Consumer

Highlights Slower nominal GDP growth explains virtually all of the increase in China's debt-to-GDP ratio over the past ten years. The authorities were unwilling to restrain debt growth as it became obvious that nominal income was decelerating because this would have only exacerbated the economic downturn. Excess private-sector savings forced the Chinese government to rely on debt-financed investment by state-owned companies (SOE) and local governments in order to keep aggregate demand elevated. Financial deregulation also encouraged debt accumulation. Debt growth linked to speculative activity can be curbed without endangering the economy, but a lasting solution to the surplus savings problem will require consumers to spend more. This will take a while. At some point over the next few years, the central government will transfer a large fraction of SOE and local government debt onto its own balance sheet. The risk to investors is that this "debt nationalization" happens reactively rather than proactively. Feature If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. - Zhou Xiaochuan, Former Governor of the People's Bank of China, October 19, 2017 The Calm Before The Storm? Stability begets instability. That is the nature of business cycles, Hyman Minsky famously argued. Rising confidence leads to excessive risk-taking, higher asset prices, and mounting economic imbalances. Eventually the mood sours. Like Wile E. Coyote running off a cliff, investors look down and see that there is nothing but thin air between them and the ground below. Panic ensues. Is China on the verge of its own Minsky Moment? A glance at the evolution of its debt-to-GDP ratio would certainly say so. But before running towards the exit door, consider the following: People have been fretting about spiraling Japanese government debt levels for over twenty years now. And yet, interest rates remain at rock-bottom levels in Japan. China's Savings Glut In many respects, China finds itself facing similar problems to those that have haunted Japan. The simultaneous bust in equity and real estate prices in 1990 sent Japan's private sector into a prolonged deleveraging cycle (Chart 1). In order to prop up demand, the Japanese government was forced to run large budget deficits. In effect, the government had to absorb the excess savings of the private sector with its own dissavings. The abundance of domestic private-sector savings forestalled a financial crisis, but it also led to today's gross government debt-to-GDP ratio of 240%. Like Japan, China suffers from a dearth of spending, or equivalently, an abundance of savings. The IMF estimates that Chinese gross national savings reached 46% of GDP in 2017. While this is down from a peak of 52% of GDP in 2008, it is still abnormally high for any major economy, even by emerging market standards (Chart 2). Chart 1 Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 2China's Savings Rate Stands Out Even By EM Standards China's Savings Rate Stands Out Even By EM Standards China's Savings Rate Stands Out Even By EM Standards By definition, whatever a country saves must either be invested domestically or channeled abroad via a current account surplus. China's savings rate has edged lower over the past ten years, but its current account surplus has dropped even more, falling from nearly 10% of GDP in 2007 to 1.4% of GDP at present. As a result, investment as a share of GDP has actually risen to 44%, a three-point increase since 2007 (Chart 3). The decline in China's current account surplus was inevitable (Chart 4). In 2007, China accounted for 6% of global GDP in dollar terms. Today it accounts for 15%. Having a massively undervalued currency, as China had in 2007, is just not politically tenable anymore, especially with Donald Trump in the White House. Simply put, China has become too big to continue exporting its way out of its problems. Chart 3Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Chart 4Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Debt As The Conduit Between Savings And Investment How does a country transform savings into investment? In an economy like China where the stock market at times appears to be little more than a casino, the answer is that credit markets must play the dominant role. Households or firms with surplus savings park their funds in banks or other financial institutions. These institutions channel the savings to willing borrowers. Debt ends up being the natural byproduct of surplus savings. China is still a relatively poor country with a lot of catch-up potential. Capital-per-worker is a fraction of what it is among advanced economies (Chart 5). Even with its bleak demographics, China would need to grow by around 6% per year over the next few years just to converge with South Korea in output-per-worker by 2050 (Chart 6). All this means that China needs to invest more than most other economies, which is only possible if it saves more than other economies. Chart 5China Has More Catching Up To Do (1) Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Chart 6China Has More Catching Up To Do (2) China Has More Catching Up To Do (2) China Has More Catching Up To Do (2) Unfortunately, one can have too much of a good thing. The fact that China's capital stock-to-output ratio has risen dramatically in recent years means that the economy is already investing too much. And the optimal amount of investment will only fall over time as potential GDP growth continues to decelerate. Unless savings come down, China will find itself increasingly awash in excess capacity. Chart 7If Only GDP Growth Did Not ##br## Decelerate Over The Past Ten Years Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Slower trend growth will also make deleveraging more difficult to achieve. The overall stock of nonfinancial debt grew at an annualized rate of 18.8% between 2008 and 2017. Notably, this growth rate was not much higher than the one of 16.5% between 2003 and 2007 - a period when the debt-to-GDP ratio was broadly stable. The main difference between the two periods lies in the denominator of the debt-to-GDP ratio, not in the numerator: Nominal GDP expanded at an annualized rate of 11.2% between 2008 and 2017, a sizable retreat from the pace of 18.4% between 2003 and 2007. Chart 7 shows that the debt-to-GDP ratio today would be virtually identical to its end-2007 level had nominal GDP continued to grow at its 2003-2007 pace over the past ten years. Financial Deregulation Has Exacerbated The Debt Problem The Chinese government's reluctance to crack down on credit growth was motivated by the desire to support aggregate demand. However, in turning a blind eye to what was happening in credit markets, a lot of debt was generated that was not directly tied to the intermediation of savings into investment. Chart 8Debt And Capital Accumulation Went Hand In Hand Debt And Capital Accumulation Went Hand In Hand Debt And Capital Accumulation Went Hand In Hand Debt can be created when someone borrows money to finance the purchase of goods or services. Debt can also be created when someone borrows money to finance the purchase of pre-existing assets. Crucially, while the former typically requires additional "savings" (i.e., someone needs to reduce their spending relative to their income), the latter does not.1 Granted, savings can still play an indirect role in facilitating debt-financed asset purchases. Financial assets are typically backed by something of value. A mortgage is backed by a piece of property. A corporate bond is backed by both the tangible and intangible capital that a firm possesses. The more a country has been able to save over time, the larger its capital stock will be. China, of course, has been saving like crazy for years. It is thus no surprise that its debt-to-GDP ratio has soared as its capital stock has expanded (Chart 8). Financial deregulation in China has allowed a large share of its capital stock to repeatedly shift hands. Debt has often been created in the process. The problem is that debt-financed asset purchases drive up asset prices, sometimes to unsustainable levels. And the higher the price of the asset, the greater the risk that it will not yield enough income to cover the borrowing costs. When asset prices are rising, borrowers and lenders are apt to disregard this risk, figuring that they can always sell the asset at a high enough price to pay back the loan. But once prices start falling, reality sets in very quickly. Stability begets instability. Consumers Need To Step Up The authorities are keenly aware of the risks discussed above. This is the key reason why they are clamping down on the shadow banking system, which has increasingly become the main source of speculative lending in China. We expect the pressure on shadow banks to persist in 2018. This will continue to weigh on credit growth. The more vexing challenge is how to reduce excessive household savings. The government's current strategy of cramming down the capital stock by taking out excess capacity from sectors such as steel, coal, and solar may be better than nothing, but it still pales in comparison to a strategy of encouraging consumer spending. Higher consumer spending would obviate the need for state-owned companies and local governments to keep people employed in make-work projects. The good news is that there are plenty of ways that China can boost household consumption. Government spending on education, health care, and pensions as a share of GDP is close to half of the OECD average (Chart 9). Increasing social transfer payments would give households the wherewithal to spend more. Unlike in most countries, the poor in China are net savers (Chart 10). Expanding the social safety net would discourage precautionary savings. Chart 9Chinese Social Welfare Spending ##br##Is Lagging The OECD Average Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Chart 10Low Income Households Are Net ##br##Savers In China Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 11).2 A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply over the past few decades (Chart 12). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 11High Tax Burden For ##br##Low Income Households In China Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Chart 12Shifting Income To Poorer Households Would Reduce ##br##China's Household Savings Rate Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Debt Nationalization Is Inevitable Chart 13Ratio Of Workers-To-Consumers Is Peaking,##br## And China Is No Exception Ratio Of Workers-To-Consumers Is Peaking, And China Is No Exception Ratio Of Workers-To-Consumers Is Peaking, And China Is No Exception Realistically, reforms aimed at encouraging consumption will take a while to implement. In the meantime, debt levels are likely to keep rising. Much of China's debt burden remains on the books of state-owned companies and local governments. At some point over the next few years, the central government will transfer a large fraction of this debt onto its own balance sheet. This would ease concerns about a mass wave of defaults. The key question for investors is whether this de facto "debt nationalization" is done proactively or reactively in response to a crisis. If the latter occurs, investors should steer clear of Chinese assets, as well as China-related plays such as commodities and commodity currencies. If the former pans out, global risk assets could rally. While the truth will fall somewhere between those two extremes, our bet is that the proactive view will prove closer to the mark, at least relative to market expectations (keep in mind that Chinese banks are trading below book value, so a lot of bad news has already been priced in). The Chinese authorities talk a lot about the importance of reducing moral hazard, but in practice, they have shown very little tolerance for defaults. Just as they did in the early 2000s, government leaders could commission state-owned asset management companies to purchase distressed debt from banks and other lenders at inflated prices. Chinese financials, which are nearly 70% of the H-share index, will benefit. Will investors balk at the prospect of the Chinese government blowing out the budget deficit in order to rescue insolvent borrowers? There might be some short-term panic, but as has been the case with Japan, as long as there are plenty of excess domestic savings to go around, the risk of a debt crisis will remain minimal. Indeed, the issuance of more government debt would help alleviate what has become a critical problem for Chinese savers: The lack of safe, liquid domestic assets available for purchase. What is true, from a longer-term perspective, is that the combination of higher debt and slower growth will eventually create a strong incentive for the Chinese government to inflate away debt. As in many other countries, China's "support ratio" -- broadly defined as the ratio of workers-to-consumers -- has peaked (Chart 13). As the growth of output and income falls behind consumption growth, China's savings glut will become a thing of the past. Rather than raising rates, the PBOC will just let the economy overheat. Such a day of reckoning is probably still at least five years away, but eventually inflation will return to China. Concluding Thoughts On The Current Market Environment A true "Minsky moment" in China - one where the financial sector seizes up due to spiraling fears of bankruptcies and defaults - is not in the cards. Nevertheless, China's economy is slowing, and growth is likely to decelerate further over the next few quarters as the authorities restrain credit growth and the property market continues to cool. The slowdown in Chinese growth is occurring at the same time as the economic data has been deteriorating around the world. The equity component of our MacroQuant model - which is highly sensitive to changes in the direction of growth - has been in bearish territory for two straight months (Chart 14). Our base case remains that global growth will stabilize over the next few months at an above-trend pace. Global bond yields are still near record-low levels and fiscal policy is moving in a more stimulative direction (Chart 15). It would be odd for the global economy to deteriorate sharply in such an environment. Chart 14MacroQuant Model Suggests Caution Is Warranted Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Trade protectionism is an obvious risk to this sanguine cyclical view. BCA has long argued that globalization is under threat from the combination of rising populism and the end of America's role as the world's sole superpower. However, the retreat from globalization will occur in fits and starts. Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now. Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff (Chart 16). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune. Chart 15Global Economy Buttressed By ##br##Accommodative Fiscal And Monetary Policy Global Economy Buttressed By Accommodative Fiscal And Monetary Policy Global Economy Buttressed By Accommodative Fiscal And Monetary Policy Chart 16Trump's Approval Rating Has ##br##Actually Risen During Equity Selloff Trump's Approval Rating Has Actually Risen During Equity Selloff Trump's Approval Rating Has Actually Risen During Equity Selloff For its part, the Chinese government is also looking to strike a deal. The U.S. exported only $131 billion in goods to China last year. This is already less than the $150 billion in Chinese goods that Trump has targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Bottom Line: The near-term picture for global equities and other risk assets is murky, but the 12-month cyclical outlook is still reasonably upbeat. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For instance, if someone buys stock on margin or takes out a second mortgage on their house, new debt is created without anyone having to cut back on spending. In the context of China, imagine a financial institution which funds the purchase of a building by issuing a certificate of deposit or by selling a "wealth management" product. Both the asset and liability side of the financial institution's balance sheet go up (i.e., new debt is created). Suppose further that the company that sold the building puts the proceeds into a certificate of deposit or wealth management product. The entire transaction is self-financing. The example above illustrates that debt can go up in some situations even if everyone's spending habits remain the same. The need to intermediate savings is one source of debt growth, but it does not have to be the only one. 2 Please see "People's Republic Of China: Selected Issues," IMF Country Report, dated August 15, 2017.

Highlights BCA expects consumer spending to remain supportive of above-trend economic growth in the U.S. in the next few quarters. Our view is that the 2018 outlook for both the U.S. economy and corporate profits remains constructive, but evidence is gathering that worldwide growth is peaking. Today's elevated levels of corporate leverage could intensify the pullback in business spending in the next recession. Housing is a reliable leading indicator of economic activity. Spending on new construction will enhance growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Feature U.S. equity prices rallied last week, although the NASDAQ lagged the broader indices. Despite the gain in the final week of the month, the S&P 500 finished lower in March. The back to back monthly declines in February and March were the first since September and October 2016. The 10-year Treasury yield fell last week, and credit underperformed. Oil and gold prices sold-off, but the dollar rose. Worries about global growth and a widening trade war were the key drivers, as investors looked ahead to Q1 earnings reporting season, which will kick into high gear next week. BCA expects global growth to be solid this year, although there are signs that growth is peaking outside the U.S. Moreover, the U.S. economy appears to be generating positive momentum, aided by housing and capex. This is why we expect 2018 to record strong EPS growth in the U.S., which will provide the equity market with a strong tailwind. That said, elevated levels of corporate leverage and low interest coverage ratios are a concern. Stay long stocks over bonds. We expect consumer spending to remain supportive of above-trend economic growth in the U.S. in the next few quarters. Household balance sheets are the best that they have been since 2007. Net worth is soaring and the aggregate debt-to-income ratio is close to record lows last seen at the turn of this century. Moreover, conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 1 shows that at 41.4%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by almost 2 percentage points since 2012. In contrast, spending on necessities rose by a record 3% in the five years ending 2008, matching levels reached at the end of the 1980s that reflected rising interest rates, surging inflation and soaring oil prices. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of consumer spending. Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will boost disposable income. Meanwhile, U.S. inflation is heading higher. The core PCE deflator accelerated to 1.6% y/y in February, up from a low of 1.3% y/y in mid-2017. The coming months should see a further acceleration in inflation, in part due to the very soft base effects from last year (Chart 2). That said, one worrying point is that our diffusion index for the PCE deflator remains well below zero. This means that the inflation pick-up is not broad-based, but due to outsized gains in a few components. Core PCE inflation is usually decelerating when our diffusion index is below zero. Chart 1Consumer Is Not Stressed##BR##Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Chart 2BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End Bottom Line: The Q1 weakness in consumer spending and GDP growth is unlikely to persist. A return to above-trend growth and inflation inching to the 2% target will keep the Fed on a path of gradual interest rates hikes. Animal Spirits Still Intact Our view is that the 2018 outlook for both the U.S. economy and corporate profits remain constructive, but evidence is gathering that worldwide growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Globally, industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart 3). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports - a leading indicator for the global business cycle - have also weakened. It is also disconcerting that some of BCA's measures of global activity related to capital spending are lower in recent months, including capital goods imports and industrial production of capital goods (Chart 4). Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, which suggests that it is too soon to call an end in the mini capital spending boom. Furthermore, our global leading indicators are not heralding any major economic slowdown (Chart 5). BCA's Global LEI continues to trend up and its diffusion index is above the 50 line. Chart 3A Downshift In##BR##Global Growth? A Downshift In Global Growth? A Downshift In Global Growth? Chart 4Some Measures Of##BR##Global Capex Have Softened Some Measures Of Global Capex Have Softened Some Measures Of Global Capex Have Softened Chart 5Global Leading Indicators Are Not##BR##Heralding A Major Economic Slowdown Global Leading Indicators Are Not Heralding A Major Economic Slowdown Global Leading Indicators Are Not Heralding A Major Economic Slowdown Turning to the U.S., the environment for continued robust capital spending is still in place. The Tax Cut and Jobs Act of 2017 will boost capex, although we note that business spending tends to climb faster in the 12 months before a corporate tax cut than in the year afterward.1 The caveat is that there have been only three corporate tax cuts in the past 50 years. Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and robust sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 6). CEO confidence reached an all-time high in 2018Q1. According to the latest Duke Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 7, panel 1),"sixty-six percent of U.S. CFOs say corporate tax reform is helping their companies, with 36 percent saying the overall benefit is medium or large."2 Chart 6U.S. Capex Poised For Liftoff U.S. Capex Poised For Liftoff U.S. Capex Poised For Liftoff Chart 7CEO Confidence And Capex Plans Surging CEO Confidence And Capex Plans Surging CEO Confidence And Capex Plans Surging Surveys by the Conference Board and Business Roundtable show similar patterns (Chart 7, panel 1). Notably, the soundings on all three surveys climbed since Trump's election, but subsequently retreated as his pro-business agenda stalled during the summer. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support escalating capex in the next few quarters. The average reading from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high in early 2018 (Chart 7, panel 2). Furthermore, the regional FRBs' capex spending plans diffusion indices are close to a cycle high, despite a modest pullback since last summer (Chart 7, panel 3). In addition, ABC's Construction Backlog indicator (CBI),3 a leading indicator that measures in months the amount of construction underway but not yet completed, hit a peak early this year, which suggests that 2018 is poised to be a strong year for nonresidential building activity (Chart 8). Moreover, architectural billings hit a new cycle high in Q4 2017(not shown). This signifies that investment in office, industrial and commercial space will accelerate in the coming year. However, there are some warning signs in the nonresidential construction portion of capital spending. Commercial real estate (CRE) prices have galloped to new heights (Chart 9, panel 1). Rent growth in all but the industrial buildings sub component of the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 9, panel 2) and that a slowdown in construction may ensue. Chart 8Nonresidential Construction##BR##Backlog At Eight Year High Nonresidential Construction Backlog At Eight Year High Nonresidential Construction Backlog At Eight Year High Chart 9Commercial Real Estate Prices Have##BR##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Corporate Health Fundamentals Last week's National Accounts (NIPA) corporate profit report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 10). The level of the CHM improved slightly between Q3 and Q4, but the overall reading remains in 'deteriorating health' territory. However, the CHM moved slowly back toward "improving health" in 2017. The improvement in Q4 was broad-based, as five of the six components improved. Liquidity decreased slightly between Q3 and Q4. Leverage declined and interest coverage improved. Our CHM has a tendency to improve during phases of increased fiscal thrust.4 In contrast, corporate leverage increases substantially in the 12 months following a corporate tax cut. As an economic expansion enters the late stages, investors focus on where leverage pressure points may lurk. The Bank Credit Analyst's March 2018 Special Report5 on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. In a sample of 770 companies, we estimated how much interest coverage for an average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits tumble by 25% peak to trough. Given the number of client inquiries, we re-examined our results. We questioned whether our sample of high-yield companies distorted the overall results because it included many small firms and outliers. We are more comfortable with the results using only investment-grade firms, shown in Chart 11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Chart 10Corporate Health Improved In 2017 Corporate Health Improved In 2017 Corporate Health Improved In 2017 Chart 11Interest Coverage Is Deteriorating Interest Coverage Is Deteriorating Interest Coverage Is Deteriorating Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart 12 shows that the interest coverage ratio has declined even as profit margins remained elevated. Normally the two move together through the cycle. The implication is that the next recession will see the interest coverage ratio fare worse than in previous recessions. Rating agencies use many other financial ratios and statistics, but our results suggest that downgrades will proliferate when the agencies realize that the economy begins to turn south. Moreover, banks may tighten their C&I lending standards earlier and more aggressively because they also will be attuned to the first hint of economic trouble given the degree of corporate leverage in their portfolios. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressures in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a more pronounced tightening in financial conditions. Therefore, corporate leverage could intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macroeconomic imbalances, such as areas of overspending that could turn a mild recession into a nasty one. The market and rating agencies will ignore the leverage issue as long as growth remains solid. Indeed, ratings migration has improved markedly following energy-related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 13). For now, we remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios. Chart 12Margins And Interest Coverage##BR##For Investment Grade Firms Margins And Interest Coverage For Investment Grade Firms Margins And Interest Coverage For Investment Grade Firms Chart 13Improving Ratings Migration##BR##Supports Our Credit Overweight Improving Ratings Migration Supports Our Credit Overweight Improving Ratings Migration Supports Our Credit Overweight Bottom Line: We are keeping an eye on our Corporate Health Monitor, bank lending standards, the yield curve and our profit margin proxy to time our exit from both corporate bonds and equities.6 We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. The tightening labor market will continue to support the housing market, despite higher mortgage rates. Risks To Housing Are Limited Residential investment will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 14). Housing affordability remains well above average and will remain supportive of housing investment even if rates climb by 100 bps (Chart 15). Recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters (Chart 16). The housing sector has also benefited from a recovery in household formation in the past few years alongside the labor market and disposable income. Chart 14Housing Fundamentals##BR##Are Stout Housing Fundamentals Are Stout Housing Fundamentals Are Stout Chart 15Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 16Supply And Demand##BR##For Mortgages Supply And Demand For Mortgages Supply And Demand For Mortgages On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 14, panel 3). Furthermore, U.S. real residential home prices are still below their 2006 peak. In addition, at under 3.9%, residential investment as a share of GDP remains well below the 12-year high of 6.6% achieved in 2005 (Chart 17, panel 1). It is difficult to see how residential investment can decline meaningfully when household formation is on the rise and home inventories are already low. Homebuilders appear to agree with this sentiment and report confidence levels near all-time peaks (Chart 17, panel 2). Employment in construction and related fields also suggests that the housing market remains on solid footing. (Chart 18, panel 1 and 2). Panel 3 shows that nearly 80% of states have escalating construction employment. This metric tends to lead construction jobs by a few months. Moreover, construction jobs tend to be at least coincident with housing construction. Segments of construction (residential and specialty employment) lead residential investment in some cases. Chart 17Real Home Prices Not Yet##BR##Back To Prior Peak Real Home Prices Not Yet Back To Prior Peak Real Home Prices Not Yet Back To Prior Peak Chart 18Housing Related##BR##Employment Trends Housing Related Employment Trends Housing Related Employment Trends Furthermore, the disconnect between the NAHB Housing Market Index and housing's contribution to economic growth (Chart 18, panel 4) also suggests housing is poised to lift off. Housing investment is the best leading indicator for real GDP growth among all sectors (Chart 14, panel 4). Construction of new homes and apartments, along with additions and alterations to existing stock, peaks as a share of GDP an average of seven quarters before the end of an expansion. Consumer spending on durable, nondurable and services reach a high, five quarters before GDP hits a zenith, while business capital spending tops out six quarters ahead of the economy. There are risks for housing despite the upbeat fundamentals. Banks have been tightening their lending standards in recent quarters, although they are still loose relative to previous cycles, and an overtightening may impede the real estate market (Chart 16). It is possible that the GOP's tax plan to significantly change the treatment of state and local real estate taxes and mortgage interest could also negatively affect housing demand, particularly in the luxury market. Additionally, rising foreign demand in certain U.S. markets may lead to mini-bubbles in coastal areas. The latest reading on the Case-Shiller home price index showed nominal housing prices climbing at the fastest rate in three years, although as noted above, inflation-adjusted house prices remain below prior peaks. A prolonged period of house price increases above income gains would challenge our sanguine view of housing affordability. However, the Fed and the banking system are hyper-vigilant about excesses in the housing market, therefore, it is unlikely that another housing bubble will be tolerated. Bottom Line: Housing is a reliable leading indicator of economic activity. Spending on new construction will enhance growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Faster GDP growth will be accompanied by higher inflation and a more active Fed, especially relative to current market expectations. BCA expects global growth to be solid this year although there are signs that growth is peaking outside the U.S. Moreover, the U.S. economy appears to be generating positive momentum even before the effects of tax cuts fully kick in. This is why we expect 2018 to record strong EPS growth in the U.S., which will provide the equity market with a strong tailwind. Stay long stocks over bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report "Opportunity," dated December 11, 2017, available at usis.bca.research.com. 2 http://www.cfosurvey.org/2018q1/press-release.html 3 https://www.abc.org/News-Media/Construction-Economics/Construction-Backlog-Indicator/entryid/13680/abc-s-construction-backlog-indicator-hits-a-new-high-2018-poised-to-be-a-very-strong-year-for-construction-spending 4 Please see BCA U.S. Investment Strategy Weekly Report "Opportunity," dated December 11, 2017, available at usis.bca.research.com. 5 Please see The Bank Credit Analyst Monthly Report, dated February 22, 2018, available at bca.bcaresearch.com. 6 Please see The Bank Credit Analyst Monthly Report, dated February 22, 2018, available at bca.bcaresearch.com.

Highlights Consumer spending is well supported despite weak readings on household purchases in early 2018. The recent rollover in M&A activity does not signal a top in equity markets nor warns that a recession looms. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. Feature Investors began to worry last week about a slowing U.S. economy sending prices of risk assets and Treasury yields lower. The threat of a wider trade spat with China was also a concern, along with the latest round of political intrigue at the White House. Oil fell more than 1% on supply concerns. While the U.S. economic surprise index moved lower since the start of the year, BCA's view is that the U.S. economy is poised to grow well above potential in the first half of the year. Consumer spending is well supported despite weak readings on household purchases in early 2018. The FOMC will provide a new set of economic forecasts and dot plots at this week's meeting. BCA expects the Fed to raise rates this week and three additional times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. According to our U.S. Equity Strategy service's "buy the dip" cycle-on-cycle analysis, a retest of the recent equity lows typically occurs in the first month following the initial shock, suggesting that the S&P 500 is already out of the woods.1 The return of vol may keep a lid on the SPX for a while longer, but our strategy since February 8 is to buy the dips as we do not foresee an end to the business cycle in 2018. Moreover, the recent weakness in M&A activity is not a sign that the bull market is finished. Despite the dip below 2.90% last week, BCA's U.S. Bond Strategy services pegs fair value for the 10-year Treasury yield at 2.96%.2 Assuming a 3% terminal fed funds rate, our U.S. Bond Strategy team expects the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%.3 Too Cold? Chart 1Weak February Retail Sales At Odds##BR##With Strong Consumers Fundamentals Weak February Retail Sales At Odds With Strong Consumers Fundamentals Weak February Retail Sales At Odds With Strong Consumers Fundamentals The Tax Cut and Jobs Act put extra cash into consumers' pockets and helped to lift consumer confidence to a cycle high. Household net worth is at a record level, the labor market is strong and wage growth is accelerating, albeit modestly at this point in the cycle. Despite the favorable backdrop, consumers are on the sidelines in early 2018 (Chart 1). Moreover, early March's unusually harsh winter weather in the Northeastern U.S. may prolong consumers' malaise for another month. The retail sales control group, which feeds into GDP calculations, rose a scant 0.1% m/m in February. The reading was well below the consensus of a 0.5% m/m gain. Headline retail sales dipped by 0.1%, well short of expectations (+0.4%). Auto sales (-0.9%) declined for the fourth month in a row in February. It is clear that the surge in auto sales in the wake of last fall's hurricanes pulled up demand. The weakness in February's spending was broadly based, with 7 of 13 major retail sales categories showing month-over-month declines. However, the recent weakness in consumer outlay masks the robust activity in the past 12 months. Overall retail sales are up a solid 4.1% from a year ago, while sales in the retail control group rose by 4.3%. In addition, sales are higher in 12 of the 13 main categories in the past year, led by non-store retailers (+10.1%), miscellaneous store retailers (+7.5%), clothing (+4.9%) and building materials (+4.6%). As a result of the tepid consumer spending readings in early 2018, the Atlanta Fed's GDPNow model has projected Q1 real GDP growth of just 1.8%, adjusted downward from 2.5% on March 9 (Chart 2). At the start of this month, the Atlanta Fed pegged Q1 GDP at 3.5%. Accordingly, some investors are concerned that household spending is nearing a peak and a recession may be imminent. We see it differently. BCA's stance is that consumer spending should continue to grow by at least 2% in 2018. U.S. consumer health has improved markedly in the past year, driving BCA's Consumer Health Indicator into positive territory (Chart 3). Higher equity prices, a stout labor market and an acceleration in real incomes are behind the improvement. Consumer spending growth tends to accelerate when the Health Indicator is rising. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least in the next 12 months. Chart 2Q1 GDP Estimates Have Moved Sharply Lower Q1 GDP Estimates Have Moved Sharply Lower Q1 GDP Estimates Have Moved Sharply Lower Chart 3The Consumer Is In Good Shape The Consumer Is In Good Shape The Consumer Is In Good Shape Household net worth in 2017Q4 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q4 (Chart 4). Moreover, the composition of households' balance sheet is less alarming today than at prior peaks, because equities and real estate relative to household income or total assets are more reasonable. Furthermore, debt levels are tamer today than in 2006. Households may be less vulnerable to unexpected shocks (Chart 4 again) in light of their more resilient balance sheets. BCA's view is that financial vulnerabilities from the household sector are well contained. Household borrowing is increasing modestly at an annual pace of 4%, in sharp contrast with a 12% rate in the middle of the first decade of the 2000s. A broad measure of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recessionary readings. Furthermore, liquidity buffers (liquid assets-to-liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 5). Chart 4Household Sector Balance Sheet Composition Household Sector Balance Sheet Composition Household Sector Balance Sheet Composition Chart 5Household Sector Buffers Are Solid Household Sector Buffers Are Solid Household Sector Buffers Are Solid Nevertheless, risks may dampen the pace of consumer spending. Debt-to-income ratios have bottomed for the cycle (Chart 5 again) and banks are tightening their lending standards. The result is that consumer delinquency rates are on the upswing, notably in credit cards and autos (Chart 6). Moreover, the personal savings rate cannot sustainably remain around its recovery low of 3.2% (Chart 7, last panel). Chart 6Consumer Loan Metrics Consumer Loan Metrics Consumer Loan Metrics Chart 7Key Supports For Consumer##BR##Spending Remain In Place Key Supports For Consumer Spending Remain In Place Key Supports For Consumer Spending Remain In Place At 2.8%, annual wage compensation growth remains sluggish and far from the 3-4% rate per year that the Fed stated would be consistent with an economy closer to 2% inflation (Chart 7, panel 4). Moreover, households are still unlikely to binge on more debt to smooth out their expenditures as they did in the middle years of the first decade of the 2000s. A further acceleration in consumer spending would occur only alongside steady improvement in the labor market and improving household confidence on future employment and income gains. Bottom Line: Consumers' good mood and healthy balance sheets have not translated into firmer spending growth so far in 2018. Nonetheless, even with below-average consumer spending, the U.S. economy is expanding above the Fed's estimate of potential GDP, the labor market is tightening and inflation is grinding higher. The Fed remains on track to hike rates four times this year. The outlook for the U.S. consumer remains bright because of solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. Consumer headwinds to monitor are households' historically low saving rates, still tepid wage inflation and escalating delinquency rates. Too Hot? U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and in 2007. Some investors are concerned that the recent rollover in deal volume is a signal that a recession or an equity market top is nigh. Deal volume in dollars and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016. Since then, merger activity has moved lower. The decline in corporate combinations accompanied a sizeable rally in equity markets and robust U.S. and global economies. Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. The recent peak in corporate takeovers (July 2017) relative to GDP matched those prior highs, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, last summer's zenith in global or cross-border M&A, a better indicator of market zest than U.S.-only activity, did not eclipse the peaks in 2007. Even at last summer's high, measured against both global GDP and market cap, worldwide corporate combinations remained below their 2015 top and well below their 2007 peak. At just 6.5% in early 2017, the GDP-based metric was significantly under the 2007Q3 pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were boom years for M&A. Moreover, Phase I of the Fed funds rate cycle4 (the Fed is tightening, but policy is still accommodative) supports accelerating M&A activity (Chart 8A). Corporate combinations also climb during Phase II (Fed tightening, but policy is restrictive). However, M&A activity peaked at the end of Phase II in 2000 and 2007 (Chart 8B). BCA's view is that we will remain in Phase I until at least the end of 2018 and that Phase II may not be over until the end of 2019 or later. Chart 8AM&A Activity In Phase I Of The Fed Cycle... M&A Activity In Phase I Of The Fed Cycle... M&A Activity In Phase I Of The Fed Cycle... Chart 8BM&A Activity In Phase II Of The Fed Cycle... M&A Activity In Phase II Of The Fed Cycle... M&A Activity In Phase II Of The Fed Cycle... Bottom Line: The recent rollover in M&A activity does not signal a top in equity markets nor warn that a recession looms. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks and M&A) is not out of line with previous economic expansions (Chart 9). Stay overweight stocks versus bonds as the U.S. economic expansions becomes a decade-long phenomenon. Chart 9Comparison Of Corporate Outlays Across Four Economic Expansion Phases Goldilocks Goldilocks Just Right Wage inflation remains in a gradual upward trend, accelerating just enough to nudge up price inflation and prompt the Fed to hike rates four times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. However, the January reading (+2.8 yoy) on average hourly earnings (AHE) stoked fears of the former, while the February reading (+2.6%) raised concerns of the latter. Chart 10 confirms that most measures of labor market slack have returned to normal. Moreover, the latest soundings on the job market from the National Federation of Independent Business suggest that small business owners have the most job openings in at least 18 years (Chart 11, panel 1). In addition, key concerns have shifted to the quality of the job applicants (panel 2) and the cost of labor (panel 3), away from taxes and over-regulation. Chart 10Labor Market Slack##BR##Is Disappearing Labor Market Slack Is Disappearing Labor Market Slack Is Disappearing Chart 11Hiring And Labor Costs A##BR##Key Concern For Small Businesses Hiring And Labor Costs A Key Concern For Small Businesses Hiring And Labor Costs A Key Concern For Small Businesses Those concerns were underscored in the Federal Reserve's January and February Beige books. Table 1 shows industries with labor shortages; in the year ended February, the gain in average hourly earnings in all but 3 of the industries was faster than average. Moreover, in all but 1 of these categories, labor market conditions are now the tightest since before the onset of the 2007-2009 recession. A recent Fed study5 examines the labor shortages in the manufacturing sector in more detail. The Beige Books noted that many businesses are having trouble finding low-skilled (and to a lesser extent, middle-skilled) workers, with a few mentions of the challenges of finding/retaining highly skilled employees, especially in STEM job functions. Chart 12 shows the wage gains for supervisory staff, a proxy for skilled (panel 1) and non-supervisory employees, and an imperfect proxy for low-skilled workers (panel 2). Both metrics are rising, but the skilled worker proxy accelerated more than the low-skilled metric. Moreover, at 3.1%, the latest reading on supervisory employees is nearly double the pace of non-supervisory personnel. The Atlanta Fed's Wage Tracker provides another lens on wage gains by skill level. Chart 13 shows that wage inflation among skilled positions is running well above average. Raises among mid- and low-skilled labor lag far behind. Notably, wages in all three have rolled over since late 2016. Table 1Labor "Shortages" Identified##BR##In The Beige Book Goldilocks Goldilocks Chart 12Supervisory Vs. Production##BR##Wage Inflation Supervisory Vs. Production Wage Inflation Supervisory Vs. Production Wage Inflation Chart 13Wage Inflation##BR##By Skill-Level Wage Inflation By Skill-Level Wage Inflation By Skill-Level Chart 14 argues that slightly faster compensation growth is imminent. The top panel shows that more than 80% of U.S. states register unemployment below the Fed's estimate of full employment. In the past, rates over 60% have been associated with wage pressures. The percentage climbed above 60% in January. The bottom panel of Chart 14 demonstrates the relationship between state unemployment rates and wage gains in each state. Chart 1480%+ Of States Have Unemployment Rates Below NAIRU 80%+ Of States Have Unemployment Rates Below NAIRU 80%+ Of States Have Unemployment Rates Below NAIRU Bottom Line: The labor market is back to normal, but is not overly tight, as shown in Chart 10. Wages and employment costs are in an uptrend, yet firms are still reluctant to give large pay increases to their labor force. That said, against the backdrop of fiscal stimulus, real GDP growth will remain well above potential, which means that the unemployment rate is headed to 3½% or even below. At some point, the labor market will overheat. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Reflective Or Restrictive", published March 12, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "From Headwinds To Tailwinds", published March 6, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Two-Stage Bear Market In Bonds", published February 20, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Lingering In The Policy Sweet Spot," September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," December 23, 2013. Both available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm

Highlights Q4 earnings are beating raised expectations, and the bar for 2018 EPS is even higher. Housing, capex and a nudge from government spending are set to boost GDP in 2018. BCA's consumer spending model shows that economic factors, not sentiment or political affiliation, are the main drivers of household consumption. Feature Risk assets continued their early 2018 surge last week, supported by better than expected Q4 corporate earnings results, solid economic growth and a weaker dollar. The headline 2.6% gain in Q4 GDP understated the strength in the U.S. economy as 2017 ended (Chart 1). Real final sales to domestic purchasers rose 4.3% in Q4, the fastest clip in nearly four years. Moreover, the economy is poised to grow well above its long term potential in the first half of 2018, aided by surging capex, the lagged effect of easy financial conditions and the tax bill. Faster growth will push down the unemployment rate and lead to higher inflation by year end. Q4 corporate earnings are beating raised expectations. However, managements have raised the bar for 2018 results, which may lead to disappointment later this year. Investors have correctly ignored the elevated level of political polarization in Washington and focused on the fundamentals. The final section of this week's bulletin suggests that despite a widening gap in consumer sentiment between political parties, economic fundamentals, not political affiliation, drives consumer behavior. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target As Good As It Gets? As Good As It Gets? Raising The Bar The Q4 earnings reporting season is off to a strong start, with both EPS and revenue growth ahead of consensus expectations at the start of January. Moreover, the counter-trend rally in margins remains in place. We previewed the Q4 2017 S&P 500 earnings season earlier this month.1 Table 1S&P 500: Q4 2017 Results* As Good As It Gets? As Good As It Gets? Just under 30% of companies have reported results thus far, with 80% beating consensus EPS projections, well above the long term average of 69%. Furthermore, 82% have posted Q4 revenues that topped expectations, which exceeded the long-term average of 56%. The surprise factor for Q4 stands at 5% for EPS and 1% for sales. Both readings are right at the average surprise in the past five years. The surprise figures are even more impressive given that analysts' views of Q4 results increased between the start of Q4 2017 and the start of Q4 reporting season. Analysts' estimates typically move lower as the quarter unfolds, in effect lowering the bar for results. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q4 will be another quarter of margin expansion. Average earnings growth (Q4 2017 versus Q4 2016) is solid at 13% with revenue growth at 7%. However, on a four quarter basis, U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Strength in earnings and revenues are broadly based (Table 1). Earnings per share increased in Q4 2017 versus Q4 2016 in 9 of the 11 sectors. EPS results are particularly stout in energy (140%), materials (28%), technology (18%) and financials (15%). The energy, materials and technology sectors likewise experienced significant sales gains (21%, 11%, and 11% respectively). The 5% year-over-year increase in financial sector earnings follows the 7% drop in Q3, owing to the impact of Hurricanes Harvey and Irma on the insurance and reinsurance industries. Excluding energy, S&P 500 profits in Q4 2017 versus Q4 2016 are a still-robust 11%. Upbeat managements have raised the bar significantly for 2018 results in the past few months (Chart 2). On October 1, 2017, before the GOP introduced the bill, the bottom-up estimate for 2018 S&P 500 EPS growth stood at 11%. As of January 26, 2018, the estimate is 17%. Moreover, the upward revisions are widespread. 2018 EPS growth rate estimates in 9 of 11 sectors are higher today than at the start of October (Table 2). 2018 consensus projections increased the most for Telecom, Financials, Energy, and Consumer Discretionary. Analysts have cut their view of 2018 results for the Utilities and Real Estate sectors since the bill was introduced. Our U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors earlier this month.2 Chart 2Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Table 2Estimated Earnings Growth For 2018 As Good As It Gets? As Good As It Gets? The Tax Cut and Jobs Act of 2017 is behind most of this ebullience, but improving global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As we noted in last week's report,3 companies are likely to return almost all of that cash to shareholders via increased buybacks. Moreover, a few firms are marking up 2018 estimates in anticipation of a surge in capital spending, as managements pull ahead new investment into 2018 from later years to benefit from the bill. Chart 3Profit Growth Will Peak In 2018 Profit Growth Will Peak In 2018 Profit Growth Will Peak In 2018 Analysts expect EPS growth to slow significantly in 2019 from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking on a four-quarter moving total basis, and should begin to decelerate in 2H 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). After-tax earnings growth will be higher than this, however, due to the recently passed tax cuts. Margins will crest in mid-2018, but BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors, and it remains to be seen whether managements can match the lofty projections, especially in the second half of the year. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Further weakness in the dollar, counter to our call for a 5% gain in the DXY, would also provide a modest boost to S&P 500 results in 2018. Strong domestic economic activity will also boost profits this year. Setting The Stage For 2018 Q4 GDP posted a 2.6% gain, failing to match (raised) expectations of a 2.9% increase (Chart 1 again). At 2.5%, the year-over-year change in GDP exceeded the FOMC's forecast for 2017 GDP (2.1%) at the start of 2017. Moreover, the 2.5% year-over-year reading in Q4 is well above the Fed's estimate of potential GDP (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in March are over 90%, and investors expect almost three additional hikes in the next 12 months (Chart 4). The FOMC expects to raise rates three times this year. BCA's stance is that the Fed will raise rates 4 times. Chart 4The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 BCA's view is that U.S. economic growth is set to accelerate in the first half of 2018 aided by the tax cut, strong global growth and the lagged effect of easier financial conditions. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. Full expensing of capital goods and changes to the budget sequesters would add another 0.2 percentage points. Global growth estimates are still on the upswing, which will provide U.S. capex a boost (Charts 5 and 6). Moreover, financial conditions have eased since the Fed's initial hike of the cycle (Chart 7). Financial lead GDP growth by 6 to 9 months, suggesting that real GDP growth in the U.S. will remain at or above 3% for at least the first half of 2018 (Chart 8). The New York Fed's Nowcast for Q1 2018 stands at 3.1%, while the Atlanta Fed's GDP Now reading for Q1 is 3.4% (Chart 9). Chart 5Global Growth Expectations##BR##Are Accelerating Global Growth Expectations Are Accelerating Global Growth Expectations Are Accelerating Chart 6Capex Poised##BR##For Liftoff Capex Poised For Liftoff Capex Poised For Liftoff Chart 7Financial Conditions Have Eased Since##BR##The Fed's First Rate Hike Of The Cycle Financial Conditions Have Eased Since The Fed's First Rate Hike Of The Cycle Financial Conditions Have Eased Since The Fed's First Rate Hike Of The Cycle Chart 8Easier Financial Conditions##BR##Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 9Solid GDP Growth##BR##Expected In Q1 Solid GDP Growth Expected In Q1 Solid GDP Growth Expected In Q1 Residential investment, which surged in Q4 as communities in Texas and Florida began to rebuild after the storms, will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 10). Housing affordability remains well above average, and will remain supportive of housing investment even if rates rise by 100 bps (Chart 11). Bank managements are upbeat about credit quality and loan growth,5 although the recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters. However, banks' lending standards for home loans remain relatively loose (Chart 12). Moreover, household formation recovered in the past few years alongside the labor market, providing additional support for housing. Risks to housing include the impact of the limits to mortgage interest and state and local taxes imposed by the Tax Cut and Jobs Act of 2017. Chart 10Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 12Mortgage Spigot##BR##Open For Homebuyers Mortgage Spigot Open For Homebuyers Mortgage Spigot Open For Homebuyers Bottom Line: U.S. economic growth is poised to string together the longest period of above-potential GDP growth since early in the recovery. The odds of a recession in 2018 are very low (Chart 13). Housing, capital spending and a modest lift from government spending will lift GDP, pushing the output gap further into positive territory (Chart 14). The added support to the economy from the tax bill makes it more likely that the economy will overheat, and lead to higher inflation and faster rate hikes than the market, or the Fed, expects. Stay underweight duration and overweight stocks versus bonds for now, although we plan to take some risk off the table later in the year. Despite record levels of political polarization, the U.S. consumer will provide support for the economy in 2018 as well. Chart 13Odds Of A Recession Are Low Odds Of A Recession Are Low Odds Of A Recession Are Low Chart 14U.S. Economy Growing Faster Than Potential U.S. Economy Growing Faster Than Potential U.S. Economy Growing Faster Than Potential Tribal Economics Chart 15Income Inequality Fosters Polarization Income Inequality Fosters Polarization Income Inequality Fosters Polarization Many of our clients have been asking: "Why is consumer confidence so high if Americans are so angry?" BCA's view is that Americans' anger is based to some extent on "economic discontent",6 driven largely by political orientation. However, economy-wide, the negative attitude based on party affinity is more than offset by a higher level of optimism based on economic fundamentals. Moreover, the dissatisfaction among households may be about structural issues that have long-term implications, like income inequality, which fosters or nurtures polarization and where the latter continues to grow. The polarization in the cultural realm has been mirrored in the political arena. According to political scientists Keith Poole and Howard Rosenthal, polarization in Congress is currently at its highest level since World War II (Chart 15). Furthermore, BCA's Geopolitical Strategy service stance is that the long-term implications of polarization are here to stay as income inequality remains the most significant driver, among five main factors, that explain the polarization in the U.S. today.7 & 8 The election of President Trump in November 2016 ushered in a period of significant polarization and partisan conflict. Compared with other administrations, Trump effected the most change in economic expectations9 (Table 3). Moreover, even a year later, the partisan gap (Republicans minus Democrats) has widened further; Republicans are most optimistic and Democrats are most pessimistic (Chart 16). Table 3Change In Economic Assessments##BR##Pre And Post Elections As Good As It Gets? As Good As It Gets? Chart 16Partisan Gap Is Widest##BR##And Persistent, For Now Partisan Gap Is Widest And Persistent, For Now Partisan Gap Is Widest And Persistent, For Now To further understand the divergence between the elevated consumer sentiment readings and households' high level of anger, it is useful to look through the lens of the stages of "economic discontent".10 The framework pioneered by the University of Michigan identifies five typical stages of a collapse in economic confidence (Table 4). The study acknowledges that consumers are rational individuals. As such, households tend to shape their economic expectations on cyclical fundamental drivers of the economy, rather than political affiliation (Chart 17). The implication is that as long as consumers remain satisfied with the performance of the three cyclical drivers, readings on consumer sentiment will hold up, as the positive views on fundamentals outweigh any resentment they may have about long-term issues like income inequality. Finally, it is clear that households have not lost all hope (stage four), where economic discontent turns into political discontent. Consumers are very far away from total despair, not seen since the 1930s! Nonetheless, BCA's view is that with recession likely by late 2019/early 2020, the U.S. will see a revolt of some kind by the 2020 election.11 Table 4Five Stages Of##BR##Economic Discontent As Good As It Gets? As Good As It Gets? Chart 17Expectations For Cyclical##BR##Fundamental Drivers Are Solid Expectations For Cyclical Fundamental Drivers Are Solid Expectations For Cyclical Fundamental Drivers Are Solid Consumers have hope that their economic expectations will be met by the Trump administration's policies as the economy continues to deliver strong job growth/job security and tame inflation, preserving households' purchasing power. BCA's consumer spending model shows that economic factors, not sentiment, are the main drivers of household consumption (Chart 18). Several academic studies support this view. Researchers at Princeton University and the National Bureau of Economic Research find that political polarization's impact on consumer spending is trivial.12 Furthermore, a recent study by the Federal Reserve Bank of New York,13 also finds that the election of President Trump had negligible partisan impact on consumer spending patterns. Economists at the NY Fed show that consumers' expectations in surveys may include "true beliefs" based on economic factors and "some noise". They conclude that if the partisan gap does not cause economic decisions to vary significantly, then macroeconomists and policymakers should downplay the impact of consumers' political views on spending patterns. Chart 18Consumption Has##BR##Room To Grow Consumption Has Room To Grow Consumption Has Room To Grow Chart 19Lower-Lows In The Personal##BR##Savings Rate Unlikely Lower-Lows In The Personal Savings Rate Unlikely Lower-Lows In The Personal Savings Rate Unlikely Bottom Line: BCA expects consumer spending to grow by at least 2% in 2018. Consumption is well supported by record high household net worth, and accelerating wages. On the other hand, employment growth will slow later this year and we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 19). John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Smooth Transition" published January 15, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models" published January 16, 2018. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme" published January 22, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme", published January 22,2018. Available at usis.bcaresearch.com. 6 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 7 Please see BCA Research's Global Investment Strategy Special Report, "The Future Of Western Democracy: Back To Blood", dated November 18, 2016. Available at gis.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016. Available at gps.bcaresearch.com. 9 "Consumer Expectations: Politics Trumps Economics", Richard Curtin, University of Michigan, June 1, 2017. 10 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 11 Please see BCA Research's Geopolitical Strategy Special Report "Populism Blues: How And Why Social Instability Is Coming To America" June 9, 2017. Available at gps.bcaresearch.com. 12 "Partisan Bias, Economic Expectations, and Household Spending", Atif Mian, Amir Sufi and Nasim Koshkhou, Stanford University, University of Chicago Booth of Business, NBER and Argus Information and Advisory Services, July 2017. 13 "Political Polarization In Consumer Expectations", Olivier Armantier, John J. Conlon and Wilbert van der Klaauw, Federal Reserve Bank of New York, December 15, 2017.

Highlights BCA expects the 2/10 curve to steepen in 1H in 2018, then flatten in 2H. U.S. equities, the stock-to-bond ratio and oil thrive when the curve is flat. Small caps struggle. Record household net worth matters more for household saving than for consumption. Feature Wrangling over the GOP's tax plan and the Federal Open Market Committee's final meeting of 2017 provided the backdrop for financial markets last week. The dollar was the big loser, as investors doubted the ability of the Republican leadership in Congress to find the votes needed to pass the bill. BCA's view remains that Congress will pass a tax cut package by the end of Q1 2018. Even though inflation missed the Fed's forecast in 2017 (Chart 1), the FOMC left its inflation and interest projections unchanged for the next two years given its outlook for stronger growth and lower unemployment. Inflation will reach the 2% target by the end of 2019. As a consequence, the Fed expects to lift interest rates three more times in 2018 and another two times in 2019 (Chart 2). Chart 1Persistent Inflation Shortfall Persistent Inflation Shortfall Persistent Inflation Shortfall Chart 2The FOMC's Latest Forecasts The FOMC's Latest Forecasts The FOMC's Latest Forecasts The economy is now expected to grow 2.5% in 2018, up from the Fed's previous forecast of 2.1%. Growth is seen remaining above the 1.8% trend rate for three years. The Fed nudged its forecasts for the unemployment rate down by 0.2% for the next three years, based on the higher growth projections. The jobless rate is now expected to dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. If anything, these forecasts look too conservative. Importantly, the Fed left its estimate for long-run unemployment unchanged at 4.6%. Therefore, the labor market is expected to tighten further beyond full employment. Consequently, wage gains should accelerate and allow inflation to return to the Fed's 2% target in 2019. We don't have any major disagreements with the Fed's interest rate forecasts for 2018, but inflation must turn higher. The Fed has raised rates five times over the last two years, but CPI inflation has made no progress toward the 2% objective. However, the New York Fed's Underlying Inflation Gauge continues to move steadily higher (Chart 1, panel 1). Nevertheless, the real Fed funds moved closer to its neutral level and the yield curve has continued to flatten (panel 3). Bottom Line: BCA expects the yield curve to steepen in the first half of 2018, driven either by rising inflation or a more dovish Fed. However, a flat curve is not the death knoll for risk assets. The yield curve will not invert until inflation has recovered to the Fed's target. This means that a period of modest curve steepening is likely, driven either by rising inflation or a more dovish Fed. Powell Versus The Market BCA's view is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates, but inflation fails to rise, then the yield curve will invert in the coming months. The inversion would signal that bond investors anticipate a recession and the Fed has not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves three possible outcomes for Fed policy and the Treasury curve during the next six months.1 1) The Fed Is Right In this scenario, inflation would rebound in the coming months, pushing up the compensation for inflation protection embedded in long-dated bond yields. This would cause an increase in long-maturity nominal yields and probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates. BCA's Outlook for 2018 makes a case why inflation will likely bottom in the coming months. Therefore, we view the "Fed is Right" scenario as the most probable outcome.2 2) The Fed Is Proactive In another scenario, the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. Therefore, the Fed may proactively adopt a more dovish policy stance to prevent the yield curve from inverting. The yield curve would also steepen, but this time it would be a bull-steepener where short-maturity yields fall more than long-maturity yields. This outcome would be the least likely of our three scenarios. The Fed will cling to its forecast that inflation will climb, given that economic growth is accelerating. If inflation fails to respond, then risky assets will eventually sell-off. 3) The Fed Is Reactive The Fed has a strong track record of reacting to tighter financial conditions and risk-off periods in equities and credit markets. If the yield curve continues to flatten, then we will soon see credit spreads widen and equities sell-off. At that stage, the Fed would almost certainly respond by signaling a slower pace of rate hikes. This would steepen the curve and ease pressures on risky assets. We view this development as more likely than the one where the Fed is proactive. Trouble With The Curve BCA's U.S. Bond Strategy team expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 53 bps in mid-December 2017 through mid-year 2018, and then flatten into year-end. Which asset classes would benefit if BCA's curve call is accurate? Charts 3 through 7 show how several key financial markets have performed in previous yield curve environments. Chart 3A shows that the S&P 500 performs best when the curve is flat (between 0 and 50 bps), with average annualized returns of 22% and median annualized returns of 21%. Moreover, S&P 500 returns are negative less than 5% of the time when the curve is flat, but are negative 25% of the time when the curve is very steep (+100 to +150 bps) (Chart 3B). In general, Chart 3A demonstrates that returns diminish as the curve climbs. Chart 3AS&P 500 Total Return & Yield Curve##BR##(1988- Present) The Bucket List The Bucket List Chart 3BPercent Of Months With Negative##BR##S&P 500 Returns (1988- Present) The Bucket List The Bucket List A flat slope of the 2/10 curve is also the sweet spot for the stock-to-bond ratio (Chart 4A). Treasuries outperform stocks only in 5% of months when the 2/10 Treasury curve is flat (Chart 4B). As with stocks, the performance of the stock-to-bond ratio deteriorates as the curve steepens. The stock-to-bond ratio declines more than a third of the time when the curve is very steep. A 2/10 slope of +100 to +150 bps is the worst backdrop for the stock-to-bond ratio. Stocks underperform bonds 40% of the time in this situation. Chart 4AStock-To-Bond Total Return & Yield Curve##BR##(1988 - Present) The Bucket List The Bucket List Chart 4BPercent Of Months With Negative##BR##Stock-To-Bond Total Return (1988 - Present) The Bucket List The Bucket List However, a flat curve is a poor setting for small-cap excess performance (Chart 5A). Small caps underperform large caps nearly 80% of the time when the curve is flat (Chart 5B). The average underperformance is 600 bps. Moreover, a flat curve is the most unhealthy climate for small-cap excess returns, even poorer than when the curve inverts. A precipitous curve is the best environment for small caps, with small caps outperforming large by 400 bps on average. Small caps beat large caps 60% of the time when the curve is between 100 and 150 bps. Chart 5AS&P Small/Large TOTAL Return & Yield Curve##BR##(1988- Present) The Bucket List The Bucket List Chart 5BPercent Of Months With Negative##BR##S&P Small/Large Total Return (1988- Present) The Bucket List The Bucket List Our U.S. Bond Strategy colleagues note that the flatter the curve, the higher the risk of a sell-off in high-yields relative to Treasuries.3 Junk bonds underperform Treasuries 48% of the time when the curve is flat, which we expect in 2018 (not shown). The implication for investors is that the first half of 2018 will be the best period for junk bond returns. Investment-grade corporates have a similar return profile relative to the curve. Oil performs best when the 2/10 curve is inverted (Chart 6A). However, WTI oil returns an annualized 10-15% when the curve is between 0 and 100 bps. Plus, oil is higher 75% of the time when the curve is between 50 and 100 bps, which is the environment we expect in the first half of next year (Chart 6B). Chart 6AWTI Crude Oil Price Return & Yield Curve##BR##(1988- Present) The Bucket List The Bucket List Chart 6BPercent Of Months With Negative##BR##WTI Crude Oil Price Return (1988- Present) The Bucket List The Bucket List Forward earnings per share perform well with a flat curve, but earnings growth is optimal when the curve is inverted. The steeper the curve, the bigger the headwind for EPS. Since 1988, earnings growth has been positive when the curve inverts and is positive 95% of the time when the curve is flat. Chart 7 provides the historical context for a flat yield curve (0 to 50 bps) in terms of the performance of stocks, Treasury bonds, the stock-to-bond ratio, small caps and oil. The Appendix (see page 13) also includes three other charts that provide a perspective on asset class performance when the curve is moderately steep (50 to 100 bps), steep (100 to 150bps) and above 150 bps. Chart 7Stocks, Treasuries, Small Caps And Oil When The Curve Is Flat Stocks, Treasuries, Small Caps And Oil When The Curve Is Flat Stocks, Treasuries, Small Caps And Oil When The Curve Is Flat Bottom Line: BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive next year; earnings growth is higher 75% of the time when the curve is flat. Household Net Worth Loses Influence Chart 8The Consumer Is In Good Shape The Consumer Is In Good Shape The Consumer Is In Good Shape U.S. consumer health has improved markedly since early this year, driving BCA's Consumer Health Indicator into positive territory (Chart 8). These elevated readings should bolster household consumption well into 2018. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least over the next 12 months. Real consumer spending is underpinned by advances in real disposable income stemming from increasingly healthy labor market. Moreover, household net worth has continued to soar to an all-time high in 2017Q3 as equity markets remain frothy and house prices stable. However, net worth's direct influence on overall household consumption is not as significant as before the Great Recession. During the housing bubble in the early 2000s, U.S. households leveraged their spending through extensive mortgage refinancing and mortgage equity withdrawal. Real estate was the principal holding on most households' balance sheets. However, as the Great Recession unfolded, household net worth suffered with a collapse in both house prices and equity markets. By 2009, U.S. households were tapped out and grossly over-indebted. Deleveraging is now over, U.S. households have re-fortified their balance sheets and consumer spending is back in line with income growth. In the long term, inflation-adjusted disposable income is more highly correlated with inflation-adjusted consumer spending growth than real household net worth (Chart 9). Positive momentum should continue to support further real consumer spending over the next few quarters, given that unemployment is at a 17-year low and consumer confidence is at a 17-year high, and also given elevated consumers' expectations of real income gains over the next year or two. Chart 9Consumer Spending More Correlated With Income Than Net Worth The Bucket List The Bucket List Household net worth matters more for household saving than for consumption. Chart 10 shows the inverse relationship between net worth and the saving rate. Empirical research has demonstrated the risk that the structural decline (since the mid-1990s) in personal savings has on consumer spending and the overall economy. An often cited conclusion drawn by the investment community is that a lower savings rate raises the risk of consumer retrenchment.4 Chart 10Low Savings Rate, Record High Household Net Worth And Rising Income Expectations Low Savings Rate, Record High Household Net Worth And Rising Income Expectations Low Savings Rate, Record High Household Net Worth And Rising Income Expectations Even though the personal savings rate can be considered a contrarian measure for consumer spending, like many measures from the BEA national accounts (NIPA), it is subject to regular revisions. Over the long-term, according to the BEA, the level of the savings rate is often revised upwards but the trend over the last 45 years remains unchanged. There was a downtrend path to revisions in the mid-2000s housing bubble, but there has been a subtle uptrend since 2008 (Chart 11). Even so, in the long run, BCA views the low personal savings rate as a potential headwind for consumer spending as it cannot sustainably remain at its recovery low of 3.2%. However, rising income expectations and a sturdy labor market are offsets to depressed savings and will ensure that the economic expansion remains sustainable and, therefore, less vulnerable to volatile saving patterns. Does record high net worth alter the risks to the FOMC's goals of price stability and sustainable economic growth? In a recent research paper, the Federal Reserve of St-Louis looked at the most exuberant peaks in the ratio of household net worth to income in 1999 and 2006, which occurred before collapses in asset prices and recessions. Although caution is prescribed as household net worth keeps making new highs, the report noted that the composition of households' balance sheet is less alarming today than prior peaks, as equities and real estate relative to household income or total assets are more reasonable. Debt levels are also much more tame today than in 2006. With more immune balance sheets, households may be less vulnerable to unexpected shocks in the future (Chart 12).5 BCA's view is that financial vulnerabilities from the household sector are well contained. Outside of subprime auto loans, household borrowing is increasing modestly at an annual pace of 3.6%, in stark contrast with a 12.9% rate in the early-to-mid 2000s. Broad measures of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recession levels. Furthermore, liquidity buffers (liquid assets to liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 13). Chart 11Savings Rate Level Often Revised Upwards Savings Rate Level Often Revised Upwards Savings Rate Level Often Revised Upwards Chart 12Household Sector Balance Sheet Composition Household Sector Balance Sheet Composition Household Sector Balance Sheet Composition Chart 13Household Sector Buffers Are Solid Household Sector Buffers Are Solid Household Sector Buffers Are Solid BCA expects the Fed to remain vigilant about financial stability.6 Policymakers will take comfort that household liquidity and solvency ratios have improved dramatically in the past nine years, aided by the cumulative gains in housing and financial assets. Bottom Line: The outlook for the U.S. consumer is bright as incomes continue to improve amid tight labor market conditions. However, record household net worth is more relevant today for savings than for consumption. The Fed should remain committed to gradual rate hikes, but the central bank's quandary will be to determine the optimal pace to foster maximum employment and price stability. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?," published on December 12, 2017. Available at usbs.bcaresearch.com. 2 Please see BCA Research's "2018 Outlook Policy And The Markets: On A Collision Course ," published December 2017. Available at bca.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "Proactive, Reactive Or Right?," published on December 12, 2017. Available at usbs.bcaresearch.com. 4 "Should The Decline In The Personal Savings Rate Be A Cause For Concern?", Alan C. Garner, The Federal Reserve Bank of Kansas City, 2006Q2; and "The Decline in the U.S. Personal Savings Rate: Is It Real and Is It A Puzzle?", Massimo Guidolin and Elizabeth A. La Jeunesse, The Federal Reserve Bank of St-Louis, November/December 2007. 5 "Household Wealth Is At A Post-WW II High: Should We Celebrate or Worry?", William R. Emmons and Lowell R. Ricketts, Federal Reserve Bank of St-Louis, In the Balance, Perspectives on Household Balance Sheets, May 2017. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Powell's In Power," published on November 6, 2017. Available at usis.bcaresearch.com. Appendix Chart 14U.S. Financial Markets When The 2/10 Curve Is Between 50 And 100 Bps U.S. Financial Markets When The 2/10 Curve Is Between 50 And 100 Bps U.S. Financial Markets When The 2/10 Curve Is Between 50 And 100 Bps Chart 15U.S. Financial Markets When The 2/10 Curve Is Between 100 And 150 Bps U.S. Financial Markets When The 2/10 Curve Is Between 100 And 150 Bps U.S. Financial Markets When The 2/10 Curve Is Between 100 And 150 Bps Chart 16U.S. Financial Markets When The 2/10 Curve Is Steeper Than 150 Bps U.S. Financial Markets When The 2/10 Curve Is Steeper Than 150 Bps U.S. Financial Markets When The 2/10 Curve Is Steeper Than 150 Bps

Highlights Yield Curve & Fed: The yield curve will not invert until inflation has first recovered to the Fed's target. This means that a period of curve steepening is likely, driven either by rising inflation or a more dovish Fed. Corporate Sectors: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Feature Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. [...] The broadly anticipated behavior of world bond markets remains a conundrum. - Alan Greenspan, February 20051 By the end of the week the Fed will have raised interest rates by 125 basis points since December 2015, yet the 10-year Treasury yield has risen only 7 bps (Chart 1). But unlike in 2005, there is no bond conundrum. On the contrary, the reason for low long-maturity Treasury yields is easily understood. Chart 1What Conundrum? What Conundrum? What Conundrum? Quite simply, the Federal Reserve has been lifting interest rates in-line with its projections for rising inflation, but markets are trading off the fact that this inflation has yet to materialize. The compensation for inflation protection embedded in 10-year yields is only 1.88%. Historically, when core inflation is close to the Fed's 2% target, compensation for inflation protection has traded in a range between 2.4% and 2.5%. Essentially, Fed rate hikes have lifted short-maturity yields but low inflation is keeping long-maturity yields depressed. The result is that the 2/10 Treasury slope has flattened all the way down to 58 bps from 128 bps in December 2015 (Chart 1, bottom panel). What should be clear is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates but inflation fails to rise, then the yield curve will invert in the coming months - a signal that bond investors anticipate a recession - and the Fed will have not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves us with three possible outcomes for Fed policy and the Treasury curve during the next six months. 1) The Fed Is Right In this scenario inflation starts to rebound in the coming months, pushing the compensation for inflation protection embedded in long-dated bond yields higher (Chart 2). This would certainly cause long-maturity nominal yields to increase and would probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates.2 BCA's Outlook for 2018 makes the case for why inflation is likely to bottom in the coming months, and we view the "Fed is Right" scenario as the most likely outcome.3 Chart 2Fed Expects Higher Inflation Fed Expects Higher Inflation Fed Expects Higher Inflation 2) The Fed Is Proactive In this scenario the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. It therefore proactively adopts a more dovish policy stance to prevent the yield curve from inverting. The likely first step would be signaling a slower pace of rate hikes in this week's Summary of Economic Projections. The yield curve would also steepen in this scenario, but this time a bull-steepening where short-maturity yields fall more than long-maturity yields. At least one FOMC member already seems worried enough to take this sort of action. St. Louis Fed President James Bullard said two weeks ago that: "Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts".4 But other policymakers are less concerned. Cleveland Fed President Loretta Mester downplayed the flat yield curve in a recent interview.5 We view this outcome as the least likely of our three scenarios. With economic growth accelerating (see Economy & Inflation section below), the Fed will likely cling to its forecast that inflation will move higher. If inflation fails to respond, then risky assets will eventually sell off. This brings us to the final scenario. 3) The Fed Is Reactive The Fed does not have a strong track record of proactively responding to low inflation readings, but it does have a strong track record of reacting to tighter financial conditions and risk off periods in equities and credit markets. What's more, if the yield curve continues to flatten, then we are very likely to see credit spreads widen and equities sell off quite soon. At that point the Fed would almost certainly respond by signaling a slower pace of rate hikes. That would steepen the curve and ease the pressure on risky assets. We view this third scenario as more likely than the one where the Fed is proactive. In fact, we observe that the yield curve is already flat enough that the chances of a sell-off in High-Yield corporate bonds relative to Treasuries are high. Using monthly data going back to 1988, we see that a flatter 2/10 Treasury slope is consistent with lower monthly excess returns from High-Yield (Chart 3). We also see that a flatter yield curve is consistent with more frequent risk-off periods (Chart 4). Chart 3Junk Monthly Excess Returns & ##br##Yield Curve (1988-Present) Proactive, Reactive Or Right? Proactive, Reactive Or Right? Chart 4% Of Months With Negative High-Yield ##br##Excess Returns (1988- Present) Proactive, Reactive Or Right? Proactive, Reactive Or Right? This makes sense intuitively. An inverted yield curve is a well-known recession indicator. This means that when the yield curve is very flat investors are obviously nervous that any new piece of bad news could tip the curve into inversion and signal an end to the economic recovery. In other words, a risk-off episode in junk bonds, like the one witnessed in early November, would be less likely to occur if the yield curve were steeper.6 We would recommend buying the dips on any near-term correction in junk bonds, because the Fed would then be forced to get more dovish and support the credit markets. But unless inflation returns and steepens the Treasury curve from current levels, the risk of just such an episode is high. Corporate Sector Year-In-Review With 2017 nearly in the books, this week we take a quick look back at the performance of the 10 main investment grade corporate bond sectors during the year. Chart 5 shows the excess return for each sector relative to its duration-times-spread (DTS) from the beginning of the year. DTS is a common measure of risk for corporate bonds, and can be thought of much like an equity's beta. When the overall corporate bond market is rallying, then high-DTS sectors tend to perform better. Conversely, when corporate bonds underperform Treasuries, then high-DTS sectors tend to lose more than the low-DTS alternatives. As can be seen in Chart 5, given that 2017 was a risk-on year, high-DTS sectors tended to outperform low-DTS sectors with a few exceptions. The Basic Industry sector and Financials performed much better than their DTS alone would have predicted, while the Communications sector performed much worse than its DTS would have predicted. Looking ahead into 2018, we make the following observations: Excess returns for investment grade corporate bonds are likely to be lower in 2018 than in 2017.7 In turn, this means that the Credit Risk Premium - the extra return earned for taking an additional unit of DTS risk - will also be lower. We calculated the Credit Risk Premium for each year since 2000 by performing a regression of annual excess returns for each of the 10 major sectors versus their beginning-of-year DTS. The beta from that regression represents the additional return earned that year from taking an extra unit of DTS risk. Chart 6 shows that this Credit Risk Premium is an increasing function of excess returns for the overall corporate sector. Logically, if the year ahead is likely to deliver lower excess returns for the overall index, then we should also expect less additional return from increasing the DTS risk of our corporate bond portfolios. Chart 52017 Corporate Sectors ##br##Excess Returns* Vs DTS** Proactive, Reactive Or Right? Proactive, Reactive Or Right? Chart 6Excess Returns* Vs ##br##Credit Risk Premium Proactive, Reactive Or Right? Proactive, Reactive Or Right? Second, we use our corporate sector model - a model that adjusts each sector's spread by its average credit rating and duration - to identify sectors that have the potential to outperform their DTS in the coming months. This model is updated each month in our Portfolio Allocation Summary.8 The most recent update shows that the high-DTS Energy, Basic Industry and Communications sectors are all attractively valued. The most attractive low-DTS sectors are Financials and Technology (Chart 7). Chart 7Risk-Adjusted Value In Corporate Sectors* Proactive, Reactive Or Right? Proactive, Reactive Or Right? Bottom Line: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation Does Consumer Credit Growth Put The Recovery At Risk? Last week's employment report showed a sharp increase in aggregate hours worked and suggests that U.S. economic growth has indeed shifted into a higher gear. We use a combination of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 to get a rough tracking estimate for U.S. real GDP growth. After last Friday's report this proxy is up to a healthy 3.1% (Chart 8). Last Friday's Consumer Sentiment data also suggest that consumer spending, the largest component of U.S. GDP, will stay firm in the coming months (Chart 9). While consumer credit growth has started to slow (Chart 9, panel 2) and consumer delinquencies are starting to rise (Chart 9, bottom panel), we are not yet inclined to view those trends as risks to the economic recovery. Chart 8Growth Tracking Well Above Trend Growth Tracking Well Above Trend Growth Tracking Well Above Trend Chart 9Credit Growth Falling & Delinquencies Rising Credit Growth Falling & Delinquencies Rising Credit Growth Falling & Delinquencies Rising First, notice that prior to the onset of recession, consumer spending growth tends to decline while consumer credit growth accelerates. It is only well after the recession begins that consumer credit growth follows spending growth lower. This chain of events is highly logical. In the late stages of the recovery households first start to see their incomes decline and then turn to credit to support their spending needs. Eventually, banks make consumer credit less available and consumer credit growth also decelerates, but we are already well into the recession by then. Chart 10Bank Lending Standards Bank Lending Standards Bank Lending Standards In fact, judging by the patterns observed in the lead up to the last two recessions, the warning sign for the economic recovery would be if consumer credit growth is rising while consumer spending growth is falling. So far this pattern has not been observed. Potentially more troubling is the increase in the consumer credit delinquency rate. Delinquencies do tend to rise prior to the onset of recession, although at the moment delinquencies are rising off an extremely low base. It is possible that after having kept lending standards very stringent for several years after the Great Recession, an uptick in delinquencies off historically low levels simply reflects a return to "business-as-usual" for banks. In fact, the Federal Reserve's Senior Loan Officer Survey showed a large tightening of consumer lending standards during the crisis, but then a moderate easing from 2010 until quite recently (Chart 10). Further, the most recent Senior Loan Officer Survey showed an increase in banks' willingness to extend consumer installment loans. Historically, this has been associated with falling consumer delinquency rates (Chart 10, bottom panel). Bottom Line: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 For a look at what different combinations of Fed rate hikes and long-maturity yields mean for the slope of the yield curve please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 3 Please see BCA Special Report, "Outlook 2018: Policy And The Markets: On A Collision Course", dated November 20, 2017, available at www.bcaresearch.com 4 https://www.stlouisfed.org/from-the-president/speeches-and-presentations/2017/assessing-yield-curve 5 https://www.bloomberg.com/news/articles/2017-12-01/fed-s-mester-shrugs-off-flattening-yield-curve-in-call-for-hikes 6 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 8 For the most recent update please see U.S. Bond Strategy Portfolio Allocation Summary, "A Higher Gear", dated December 5, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights An extended period of synchronized global growth suggests above-potential U.S. growth will persist into 2018. BCA expects inflation to move back to the Fed's 2% target in 2018, allowing the Fed to raise rates four times. However, a new study by the SF Fed suggests that inflation could be stuck in low gear for a while longer. The U.S. consumer is poised to have a good year in 2018, aided by rising incomes, solid balance sheets and elevated confidence about future increases in employment and incomes. BCA expects a rebound in residential investment in 2018 despite higher mortgage rates. Feature BCA's Outlook for 2018 was published just recently.1 The report laid out the macroeconomic and policy themes that will impact financial markets during the next year. In this week's report we expand on those themes and discuss what they mean for the U.S. economy and financial markets specifically. A period of synchronized global growth will persist into 2018 and allow the U.S. economy to grow well above its long-term potential for a time. Overseas demand will lift U.S. profit growth in 2018, although both earnings and profit growth will peak next year. Widespread global growth and a positive output gap in the U.S. will lead to accelerating wages, higher inflation, a more aggressive Fed and higher bond yields. U.S. stocks will outperform bonds in 2018. Despite higher mortgage rates, the U.S. housing market will provide a lift to the U.S. economy in 2018 as residential investment rebounds after a challenging 2017. A peak in residential investment provides an early indication that a recession is on the horizon. Since the early 1960s, a crest in housing provided seven quarters of warning before a downturn commenced. In the long duration economic expansions in the 1980s and 1990s, residential construction provided an even earlier signal. The U.S. consumer will also add to growth in 2018, aided by solid balance sheets, near record confidence and elevated confidence about future increases in employment and incomes. Risks remain, however, and the biggest threat to our view of the U.S. economy and financial markets in 2018 is that inflation overshoots the Fed's 2.0% target. BCA's view is that inflation will return to 2% gradually. A faster pace of inflation may prompt a more aggressive Fed and catch markets off guard. If inflation fails to move back to 2%, the Fed may slow the pace of hikes, clearing the way for the current goldilocks scenario to persist even longer. Synchronized Global Growth For the first time in more than a decade, global economic activity is widespread. Led by a surge in capital spending, the economy is experiencing its strongest growth since the mid-2000s. The solid international expansion will bump U.S. industrial production and capital spending orders even higher and also support U.S. exports (Chart 1). The ebullient global backdrop may persist for a while. The OECD's global leading economic indicator is in a clear uptrend and suggests above-trend growth will persist through the end of 2018 (Chart 2). Global PMIs are also climbing (panel 2). The robust global growth has added to mounting inflationary pressures. In the U.S., the unemployment rate is below NAIRU; other OECD countries have followed suit. In all, almost 75% of member countries in the OECD are running at full employment (Chart 3). Chart 1Animal Spirits Are Stirring Animal Spirits Are Stirring Animal Spirits Are Stirring Chart 2Upbeat Global Growth Prospects bca.usis_wr_2017_12_04_c2 bca.usis_wr_2017_12_04_c2 Chart 3NAIRU Is A Global Phenomenon NAIRU Is A Global Phenomenon NAIRU Is A Global Phenomenon U.S. corporate profits will benefit from vigorous global economic activity. On average, 43% of S&P 500 sales are derived from overseas. Several sectors (Energy, Information Technology and Industrials) rely on international business for more than 50% of their sales and earnings. BCA's view that the U.S. dollar will move only modestly higher in 2018 implies that the currency will not have a major impact on EPS. When more than 90% of nations have positive GDP growth, stocks beat bonds, and the output gap narrows and closes, which leads to a lower unemployment rate and a more active Fed (Charts 4 and 5). The dollar's performance is mixed during intervals of strong global growth. The dollar climbed in the late 1990s, but sagged in the early- to mid-2000s. When global growth is strong, U.S. industrial production is generally higher. However, IP dipped in 2015 as oil prices fell at the start of the recent period of synchronized growth. Chart 4Widespread##BR##Global Growth ... Widespread Global Growth... Widespread Global Growth... Chart 5... Supports Risk Assets, Trade And##BR##A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap ... Supports Risk Assets, Trade And A Narrower Output Gap Global growth could be derailed by any one of several threats. The risk of a prolonged flare-up in geopolitical risk in northeast Asia could curtail global trade. Furthermore, BCA's Geopolitical Strategy team expects that relations between the U.S. and North Korea will follow the example of U.S. negotiations with Iran in the mid-2000s; periodic conflicts accompanied by back channel negotiations over several years.2 A policy mistake by the Fed or China may also disrupt the global bonhomie and, in turn, slow growth. Most measures of China's credit impulse are decelerating and the Chinese government's reforms may impact growth more than we expect. Moreover, weak poll numbers may lead President Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. Bottom Line: Synchronized global growth supports BCA's view that U.S. EPS growth will top out in 2018, but will remain positive. Margins should also top out in 2018. The positive backdrop will allow stocks to beat bonds next year, and credit to outperform Treasuries, even as the Fed raises rates. The environment for risk assets will stay supportive even if inflation does not accelerate. However, our forecast could be derailed by a sudden surge in inflation in 2018. Inflation At An Inflection Point? The Fed can rest a little easier following last week's rise in their preferred gauge of inflation, the core personal consumption expenditures (PCE) price index, as the monthly rise was somewhat strong at 0.2% and the annual growth rate inched higher to 1.4% (year-over-year) in October, up from the previous month at 1.3% (year-over-year). In contrast, a diffusion index which includes the components of the PCE index, unlike the CPI, has moved back below zero, implying that inflation pressures are not yet widespread (Chart 6). Regardless of current sluggish inflation dynamics, BCA's view is that inflation will rise by enough to convince the Fed that continuing to boost rates next month is the right direction for monetary policy. However, patience will be required as it is too early to say if inflation has reached an inflection point as it is still below the Fed's 2 percent inflation target and remains persistently at a low level. Outgoing Chair Yellen's voiced this concern by saying at the September 19-20 FOMC meeting that the shortfall of inflation from 2 percent is a "mystery", which echoed Fed Chair nominee Powell's sentiment at Jackson Hole (August 2017). Furthermore, prior to the PCE release last week and in her last testimony, Yellen reiterated that "Even with a step-up in growth of economic activity and a stronger labor market, inflation has continued to run below the 2 percent rate. The recent lower readings on inflation likely reflect transitory factors. As these transitory factors fade, I anticipate that inflation will stabilize around 2 percent over the medium term. However, it is also possible that this year's low inflation could reflect something more persistent. Indeed, inflation has been below the Committee's 2 percent objective for most of the past five years." As we have discussed previously,3 though the Fed is unified on its gradual path for monetary policy, Chair Yellen's current dismay about the uncertainty for the path of inflation is not a widely held view among the members of the committee. The internal debate at the Fed about this "mystery" continues, and may heat up as four new board members join the FOMC. BCA's view is that inflation will move higher over the next year. However, a recent study4 by the FRB of San Francisco takes a different view. Economists at the San Francisco Fed concluded that the path for inflation (based on core PCE) has more downside. Their work suggests that health-care services inflation will remain a drag to core PCE due to recent changes in health care legislation. Health-care services represent about 35% of the PCE spending category identified as non-cyclical (58% of core PCE is non-cyclical or "acyclical" while 42% of core PCE is "procyclical"). Authors of the study estimated that health care services have subtracted about 0.3% from core PCE compared to the last recovery period in 2002-2007 (Chart 7). Accordingly, the unrelenting decline in health-care services inflation has prevented core PCE inflation from returning to its pre-recession average above 2 percent. Moreover, overall non-cyclical inflation is subtracting about 0.6% from core PCE inflation compared with the mid-2000s. Chart 6CPI And PCE Diffusion##BR##Indices Signals Diverge CPI And PCE Diffusion Indices Signals Diverge CPI And PCE Diffusion Indices Signals Diverge Chart 7Noncyclical Sources##BR##Driving Inflation Lower Noncyclical Sources Driving Inflation Lower Noncyclical Sources Driving Inflation Lower The Fed's rationale for higher rates of the previous 2004-2006 tightening cycle was quite different than today's. Just prior to the initial rate hike, the economy was "expanding at a rapid pace" and members of the FOMC had a high level of conviction that "robust growth would be sustained." More importantly, policymakers viewed the household sector as a "key driver in the expansion" as consumer spending was expected to continue to grow at a strong pace.5 Though inflation pressures were building, "most members saw low inflation (core PCE) as the most likely outcome" amid strong productivity growth. Even so, inflation persisted in an uptrend near the 2% threshold (and eventually crossed over in the following months) even as "considerable" labor market slack remained and wage growth moderated (though within the 3-4% range). That said, the bond market today is concerned about a policy mistake by the Fed. The 2/10 Treasury yield curve moved from 86 in October to 58 last week, reflecting the risk that the downward pressures on inflation remain elevated. If the i.e. transitory factors do not dissipate core inflation may get entrenched into a lower channel. The Fed may have to pause or cut short its tightening cycle if lower inflation persists and is accompanied by a decline in market-based measures of long-term inflation expectations. Bottom Line: BCA expects inflation to move back to the Fed's 2% target in 2018, allowing the Fed to raise rates four times. The market is only expecting one or two hikes next year. Our view is that the curve will steepen in 2018, as the market acknowledges the return of inflation. BCA's U.S. Bond Strategy service expects the 10-year Treasury yield to move above 2.8% next year, and may move as high as 3%. Stay overweight stocks versus bonds and underweight duration. U.S. Consumer Outlook Thanks to the consumer, the U.S. economy is operating very close to its long-term potential. Household balance sheets are in better shape than in the corporate sector. For example, total household liabilities are 11.3% below their long-term trend (since 1950) and have moved sharply lower since the early 1980s (17.2% in 1983Q1). Household net worth in 2017Q2 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q2 (Chart 8). House prices, based on the Case-Shiller National index, have increased steadily and have experienced their fastest yearly growth rate since June 2014 (6.15% year-over-year). Nationwide, housing prices are 46% above their 2012 trough and 6% above the pre-recession peak (July 2006). Moreover, given the equity market's recent new highs, households' financial position should continue to record further gains for at least the next two quarters (2017Q3 Flow of Funds data is due on December 7). Consumer confidence - although mostly a coincident indicator for consumer spending - continued to climb in November to a 17-year high. The increase was the result of elevated expectations for future gains in employment and income, though the latter decreased very slightly. These inflated readings may further support steady consumer expenditures at this late stage of the business cycle, especially heading into the holiday shopping season. Next week, we will examine previous spending cycles to better understand the implications for the 2017 holiday retail season. Consumers remain very optimistic about future labor market advances, making it easier ("jobs plentiful") rather than difficult to find a job ("jobs hard to get"). Furthermore, 46% of consumers expect stock market returns to strengthen in the next year in contrast to only 19% expecting stock prices to decrease over the same period. Nevertheless, there are risks that may dampen the pace of consumer spending. BCA expects employment growth to slow because the labor market cannot get much tighter. Plus, there is a shortage of skilled employees, according to the National Federation of Independent Business (NFIB) and the Fed's Beige Book. Moreover, the personal savings rate cannot sustainably remain at its recovery low of 3.2%. However, small businesses' upbeat plans for labor compensation still bode well for rising wages and salaries as they are at their highest level since March 2000. For consumer spending to flourish, overall labor income will need to improve. At 2.6%, annual wage compensation growth remains sluggish and far from the 3-4% per year that the Fed has stated would be consistent with an economy closer to a 2% inflation rate (Chart 9). Chart 8"Teflon" Household Balance Sheets "Teflon" Household Balance Sheets "Teflon" Household Balance Sheets Chart 9Consumer Spending Tailwinds Consumer Spending Tailwinds Consumer Spending Tailwinds Moreover, households are unlikely to binge on more debt to smooth out their expenditures as they did in the mid-2000s. A further acceleration in consumer spending would occur alongside steady improvement in the labor market and improving household confidence on future employment and income gains. As such, last week's income and spending report showed that while the consumer held back on real spending in October (+0.1% month-over-month), real personal income rose by 0.3% month-over-month. Real income growth troughed in December 2016 but has climbed by almost 2% in the past three months. Fed policymakers can take comfort that over the medium-term, consumer spending remains quite stable at around 2.5-3.0%. BCA still expects consumer spending to continue to grow by at least 2% pace in 2018 which should keep the expansion humming along. Bottom Line: The outlook for the U.S. consumer remains bright due to solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. This should continue to support the domestic economy and global growth, especially ahead of the holiday shopping season. Consumer headwinds to monitor are households' incentive to start saving more as wages remain stagnant and employment growth slows. However, as the fundamental tailwinds outweigh the headwinds for household spending, BCA still expects the U.S. consumer sector to remain steady over the near term. Residential Investment: More Than Just A Q4 Snapback Housing will boost GDP growth in 2018. BCA's view is that housing did not peak in early 2016 (Chart 10, panel 4). Investment in residential construction in Q2 was held down by higher rates and a mild 2016-17 winter that pulled construction ahead into Q1. Hurricanes Harvey and Irma made a major dent in Q3. A bounce in activity is underway in Q4, but we expect more than just a single quarter snapback. Instead, conditions are in place for an extended period of growth in residential investment. Low inventories, a rising homeownership rate, and a 12-year high in homebuilder sentiment, all support our bullish view (Chart 10). Inventories of unsold new and existing homes are near record lows (panel 2), and in many areas of the country, low inventories are limiting sales activity and pushing up prices. Homeownership rates are escalating again (panel 3), led by solid momentum in real disposable income, which in turn, and is a product of the booming labor market and rising wage inflation. Moreover, housing affordability will remain above average even if our forecast for a 2.8% 10-year Treasury yield is met (Chart 11). A 200 bps rise would push affordability below its long-term average for the first time in nine years. A more plausible path for rates would be a 100 bps increase in mortgage rates. Under this scenario, the affordability index would deteriorate, but remain a tailwind for the housing market. Chart 10Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing investment is not only an important gauge of economic growth, but it also is the best leading indicator among all sectors. Construction of new homes and apartments, along with additions and alterations to existing stock, peaks as a share of GDP, on average seven quarters before the end of an expansion. Consumer spending on durable, nondurable and services reach a high five quarters before GDP hits a zenith, while business capital spending tops out six quarters ahead of the economy. There are risks for housing despite the upbeat fundamentals. Banks have been tightening their lending standards in recent quarters and an overtightening may impede the real estate market. A major change in the treatment of state and local real estate taxes and mortgage interest in the GOP tax plan may also negatively affect housing demand, particularly at the high end of the market. Additionally, rising foreign demand in certain U.S. markets may lead to mini-bubbles in coastal areas. The latest reading on the Case Shiller home price index showed housing prices up at the fastest rate in three years. A prolonged period of home price increases above income gains would challenge our sanguine view of housing affordability. However, the Fed and the banking system that it regulates are hyper-vigilant about excesses in the housing market, and it is unlikely that another housing bubble will be tolerated.6 Bottom Line: Housing is a reliable leading indicator of economic activity. Spending on new construction will add to growth in the coming year, allowing the economy to expand at a pace well above its long-term potential. Faster GDP growth will be accompanied by higher inflation and a more active Fed, especially relative to current market expectations. Moreover, a healthy housing market will continue to support solid consumer spending, the economy's largest and most important sector. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Outlook 2018, "Policy And The Markets: On A Collision Course", November 20, 2017. Available at bca.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report, "Can Pyongyang Derail The Bull Market?", August 16, 2017. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Managing The Risks", published October 2, 2017. Available at usis.bcaresearch.com. 4 Mahedy, Tim and Shapiro, Adam, "What's Down With Inflation?", Federal Reserve Bank of San Francisco, November 27, 2017. http://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Minutes of The Federal Open Market Committee, May 4, 2004: https://www.federalreserve.gov/fomc/minutes/20040504.htm 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com.

Highlights Powell's nomination will not change the Fed's gradual rate hike path, but open Board seats are a worry. Household debt growth is slower than usual, but auto debt levels are a concern. Stocks will beat bonds and oil will rise after EPS growth peaks next year. Funding liquidity should remain adequate as the Fed unwinds its balance sheet. Feature Last week was an extraordinarily busy week for U.S. financial markets, but BCA's view on the economy, the Fed and asset class returns remains the same. President Trump named Jerome Powell to replace Janet Yellen as Fed Chair and the GOP released additional details of their tax plan. The October readings on employment, manufacturing, and wage growth fell short of expectations. However, data on consumer confidence, non-manufacturing ISM and vehicle sales for October exceeded expectations. The Q3 Employment Cost Index will give Fed policymakers confidence that the Phillips curve is not dead, but the persistent weakness in unit labor costs (the Q3 data was released last week) will concern the FOMC. The Fed remains on track to raise rates by 0.25% in December and three more times in 2018, matching their dot plot. While average hourly earnings disappointed in October, the impacts of Hurricanes Harvey and Irma make the data difficult to interpret. Nonetheless, the year-over-year growth in the 3-month moving average of average hourly earnings was 2.6% in October, up from 2.5% in July, before Harvey made landfall in Texas. Moreover, real GDP is growing faster than the economy's long term potential (1.8% per the Fed), and at 4.1%, the unemployment rate is well below the Fed's measure of full employment (4.6%) (Chart 1). Jerome Powell will continue to pursue the gradual rate hikes preferred by his predecessor. However, Powell is the first Fed Chair since G. William Miller (1978-79) to not have a PhD in economics. He is not known as a policy hawk or a dove, and this lack of conviction in his own policy suggests that he will rely on more on his Board colleagues for direction than recent chairs. The potential power shift from the chair to the committee may make FOMC communications more difficult to interpret. After Yellen departs the Fed early next year, the seven-member board will be down to just four, providing Trump the opportunity to further shape monetary policy. Table 1 provides Powell's comments on key aspects of the economy, monetary and regulatory policy. Chart 1Labor Market Conditions Tightening##BR##And Support More Rate Hikes Labor Market Conditions Tightening And Support More Rate Hikes Labor Market Conditions Tightening And Support More Rate Hikes Table 1Powell On Monetary Policy, The Economy And Regulation Powell's In Power Powell's In Power BCA expects that Powell, a Republican, will be confirmed by the Senate and preside over the FOMC meeting in March 2018. Powell already sits on the Fed Board. In 2012 President Obama appointed Powell to the Fed to fill an unexpired term. The Senate voted 74-21 to confirm. Two years later, Powell was confirmed 67-21 for a full term (14 years) as a governor. Fifty-one votes are required for confirmation. BCA's Chief Economist, Martin Barnes, wrote about the potential for change at Federal Reserve Board earlier this year.1 The bottom line is that looming changes in the composition of the Fed's Board of Governors are important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Subprime Auto Sector Signals Household deleveraging has ended, but consumers are reticent to take on new debt despite an improving labor market and record household net worth. Household debt is growing at under 2% a year, less than half the pre-crisis pace. Moreover, household debt relative to disposable income remains well below a decade ago, but the household indebtedness profile is not uniform. While the debt-to-disposable income ratio of mortgage and revolving consumer credit has moved lower, the ratio of non-revolving credit (which includes both auto and student loan debt) has moved up since 2010 and surpassed the 15.8% pre-crisis peak in 2012 (Chart 2). Chart 2Household Debt By Sector Household Debt By Sector Household Debt By Sector In 2016, 34% of U.S. families had vehicle loans, up from a low of 30% in 2010. In 2004-2007, more than one-third of U.S. families carried auto debt (Chart 3). The median value of households' auto loans is $13,000 (in 2016 dollars), up from $11,000 in 2010, but still below the 2004-2007 peak of $14,000 (Chart 4). However, delinquency rates are on the rise in those areas where consumers have been adding debt (credit cards, auto loans and student loans) (Chart 5). Chart 3Rise In % Of Families With Auto Loan Debt... Rise In % Of Families With Auto Loan Debt... Rise In % Of Families With Auto Loan Debt... Chart 4...But Auto Debt Levels Are Manageable ...But Auto Debt Levels Are Manageable ...But Auto Debt Levels Are Manageable In particular, default rates in auto and student loans are above their mid-2000s readings, but are below their 2010-2012 zenith. Lending standards for vehicle loans were easy at the start of the decade, became less so recently and then turned restrictive in mid-2016. In the mid-2000s, borrowing guidelines for student loans and credit cards (data on bank lending standards for auto loans began in 2011) were easy in 2004-2007. Banks are taking a cautious approach to consumer lending in this cycle. The gradual tightening of lending criteria between 2010 and 2016 led to a drop in the average FICO score for new auto loans. However, as standards tightened in 2016 and into the first quarter of 2017, the average FICO escalated. FICO scores for new vehicle loans moved sharply lower in Q2; it may be a new trend or perhaps a blip in the data. Even with the latest dip, the FICO for new auto loans (698) is well above the 675-685 range that prevailed in 2004-2006 (Chart 6, bottom panel). Chart 5Consumer Loan Metrics Consumer Loan Metrics Consumer Loan Metrics Chart 6ABS Market Overview ABS Market Overview ABS Market Overview Subprime auto loans as a percentage of all auto loans remain well below pre-crisis levels and should limit a wave of subprime auto defaults in the years ahead. Only 22% of the $148 billion in new vehicle loans recorded in Q2 2017 were issued to borrowers with FICO scores below 620. The latest reading is in the middle of the range that has been in effect since 2010 (18-25%). Between 2004 and 2007, the share of auto loans issued to subprime borrowers was as high as 32% in 2006 and averaged 28%. The FOMC has elevated financial stability in its recent deliberations2 and is watching for imbalances. The September 20-21 FOMC meeting minutes noted that "Subprime auto loan balances have declined so far this year, partly reflecting the tighter lending standards, and the average credit score of all borrowers who obtained an auto loan in the second quarter remained near the upper end of its range of the past few years." We expect the Fed to remain vigilant on this issue. Bottom Line: Household debt ratios are well below the pre-2007 peak, but consumers are piling on more auto debt. While delinquency rates for auto debt are rising, banks are tightening lending requirements and have not extended auto credit to subprime borrowers outside of historical norms. If household incomes, the stock market and housing prices rise, and banks and regulators remain vigilant, then the subprime auto sector would not pose a systemic risk to the U.S. economy or financial system.3 BCA's U.S. Bond Strategy service prefers Aaa-rated credit card ABS over Aaa-rated auto loan ABS (Chart 6). Investment Direction After EPS Peak Chart 7Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon The BCA earnings model shows that S&P 500 EPS growth is peaking and should slow through 2018 toward a level commensurate with 3½-4% nominal GDP growth (Chart 7). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller force. This forecast excludes any positive effects on growth from tax cuts that would encourage EPS and the S&P 500 index in the short term, although this would also bring forward Fed rate hikes. We will provide an update on the Q3 earnings reporting season in next week's report. Investors are questioning what will happen to risk assets after earnings growth peaks, but before it slips below zero (Table 2). BCA has identified seven episodes between 1973 and 2015 when S&P 500 EPS growth reached a top and subsequently dipped below zero. Four of the seven periods (1973-75, 1976-80, 1988-1991, and 1993-2001) partially overlapped with recessions. The U.S. economy was in recession during the entire 1973-75 period but the recession occurred at or near the end in the other three occurrences. U.S. stocks, Treasuries and oil behave consistently during these periods. The performance of gold, the dollar, small caps (relative to large) and high yield (relative to Treasuries) is not consistent, and investment-grade corporate debt underperformed Treasuries in six of the seven intervals. On average, stocks beat bonds by 3,000 bps after earnings decelerate, but before they turn negative. Oil (+8,310 basis points) and gold (+6,950 bps) are the standouts; both commodities beat stocks) as earnings growth fades. Small caps barely outperform large, and the dollar, on average, is flat across all seven periods. Investment-grade corporate debt underperforms Treasuries by an average of 50 bps during these episodes. Table 2U.S. Asset Class Performance As EPS Growth Slows Powell's In Power Powell's In Power The three occasions when EPS growth crested and then slowed to zero, but the economy avoided a recession, were in the mid-1980s, the mid-2000s and the early part of the current decade. These mid-cycle slowdowns were triggered by Fed rate hikes in the mid-1990s and mid-2000s; in the early 2010s, there were similar fears of a rate increase, coupled with a stronger dollar and a collapse in oil prices. The performance of risk assets during these mid-cycle earnings corrections was similar to the entire sample, although the magnitude of the asset class performances shifted. Oil (+12,560 bps) and gold (+8,400 bps) were standouts; equity and Treasury prices both rose, but equities beat Treasuries by nearly 10,000 bps, easily surpassing the 3,000 bps outperformance in all periods. Small caps underperformed large caps and the dollar climbed (Chart 8). Chart 8U.S. Asset Class Performance As EPS Growth Slows U.S. Asset Class Performance As EPS Growth Slows U.S. Asset Class Performance As EPS Growth Slows Bottom Line: S&P 500 earnings growth will peak in 2018. Stocks will outperform bonds as profit growth slows, which matches BCA's stance for the next 12 months. Gold and oil have both outpaced equities as earnings abate; this supports BCA's bullish position and above-consensus view of oil for 2018. BCA's modestly bullish stance on the dollar in the next 12-18 months aligns with the historical achievements of the dollar as earnings moderate, but BCA's bullish view on small caps runs counter to history after EPS growth crests. The Great Balance Sheet Unwind Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart 9 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. In an October 2017 Special Report,4 the Bank Credit Analyst outlines how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. Chart 10 presents our forecast for how quickly the Fed's balance sheet will contract. Following the September 19-20 FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Chart 9G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets G4 Central Bank Balance Sheets Chart 10Fed Balance Sheet Fed Balance Sheet Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.5 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario, the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. The bond market's reaction will be far more important than balance sheet shrinkage. Empirical estimates suggest that the Fed's shedding of Treasuries could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio; As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. However, it will be a whole different story if inflation lurches higher. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Should You Fear Looming Changes At The Federal Reserve?", September 21, 2017. Available at bca.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade," October 3, 2017. Available at usbs.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Liquidity And The Great Balance Sheet Unwind," In the October Monthly Report. Available at bca.bcaresearch.com. 5 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017).

Highlights London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago. Stay underweight U.K. real estate and consumer services versus German real estate and consumer services. The global bond yield mini-cycle is driving asset allocation, sector allocation, value/growth allocation and country allocation. We are more than half way through the current mini-upswing in global bond yields. Look for opportunities to cut back overall portfolio cyclicality towards the end of the year. Feature London house prices have dropped 7% since the U.K. Government started the formal process of Brexit seven months ago (Chart of the Week). The average London home is now worth £584,000,1 down from £628,000. Moreover, our leading indicator for London house prices which compares the number of new viewings (demand) with the number of new listings (supply) suggests no imminent end to the sharpest price decline since the 2008 financial crisis (Chart I-2). Chart I-1Brexit Begins To Bite In London Brexit Begins To Bite In London Brexit Begins To Bite In London Chart I-2The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... The Sharpest Decline In London House Prices Since 2008... Unsurprisingly, the many uncertainties surrounding the unfolding Brexit process are having a much greater impact on the London housing market than on the U.K. housing market as a whole. Outside London, the housing market is broadly flat-lining (Chart I-3). The average U.K. home outside London is now worth £256,500, modestly down from £260,000. Chart I-3 ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining ...But Outside London, Prices Are Flat-Lining U.K. Households Squeezed We are writing ahead of the Bank of England monetary policy meeting, at which the BoE may deliver its first interest rate hike since July 2007. But hike or no hike, we can confidently say one thing: U.K. households will be squeezed. If the BoE does hike the base rate in an attempt to counter overshooting inflation, it could tip the precariously flat-lining housing market outside London into a downturn - as this market is much more exposed to mortgage affordability than it is to Brexit uncertainties. Alternatively, if the BoE does not hike the base rate, the boost to sterling from recent hawkish rhetoric will be priced out, and the pound will come under renewed downward pressure. This would keep U.K. inflation elevated, and further choke U.K. households' real incomes. Absent the post Brexit vote slump in the pound, U.K. inflation would be substantially lower than it is (Chart I-4 and Chart I-5). So the pound's weakness explains why the U.K. is one of the few major economies where inflation is running well north of 2%. Unfortunately for U.K. households, nominal wage inflation has not followed price inflation higher. And as we explained in Why Robots Will Kill Middle Incomes,2 nor is it likely to in the near future. Chart I-4The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... The Weaker Pound Lifted U.K. Headline Inflation... Chart I-5...And U.K. Core Inflation ...And U.K. Core Inflation ...And U.K. Core Inflation But doesn't textbook economic theory say that the pound's weakness should make U.K. exports more competitive - thereby boosting the net export contribution to economic growth? Yes, the theory does say that a currency devaluation should allow firms to trade in markets that were previously unprofitable to them. However, to trade in these newly profitable markets, firms first need to invest - for example, in marketing and distribution. The trouble is that, post-Brexit, many of the newly profitable markets may be unavailable, or come with heavy tariffs. So firms will hold off making the necessary investments, unless the currency devaluation is massive. But in this case, the corresponding surge in inflation and choke on households' real incomes would also be massive. In summary, U.K. consumer spending faces a continued squeeze. If the BoE delivers a rate hike, household borrowing is likely to fade as a driver of spending. But if the BoE does not deliver the rate hike, the pound will once again weaken, keeping inflation elevated and weighing on real incomes. Stay underweight U.K. consumer services versus German consumer services (Chart I-6). And stay underweight U.K. real estate versus German real estate - expressed either through direct real estate exposure or through real estate equities (Chart I-7). Chart I-6U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming U.K. Consumer Services Equities Are Underperforming Chart I-7U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming U.K. Real Estate Equities Are Underperforming Investment Reductionism Illustrated Turning to markets more generally, it is crucial to understand that most of the moves in most financial markets reduce to a very small number of over-arching macro drivers. We call this very important principle Investment Reductionism. Investment Reductionism emerges from two guiding philosophies: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle (the 80:20 rule) - which says that a small minority of causes usually explain a large majority of effects. The upshot of Investment Reductionism is that the seeming complexity of asset allocation, sector selection, the choice between value or growth, and country allocation usually reduces to something much simpler. Let's illustrate this. The global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset allocation (Chart I-8). The direction of the global bond yield drives sector selection: for example Banks versus Healthcare. This is because higher bond yields imply higher net interest margins for banks as well as an improving growth outlook, favouring cyclicals over defensives. And vice-versa (Chart I-9). Chart I-8Investment Reductionism Step 1: ##br##The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield Drives ##br##Sector Performance Step 2: The Bond Yield Drives Sector Performance Step 2: The Bond Yield Drives Sector Performance Banks versus Healthcare determines the European Value versus Growth decision. This is because in Europe, Banks and Healthcare are the dominant value sector and growth sector respectively (Chart I-10). Banks versus Healthcare also determines the country allocation between, say, Italy's MIB - which is bank heavy - and Denmark's OMX - which is healthcare heavy (Chart I-11). Chart I-10Step 3: Sector Performance Drives Value ##br##Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Step 3: Sector Performance Drives Value Vs. Growth Chart I-11Step 4: Sector Performance Drives ##br##Country Performance Step 4: Sector Performance Drives Country Performance Step 4: Sector Performance Drives Country Performance Therefore, the important lesson from Investment Reductionism is to ignore the hundreds of things that matter little, and to focus on the very small number of things that matter a lot. And one of the things that matters a lot is the global bond yield mini-cycle. Where Are We In The Bond Yield Mini-Cycle? Empirically, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern, with each half-cycle lasting about 8 months (Chart I-12). The global bond yield shows a similarly regular wave like pattern with each half-cycle also averaging about 8 months (Chart I-13). Chart I-12The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern The Global Credit Impulse Has Also Shown A Regular Wave Like Pattern Chart I-13The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern The Global Bond Yield Has Shown A Regular Wave Like Pattern It is not a coincidence that the bank credit impulse and bond yield exhibit near identical half-cycle lengths. The global credit impulse and global bond yield are inextricably embraced in a perpetual mini-cycle. A stronger credit impulse boosts economic growth. In response to the stronger economic data, the bond yield rises, which slows credit growth. A weaker credit impulse weighs down economic growth. In response to the weaker economic data, the bond yield declines, which re-accelerates credit growth. Go back to step 1 and repeat ad perpetuam. At this moment, from an investment perspective, there are three points worth making: first, bond yield mini-upswings tend to occur mostly within the credit impulse upswing; second, credit impulse mini-upswings have a consistent duration lasting about 8 months; and third, the current mini-upswing started in May. What does this mean for investment strategy? It means that we are more than half-way through the current mini-upswing which we would expect to end around January/February. And at some point early next year we are likely to enter a mini-downswing. So it is slightly premature to cut back cyclical exposure right now. But we would certainly consider opportunities as we move to the end of the year - especially if our now tried and tested fractal timing indicators signal that the price action in specific investments has reached a technical tipping point. Stay tuned. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Source: LSL Acadata 2 Please see the European Investment Strategy Special Report "Why Robots Will Kill Middle Incomes", dated August 10 2017 available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the New Zealand dollar is oversold and ripe for a technical rebound. The recommended trade is long NZD/USD with a profit target/stop loss set at 3%. In other trades, long Canada 10-year bond/short German 10-year bund achieved its profit target while short Norway/long Switzerland hit its stop loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-14 Long NZD/USD Long NZD/USD * 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. 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