of "revenue neutral" - meaning that any tax cuts would need to be offset by other revenue-raising measures - tax reform seriously. This is easier said than done. The three main ways that House Republicans have offered to pay for corporate and personal tax cuts - introducing a border adjustment tax, eliminating the deductibility of business interest payments, and jettisoning the deduction for state and local income taxes for individuals - will all face resistance from vested interests. We suspect that the GOP will produce some revenue offsets, but not enough to have a revenue-neutral tax reform. The path of least resistance, therefore, will be to bust the budget and then force the measures to expire over the life of the budget-setting window. White House budget director Mick Mulvaney has already floated the idea of extending the 10-year budget scoring window to 20 years. This would allow tax reform measures, even if they are characterized by the CBO as profligate, to expire in two decades. That's practically a lifetime away, as far as any investor is concerned. What is the investment significance of a stimulative tax reform package? Our colleague Peter Berezin has recently pointed out that it is ironic that fiscal stimulus is coming to America only when the economy has reached full employment. This means that much of the increase in aggregate demand arising from a more expansionary fiscal stance will be reflected in higher inflation rather than faster growth. This does not represent a major threat to risk assets now, but could later next year, as the Fed responds to greater fiscal thrust with tighter monetary policy.13 We encourage our clients to read BCA Special Report "Beware The 2019 Trump Recession," penned by Martin Barnes in March, which details the likely path that assets and the economy will take over the next two years.14 In the short term, the market will continue to fret that tax reform is doomed and that Republicans are committed to austerity. However, budget-busting tax reform could begin to be priced in by the market well before the reconciliation bill is ultimately passed. We suspect that the outlines of tax reform will emerge this summer. The market may realize that stimulus is coming as soon as the FY2018 budget resolution, containing tax reform instructions, is passed in Q3 or Q4 2017. Such a realization later this year could augur a violent snap-back in the USD. Currently, the two-year real interest rate differentials between the euro area and the U.S. have widened by 58 basis points in favor of the latter since the end of March, even though EUR/USD has actually rallied over this period (Chart 10). We have been long EUR/USD since March 22,15 in expectations that investors would be busy covering their euro hedges that they put on in the lead up to the French elections, the outcome of which we have had a high conviction on since November.16 However, now that net long speculative positions in the euro have risen to a three-year high - having been deeply short just a few weeks ago - the speculative demand for euros will ultimately subside (Chart 11). Chart 10Widening Real Rate ##br##Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Widening Real Rate Differentials Support The Dollar Chart 11Speculators Are Long The Euro##br## For The First Time In Three Years Speculators Are Long The Euro For The First Time In Three Years Speculators Are Long The Euro For The First Time In Three Years We are therefore closing our USD short versus both the euro and the pound, for gains of 3.48% and 3.34% respectively. As we expected, the ECB is going to look to guide investors towards a "dovish" tapering of its QE program. Speaking before the European Parliament's committee on economic affairs, ECB President Mario Draghi confirmed that "very accommodative financing conditions" reliant on "a fairly substantial amount of monetary accommodation" would continue. The ECB will have to make a decision whether to extend its sovereign bond purchase program into the next year or start winding it down as planned. Given news flow out of Italy that an election may be planned as early as September, the ECB may be forced to stand pat until after the end of the year. Given our view that tax reform in the U.S. would ultimately happen, and that it would eventually be marginally stimulative, any resurfacing of political risks in Europe - which we are expecting - should be negative for the EUR/USD. What should investors do about European equities? We are cautious. As we have been pointing out to our clients since September of last year, Italy is the political risk in Europe.17 However, we think that most investors are willing to bet that European equities can survive Italian political turbulence. This could be a mistake in the short term, as we think that Euroskeptic (albeit evolving) Five Star Movement could win a plurality in the next election. In the long term, Italy will become ECB's proverbial boulder, that Draghi must push up a hill like Sisyphus, only to see it roll down to the bottom with each bout of Italian political instability. As such, Italy's instability will force ECB to set its monetary policy for the weakest link in the Euro Area (Italy), rather than the aggregate. This should be positive for Euro Area risk assets, but negative for the euro, all other things being equal. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Strike While The Iron Is Hot," dated September 2, 2016, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com. 6 The dates for the two rounds of the legislative elections are June 11 and 18. 7 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 10 We draw on several overviews of the budget reconciliation process in this report. Please see David Reich and Richard Kogan, Center on Budget and Policy Priorities, "Introduction To Budget 'Reconciliation'," dated November 9, 2016, available at cbpp.org; Megan S. Lynch, Congressional Research Service, "The Budget Reconciliation Process: Timing Of Legislative Action," dated February 23, 2016, available at fas.org; and Megan S. Lynch, Congressional Research Service, "Budget Reconciliation Measures Enacted Into Law: 1980-2010," dated January 4, 2017, available at fas.org. 11 To reach the required 60 seat filibuster-proof majority the Democrats relied on some luck and cunning. Democrat Al Franken unseated Republican Incumbent Norm Coleman in a recount in Minnesota and Arlen Specter, a Republican from Pennsylvania, switched his party affiliation to Democrat. 12 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and the courts upheld the legislation. Hence, there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar tax years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 13 Please see BCA Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight," dated May 26, 2017, available at gis.bcaresearch.com. 14 Please see BCA Research Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off Growth Momentum Already Starting To Cool Off Growth Momentum Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Stable NZ Growth...For Now Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President Markets Not Worried About The New President Markets Not Worried About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea Sluggish Growth In South Korea Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets" dated May 24 2017, available at gps.bcaresearch.com. 7 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Distant Early Warning Distant Early Warning Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Feature Chart 1 C1 C1 Senior officials at the Federal Reserve have begun preparing the market for the eventual run down of the central bank's balance sheet. After several rounds of quantitative easing (QE), total assets held by the Fed currently stand at US$4.5 trillion - a dramatic increase from US$900 billion before the global financial crisis. Indeed, efforts to shrink the Fed's balance sheet are essentially reverse QE. As the 2013 'Taper Tantrum" suggests, such a profound change in U.S. monetary policy can have a significant impact on interest rates and broader financial assets, and Fed officials are working hard to properly anchor market expectations. In comparison, how the People's Bank of China manages its balance sheet is much less transparent and less understood by market participants, even though the PBoC has the biggest balance sheet among the world's major central banks (Chart 1). Currently, the PBoC's total assets amount to US$4.9 trillion, compared with about US$4.5 trillion for both the Fed and the European Central Bank (ECB). Moreover, its balance sheet has stopped growing since 2015 in local currency terms and has been shrinking in dollar terms, but the impact on the economy and financial markets has so far not been material. Generally speaking, a central bank uses its balance sheet to aid monetary policy. It controls the size and composition of its assets to affect interest rates, and in turn the economy. Through "operation twist" and QE, the Fed significantly increased its holdings of longer-dated Treasury securities and mortgage backed securities (MBS), which currently account for 95% of its assets (Table 1). Therefore, shrinkage of the Fed balance sheet means that the Fed's holdings of long-term securities will gradually be reduced - likely by allowing them to run off at maturity rather than selling them in the open market. This should nonetheless put some upward pressure on long-term risk-free rates going forward. Table 1The Fed's Balance Sheet Shrinking Of The PBoC's Balance Sheet Shrinking Of The PBoC's Balance Sheet In a Special Report we published six years ago, we pointed out the explosion in the PBoC's balance sheet and its unique features compared with other central banks.1 In a nutshell, the PBoC's biggest holdings on its asset side were U.S. Treasurys rather than domestic risk-free assets. The Chinese central bank was essentially engaging in a massive "currency swap" in which it accumulated U.S. Treasurys while dramatically increasing the country's monetary base. Meanwhile, it was also working hard to "sterilize" by forcing commercial banks to maintain an increasingly massive sum of required reserves with the central bank. These policy tools, however, were inherently crude and clumsy, with huge volatility in monetary market rates and overall financial volatility being a key after-effect. This week we are revisiting the PBoC's balance sheet to highlight some major shifts in recent years. Some developments are worth highlighting. Dynamics have completely reversed since 2015, when Chinese official reserves began to fall, leading to a shrinking in the PBoC's balance sheet by about US$500 billion since the all-time peak. The "sterilization" process has also been reversed, as the PBoC has been releasing liquidity back into the domestic financial system. The overall liquidity situation has been largely stable. Normally a decline in the PBoC's foreign asset holdings would lead to a decline in the reserve requirement ratio (RRR) to offset the liquidity outflows, leading to a simultaneous decline in both sides of the central bank's balance sheet. The PBoC, however, has been resisting shrinking its balance sheet. As its foreign asset holdings (U.S. Treasurys) have been declining, the PBoC has significantly ramped up domestic asset holdings by increasing direct claims on commercial banks through repos and other lending facilities. The central bank appears to be concerned that a lowered RRR will stoke more domestic capital outflows, which risks creating a vicious circle. How the PBoC manages domestic liquidity has seen major shifts in recent history, and will likely continue to evolve going forward. The RRR, as a monetary policy tool, will likely be gradually phased out.2 Over the long run, this will lead to important changes in the PBoC's balance sheet and the way it conducts monetary policy. In the short term, commercial banks' excess reserves are at close to record low levels. The odds are rising that the RRR will be lowered in the coming months, especially if the RMB stabilizes against the dollar, as we expect.3 Finally, it is worth noting that the most aggressive phase of the Fed's QE efforts coincided with the most rapid phase of the PBoC's balance sheet expansion. This means that both central banks were aggressive buyers of U.S. Treasurys and risk-free assets in previous years. Looking forward, if a shrinking Fed balance sheet leads to a sharp increase in U.S. interest rates and a dollar rally, it could force the PBoC to also liquidate its holdings of U.S. Treasurys to stabilize the RMB exchange rate. This means both the Fed and the PBoC could become marginal sellers of Treasurys, which would have a much more profound impact on U.S. interest rates and the growth outlook. Monitoring the PBoC's balance sheet will become increasingly important for Fed watchers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Delving Into the PBoC'S Balance Sheet," dated July 27, 2011, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "More On The Chinese Debt Debate," dated April 20, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Can The RMB Appreciate Against The Dollar, Again?" dated May 11, 2017, available at cis.bcaresearch.com. Table 2 offers a simplified balance sheet of the People's Bank of China. Foreign assets still account for 65.6% of its total assets, down from a peak of 83% in 2014. In comparison, most other major central banks' assets are predominantly domestic government bonds. The explosive growth of the PBoC's holding of foreign assets had been the only source of its balance sheet expansion before 2015. In the past two years the PBoC's domestic assets have increased sharply. Overall the PBoC's balance sheet has stayed flat in the RMB terms. PBoC's holding of foreign and domestic assets has been matched by expansion of reserve money (monetary base) on the liability side of the PBoC's balance sheet, including currency issuances (M0 and cash in the vaults of depository institutions) and deposits of commercial banks in the central bank. Commercial banks' reserve deposits at the PBoC have continued to grow even though the PBoC balance sheet expansion has stalled. (Chart 2) Table 2The PBoC's Balance Sheet Shrinking Of The PBoC's Balance Sheet Shrinking Of The PBoC's Balance Sheet Chart 2 C2 C2 PBoC holdings of foreign assets include foreign exchange reserves and gold. Foreign reserves currently account for 63% of PBoC total assets, compared with a peak of 84% in 2014. Official record shows that gold is still a negligible share of its total assets. Other major items on the asset side of the PBoC's balance sheet include claims on the government, commercial banks and other financial corporations. The PBoC's claims on the government (entirely on the central government) account for 4.5% of its total assets. In 2007 the government set up a sovereign wealth management fund to manage part of the country's reserves. The government issued bonds to the PBoC in exchange for foreign exchange reserves, which was used as capital of the investment firm. Legally the PBoC is forbidden to directly hold government bonds. The PBoC's claims on other depository corporations (commercial banks) include loans and rediscounts to commercial banks and the net amount of repurchase agreements, which has increased sharply since 2016. The PBoC claims on other commercial banks were a major policy tool to control liquidity in the early 2000s. The central bank's claims on other financial corporations mainly include loans to the asset management firms that the government set up in the late 1990s to deal with bad loans spun off from commercial banks. There has been no change in this item in recent years. (Chart 3 and Chart 4) Chart 3 C3 C3 Chart 4 C4 C4 On the liability side of the PBoC's balance sheet, the dominant item is reserve money, which includes currency issuances and deposits of depository corporations. Taken together these items account for almost 90% of banks' total liabilities. However, currency issuances (M0 and cash in vault) have been hovering around 20% of the PBoC balance sheet in recent years. Deposits of depository corporations account for about 66%. Deposits of commercial banks in the central bank include required and free reserves. Currency issuance and free reserves make up China's "high power money" that can result in a much larger increase in money supply through the money multiplier. Therefore, adjusting the reserve requirement ratio (RRR) on banks has been a key policy tool for the PBoC to control "loanable" funds and liquidity. The central bank, however, been reluctant to adjust RRR since 2016 despite continued liquidity outflow. Commercial banks used to hold large amounts of free reserves with the central bank, which however have declined sharply in recent years. The massive reserves of commercial banks in the PBoC offer a critical liquidity buffer for banks at times of crisis. As banks' free reserves have been running thin, there is a building case for an RRR reduction in coming months. (Chart 5 and Chart 6) Chart 5 C5 C5 Chart 6 C6 C6 Other major items on the liability side of the PBoC's balance sheet include bond issues, government deposits and foreign liabilities. The central bank started to issue bonds (notes) in 2002 as a way to sterilize foreign capital inflows, a tool that has essentially been phased out. Currently, total outstanding bonds amount to RMB 50 billion, a mere 0.1% of the PBoC total liability, compared with almost 30% in 2007. The PBoC's foreign liabilities are deposits of international financial institutions, which account for a negligible share of its total assets. Government deposits account for 8.4% of the central bank's total liabilities, or RMB 2.88 trillion at the end of April 2017. The PBoC regularly auctions off fiscal deposits to commercial banks as a way to adjust interbank liquidity. (Chart 7 and Chart 8) Chart 7 C7 C7 Chart 8 C8 C8 There are four main items on the PBoC's balance sheet that the central bank uses at its discretion to manage domestic liquidity: claims on depository corporations (banks), deposits of depository corporations, liabilities to the government (fiscal deposits) and bond issues. Claims on depository corporations are on the asset side, and include loans and rediscounts to commercial banks and the net amount of repurchase agreements. The PBoC has significantly expanded some new liquidity tools, such as various lending facilities and open market operations. These assets are mostly short term, allowing the central bank flexibility to adjust the quantity quickly. Reserve deposits of commercial banks, central bank bond issues and fiscal deposits are on the liability side of the PBoC's balance sheet, but reserve deposits play by far the largest role in the central bank's sterilization efforts. Commercial banks reserve deposits are still hovering around record high levels. (Chart 9 and Chart 10) Chart 9 C9 C9 Chart10 C10 C10 Taken together, the ebbs and flows of the PBoC's sterilization operations coincide with the pace of country's foreign reserve accumulation. The PBoC was able to "sterilize" about 80% of foreign capital inflow before 2015, and it has been quickly adjusting its balance sheet to offset domestic capital outflows in the past two years. All these items on the PBoC's balance sheet should be cross-checked to assess its liquidity operations, rather than focusing on one item. Looking forward, the PBoC's liquidity operations will remain contingent on the situation of cross-border capital flows in the near term, and its monetary independence will remain compromised. Over the long run, a free-floating RMB exchange rate will diminish the purpose of PBoC's precautionary holdings of foreign reserves, which will in turn impact how the central bank manages its balance sheet for domestic considerations. (Chart 11 and Chart 12) Chart 11 C11 C11 Chart 12 C12 C12 Cyclical Investment Stance Equity Sector Recommendations