Business Cycles

Highlights Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures. The most reliable leading (forward looking) indicators of Chinese business cycle have been money and credit. Presently, all money and credit indicators forecast an imminent slowdown in the industrial sectors and a relapse in base metals prices. A new trade: short copper / long Chilean peso. Inflation in Hungary will surge. Continue betting on yield curve steepening in Hungary and stay short HUF versus PLN. Feature Copper and industrial metals prices continue to signal strong growth in China, while the majority of the country's money and credit measures forecast an imminent growth slump. Which one is correct, and which one should investors heed to when formulating their investment strategy? Chart I-1 demonstrates that our broad money measure (M3) and private and public credit impulses for China both lead copper and industrial metals prices by about nine months. Based on the historical track record, odds are that investors will be better off following these money and credit indicators rather than heeding the bullish message from copper and other industrial commodities. While copper prices are coincident with the business cycle, money and credit impulses lead not only the real economy but also industrial metals prices. Copper Copper prices have surged of late (Chart I-2), seriously challenging our negative view on Chinese capital spending, commodities and EM. In fact, the rally in industrial metals has not been confined to copper but has been broad-based, and is, at first blush, suggestive of continued strength in global and Chinese industrial cycle. Chart I-1China's Money/Credit Leads Industrial Metals Prices Chart I-2Traders Are Very Bullish On Copper: A Contrarian Signal? Consistently, China's manufacturing PMI has picked up over the past three months, as has the overall EM PMI ex-China (Chart I-3). China's aggregate imports of copper products, unwrought copper, copper ore and concentrate as well as copper scrap have been contracting since May, and interestingly, they have historically often been negatively correlated with copper prices (Chart I-4). Hence, little insight can be drawn from Chinese imports of copper, as these purchases do not correlate with the mainland's business cycle. Chart I-3China/EM PMIs Have Risen Chart I-4Chinese Copper Imports And ##br##Copper Prices: Negative Correlation? On the contrary, Chinese imports of copper typically rise when copper prices fall and its industrial sector is decelerating. The reason: Chinese importers time their commodities purchases when prices slump, and do not chase prices higher. In short, when attempting to predict the sustainability of Chinese economic activity, there is little to be gained in examining Chinese copper imports. Bottom Line: Industrial metals prices are signaling that China's business conditions are presently robust, but they lag the credit and money measures discussed below. Leading Indicators: Money And Credit In our experience, the best leading indicators of the Chinese business cycle have been money and credit growth, more specifically, their impulses. The latter is the change in money/credit growth, or the second derivative of outstanding money/credit. In fact, money/credit impulses lead both the leading economic indicator and the well-known Li Keqiang index (Chart I-5). The latter two are often used by analysts and investors to gauge the direction of the Chinese economy. In recent months, we have done extensive work to properly measure money and credit. This has led us to the realization that China's official M2 and total social financing have not reflected the true dynamics in money creation and leverage formation over the past two years. In particular, M2 has over the years become a less all-encompassing money measure, as the size of commercial banks' liabilities that are not counted as part of M2 has exploded in recent years. So, the gap between M2 and other measures of money and credit has in the recent years widened as depicted on the top panel of Chart I-6. Chart I-5China: Money/Credit Leads ##br##Leading Economic Indicators Chart I-6China: Money/Credit Growth Have Fallen To New Lows The bottom panel of Chart I-6 demonstrates official M2, our version of broad money M3 (calculated using commercial banks' liabilities), credit-money (computed based on banks' balance sheet assets) and aggregate of private and public credit. All these measures have slowed to new lows. The most reasonable and all-inclusive measures from the four, in our view, is our measure of broad money M3 and private and public credit. As such, this is what we use to gauge the Chinese business cycle outlook. Chart I-7A and Chart I-7B demonstrate that the impulses of both M3 and private and public credit lead various business cycle and financial variables such as nominal GDP, manufacturing PMI, total imports, imports of capital goods, the freight index and producer prices as well as industrial profits. Chart I-7AChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (II) Chart I-7BChina: Money And Credit Impulses ##br##Entail Business Cycle Slowdown (I) Regardless of which money and credit measure we use, and regardless of their past track record, all of them currently suggest that China's business cycle is about to experience a considerable slump. Besides, money and credit impulses typically lead copper and industrial metals prices by about nine months, as shown in Chart I-1. These are the primary fundamental reasons why we are reluctant to alter our negative view on China's industrial cycle. Bottom Line: The most reliable leading indicators of the mainland business cycle have been money and credit. All money and credit indicators presently forecast an imminent slowdown in the industrial sectors. Financial markets are typically forward looking, and they change their direction before business cycles actually turn. Hence, from an investment strategy perspective, it makes sense to heed messages from leading indicators. Other Big Picture Considerations We have for several years argued that the rampant build-up in China's debt and credit excesses is unsustainable, and when credit growth normalizes/slows the economy will undergo a marked deceleration. Chart I-8Rising Interest Rates Herald A Further ##br##Slowdown In Money/Credit Growth Have these excesses been partially unwound, and has credit growth normalized? Not at all - the credit excesses have gotten larger. In fact, corporate and household debt and shadow banking credit have expanded enormously in the past two years. Even after the recent deceleration, broad money and credit continue growing at around 10% from a year ago (Chart I-6, bottom panel on page 5). Importantly, borrowing costs in China have recently resumed their upward move (Chart I-8, top panel) and rising interest rates will further dampen already slowed money and credit growth (Chart I-8, bottom panel) and thereby economic activity. In brief, from a big-picture standpoint, China's leverage situation has worsened, and interest rates are rising. While growth momentum is currently strong, financial markets leveraged to China's growth have already rallied a lot, and investor sentiment is quite bullish, as illustrated in Chart I-2 on page 2 in the case of copper. This makes the investment risk-reward profile of EM risk assets and commodities poor. Finally, some readers might wonder why we have been spending so much time focusing on China versus other developing economies. The basis is that China is now a major pillar of the global economy, and its cyclical economic trend materially influences those of many EM and DM countries. In short, every other developing country is too small to affect EM financial markets. But China does affect financial market dynamics in many other parts of the EM world. So, to gauge overall trends in EM financial markets, China and other global variables matter, yet individual developing countries do not. For the majority of emerging economies in Asia, Latin America and Africa, China is the dominant external force, similar to how the U.S. is for many of its trading partners. Similarly, Chinese interest rates are as important as borrowing costs in the U.S. Therefore, developments in Chinese interest rates, money/credit and economic activity are of paramount significance to many emerging markets. In particular, China's money as well as private and public credit impulses lead both EM and DM export shipments to China by about nine months (Chart I-9A and Chart I-9B). These developing nations' exports to China make up a meaningful part of their respective economies. In addition, industrial metals prices are by and large driven by China's capital spending, and hence affect commodities-producing countries. Chart I-9AExports To China Correlate ##br##With China's Money/Credit Chart I-9BExports To China Correlate ##br##With China's Money/Credit Bottom Line: In 2015 and 2016, China resorted to its standard playbook: money and credit origination, boosting capital spending and overall growth. In particular, China's broad money M3 and private and public credit both have surged by RMB 46 trillion in the past two years alone. Consequently, the excesses have become larger. That said, President Xi Jinping's ongoing campaign to control financial risks - and consequential tightening of monetary/liquidity conditions - entails considerable growth deceleration ahead. Risks Of Relying On Money And Credit There are a number of risks involved in relying on measures of money and credit. We discussed the velocity of money, the money multiplier and productivity in our last report1, and will only touch on these briefly this week: An economy can accelerate with sluggish or slowing money growth if the velocity of money rises materially. However, there is no basis to expect the velocity of money to rise in China now, given it has been declining for the past 10 years. Money and credit growth can recover quickly, despite rising interest rates, if the money multiplier spikes. However, the money multiplier is already extremely elevated in China, and the odds are low that it will surge further. This is especially true amid rising interest rates and the ongoing regulatory crackdown on off-balance sheet assets of banks and shadow banking. Real economic output can improve if productivity growth notably accelerates. Money growth and velocity of money will define nominal output, yet productivity will boost real output. However, it is unrealistic to expect productivity to improve meaningfully in China when structural reforms have not been widely implemented. Chart I-10China's Exports To The U.S. And EU Are ##br##Small Compared With Credit Origination Finally, some argue that robust exports to the U.S. and Europe can boost mainland growth, even if domestic demand slips. We disagree. China's combined annual exports to the U.S. and EU currently make up only US$ 0.77 trillion (6.6% of GDP). On the other hand, the amount of new private and public debt origination has amounted to US$ 3 trillion (25% of GDP) in the past 12 months (Chart I-10). Bottom Line: Given money and credit growth have already slumped, our negative outlook for China's capital spending and imports will be wrong if the 1) velocity of money rises considerably, 2) the money multiplier shoots up, or 3) productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial increase in either the velocity of money, the money multiplier or productivity from current levels would be highly conjectural, speculative and unreasonable. Some Market Observations: The U.S. Dollar And Oil The Greenback Chart 11 demonstrates that the U.S. dollar sits on its three-year moving average. A three-year moving average sometimes marks the borderline between structural bull and bear markets, as demonstrated in the case of the S&P 500 in the bottom panel of Chart I-11. Hence, the U.S. dollar is flirting with a structural bear market. Indeed, if the greenback slides further, it would signify a breakdown into a structural bear market. That said, if the broad trade-weighted U.S. dollar finds a bottom here, a meaningful rebound will ensue. Interestingly, the U.S. dollar has plunged even though U.S. real rates have not declined much (Chart I-12). The overwhelming portion of the drop in U.S. bond yields since early this year has been due to inflation expectations. Chart I-11Will The Greenback Find ##br##Support At Current Levels? Chart I-12U.S. TIPS Yields Have Not Dropped A Lot Typically, stable real rates amid falling inflation expectations are neutral-to-positive for an exchange rate. This has not been the case with the dollar this year. Pessimism within the fixed income and currency markets on U.S. growth is overdone. U.S. domestic demand is strong, the labor market is tight and global disinflationary forces that have suppressed U.S. inflation are alive and rampant in other parts of the world as well. Hence, there is no basis why the U.S. dollar should be punished more than other currencies because of secular global disinflation. Odds are that the euro has seen its lows in this cycle, and any selloff will not take it anywhere close its 2015-16 lows. Nevertheless, the outlook for EM currencies is meaningfully negative. The basis is that we believe EM business cycle amelioration is not sustainable - a growth slump in China, as discussed above, lower commodities prices and the hangover from the preceding credit booms in a number of countries will cap EM growth and weigh on their currency values. Bottom Line: Our take is that the dollar has been hammered too fast too far. Unless the U.S. dollar is in a structural bear market, odds are it will likely find floor here. Oil The current bear market in oil prices is tracking the 1980s bear market in crude reasonably well (Chart I-13). Based on this profile, oil prices will relapse further. We are reiterating our trade recommendation from March 8, 2017: short the spot oil price / long the Russian ruble. While both are correlated, the ruble offers 7.8% carry and will have less downside than crude. Hence, by being long the ruble, traders are being paid to short oil (Chart I-14). Stay with this position. Chart I-13Oil Is Tracking Its 1980s Bear Market Chart I-14Maintain Short Oil / Long Ruble Position A New Trade: Short Copper / Long CLP This week we recommend replicating the above oil trading strategy in the copper market. We believe shorting copper and going long a copper-related currency such as the Chilean peso offers an attractive risk-reward profile. The rationale to short copper is the potential relapse in China's growth (Chart I-1 on page 1) and elevated bullish sentiment on copper as shown in Chart I-2 on page 2. To hedge the timing risk and earn some carry, it makes sense to complement the short copper position with a long leg in a currency exposed to industrial metals/copper prices that is not vulnerable due to domestic reasons, i.e., beside copper price effect. Such a currency is the Chilean peso, in our view. The country's macro fundamentals are fine: domestic demand seems to be bottoming out and inflation is under control (Chart I-15). The primary risk to this exchange rate is copper prices. Chart I-16 depicts the total return of the combined return of a short copper and long CLP position accounting for the carry. The CLP has lagged the recent surge in copper prices and this trade offers a good entry point. Chart I-15Signs Of Bottom In The Chilean Economy Chart I-16A New Trade: Long Chilean Peso / Short Copper Bottom Line: Short copper and go long the Chilean peso. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Hungary: Inflation Is Set To Surge The dovish tone following the National Bank of Hungary's (NBH) most recent monetary policy meeting has reinforced the notion that more unconventional policy tools are likely to be forthcoming. In our view, the NBH is displeased about the recent currency strength and is presently laying the groundwork for pegging/depreciating the currency. This reinforces our view that inflation is set to surge. We have been recommending a short HUF / long PLN trade since September 28, 2016 on the basis that the NBH will remain dovish far longer than the National Bank of Poland (NBP) in the face of rising genuine inflationary pressures in both economies2 (Chart II-1). Also, the NBH has much less appetite for tolerating currency appreciation than the NBP. In turn, the NBP will hike interest rates and allow the zloty to appreciate. The latest rhetoric from the NBH reinforces our conviction, and today we are reiterating our short HUF / long PLN trade. Furthermore, relative to the forint, the zloty is still cheap based on relative real effective exchange rates, calculated using unit labor costs (Chart II-2). Chart II-1Relative Swap Rates Justify Higher PLN/HUF Chart II-2Zloty Is Cheap Versus Forint When a central bank favors extremely low interest rates and a cheap currency amid an economy that is operating above full employment and a labor market that is extremely tight, inflation is set to surge. This is exactly what is happening in Hungary. The NBH has been downplaying the tight labor market, noting that so far there has been little impact on inflation. We see a major problem with this argument. Inflation is a lagging indicator; to gauge where inflation will be headed in the coming six to 12 months, one has to monitor forward-looking indicators such as labor market dynamics and money/credit conditions. Presently, the majority of these indicators point toward much higher inflation in the coming months: The labor market is definitely tight - labor shortages are widespread, the unemployment rate is making historical lows and the participation rate is high (Chart II-3). Both wages and unit labor cost growth are surging (Chart II-4). Chart II-3Labor Market Is Super Tight In Hungary Chart II-4Hungary: Labor Costs Are Surging While private credit growth is meager, money supply is booming at a double-digit rate (Chart II-5). Such a gap between money and credit is probably due to loan write-offs. In brief, new loan origination is much stronger than implied by private credit growth, which is being affected by loan write-offs. Besides, government spending growth is currently above 20%, and banks have been funding the government by increasing their holdings of government bonds. This has also boosted money supply and is ultimately inflationary. All in all, odds are that the NBH will allow inflation to run away. As a result, long-dated local bond yields will spike, while short-term yields will be anchored by the NBH's dovish policy. We have been recommending betting on the yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. This trade remains intact (Chart II-6). Chart II-5Money Growth Is Booming Chart II-6The Yield Curve Will Steepen Further Bottom Line: Stay short the HUF versus the PLN. Maintain a bet on yield curve steepening in Hungary: receive 1-year / pay 10-year swap rates. For other fixed-income and currency as well as equity positions in central Europe and elsewhere in the EM universe, please refer to pages 19-20. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Making Sense Of The EM Business Cycle", dated August 30, 2017, link available on page 21. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Central European Strategy: Two Currency Trades," dated September 28, 2016 and Emerging Markets Strategy Special Report, titled "Central Europe: Beware Of An Inflation Outbreak," dated June 21, 2017, links available on page 21. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. Our negative outlook for China's capital spending and imports will be wrong if the money velocity or the money multiplier or productivity growth rise materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity would be highly speculative and unreasonable. With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Feature Chart I-1EM Share Prices Are ##br##Facing A Technical Hurdle In this week's report we elaborate on the following interrelated questions: Where do EM economies stand in terms of their respective business cycles? What are the key drivers and risks to our view? EM share prices in U.S. dollar terms are facing another technical hurdle (Chart I-1). Even though EM risk assets have been trading well, we still find their risk-reward profile unattractive, and below we elaborate why. The EM Business Cycle EM economic data have differed greatly over the course of the current rally, and various economic parameters presently exhibit very different phases of the business cycle in developing economies. For example, Asian export growth has rolled over having expanded at a double-digit pace early this year (Chart I-2). In general, EM exports have posted a broad-based recovery: the recovery in Chinese, U.S. and European imports has helped Asian exports, while higher commodities prices have boosted export revenues of commodities producers. On the flip side, domestic demand in EM ex-China has been rather mediocre. In fact, there has been very little domestic demand recovery, as evidenced by retail sales and auto sales (Chart I-3). Importantly, bank loan growth has not recovered at all (Chart I-3, bottom panel). Based on the above, we can summarize the above divergences as follows: the global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Chart I-2Asian Export Growth ##br##Has Rolled Over Chart I-3EM ex-China: Domestic ##br##Demand Has Not Yet Recovered In turn, China's imports surge has been due to the revival in new money/credit origination that has been in play since the middle of 2015. China's commercial banks have originated about RMB 43 trillion of new money/credit in the past two years. This has greatly helped many developing countries selling to China, boosted commodities prices, creating fertile ground for capital flows to EM financial markets. Going forward, the pertinent question for the EM business cycle is which of the following two scenarios will likely play out: (1) China's imports relapse materially soon, weighing on commodities and other EMs and capping the recovery in their domestic demand; or (2) Chinese import growth holds and the recovery in EM ex-China domestic demand gains momentum. The first scenario entails a bearish outcome for EM share prices, while the second would imply a continuation of the EM rally. BCA's Emerging Markets Strategy team envisages the first scenario. The basis of our argument is that the deceleration that has already occurred in Chinese money growth combined with ongoing monetary tightening are about to cause a considerable slowdown in China's real economy and imports (Chart I-4). What about the other two pillars of global imports - the U.S. and Europe? U.S. imports have in the past year outpaced final sales to domestic purchasers (Chart I-5). As can be seen in this chart, imports are more volatile than domestic demand and this discrepancy is reflective of inventory cycles. After outpacing final domestic demand for the past seven months, odds are U.S. imports growth will moderate in the next 12 months. That said, we do not expect a contraction in U.S. imports. Even if European imports remain robust, a material slowdown in China and some moderation in U.S. imports will be sufficient to produce a slump in EM aggregate exports. The rationale is twofold: First, for many developing countries, China as a destination for shipments is larger than or as large as the U.S. and Europe combined. Chart I-4China: Money Growth And Business Cycle Chart I-5U.S. Import Growth to Moderate Second, mainland demand for raw materials is critical for their prices. In turn, the trend in commodities prices often defines EM financial markets dynamics. This is why we focus so much on China's credit/money cycle, which in turn drives China's capital spending and an overwhelming majority of its imports. Notably, the reason why Chinese imports are much more sensitive to credit compared to other EM and DM economies is because the mainland's imports consist of 42% of commodities and raw materials and 55% of capital goods. Hence, 97% of imports is for investment spending, with the latter financed and driven by money/credit. Bottom Line: The global economic recovery has been driven by demand in China, the U.S. and Europe, while domestic demand in EM ex-China has not recovered much. Going forward, the key to EM financial markets performance will be Chinese imports and commodities prices. The Key Pillar Of Our View The key area where we differ from the bullish consensus on EM/China is our expectation that Chinese growth will slow before year-end due to a combination of ongoing policy tightening and lingering credit excesses. Regardless of which broad money measure we use - official M2, money calculated using commercial banks' liabilities (we refer to it as deposit-money or M3 hereafter) or banks' assets (we refer to this as credit-money) - the current message is the same: broad money growth has fallen to historic lows (Chart I-6). An imperative question is: what does the recent gap between broad money (our calculation of M3) and private (corporate and household) credit growth, as evidenced by the top panel of Chart I-7A, mean for investors? Chart I-6China: Various Versions Of Broad Money Chart I-7Comparing Broad Money And Credit Growth From the perspective of the outlook for growth, it is the aggregate of private and public credit that matters. When we substitute private credit with the aggregate of private and public credit, there does not appear to be much decoupling (Chart I-7, bottom panel). Readers should note that the historical time series for aggregate private and public credit is from BIS and the data for 2017 are our estimates based on general government fiscal deficit and total social financing. If past correlations between money, credit and economic growth and their respective time lags hold, the cyclical parts of the Chinese economy should slow down before year-end (Chart I-8). This differs from the consensus view on the street that a slowdown is not in the cards until well into next year (or later). China's currently flat yield curve also supports our view on imminent growth deceleration (Chart I-9). In fact, Chinese money market rates and onshore corporate bond yields have begun drifting higher following two to three months of consolidation. Chart I-8China: A Slowdown Before Year-End? Chart I-9China: Yield Curve And PMI Finally, we believe the depth of the impending slowdown will be material because ongoing liquidity tightening is occurring amid lingering credit excesses/credit bubble. While policymakers do not plan to push the economy into a vicious downturn, they may be open to the idea of attempting mild short-term deleveraging to contain risks in the long run. Furthermore, the Chinese authorities - like in any other country - may not have perfect foresight about the magnitude of a potential slowdown. Hence, their reversal of tightening policies is likely to be late, resulting in a rough spot in growth. Bottom Line: The key difference between our stance and the bullish view on EM is on China's growth trajectory and commodities prices. Risks To Our View Given that the main pillar of our view is that China's credit and money growth is driving mainland capital spending and imports, our recommended investment strategy will be wrong if the already transpiring slowdown in money growth does not translate into investment spending deceleration. This could happen because of the following: Strong nominal growth can coincide with slower money growth only if the velocity of money accelerates. In short, our view will be wrong if China's nominal output growth holds up or quickens, despite the slowdown in broad money growth that has already occurred. This could happen if the velocity of money suddenly shoots up - i.e., the same amount of money simply turns faster facilitating faster expansion of nominal output. There is no way to forecast changes in money velocity in any country in any period with any precision. As a rule, we (and the vast majority of other market participants) simply assume money velocity will be constant over our forecast horizons. Money velocity is calculated as nominal GDP divided by broad money supply. From a historical perspective, Chart I-10 demonstrates that China's money velocity has actually drifted lower in the past 10 years or so. Therefore, a material rise in China's money velocity would be an exception from the trend of past decade. Consequently, before assuming a rising money velocity, one needs to prove why it will escalate going forward. This does not mean it is impossible or could not happen, but it is reasonable to challenge the nature and timing of it. Our view will be wrong if money growth accelerates sharply from current levels without more liquidity (banks' excess reserves) provisioning by the People's Bank of China (PBoC). In such a scenario, broad money growth acceleration amid low levels of banks' excess reserves would signify a spike in the money multiplier. However, the money multiplier for China - measured as broad money divided by commercial banks' excess reserves at the central bank - is already at the second highest of the past ten years (Chart I-11, top panel). In level terms, there is currently about RMB 212 trillion of broad money - measured by commercial banks' liabilities/deposits (our measure of M3) versus RMB 2 trillion of commercial banks' excess reserves at the end of June. Chart I-10China: Velocity Of Money ##br##Has Been Drifting Lower Chart I-11China: Money Multiplier ##br##Is Already Elevated We assume the money multiplier will be flat to down in China over the next 12-18 months. Banks have already become overextended with respect to the money multiplier, and are operating on thin liquidity/excess reserves (Chart I-11, bottom panel). With interest rates rising and regulatory tightening forcing banks to bring off-balance-sheet assets onto their balance sheets, it is reasonable to assume a flat-to-down money multiplier. Finally, another risk to our view stems from productivity. If productivity growth is set to accelerate considerably in China, it will boost real output growth despite the slump in money/credit. Chart I-12China: Structural Slowdown ##br##In Productivity Growth It is hard to measure productivity ex-post, let alone to forecast it. This is especially true for developing economies. This is why we assume that productivity growth in China will be stable in the medium term but will decelerate in the long run if structural reforms are not implemented and the economy's reliance on abundant money/credit is not reduced. Simply put, when money/credit are plentiful, people and companies make a lot of money without working hard and innovating. This is why money/credit deluges and asset bubbles often lead to a considerable productivity slowdown in any country. Provided that China's economy has been primarily fueled by copious amounts of money and credit since early 2009, it is reasonable to assume that productivity growth has slowed (Chart I-12). Without structural reforms, the quality of capital allocation will not improve. Therefore, productivity growth is bound to slow rather than accelerate. We will discuss the structural outlook for China including productivity and economic rebalancing toward the service sector in a special report to be published in the coming weeks. Bottom Line: Our negative outlook for China's capital spending and imports will be wrong if the money velocity rises considerably or the money multiplier shoots up or productivity growth accelerates materially. If any one of these were to occur, relying on money growth to forecast economic growth will prove futile. That said, assumptions about a substantial rise in either money velocity, the money multiplier or productivity from current levels would be highly speculative and unreasonable. Risk Off And Fund Flows Into EM Last week we downgraded Korean stocks due to expectations that geopolitical tensions are set to rise in the near term. BCA's Geopolitical Strategy service does not expect war on the Korean peninsula as long-standing constraints to conflict are still in place, starting with Pyongyang's ability to cause massive civilian casualties north of Seoul via an artillery barrage. As such, the ultimate resolution to the conflict will be a peaceful one. However, getting from here (volatility) to there (negotiated resolution) requires more tensions. The U.S. has to establish a "credible threat" of war in order to move China and North Korea towards a negotiated resolution.1 And that process could take more time, which means more volatility in the markets.2 The risk-off dynamics in EM due to tensions in the Korean Peninsula is a near-term risk and might become a trigger for a rollover in EM risk assets via reversal of portfolio flows. One of the narratives supporting the EM rally has been the changing composition of foreign capital flows into EM. This narrative argues3 that international flows to EM have been dominated by foreign direct investment (FDI) rather than portfolio inflows. This presages that EM risk assets are much less exposed to portfolio outflows than before. However, this is factually wrong. The composition of international capital flows into EM has been dominated by portfolio flows rather than FDI. In fact, FDI inflows have not yet recovered (Chart I-13). For the calculation of this aggregate we exclude not only China, Korea and Taiwan - which have large current account surpluses and do not require FDI inflows - but also Brazil. We exclude Brazil because its FDI and portfolio flows data have been distorted due to disadvantageous tax treatment of portfolio flows relative to FDIs. Chart I-14 illustrates that FDIs inflows have been robust and net portfolio inflows have been negative in the past 18 months. The latter does not pass our smell test because Brazil's financial markets have rallied tremendously since early 2016. This appears simply non-credible and confirms lingering speculation that a lot of foreign capital inflows have been registered in Brazil as FDI inflows to get preferential tax treatment - and were subsequently invested in financial markets, specifically in domestic bonds, not the real economy. Chart I-13EM ex-China, Korea, Taiwan And Brazil: ##br##FDI Inflows Have Not Recovered Chart I-14Brazil: The Puzzle of FDI ##br##Inflows And Portfolio Flows Chart I-15Brazil: Strong FDI Inflows ##br##And Collapsing Capital Spending Consistently, capital spending has not recovered at all, despite the preceding collapse (Chart I-15). All in all, excluding Brazilian data, there has been little recovery in EM FDI inflows (Chart 16A and Chart I-16B). Chart I-16AFDI Inflows Into Various EM Countries Chart I-16BFDI Inflows Into Various EM Countries Bottom Line: With respect to capital flows, EM currencies have been supported by portfolio flows, not FDI inflows. Hence, any reduction or reversal in these portfolio flows is a major risk to EM exchange rates. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," April 19, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?," August 16, 2017, available at gps.bcaresearch.com. 3 Please see, "Globalisation in retreat: capital flows decline since crisis", August 21, 2017, available at https://www.ft.com/content/ade8ada8-83f6-11e7-94e2-c5b903247afd Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) Chart I-9BChina's Growth To Decelerate A Lot (I) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Four separate indicators provide compelling evidence for a 'mini-cycle' in activity. 1. The bond yield. 2. The credit impulse. 3. The steel equity sector price. 4. The consumer price index (CPI). Right now, the mini-cycle is about 4 months into downswing whose average duration tends to be about 8 months. Hence, the surprise in the coming months could be that inflation comes in below expectations. Feature Central to our European investment philosophy is the existence of what we call a 'mini-cycle' in global activity. Right now, this cycle is about 4 months into a mini-downswing whose average duration tends to be about 8 months. Within this global mini-cycle the irony is that Europe itself has been a paragon of stability. Quarter on quarter growth has remained within a remarkably narrow 1.2-2.2%1 band for eight consecutive quarters. And the dispersion of growth across euro area countries now stands at a historical minimum. We expect the euro area's relative stability to persist given the recent bottoming of the euro area 6-month bank credit impulse. Nevertheless, for the European investment and inflation outlook, the global growth cycle is as important, or more important, than the domestic cycle. In highly integrated and correlated international markets, the absolute direction of European asset prices takes its cue from a global rather than a local conductor. The pace of consumer price inflation also tends to be a global rather than a local phenomenon. For example, through the past 10 years, the inflation cycles in the euro area, U.K. and U.S. have been near identical (Chart I-2). Chart Of the WeekThe Steel Sector Has A Clear Mini-Cycle Chart I-2The Inflation Cycle Is Global, Not Local In this light, the ECB now correctly assesses that "the risks surrounding the euro area outlook relate predominantly to global factors." As we go on to show below, the surprise in the coming months could be that inflation comes in below expectations. This would slow the ECB's exit from its current ultra-accommodative monetary policy. But because these downside inflation surprises were coming from outside the euro area, it would force other central banks to become even more dovish relative to current expectations. On this basis, we are very comfortable to maintain our relative return positions in European investments: expect euro currency outperformance; T-bond/German bund yield spread convergence; and euro area Financials outperformance versus global Financials. For absolute return positions, expect the relatively benign backdrop for bonds to continue into the summer months. Mini-Cycles: The Evidence Mounts In previous reports, we presented two pieces of evidence for economic mini-cycles. First, the global bond yield shows a remarkably regular wave like pattern with each half-cycle averaging about 8 months (Chart I-3). Second, the acceleration and deceleration of bank credit flows - as measured in the credit impulse - also exhibits a remarkably regular wave like pattern, with each half-cycle also lasting about 8 months (Chart I-4). Chart I-3The Bond Yield Has A Clear Mini-Cycle Chart I-4The Credit Impulse Has A Clear Mini-Cycle We proposed that the bond yield and credit impulse cycles are inextricably embraced in a perpetual feedback loop: a higher bond yield weighs on credit flows; this slows economic growth which then shows up in activity data; in response, the bond market lowers the bond yield; the lower bond yield boosts credit flows, which lift economic growth; and so on... But as each stage in the sequence comes with a delay, the bond yield and credit impulse mini-cycles should be 'out of phase'. And this is precisely what the empirical evidence shows (Chart I-5). Chart I-5The Bond Yield And Credit Impulse Mini-Cycles Are Out Of Phase Now, to build an even stronger case for mini-cycles we will add a third and fourth piece of compelling evidence. The third piece of evidence is the steel equity sector price, which is an excellent real-time indicator of the growth cycle, and shows exactly the same mini-cycle profile as the bond yield (Chart of the Week). The fourth piece of evidence is the consumer price index (CPI) which also presents an identical mini-cycle profile (Chart I-6). Chart I-6The Consumer Price Index Has A Clear Mini-Cycle As with the bond yield and the steel equity sector price, we have de-trended the CPI to better show the underlying cyclicality. But in the case of the CPI, our chosen de-trending rate of 2% has special significance: 2% is the inflation target for most central banks. Hence, if the de-trended CPI is rising, inflation is running above the 2% target; if the de-trended CPI is falling, inflation is running below the 2% target. In this regard, the mini-cycle in the CPI carries a disturbing asymmetry. Observe that in recent mini-upswings, inflation has just about reached the 2% target. But in each and every mini-downswing, inflation has substantially undershot the 2% target. Based on the regularity of the mini-cycle through the past 10 years, we can estimate that we are about half way into a mini-downswing. If so, the surprise in the coming months could be that inflation comes in below expectations, frustrating the ECB. Still, as the disinflationary surprises will emanate from outside the euro area, other major central banks might be even more frustrated. And this supports our aforementioned relative positions in European investments. What Is Your Most Provocative Non-Consensus View? The observation that inflation has struggled to reach 2% in mini-upswings, but substantially undershot 2% in each and every mini-downswing is very telling. The strong suggestion is that the recent modest uplift in inflation towards 2% could just be a mini-cyclical rather than structural phenomenon. The death of debt super-cycles combined with an incipient wave of Artificial Intelligence (AI) led automation still constitutes a very powerful structural deflationary force, which should not be underestimated. The technical pattern of bond yields also supports this thesis. Chartists will point out that the global bond yield is still in a well-defined pattern of lower highs and lower lows - which is to say a well-established downward channel (Chart I-7). And that it would take the yield to rise by a quarter (about 40 bps) to breach this channel. The German 30-year bund yield gives a very similar message (Chart I-8). Chart I-7Still In A Structural Downtrend: The Global Bond Yield... Chart I-8...And The German 30-Year Bund Yield At meetings, clients often ask for the most non-consensus investment view - something to which the street attributes a 10% chance, but to which I attribute a 50% or higher chance. Given the asymmetrical mini-cycle behaviour of both inflation and bond yields and the powerful structural forces of deflation shown in the preceding charts, here is my provocative answer: Perhaps the structural low in bond yields is not behind us; perhaps it is to come in the next major global downturn. But this is a personal view. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. Fractal Trading Model* There are no new trades this week, leaving us with four open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Fractal Trading Model * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Bank Credit Analyst

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Chart I-11Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too Chart II-16Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide 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 WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Chart III-19Euro Technicals Chart III-20Euro/Yen Technicals Chart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Highlights Bonds are universally unloved. The economic 'mini-upswing' is extended. 6-month bank credit impulses have rolled over. Europe is entering a period of high-impact political events. Equities are universally loved. If bond prices bounce back, Bank equities are losers and Real Estate equities are winners. Feature From time to time it is worth stepping out of the herd and asking: is the herd heading in the right direction? Given the seemingly universal dislike of high-quality government bonds, this week's report goes through five reasons why bonds could make a surprising comeback in the coming months.1 Chart of the WeekBrexit And Trump Distorted An Otherwise Typical Mini-Cycle Upswing 1. Bonds Are Universally Unloved The extent of herding in bonds is extreme on both a 65-day and 130-day basis (Chart I-2). The herd is a good metaphor for financial markets given the capacity for investor sentiment to move en masse. However, excessive herding is dangerous, because it destroys market liquidity. Chart I-2The Extent Of Herding In Bonds Is Extreme Liquidity - defined as the ability to buy or sell an investment in large volume without moving its price - requires healthy disagreement. After all, at today's price, if you sell a bond and I buy it from you, we are disagreeing about the attractiveness of the price. If many investors disagree on the attractiveness of the price, then there will be plenty of liquidity. The main reason for healthy disagreement and plentiful liquidity is that the market is usually split between short-term momentum traders and long-term value investors. If the price fluctuates downwards, the momentum trader interprets this as a strong sell-signal but the value investor sees it as an equally strong buying-opportunity. Hence, the two types of investor can trade with each other in large volume without moving the price (much). However, if the value investor flips to become a momentum trader and sells rather than buys, the price must fall until it attracts a bid from a deep value investor. If the deep value investor then also flips to become a momentum trader, the price must fall further until it attracts a bid from an even deeper value investor. And so on... As everybody in turn flips to the same view, the herd and the trend will get stronger and stronger. The tipping point comes when there is nobody left to flip and to join the herd. If a value investor then suddenly reverts to type and puts in a buy order, he will find that there are no sellers left. Liquidity has evaporated, and to replenish it might require a substantial reversal in the price. On both our 130-day and 65-day herding indicators, bonds appear vulnerable to such a reversal in the coming weeks. 2. The Economic 'Mini-Upswing' Is Extended Chart 1-3Major Economies Exhibit ##br##Very Clear 'Mini-Cycles' A typical business cycle lasts multiple years. But within this longer cycle, major economies exhibit very clear 'mini-cycles' whose upswings and downswings last 6-12 months (Chart I-3). As we demonstrated in Slowdown: How And When? 2 these mini-cycles result from the perpetual interplay between changes in bond yields, accelerations/decelerations in credit growth, and accelerations/decelerations in economic growth. The inception of the current mini-upswing coincided with last February's G20 meeting in Shanghai. At the start of 2016, global growth appeared to be stalling and financial markets were fragile. In response, a so-called 'Shanghai Accord' facilitated a synchronized stimulus in the major economies - either directly, or in the case of the U.S., a watering down of monetary tightening expectations. By spring last year, bond yields were forming a typical mini-cycle bottom. But in June, the Brexit shock sent yields sharply, but briefly, lower. Conversely, the Trump shock-victory in November accelerated the upswing in yields that was already well underway (Chart of the Week). Absent these two political shocks, 2016 produced a typical mini-upswing whose duration is now approaching 12 months - making it long in the tooth. Mini-upswings do not die of old age. But it would be highly unusual for the economy's credit-sensitive sectors not to feel a strong headwind now from the sharp upswing in bond yields. 3. 6-Month Bank Credit Impulses Have Rolled Over 6-month credit impulses have indeed rolled over in the major economies (Chart I-4 and Chart I-5), exactly as would be expected after a sustained upswing in bond yields. Chart I-46-Month Credit Impulses Have ##br##Rolled Over In Major Economies... Chart I-5... And ##br##Globally Now you could argue that the upswing in bond yields is simply a response to improved expectations for growth. The problem with that argument comes from the inter-temporal and geographical distribution of that potential growth pickup. U.S. fiscal stimulus and infrastructure spending is an uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Furthermore, this stimulus is unlikely to benefit Europe or other economies outside the U.S. Yet the recent rise in bond yields and weakening of credit impulses has occurred everywhere. Compared to Trump's intangible stimulus, the choke on credit-sensitive sectors is a certain headwind whose impact will be felt sooner and more universally. 4. Europe Is Entering A Period Of High-Impact Political Events The next few months will also see a sequence of potentially high-impact political events in Europe. The Netherlands and France hold elections in which disruptive populist politicians are likely to perform well, though probably not well enough to gain power. Meanwhile, Greece appears to be reneging on the terms and conditions of its latest bailout - whose next tranche of funds it needs to make a large debt repayment in July. Into this sensitive mix, add the start of the formal and potentially acrimonious divorce proceedings between the U.K. and the EU27, due to start by the end of March. To be clear, the probability of a shock outcome in any of these individual events is low. But the probability of a shock from at least one of these multiple events is not so low. If the probability of an individual shock is, let's say, 20% then the probability that the event goes smoothly is clearly 80%. Therefore, the probability that all four events go smoothly would be 0.8 to the power of 4, equal to 41%.3 Which means that the probability of at least one shock would be a significant 59%. Perhaps the probability of an individual shock in any of these four events is less than 20%. However, there are also other more nebulous sources of risk, such as the possibility of early elections in Italy, and a disruptive outcome. To reiterate, an individual risk might be low or very low. But the chance of at least one shock in the upcoming sequence of events must be close to evens. And this is the chance that high-quality government bonds will receive significant haven demand at some point in the coming months. 5. Equities Are Universally Loved High-quality government bonds are universally unloved, but mainstream equities have the opposite problem. They are universally loved. The extent of herding in equities is extreme on a 65-day basis (Chart I-6). Chart I-6The Extent Of Herding In Equities Is Extreme This perfect symmetry of herding behaviour suggests to us that if investors suddenly fall out of love with equities - even briefly - then unloved bonds would be the very likely beneficiaries. Pulling all of the five arguments above together, we conclude that the odds of a tactical retracement in high-quality government bond yields in the next 3-6 months are more than evens. And we would position accordingly. In this eventuality, stock market investors should note that the sector that might be most vulnerable is Bank equities (Chart I-7). Conversely, the sector that might be one of the biggest beneficiaries is Real Estate equities (Chart I-8). Chart I-7If Bond Prices Bounce Back, ##br##Bank Equities Are Losers... Chart I-8... And Real Estate ##br##Equities Are Winners Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Our analysis throughout uses the JP Morgan Global Government Bond Index as the best representation of the direction of high-quality government bonds, including those in Europe. 2 Published on February 2, 2017 and available at eis.bcaresearch.com 3 Strictly speaking, this assumes that all four events are independent - that is, the outcome of one does not influence the outcome of another. Fractal Trading Model There are no new trades this week. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Empirical evidence shows the clear existence of 'mini-cycles' - with the credit impulse and bond yield cycles 'out of phase' with each other by about 6 months. The credit impulse mini-cycle rolled over in October, suggesting that the bond yield mini-cycle will roll over in April. The bond yield mini-cycle is also approaching a technical limit. Hence, on a 3-month horizon, lean against the rise in bond yields and bank equities. And underweight the bank-heavy Italian MIB and Spanish IBEX versus the Eurostoxx600. Feature The euro area's flash GDP print for Q4 confirms that the single-currency bloc has been one of the world's top-performing major economies through recent quarters. Furthermore, the latest inflation data confirm that euro area inflation is no different to other major economies when compared on an apples for apples basis - supporting our argument last week in Fake News In Europe.1 Having said that, the economy's latest 'mini-upswing' is likely approaching its end. And according to our framework, the euro area might not be alone in this experience. Mini-Cycles Everywhere Empirically, the economy exhibits very clear 'mini-cycles' whose upswings and downswings last 6-12 months. These economic mini-cycles overlay the much longer business cycle which lasts multiple years. Compelling evidence for these 6-12 month mini-cycles is everywhere. Just look at the credit impulse, the bond yield, commodity price inflation, or perhaps most fundamentally, GDP growth rates (Chart of the Week and Chart I-2, Chart I-3 and Chart I-4). Chart of the WeekThe 6-Month Credit Impulse Rolled Over In October Chart I-2Mini-Cycles In The Bond Yield Chart I-3Mini-Cycles In Commodity Price Inflation Chart I-4Mini-Cycles In 6-Month GDP Growth But bear in mind that to see any cycle it is crucial to focus on the right periodicity. If you look at a clock pendulum once every second, you will not see its cycle. The pendulum will appear motionless. Only when you look at the pendulum once every half-second will you see its regular cycle. Likewise, to see the economic mini-cycles you need to look at rates of change not over a year but over a half-year. The Economy: A Naturally-Oscillating System The economy's clear mini-cycles are the hallmark of any system that possesses two characteristics: Internal regulating feedback. Time delays in the system response to the feedback. As a familiar example, think of the thermostat that controls the central heating in your home. If there is a delay in the thermostat's response to a temperature setting of 20 degrees, the thermostat will switch the heating on and off slightly late. Which will cause the temperature to oscillate perpetually between 19 and 21 degrees, rather than to stay at a constant 20 degrees. A better example is the cruise control on your car. In the internal regulating feedback: the speed regulates the gas pedal; the gas pedal regulates the gasoline flow; the gasoline flow regulates the engine; and the engine regulates the speed. Assuming this internal regulating feedback works instantaneously from start to finish, the car will cruise at a constant 60 mph. But if there are delays in the system response, the speed will oscillate between, say, 58 mph and 62 mph. Now let's translate this to the economy with the following equivalences (Figure I-1): Speed = GDP growth data Gas pedal = Bond yield Gasoline flow = Credit flow Engine = Economy Figure I-1Internal Regulating Feedback + Time Delays = Mini-Cycles In the economy's internal regulating feedback: the GDP growth data regulates the bond yield; the bond yield regulates the credit flow; the credit flow regulates the economy; and the economy regulates the GDP growth data. But just like the cruise control, if there are delays in the system response, the economy will exhibit oscillations. Crucially, there are delays in the economic system response. For a change in the bond yield to register with households and firms and fully impact credit flows, it clearly takes time - empirically in the range of 3-9 months. The credit flows do not generate instantaneous economic activity either. Fully spending the credit flows takes time - again empirically in the range of 3-9 months. Once you accept these assumptions of internal regulating feedback combined with clear delays in economic response, the economy has to be a naturally-oscillating system. For those who are mathematically inclined, Box I-1 shows how to derive the differential equation of the economic mini-cycle using first principles. Box I-1The Mathematics Of Mini-Cycles From Theory To Practice So much for the elegant theory, does it actually work? The real economy is complicated by other factors which can stretch and distort the theory. Specifically, aggressive and experimental policy from central banks can cause bond yields to overshoot or undershoot fundamentals. Financial or political shocks can depress animal spirits or, as we have just seen, make them euphoric. A flight to or from safety can distort both bond yields and short-term economic activity. These distortive overlays can shorten or extend the amplitude and/or duration of a mini-cycle. So each mini-cycle is slightly different in size and length from its predecessor. The distortions also explain how a mini-upswing or mini-downswing can become amplified into a boom or recession. The analogy would be a car's cruise control trying to slow the speed to 60 mph whilst also coping with a very steep hill and gale-force headwind. Quite likely, the speed would slow to well below 60 mph. For the past 10 years, aggressive monetary policy shifts, financial shocks and political shocks have been a regular distortive feature of the economic landscape. Yet Chart I-5 clearly shows that 6-12 month mini-upswings and mini-downswings have existed with remarkable consistency and durability through the whole period. Chart I-5The Credit Impulse And Bond Yield Cycles Are 'Out Of Phase' By About 6 Months The empirical evidence shows the clear existence of mini-cycles - with the credit impulse and bond yield cycles 'out of phase' by about 6 months, exactly in line with theory. What Does This Mean For European Investors? The credit impulse mini-cycle rolled over in October. Using the average 6-month lag, this means that the bond yield mini-cycle should roll over in April. However, the current cycle could have a slightly shorter lag or a slightly longer lag than the average cycle. So today, we are delighted to introduce a new piece of proprietary analysis. For the bond yield itself, we can independently assess the extent of groupthink in its recent trend, and how close that is to its limit. Previously, we have done this using its 65-day (3-month) fractal dimension.2 But given that mini-cycle upswings and downswings average 6 months, it is more logical to use a 130-day (6-month) fractal dimension. As readers can see in Chart I-6, this indicator has an excellent track-record in identifying mini-cycle turning points. And it is now signalling that the current trend is reaching its technical limit. Chart I-6A Near-Perfect Indicator For Bond Market Turning Points Bottom Line: On a 3-month horizon, lean against the rise in bond yields3 and bank equities. And underweight the financial-heavy Italian MIB and Spanish IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 26, 2017 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Weekly Report, titled "The Use And Abuse Of Liquidity", June 9, 2016 available at eis.bcaresearch.com 3 The house view is tactically below benchmark duration Fractal Trading Model* Pleasingly, both of our most recent trades: short MIB/long Hang Seng and long NOK/RUB hit their profit targets in classic liquidity triggered trend-reversals. This week's trade is to go short Basic Materials equities. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-7 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Special Report

This week, we are sending a <i>Special Report </i>written by BCA's Chief Global Strategist Peter Berezin, discussing the end of the 35-year global bond bull market.