Currencies

Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1Sell-Off Didn't Trigger Risk Signals Sell-Off Didn't Trigger Risk Signals Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Spike In Vix Is Not A Sell Signal Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Monthly Portfolio Update Monthly Portfolio Update Chart 4Earnings Growth Gets A Boost Too Earnings Growth Gets A Boost Too Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Unit Labor Costs Don't Point To Jump In Inflation Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Still Some Slack In Labor Market Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed Market Has Caught Up To The Fed Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Inflation Expectations And Real Yields To Rise Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Net Government Bond Supply To Increase Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Rising Rate Differentials Fails To Boost Dollar Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Do Twin Deficits Matter For Dollar? Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Tighter Monetary Conditions in China Tighter Monetary Conditions in China Chart 13Oil Inventories To Draw Down Further Oil Inventories To Draw Down Further Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights We are shifting our U.S. recession call from late-2019 to 2020. A cheap dollar and fiscal support will give the Fed more scope to raise rates before monetary policy moves into restrictive territory. The fiscal impulse will fall sharply in 2020. By then, financial conditions will be tighter and economic imbalances will be more pronounced. As is usually the case, a downturn in the U.S. will infect the rest of the world. Emerging markets with large current account deficits and high debt levels are most vulnerable. A cyclical overweight to global equities is still appropriate, but long-term investors should begin to scale back risk exposure. Feature Records Are Meant To Be Broken The NBER Business Cycle Dating Committee, which contrary to popular belief does not serve as a matchmaking service for lonely-heart economists, estimates that the current economic expansion is going on nine years. If it makes it to July 2019, it will be the longest in history (Chart 1). Considering that records begin in 1854 - encompassing 33 business cycles - that will be an impressive achievement. Chart 1Nine Years And Still Going Strong Nine Years And Still Going Strong Nine Years And Still Going Strong There is an old adage that says "Expansions do not die of old age. They are murdered by the Fed." A year or so ago, it looked like the Fed would pull the trigger sometime in 2019. Now, however, it looks more likely that the deed will be committed in 2020. Two things have changed since the start of last year. First, the real trade-weighted dollar has fallen by 8%. According to the Fed's SIGMA macroeconomic model, this should boost growth by about 0.3% over the next two years. Chart 2U.S. Fiscal Policy Has Become##BR##Much More Stimulative The Next Recession: Later But Deeper The Next Recession: Later But Deeper Second, U.S. fiscal policy has become much more stimulative, a point very much in keeping with our Geopolitical Strategy team's long-standing view that age of austerity is giving way to a new age of populism.1 My colleague Mark McClellan estimates that the U.S. fiscal impulse will reach 0.8% of GDP in 2018 and 1.3% of GDP in 2019, up from -0.4% and 0.3%, respectively, in the IMF's October 2017 projections (Chart 2). Mark's calculations incorporate the CBO's assessment of the tax cuts, the recent Senate deal to raise the caps on defense and nondefense expenditures, and $45 billion in hurricane relief. He assumes some delay between when the bill is passed and when the spending takes place. According to the Congressional Budget Office, a little more than half of the expenditures in the 2013 and 2015 spending bills occurred in the same year the funding was authorized. These fiscal measures will cause the federal budget deficit to swell by about 2.3 percentage points to 5.6% of GDP in FY2019. Even that may be an understatement, as this does not include any additional infrastructure spending nor the possible restoration of "earmarks"- the widely criticized practice that allows members of Congress to add appropriations to unrelated bills to fund what often turn out to be politically motivated projects in their districts - which could add a further $25 billion in annual spending. Meanwhile, federal government revenue is coming in below target, which the Office of Management and Budget (OMB) has attributed to lower-than-expected taxable income from pass-through businesses and capital gains realizations. This problem could worsen over the next few years as creative accountants find new loopholes to exploit in the recently passed tax bill. Too Much, Too Late All this stimulus is arriving when the economy least needs it. The unemployment rate currently stands at 4.1%, 0.5 points below the level the Fed regards as consistent with full employment. It has been stuck at that number for four straight months, largely because job growth in the Household survey (which the unemployment rate is based on) has lagged the Establishment survey by a considerable margin. Given the underlying strength in GDP growth, it is likely the job gains in the Household survey will rebound strongly over the course of 2018, taking the unemployment rate down to 3.5% by year-end, well below the Fed's end-2018 projection of 3.9%. A lower-than-projected unemployment rate will permit the Fed to raise rates four times this year, one more hike than currently implied by the dots. The Fed will probably also hike rates three or four times next year. Yet, even those additional rate hikes will not come close to offsetting all the fiscal stimulus coming down the pike. In the absence of a sustained increase in productivity or labor force growth - neither of which appear forthcoming - the economy will continue to overheat. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). The Fed knows this perfectly well, but has chosen to let the economy run hot for fear that a premature tightening will sow the seeds for a deflationary spiral. Chart 3Inflation Is A Lagging Indicator The Next Recession: Later But Deeper The Next Recession: Later But Deeper By the time the next recession rolls around, inflation will be higher and financial and economic imbalances will be greater. The fiscal impulse will also fall back towards zero in 2020 as the budget deficit stabilizes at an elevated level. It is the change in the budget balance that is correlated with GDP growth. If output is already being constrained by a lack of spare capacity going into late-2019, the subsequent decline in the fiscal impulse in 2020 could push growth below trend, leading to rising unemployment. And, as we have often noted, once unemployment starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point that was not associated with a recession (Chart 4). Chart 4Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle A recent IMF report highlighted that changes in U.S. financial conditions strongly influence growth abroad.2 As the U.S. falls into a recession, equity prices will tumble and credit spreads will widen. Financial conditions will tighten, transmitting the downturn to the rest of the world. Emerging markets with large current account deficits and high debt levels will be the most vulnerable. The only saving grace is that interest rates will be higher in 2020 than they would have been if the recession had begun in 2019. This will give the Fed a bit more scope to ease monetary policy again. As discussed last week, this will likely set the stage for a stagflationary episode following the recession.3 For Now, Leading Indicators Look A-Okay While our baseline view is that the next recession will occur in 2020, this is more of an educated guess than a firm prediction. Many things, including an overly aggressive Fed, a sharp appreciation in the dollar, and a variety of political shocks, could cause the recession to occur sooner than anticipated. As such, we continue to watch a wide swathe of data to help guide our investment recommendations. The good news is that right now, none of our favorite leading economic indicators such as the level of ISM manufacturing new orders minus inventories, capital goods orders, initial unemployment claims, and building permits are flashing red (Chart 5). Many of these indicators appear in The Conference Board's LEI, which is still rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator (Chart 6). We are still far from that point. Chart 5U.S. Leading Indicators Looking A-OKAY U.S. Leading Indicators Looking A-OKAY U.S. Leading Indicators Looking A-OKAY Chart 6U.S. LEI Is Not Flashing Red U.S. LEI Is Not Flashing Red U.S. LEI Is Not Flashing Red The same goes for leading financial variables such as credit spreads and the yield curve. The yield curve has inverted in the lead-up to every recession over the past 50 years (Chart 7). The fact that the 10-year/3-month slope has steepened by 30 basis points since the start of the year gives us some comfort that the next recession is still some time away. Chart 7An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession Keep An Eye On Credit Credit spreads remained well contained during the recent bout of market turbulence but we continue to watch them closely. Credit typically starts to underperform before equities do, which makes it a good leading indicator for the stock market. This is likely to be especially the case over the next two years. If there is one area where financial imbalances have accumulated to worrying levels, it is in the corporate debt arena. This month's issue of the Bank Credit Analyst estimates that the interest coverage ratio for U.S. companies would drop from 4 to 2½ if interest rates were to increase by 100 basis points across the corporate curve.4 This would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 8). Consumer staples, tech, and health care would be the most affected. Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) We currently maintain an overweight to equities and spread product but expect to move to neutral later this year and to underweight sometime in 2019. Long-term investors should consider paring back exposure to both asset classes already, given that valuations have become stretched. The Dollar And The Return Of "Twin Deficits" Bigger budget deficits will drain national savings. Since the current account balance is simply the difference between what a country saves and what it invests, the U.S. current account deficit is likely to increase. How the emergence of these twin deficits will affect the dollar is a tough call. Historically, there is no clear relationship between the sum of the fiscal and current account balance and the value of the trade-weighted dollar (Chart 9). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a decline in the household saving rate from the booming housing market. Much depends on what happens to real interest rates. If investors come to believe that persistently large budget deficits will lead to higher inflation, long-term real yields could decline, pushing the dollar lower. In contrast, if investors conclude that the Fed will raise rates by enough to keep inflation from spiraling upwards, real yields could rise. U.S. real yields have gone up across all maturities since the start of the year. As a result, real rate differentials have widened between the U.S. and its developed market peers (Chart 10). However, some of the increase in U.S. real rates has been due to a rising term premium, with the rest reflecting an upward revision to the expected path of policy rates. The latter is good for the dollar. The former is not, because it means that investors are starting to worry about the ability of the market to absorb the increasing supply of Treasurys. Meanwhile, rising interest rates threaten to put further pressure on the U.S. current account deficit. The U.S. net international investment position has deteriorated from -10% of GDP to -40% of GDP since 2007 (Chart 11). The U.S. owes the rest of the world about 68% of GDP in debt - almost all of which is denominated in dollars - but holds only 23% of GDP in foreign debt. Thus, a synchronized increase in global bond yields would cause U.S. net interest payments to rise. If yields in the U.S. increase more than elsewhere, net payments would rise even more. Chart 9Twin Deficits And The Dollar:##BR##No Clear-Cut Relationship Twin Deficits And The Dollar: No Clear-Cut Relationship Twin Deficits And The Dollar: No Clear-Cut Relationship Chart 10Real Rate Differentials Have##BR##Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Chart 11Deterioration In U.S. Net##BR##International Investment Position The Next Recession: Later But Deeper The Next Recession: Later But Deeper America's status as a major net external debtor could also constrain the extent to which the dollar appreciates. If the greenback were to strengthen, the dollar value of U.S. external assets would decline, as would the dollar value of interest or dividend payments that the U.S. receives from abroad. This would result in a deterioration in the current account balance and in a worsening in the U.S. net international investment position. Some Positives For The Greenback While the discussion above is bearish for the dollar, it needs to be put into some context. The U.S. current account deficit stands at 2.3% of GDP, down from almost 6% of GDP in 2006 (Chart 12). Much of the improvement in the U.S. balance of payments can be traced back to the plunge of almost 70% in net oil imports, a development that is likely to be permanent given the shale boom. Furthermore, the U.S. trade balance should benefit over the coming quarters from the lagged effects of a weaker dollar. And while we estimate that the primary income balance will deteriorate by about 0.6% of GDP over the next two years, it should still remain in positive territory and above the levels from a decade ago (Chart 13). Chart 12U.S. Balance Of Payments:##BR##Improvement Due To Sinking Oil Imports U.S. Balance Of Payments: Improvement Due To Sinking Oil Imports U.S. Balance Of Payments: Improvement Due To Sinking Oil Imports Chart 13Primary Income Balance Will Decline,##BR##But Will Remain In Positive Territory Primary Income Balance Will Decline, But Will Remain In Positive Territory Primary Income Balance Will Decline, But Will Remain In Positive Territory On the fiscal side, the projected rise in U.S. government debt levels at a time when the economy is booming is concerning. Nevertheless, the U.S. debt profile still compares favorably to countries such as Japan and Italy, two economies with worse growth prospects than the U.S. Italian 30-year bond yields are actually lower than in the United States. If one of the two countries is going to have a debt crisis over the next decade, our guess is that it will be Italy and not the U.S. A Cresting In Global Growth Could Help The Dollar Our preferred explanation for why the dollar began to weaken in 2017 focuses on the role of global growth as well as on technical factors. Chart 14USD Is A Momentum Winner The Next Recession: Later But Deeper The Next Recession: Later But Deeper Strong global growth - especially when concentrated outside the U.S., as was the case last year - tends to hurt the dollar. There are a number of reasons for this. First, a robust global economy pushes up natural resource prices, which boosts the terms of trade for commodity-exporting economies. Second, manufacturing represents a smaller share of the U.S. economy than it does in most other countries. Since manufacturing activity is quite cyclically-sensitive, faster global growth benefits economies such as Germany, Sweden, Japan, China, and Korea more than the U.S. Third, stronger global growth tends to boost risk appetites. This has translated into large inflows into EM funds and peripheral European debt markets. The latter have also seen an ebbing of political risk, which has translated into sharply lower sovereign spreads. The acceleration in global growth came at a time when long dollar positions had reached elevated levels. As those positions were unwound, the dollar began to tumble. At that point, the strong upward momentum that fueled the dollar rally following the U.S. presidential election was replaced by downward momentum. The U.S. dollar is one of the most momentum-driven currencies out there (Chart 14). Weakness led to even more weakness. It is impossible to know when the dollar's downward momentum will exhaust itself. What can be said is that speculative positioning has become increasingly dollar bearish. This raises the odds of a short-covering dollar rally (Chart 15). Chart 15Speculative Positioning Has Gotten Increasingly Dollar Bearish The Next Recession: Later But Deeper The Next Recession: Later But Deeper Perhaps more importantly, global growth may be peaking. China's economy has slowed, as gauged by the Li Keqiang index, which combines electricity production, freight traffic, and bank lending (Chart 16). Growth in Europe and Japan has also likely reached top velocity. U.S. financial conditions have eased sharply relative to the rest of the world (Chart 17). This, in conjunction with an easier U.S. fiscal policy, suggests that the composition of global growth will shift back towards the U.S. over the coming months. If this were to happen, the dollar could recoup some its losses. Chart 16Chinese Economy##BR##Has Slowed Chinese Economy Has Slowed Chinese Economy Has Slowed Chart 17U.S. Financial Conditions Have##BR##Eased Sharply Relative To ROW U.S. Financial Conditions Have Eased Sharply Relative To ROW U.S. Financial Conditions Have Eased Sharply Relative To ROW Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016. 2 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, April 2017. 3 Please see Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. Available at bca.bcaresearch.com. 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Highlights The combined U.S. current account and fiscal deficits are set to rise as Trump's profligacy and higher interest rates kick in. In and of itself, this does not spell doom for the dollar. The Fed's response to the twin deficit is what will ultimately set the path for the greenback. Stimulus hitting an economy at full employment raises the likelihood that the Fed will not stand idly by. The dollar's momentum is not deteriorating anymore, global growth could hit a soft patch, and U.S. hedged yields might regain some composure versus European hedged yields. These factors are likely to precipitate a dollar rebound. The durability of this rebound remains an unknown. An opportunity to go short EUR/SEK has emerged. Feature When it comes to the U.S. dollar, the story of the day has become the twin deficits. It is now presented as the key factor that will drag the dollar lower over the course of the cycle. We do agree there are plenty of reasons to be concerned with the long-term outlook for the dollar. However, we remain unconvinced whether the twin deficits really are the much-vaunted "boogey man" that will haunt the greenback. In fact, we would argue that while they are a handicap for the dollar, the role of the Federal Reserve, global growth and hedging costs take precedence over the evil twins. The Twin Deficit Will Widen We take no offence with the assertion that the twin deficits are set to increase. According to the work of Mark McClellan, who writes The Bank Credit Analyst, the U.S. fiscal deficit is set to increase to 5.5% of GDP over the course of the next two years. U.S. President Donald Trump's tax cuts and the recent spending agreement will undeniably contribute to this.1 The current account deficit is also set to widen. Chart I-1 shows our estimate for the path of the current account. We anticipate it to move to -3.4% of GDP by late 2018 or early 2019. This is a noteworthy deterioration, but one that only brings the U.S. current account to a level last experienced in 2009. One contributor is obviously the trade balance. The Bank Credit Analyst estimates that the impact of the combined fiscal measures announced will reach 0.3% of GDP in 2018. The biggest source of deterioration will not come from trade: it will come from a fall in the net primary income balance of the U.S., which currently stands at 1.1% of GDP. Essentially, higher interest rates in the U.S. means that foreigners will receive greater income from the U.S. Based on the current level of the median long-term interest rate forecasts by the FOMC's participants, my colleague Ryan Swift estimates that a move in 10-year Treasury yields to 3.5% is likely by year end.2 Based on our estimate, this will push down the primary income balance to 0.4% of GDP. It is important to acknowledge that this forecast for the current account is likely to prove to be a worst-case scenario. To begin with, the trade balance could continue to be buffeted by the fact that U.S. energy production keeps expanding, which is slowly but surely moving the U.S. toward a positive energy trade balance (Chart I-2). Moreover, periods of weakness in the USD have been followed by improvements in the U.S. primary income balance. This is because while payments made by the U.S. to foreigners are mostly in the form of interest, 55% of U.S. income receipts are earnings on FDIs. If we add dividends received on foreign equity holdings, this share rises to 80% of U.S. gross primary income. Thus, if the dollar weakens, U.S. receipts benefit from a translation effect as corporations convert their foreign earnings back into U.S. dollars at more beneficial exchange rates. Chart I-1Higher U.S. Rates ##br##Will Hurt The Current Account Higher U.S. Rates Will Hurt The Current Account Higher U.S. Rates Will Hurt The Current Account Chart I-2U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance But do twin deficits even matter? We would argue, it depends. Bottom Line: The U.S. twin deficits are set to increase. The U.S. fiscal deficit will move to 5.5% of GDP and the current account to -3.4% of GDP as interest owed to foreigners is set to increase. Twin Deficit, So What? It is one thing to anticipate a widening of the twin deficits, but does history suggest that twin deficits have an impact on the dollar? Here, the empirical evidence is rather mixed. As Chart I-3 illustrates, there has been no obvious link between twin deficits and the dollar. In fact, Arthur Budaghyan highlighted in BCA's Emerging Market Strategy service the following phases:3 1970s: no discernable relationship; First half of the 1980s: Substantial widening of twin deficits, but a massive dollar bull market materialized; 1985 to 1993: no reliable relationship between twin deficits and the dollar; 1994 to 2001: The dollar did rally as twin deficits narrowed on the back of the fiscal balance moving from roughly -4% of GDP to 2% of GDP; 2001 to 2011: dollar weakened as twin deficits grew deeper; 2011 to 2016: When twin deficits narrowed considerably, the dollar was stable, but when they stopped improving, the dollar rallied 25%. Chart I-3In My Time Of Dying? No Stable Relationship Between U.S. Twin Deficits And Dollar In My Time Of Dying? No Stable Relationship Between U.S. Twin Deficits And Dollar In My Time Of Dying? Let us focus on the growing twin deficits episodes. As it turns out, the missing link between twin deficits and the dollar is Fed policy. A widening in twin deficits is normally associated with a strong economy. Profligate government spending can boost domestic demand, and because imports have a high elasticity to domestic demand, a widening current account also tends to come alongside robust growth. The Volcker Fed played a high-wire act from 1979 to 1982, plunging the U.S. into a vicious double-dip recession in order to bring realized and expected inflation back to earth after the 1970s. Volcker was not about to let former President Ronald Reagan's stimulus boost growth to the point of lifting inflation expectations again, undoing all the Fed's previous good work. He elected to increase real rates sharply, which was the key factor behind the dollar's strength. The 2001 to 2011 experience needs to be broken down in parts. From 2001 to 2003, the twin deficits were expanding thanks to former President George Bush's wars and tax cuts. Yet the Fed did not play the same counterweight as it did in the mid-1980s. Instead, it kept cutting rates all the way until 2003 as then-Chairman Alan Greenspan was worried about deflation. U.S. real rates did not experience the necessary lift required to fight the negative impact of the twin deficits on the dollar. From 2003 to 2007, the twin deficits were in fact narrowing, real rates were trendless and the dollar was experiencing mild depreciation. During that time frame, global growth was extremely robust, China was growing at a double-digit pace and EM economies were booming. Money was flowing toward these destinations. From 2007 to mid-2008, while the twin deficits continued to narrow, the dollar plunged. The sharp fall in real rates as the Fed engaged in aggressive rate cutting explains this apparent inconsistency. From the second half of 2008 to 2009, the dollar surged, despite a further widening of the twin deficits. Real rates rebounded as inflation expectations melted, and risk aversion prompted investors to seek the safety of the global reserve asset and the global reserve currency - Treasurys and the greenback, respectively. From 2009 to the middle of 2011, the twin deficits stabilized, real rates stabilized, and the dollar stabilized as well, but nonetheless experienced wild gyrations as the global economy kept experiencing aftershocks from the great financial crisis. Neither the twin deficits nor real rates were offering a clear path forward, thus the dollar was also mixed. Bottom Line: A close look at various episodes of twin deficits in the U.S. pushes us toward one conclusion: if twin deficits are expanding but the Fed is trying to tighten policy and real rates are rising, the dollar ignores the twin deficits and, in fact, manages to rise. If, however, the twin deficits expand, and real rates do not experience enough upside to counterbalance this development, the dollar weakens. This means one thing for the coming years: Forecasting twin deficits is not sufficient to predict a dollar bear market. Instead, we also need a view on the Fed and the outlook for real rates. So Where Will The Dollar Go In 2018? We expect there could be some upward pressure on the Fed's dots as the year progresses. The reason is rather straightforward. The U.S. economy will receive a very large shot in the arm this year and next. Mark's calculations show that the fiscal thrust in 2018 and 2019 will morph from -0.4% of GDP to 0.8% of GDP, and from 0.3% of GDP to 1.3% of GDP, respectively (Chart I-4). While currently the fiscal thrust is expected to become a large negative in 2020, that year is an election year. There is a non-trivial probability that the fiscal cliff anticipated that year may in fact be postponed: it is not in the interest of the Republicans or Democrats to be blamed for a slowing economy in a year where Americans are hitting the voting booths! This stimulus is not happening in a vacuum either: it is materializing in an environment where the labor market seems to be at full employment, where capacity utilization is tight, and where financial conditions remain easy (Chart I-5). Stimulating when the economy is at full capacity is likely to lift prices more than it will boost real economic activity. The Fed is fully aware of this risk. Chart I-4Much Stimulus ##br##In The Pipeline Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card Chart I-5Could Fiscal Stimulus Be Inflationary With This Backdrop?##br## We Think So Could Fiscal Stimulus Be Inflationary With This Backdrop? We Think So Could Fiscal Stimulus Be Inflationary With This Backdrop? We Think So However, it remains possible that the Fed will err on the side of caution and wait until the impact of the stimulus measures on the economy become more evident before sending a more hawkish message to the markets. Chart I-6Twin Deficits Narratives ##br##Look Like Ex-Post Explanations Because The Narrative Is Scary Twin Deficits Narratives Look Like Ex-Post Explanations Because The Narrative Is Scary Twin Deficits Narratives Look Like Ex-Post Explanations If the Fed elects to be proactive and adjusts its message regarding the future path of policy before the impact of the stimulus becomes evident, the dollar could rise as it would put upward pressure on U.S. real rates. If, however, the Fed elects to be reactive and wait until the economy responds to the stimulus package with higher wage growth and inflation, then the dollar could weaken as real rates experience little upside and the twin deficits exact their toll. BCA is currently conducting research to assess which path is more likely. In the meanwhile, there other factors to consider. First, as we highlighted three weeks ago, since 2011, spikes in the number of mentions of the twin deficits in media have historically been associated with temporary rebounds in the dollar following periods of USD weakness (Chart I-6).4 The twin deficits seem to come to the forefront of investors' minds as an ex-post explanation for previous weak-dollar periods. Second, our dollar capitulation index is not only at oversold levels, but the indicator has formed a positive divergence with the trade-weighted dollar's exchange rate (Chart I-7). Technically, this increases the probability of a meaningful rebound in the USD. Chart I-7A Positive Technical Development For The Greenback A Positive Technical Development For The Greenback A Positive Technical Development For The Greenback Third, global growth is showing signs of weakening. We have already highlighted that rollovers in the performance of EM carry trades such as the one we have been experiencing for a few months now have been very reliable leading indicators of activity slowdowns over the past 20 years.5 Korea exports are also ebbing. As Chart I-8 illustrates, when Korean exports weaken, this tends to be associated with weakness in highly pro-cyclical financial variables like EM equities, EM bonds, AUD/USD or AUD/JPY. When a slowdown in global growth materializes, especially when it does so as the U.S. economy is set to accelerate, it tends to be associated with a stronger dollar. Fourth, the super-charged strength in the euro versus the USD since the second quarter of 2017 happened as European hedged yields overtook U.S. hedged yields. Chart I-9 takes the example of a Japan-based investor. We pick Japan as an illustration because Japan is the largest creditor nation in the world, and extra-low domestic yields, Japanese investors continue to exhibit heightened yield-seeking behaviors. When the gap between European bond yields hedged into yen and U.S. bond yields hedged into yen became more negative, the euro was depreciating. Once this gap started to narrow, the euro stabilized. Once European bond yields hedged into yen became greater than U.S. bond yields hedged into yen, the euro took off. Chart I-8Growth Sensitive Assets May Be At Risk Growth Sensitive Assets May Be At Risk Growth Sensitive Assets May Be At Risk Chart I-9Are Hedged Yields The Culprit Behind The Dollar's Weakness? Are Hedged Yields The Culprit Behind The Dollar's Weakness? Are Hedged Yields The Culprit Behind The Dollar's Weakness? We expect these gaps in hedged yields to move back in the U.S.'s favor. The U.S. yield curve has some scope to begin to steepen a bit, especially as U.S. growth accelerates. Additionally, a big component of the underperformance of U.S. hedged yields has been associated with a widening of the LIBOR spread and the cross-currency basis swap spreads (Chart I-10). As we anticipated, the introduction of tax rules favoring repatriations of foreign earnings by U.S. corporations is having this effect.6 U.S. firms hold their offshore earnings in high-quality securities like bank papers or Treasurys. These securities are a vital supply of dollars in the Eurodollar market - the offshore USD market - as they are high-quality collateral that can be used to secure many transactions. As the market in December began to discount the impact of the tax changes, FRA-OIS spreads and basis swap spreads began to widen. This increased the cost of hedging U.S. bonds. Chart I-10Will The Increase In Treasurys Issuance ##br##Pull Back Down The Cost Of Hedging U.S. Assets? Will The Increase In Treasurys Issuance Pull Back Down The Cost Of Hedging U.S. Assets? Will The Increase In Treasurys Issuance Pull Back Down The Cost Of Hedging U.S. Assets? But here's one overlooked but potentially friendly outcome of the twin deficits. By increasing its current account deficit, the U.S. economy will begin to supply more USDs to Eurodollar markets, providing a relief valve to the collateral-starved offshore USD-funding markets. Moreover, because the fiscal deficit is set to mushroom, and because after many debt-ceiling debacles the Treasury's cash reserves are low, the Treasury is likely to start issuing a lot more T-Notes and T-Bills, which will also provide a source of high-quality collaterals in the system, especially as the Fed is not buying those bonds anymore. The stress in the funding market may begin to recede and hedged U.S. yields may begin to rise relative to the rest of the world. Bottom Line: While the twin deficit could become a negative for the USD, it is not yet clear that this will indeed be the case. Instead, we need to keep in mind that the U.S. government is injecting a large amount of stimulus in an economy running at full capacity. This could be inflationary. The Fed's response will dictate the USD's path. If the Fed is proactive, the USD will experience an upswing. If the Fed is reactive and waits to guide real rates higher, the dollar could remain weak. In the meanwhile, other forces are pointing toward a rebound in the dollar. The greenback is oversold and unloved; momentum indicators are forming positive divergences, raising the odds of a rebound; global growth is set to slow; and U.S. hedged yields are likely to move back in favor of the dollar. Will EUR/SEK Break Above 10? The recent inflation miss in Sweden has raised some concerns, with EUR/SEK hovering around the critical 10 level, and NOK/SEK breaking above the 1.03 handle. Headline consumer prices rose only 1.6% annually in January, while contracting by 0.8% in monthly terms. The official inflation measure tracked by the Riksbank - the CPIF - fell to 1.7% per annum. This move away from the inflation target has market participants questioning the Riksbank's willingness and ability to normalize policy this year. However, the underlying picture is not that negative. The most recent inflation figure was greatly impacted by the seasonality of Swedish CPI. As Chart I-11 shows, January tends to be a very weak number for Swedish inflation. The February data is likely to rebound significantly. Additionally, our model further highlights that based on both international and domestic factors, Swedish inflation should rise in the coming months, putting CPI much closer to the Riksbank's objective (Chart I-12). Chart I-11Seasonal Pattern In Swedish CPI Seasonal Pattern In Swedish CPI Seasonal Pattern In Swedish CPI Chart I-12Swedish Inflation Is Set To Rebound Swedish Inflation Is Set To Rebound Swedish Inflation Is Set To Rebound Reassuringly, Swedish inflation expectations have not subsided, suggesting market participants are fading the latest weak reading. As the bottom panel of Chart I-13 illustrates, CPI swap rates are still holding steady. On the macro front, consumers continue to be a source of durable strength. Real consumption is growing at a 3% annual rate, and Swedish consumer confidence is still elevated (Chart I-14). Chart I-13Swedish Inflation Expectations Are Stable Swedish Inflation Expectations Are Stable Swedish Inflation Expectations Are Stable Chart I-14The Swedish Consumer Is Still Spending The Swedish Consumer Is Still Spending The Swedish Consumer Is Still Spending Essentially, the Riksbank's extremely easy monetary policy may not have yet generated inflation in the prices of consumer goods and services, but it has generated huge debt and asset price inflation. The clearest symptom of this is Sweden's non-financial private debt, which now stands at a stunning 240% of GDP, only surpassed by Switzerland and Norway among the G10 economies. These developments imply that the positive Swedish output gap will expand further, and that inflationary pressures will only become more entrenched. Thus, we continue to anticipate a rate hike by the Riksbank this year. This is very much a consensus call. However, where we diverge from consensus is that while futures are pricing in approximately 85 basis points of interest rate hikes by March 2020, we think the scope to lift rates is greater. We also see a higher probability of hikes over that time frame than the Riksbank's own forecast. In other words, we anticipate that the Riksbank's rate forecasts will be revised to the upside. This is because inflationary pressures are growing greater and the economy is very strong. Thus, the Swedish central bank is falling behind the curve and will have to play catch up as soon as inflation moves back closer to target. This will most likely happen over the coming 12 months. As a result, selling EUR/SEK at current levels seems an interesting trade with an attractive entry point. As Chart I-15 illustrates, EUR/SEK only traded above this level during the great financial crisis. It did not manage to punch above this level during the Nordic financial crises of the early 1990s, nor did it during the 1997-'98 crisis - or directly after the September 11 attacks. Chart I-15The Line In The Sand The Line In The Sand The Line In The Sand Moreover, EUR/SEK currently trades 7.5% above its purchasing power parity equilibrium. The gap between Sweden's and the euro area's basic balance of payments is very large. While Sweden's stands at 5.1% of GDP, the euro area's is near zero. This reinforces the message that the EUR/SEK is very expensive: when the cross appreciates too much, Swedish assets become much more attractive to foreigners relative to European assets. These long-term flows end up boosting the relative basis balance in favor of Sweden. This is exactly what is happening today (Chart I-16). Chart I-16Expensive EUR/SEK Makes Swedish Assets Attractive Expensive EUR/SEK Makes Swedish Assets Attractive Expensive EUR/SEK Makes Swedish Assets Attractive From a tactical perspective, EUR/SEK also looks vulnerable. Various short-term momentum measures such as the 14-day RSI or the 13-week rate of change are diverging from actual prices. Additionally, EUR/SEK risk reversals - i.e. the implied volatility of calls versus the implied volatility of puts on this cross - have spiked up. This is true even after controlling for the rise in implied volatility that has affected the option market. It seems to suggest that investors that would have been buying EUR/SEK have already placed their bets. The marginal player is likely to now bet in the other direction. This trade is not without risks. First, a move above 10.1 could be mechanically followed by a sharp rally as stops are hit and momentum traders force the cross higher. Second, Swedish PMIs have been rolling over for six months, but so have the preliminary releases of Europe PMIs this week. What is more concerning is the weakness in Asian manufacturing production that is behind the sharp slowdown in Korean exports. This is worrisome because historically, the Swedish economy has been very sensitive to EM shocks. However, only 2008 was able to push EUR/SEK above 10. Even if EM slows, we are not anticipating a shock as large as what occurred in 2015, let alone in 2008. Moreover, while we anticipate Swedish inflation to surprise to the upside, we equally expect euro area inflation to exhibit much more limited gains. Bottom Line: Sweden's inflation report came in well below expectations, which prompted a sharp rally in EUR/SEK to near 10. However, this level has been an important resistance since the early 1990s, only breached during the great financial crisis. We are betting on it not being breached this time around. The Swedish economy is strong, and inflation is set to pick up again. As a result, we think the Riksbank will be forced to lift its interest rate forecast as time passes. Moreover, EUR/SEK is expensive, and flows are currently very much in favor of Sweden. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, dated February 29, 2018, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "On the MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EM Local Bonds and U.S. Twin Deficits", dated February 21, 2018, available at ems.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot", dated February 2, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Weekly Reports, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and "Canaries In the Coal Mine Alert 2: More on EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Special Report, "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com. Currencies U.S. Dollar U.S. data was mixed: Markit PMIs beat expectations ; Existing home sales, however, grew by less than expected at 5.38 million, a 3.2% contraction form the previous month; Continuing jobless claims outperformed expectations, coming in at 1.875 million; Initial jobless claims also outperformed with 222,000. In the meeting's minutes, FOMC members were quite positive on growth and their rhetoric suggest they intend to follow up on the current set of dot plots. Subsequently, equities sold off, the 10-year yield climbed to 2.954%, bringing them close to BCA's fair value estimate. Due to these developments, the dollar's descent seems to be taking a breather for now, and it may even experience a rebound in the coming weeks. Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro The tone of European data has been deteriorating: German PMIs underperformed expectations, with services coming in at 55.3, and manufacturing, at 60.3; European PMIs also underperformed anticipations with manufacturing coming in at 58.5 and services at 56.7; The Current Situation section of the ZEW Survey was also weaker than expected; German IFO underperformed expectations, with the Business Climate measure coming in at 115.4, and the Expectations measure also dropping to 105.4. The euro weakened substantially this week on poor data and a hawkish Fed, even if it managed to eke out a rebound on Thursday. We have recently published on the risks to global growth, and the weak European PMIs seem like a consequence of these developments. We expect the euro's bull market to pause until global growth picks back up. Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Recent data in Japan has been mixed: Imports yearly growth underperformed expectations, coming in at 7.9%. It also declined significantly from the previous 14.9% pace . Moreover, Nikkei Manufacturing PMI underperformed expectations, coming in at 54. It also declined from 54.8 in the previous month, However, exports yearly growth outperformed expectations, coming in at 12.2%. It also increased from its 9.3% pace the previous month. USD/JPY has rallied by roughly 1.5% since last week. Overall, we expect that the current volatile environment will provide strength to the yen to the point that a level of 100 for USD/JPY is plausible. However, on a long term basis the yen is likely to be weak against the U.S. dollar, as the BoJ will fight tooth and nail to prevent a strengthening yen from hampering inflation. Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Recent data in the U.K. has been mixed: The ILO Unemployment rate surprised negatively, coming in at 4.4%. It also increased form 4.3% the previous month. Moreover, retail sales and retail sales ex-fuel annual growth also underperformed, coming in at 1.6% and 1.5% respectively. However, average hourly earnings yearly growth excluding bonus outperformed expectations, coming in at 2.5% GBP/USD has depreciated by nearly 1.6% this week. There are currently 45 basis points of hikes by the BoE priced into the next 12-months. We believe that there is not much more upside beyond this, given that the end of the pound's collapse will weigh on inflation. Moreover, recent data has shown that although inflation is high, the economy rests on a shaky foundation. We continue to expect the pound to fall on a trade-weighted basis as well. Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Data out of Australia was mixed: The Westpac Leading Index stayed steady at -0.2%; Wage growth beat expectations, growing at a 0.6% quarterly rate, and 2.1% annual rate; Construction work done slowed down severely, contacting by -19.4%, greatly surpassing the expected 10% contraction. It should also be noted that much of the wage growth was driven by the growth in public sector wages, which grew by 2.4% as opposed to the 1.9% growth experienced by the private sector. RBA members highlighted the risks created by lower than expected wage growth: weaker household consumption as a below-target inflation. The RBA is therefore likely to stay put this year, and the AUD will underperform its G10 peers. Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar The kiwi has fallen by roughly 1% this week, in part due to dollar rebound in the greenback. Nevertheless, AUD/NZD has declined by 0.6%, and is now down almost 3% during the year, thanks to dairy prices surging by more than 13% in 2018. Overall, we expect that the NZD will outperform the AUD, given that the consumer sector in China should outperform the industrial sector, as the Chinese authorities are cracking on overcapacity. With this being said, NZD/JPY will probably see downside, as the current volatility in markets will weigh on this cross. Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Canadian data was weak: Wholesale sales contracted by 0.5% at a monthly pace; Retail sales contracted by 0.8%, underperforming expectations; Core retail sales, excluding autos, contracted by 1.8%. The CAD weakened against all currencies this week. However, even if it may not increase much against the U.S. dollar, the case for a stronger CAD against other major currencies is still firm as the BoC is likely to hike interest rates more than most central banks year. Additionally, stronger U.S. growth should support the health of the Canadian export sector. Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Recent data in Switzerland has been mixed: The trade balance underperformed expectation on January, coming in at CHF1.324 billion. It also declined from last month's value of CHF3.374 billion. However, industrial production yearly growth increased from last month, coming in at a stunning 19.6% pace. EUR/CHF has been relatively flat this week. Overall we believe that the franc can only rally against the euro on episodes of rising global volatility, given that the SNB will fight against any appreciation of the franc that could hurt the little progress that has been made in achieving their inflation target. Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone USD/NOK has rallied by roughly 1.3% on the back of a stronger dollar. Overall, we believe that the krone should be the best performer amongst the commodity currencies, as the economic situation has improved substantially, with the Labour Survey improving last month. This will help the Norges Bank to tighten monetary policy more than the market currently expects. Investors who want to take advantage of these developments should short CAD/NOK as an oil-neutral bet. More audacious traders could short AUD/NOK or NZD/NOK as well. Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Swedish inflation dropped by more than expected: in monthly terms, inflation contracted by 0.8%, while in annual terms it grew by only 1.6%, less than the expected 1.8%. However, this monthly contraction was in line with the seasonal pattern historically witnessed in Swedish inflation, which also tells us that inflation is likely to pick up again in the following months. EUR/SEK hit 10, an historically very strong overhead resistance, indicating that markets may be unnerved by the Riksbank's unwillingness or inability to tighten policy. While the OIS curve is pricing in 80 bps of hikes in the next two years, we believe that the Riksbank will hike more than that, as inflation will come back to Sweden with a vengeance. Not only is the economy firing on all fronts, but the currency is also very cheap. The SEK is likely to strengthen this year. Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline March 2018 March 2018 Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots U.S. Inflation Green Shoots U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset February's Volatility Reset February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration ... Partly Due to Capex Acceleration ... Partly Due to Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating Government Bond Supply is Accelerating Government Bond Supply is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment U.S. Net International Investment U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing Oil Inventory Correction Continuing Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends March 2018 March 2018 Chart II-2Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 Chart II-3Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs March 2018 March 2018 The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM BOTTOM-UP IG CHM BOTTOM-UP IG CHM Chart II-5Bottom-Up HY CHM BOTTOM-UP HY CHM BOTTOM-UP HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging March 2018 March 2018 Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta March 2018 March 2018 Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta March 2018 March 2018 Chart II-8Interest Coverage Ratio Vs. Earnings Beta March 2018 March 2018 Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) March 2018 March 2018 Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Interest Coverage Ratio Headed To New Lows Interest Coverage Ratio Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. ­­ Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long U.S. 10-Year Gov. Bond Long U.S. 10-Year Gov. Bond The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Expectations that the BoJ's yield curve control strategy is toward its tail end, general USD weakness, and brewing EM troubles are conspiring to push the yen higher. Tactically, the yen has more upside. Global financial markets are set to remain volatile and softness in China point to a tougher environment for EM bonds and commodity prices. In the coming months, USD/JPY will fall to the 104 to 102 range, and maybe even test 100. Beyond this point, the outlook remains negative for the yen. It is too early for investors to bet on the end of YCC, especially as the current yen strength hurts Japan's inflation outlook. While EUR/JPY and USD/JPY still have tactical downside, AUD/JPY and NZD/JPY are much more vulnerable. Feature No matter what happens to U.S. asset prices, bond yields, or inflation, the yen continues to rally unabashedly. A month ago, we argued that a countertrend bounce in the yen was likely as the Bank of Japan was tweaking its bond purchases. We also thought this rally would have a limited shelf life as the BoJ's yield curve control strategy is still firmly in place.1 Considering the yen's recent strength, it is an opportune time to revisit this theme. We do believe that the yen still has room to rally on a three- to six-month basis. However, a move beyond USD/JPY 100 is unlikely as the BoJ's YCC program remains firmly entrenched, only more so now that the yen is appreciating once again. Why Is The Yen Strong? We think the yen's strength can be attributed to three factors: domestic economic conditions, the dollar's weakness, and brewing EM trouble. Domestic Conditions The strength of the Japanese economy has played an important role in the yen's appreciation. Japanese industrial production is growing at an impressive 4.4% annual pace. Also, the labor market is tight: Japan's unemployment rate is 0.8% below equilibrium, the active job openings-to-applicant ratio is at a 44-year high and job creation remains decent at 1% per annum. The output gap corroborates this picture, with GDP standing 1.1% above the OECD's estimate of potential GDP. The economic wellbeing seems generalized. Exports are growing at a brisk pace, and are strong across the board. This is a consequence of perky global growth, which always tends to help export-oriented nations. Moreover, this export boom is filtering through to the domestic economy. The share of corporate profit stands near record levels at 15% of GDP. This is incentivizing firms to invest, which should push capex higher (Chart I-1). Chart I-1Japanese Capex Is Set To Rise Japanese Capex Is Set To Rise Japanese Capex Is Set To Rise Chart I-2Japan Needs Tighter Policy? Japan Needs Tighter Policy? Japan Needs Tighter Policy? Investors are beginning to replay the story of the euro in 2017 in their minds. As the narrative goes, a booming economy is giving monetary authorities a chance to move away from extraordinarily accommodative conditions. Therefore, investors are lifting their estimates of where Japanese policy will stand in three or five years. This could be even truer in Japan than in the euro area last year: unlike Europe, Japan is at full employment and the BoJ has not achieved its bond purchase objective of JPY80 trillion per year since mid-2016. However, the BoJ is keeping a firm lid on interest rates up to 10 years ahead, making it harder to observe in interest rate derivatives whether or not investors are lifting their estimates of the Japanese terminal rate. Yet a few signs exist. For one, our Bank of Japan Monitor has moved into "tighter policy territory" (Chart I-2). While this does not guarantee that Japanese rates will rise, this indicator is comprised of variables2 that most investors follow to form their expectations of the path of Japanese monetary policy. Thus, it suggests that based on historical experience, investors are potentially in the process of re-assessing the future of Japanese monetary policy. Moreover, while interest rate markets may be artificially congealed by the BoJ, other asset prices are not. If the BoJ were indeed to lift interest rates earlier than had been previously anticipated, Japanese financials should outperform the market as a more rapid and sharper lift-off would boost Japanese banks' net interest margins. Indeed, Japanese financials experienced an expansion of their multiples relative to the broader market at the onset of the yen's most recent rally (Chart I-3). Additional fuel comes from credit conditions. Over long periods of time, easy lending standards support the yen: an improving outlook for credit growth prompt investors to expect a less accommodative BoJ stance. Today, private-sector deleveraging is over and Japanese credit standards are very loose, suggesting the yen is somewhat of a coiled spring that could easily be shocked higher. It is the dovish policy of the BoJ that has made the yen softer than normally implied by credit standards. However, any hint that easy policy could be nearing an end would once again cause investors to push the yen higher. A stronger economy is currently giving traders the justification to do exactly that (Chart I-4). Chart I-3Symptoms That Investors ##br##See Higher Rates Ahead Symptoms That Investors See Higher Rates Ahead Symptoms That Investors See Higher Rates Ahead Chart I-4Orders Are Lifting The Yen Because They ##br##Point Toward Tighter Policy Orders Are Lifting The Yen Because They Point Toward Tighter Policy Orders Are Lifting The Yen Because They Point Toward Tighter Policy Bottom Line: Not only is the Japanese labor market very tight, the economy is growing strongly. As a result, investors seem to be anticipating an earlier hawkish shift by the BoJ, which is lifting the yen. Dollar Weakness Another factor that has pushed the yen sharply higher has been the weakness in the U.S. dollar. As have other currency pairs, USD/JPY has decoupled from interest rate differentials. This weakness in the dollar can be understood under many lights. First, since the end of the Bretton Woods system, the dollar has been following an interesting pattern of 10 down years followed by five to six up years. The dollar rally from 2011 to 2016 seemed to fit this mold, suggesting we have entered a protracted period of dollar weakness (Chart I-5). Second, the dollar tends to fare poorly in the last years of an economic expansion. This is because the global economy tends to outperform the U.S. during this time frame. Today, the U.S. business cycle looks long in the tooth. Companies are reporting increasing difficulty finding qualified labor, very few are worried about the outlook for demand, and the yield curve is flattening. These developments are historically associated with the last innings of a business expansion (Chart I-6). Chart I-5USD Entering The Negative Part Of Its Cycle USD Entering The Negative Part Of Its Cycle USD Entering The Negative Part Of Its Cycle Chart I-6Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Finally, the global economy is experiencing a synchronized boom. As we have previously highlighted, when global economic strength is robust and felt around the world, the dollar performs poorly.3 Bottom Line: The yen's strength not only reflects domestic considerations, it is also a reflection of the dollar's own weakness. The yen is feeding on this dollar depreciation. Emerging EM Strains EM economic activity seems to be ebbing at the margin. As we showed two weeks ago, EM manufacturing production has been weakening. Additionally, EM economies, which normally magnify booms in advanced economies, are currently experiencing a relative contraction in their PMIs (Chart I-7). China probably explains this strange softness. We have long argued that Chinese monetary conditions have been tightening, which has caused a sharp deceleration in the Keqiang index, a measure of industrial activity based on credit growth, electricity production and freight volumes. We are now seeing additional signs of this mini-malaise. China's orders-to-inventories ratio has begun to contract, import volumes are weak, export price growth is slowing sharply and the volume of cargo handled at seaports is decelerating (Chart I-8). This is because the tightening in Chinese monetary conditions is beginning to affect the channels through which China impacts the rest of the world. EM tends to be at the forefront of such waves; weakness in the highly sensitive Swedish PMI supports this interpretation. This development has visible market implications. EM stocks are rebounding in unison with DM equities, but EM bonds are not. This suggests that while higher U.S. bond yields are not yet causing much pain in advanced economies, EM economies, already facing headwinds from China, are more vulnerable to the tightening in financial conditions caused by higher Treasury rates. Yield-starved Japanese investors have been heavy buyers of EM bonds. Hence, the weakness in EM bonds could be prompting a closing of EM carry trades. This favors the yen; under these circumstances, Japanese investors repatriate their money home. These dynamics can become vicious. The more Japanese investors suffer losses on their EM holdings, the more they repatriate funds at home, which lifts the yen further, pushes bond prices lower and also tightens liquidity conditions in EM economies. As a result, EM/JPY carry trades tend to lead global industrial activity (Chart I-9). These dynamics seem to be playing a role in the current phase of yen strength. Chart I-7EM Growth Is Underperforming EM Growth Is Underperforming EM Growth Is Underperforming Chart I-8Chinese Slowdown Is Becoming Impactful Chinese Slowdown Is Becoming Impactful Chinese Slowdown Is Becoming Impactful Chart I-9EM Carry Trades Flashing A Slowdown EM Carry Trades Flashing A Slowdown EM Carry Trades Flashing A Slowdown Bottom Line: Not only domestic conditions in Japan and the generalized weakness in the dollar are helping the yen, but strains in EM economies are also aiding. EM manufacturing activity is slowing and EM bond prices are falling, creating an environment normally associated with a strong yen. Outlook For The Yen Tactical Outlook Over the next three to six months, we do see further upside for the yen. To begin with, the yen can get more overbought than it currently is. Peaks in the yen have historically materialized at higher levels in our capitulation index, especially as the yen tends to display strong momentum (Chart I-10).4 Moreover, the weakness of the dollar in the face of a strong CPI report and a steepening yield curve suggests that the dollar is under immense selling pressure. Additionally, even if the yen trades at a large discount of 12% relative to purchasing power parity, speculator are short a near-record 50% of the open interest. This means that as the yen strengthens, it could become very vulnerable to a short covering rally that would mechanically push the JPY significantly higher. The growing international impact of the policy induced Chinese soft patch could also gather further momentum, and support the yen in the process. As Chart I-11 illustrates, when Chinese imports of copper concentrates slow, it often leads to substantial depreciation in USD/JPY. These copper imports are currently decelerating sharply. Chart I-10More Upside For The Yen More Upside For The Yen More Upside For The Yen Chart I-11Chinese Dynamics Favor The Yen Chinese Dynamics Favor The Yen Chinese Dynamics Favor The Yen The large amount of complacency still present in the market further suggests that risks remain skewed to the upside for the yen. Not only could potential EM weakness weigh on commodity prices - a crucial component of our Complacency Index - but also volatility clustering suggests it is likely to spike again repeatedly in the coming months, despite having fallen precipitously after last week's surge. This combination would cause our Complacency Index to fall, a climate historically associated with a strong yen, unless the BoJ eases aggressively (Chart I-12). This picture is corroborated by the general positioning in the FX market. Speculators are massively long risky currencies versus safer ones. Historically, such skewed positioning tends to be followed by rallies in the yen, unless the BoJ eases aggressively (Chart I-13). Looking outside the FX market, investors still hate bonds. Sentiment toward Treasurys is very depressed, speculators are very short 10-year bonds and portfolio managers are massively underweight duration (Chart I-14). This makes bond yields vulnerable to a pullback. For this to materialize, Ryan Swift, who writes BCA's U.S. Bond Strategy service, argues that the U.S. surprise index has to fall back below zero.5 The more than 90-basis-point rise in U.S. bond yields since September will clip some momentum from U.S. growth - not enough to cause a large slowdown, but potentially enough to generate a patch of negative surprises. Chart I-12Less Complacency Equals Stronger Yen Less Complacency Equals Stronger Yen Less Complacency Equals Stronger Yen Chart I-13More Signs Of Complacency More Signs Of Complacency More Signs Of Complacency Chart I-14Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Duration Positioning Points To Upside Risk For The Yen Bottom Line: The international factors that have helped the yen over the past two months will be driving the tactical strength in the JPY. The BoJ is already trying to lean against the yen's strength, as it has recently increased its JGB purchases. While we do not think it is has done enough to weaken the yen in the short term, in our view, the BoJ will remain the biggest headwind for the yen beyond the next six months. Cyclical Outlook This naturally brings us to the cyclical outlook for the yen. We believe that USD/JPY is most likely to settle in the 104 to 102 range, and maybe even test 100. At these levels, we would buy this pair. Why? Simply, for the yen to rally durably, it will require an end to YCC. While markets are probably pricing this outcome right now, we think it is too early to do so. The rhetoric of the BoJ remains very clear: The central bank is committed to maintaining YCC until inflation overshoots its 2% target. Not only are we not there yet, but there are still many obstacles to beat in order to achieve this objective. Moreover, some of these hurdles are becoming more potent. First, while Japan's labor market seems at full employment, industrial capacity is still replete with excess slack. As Chart I-15 shows, Japanese capacity utilization may be near cycle highs, but it remains well below the levels that prevailed before the Great Financial Crisis. Moreover, since Japanese growth has been lifted by the recent EM boom, the country's own mini-boom will suffer from the EM slowdown. As the bottom panel of Chart I-15 illustrates, like China's, Japan's shipments-to-inventories ratio is falling. This is a reliable leading indicator of industrial production. So not only is Japan growth set to slow in the second half of 2018, but low capacity utilization will still be muting inflationary pressures. Second, as we highlighted one month ago, Japan's inflation is hyper sensitive to Japanese financial conditions. The recent improvement in Japan's consumer prices excluding food and energy reflects the lag impact of the previous easing in financial conditions (Chart I-16), which itself is courtesy of the prior weakness in the trade-weighted yen. However, this positive inflationary impulse is set to fade, and the stronger the yen gets, the more likely that inflation slows. The fall in money supply resulting from a strong yen only adds credence to this assertion (Chart I-17). This will reinforce the BoJ's willingness to keep YCC in place and could even incentivize the central bank to increase its asset purchases closer to target in order to clearly communicate its intentions to the market. Chart I-15Will The BoJ Stand##br## Idly By? Will The BoJ Stand Idly By? Will The BoJ Stand Idly By? Chart I-16Inflation Is Picking Up Because ##br##Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Inflation Is Picking Up Because Financial Conditions Eased Third, the yen's strength could hurt Japan's competitiveness and increase domestic deflationary pressures. As the top panel of Chart I-18 illustrates, CNY/JPY has broken down through a key trend line, heralding additional weaknesses. Moreover, the yen has begun to appreciate against other Asian currencies (Chart 18, bottom panel). Our Emerging Markets Strategy service is initiating a long JPY/KRW trade this week, betting on further strength in the yen against other Asian currencies. The BoJ will pay attention to these matters. This combination suggests it is premature for investors to begin betting on an end to YCC in Japan. Thus, the domestic underpinning of the yen's rally seems flawed right now. Only once inflation is more clearly vanquished, or the yen falls substantially in value - enough to generate another outsized gain in Japanese inflation - will this bet become more justified. Chart I-17The Yen Is Already Hurting Money Supply The Yen Is Already Hurting Money Supply The Yen Is Already Hurting Money Supply Chart I-18The Yen Hurts Japan Competitiveness The Yen Hurts Japan Competitiveness The Yen Hurts Japan Competitiveness Bottom Line: While we do continue to see room for the yen to strengthen over the course of the next three to six months, we think such a move will not be durable. We will look to buy USD/JPY once it falls below 104. We believe the yen's short-term strength is more likely to be powered by external factors, as it is still too early to bet on the end of YCC. The yen will be able to embark on a clear cyclical bull market once conditions fall into place for the BoJ to abandon this policy. We are not there yet. Implementation Considerations We have recommended investors sell EUR/JPY for safety reasons. From a contrarian perspective, positioning in EUR/JPY is even more skewed than positioning in USD/JPY (Chart I-19, left panel). Moreover, EUR/JPY trades at a significant premium to our short-term fair value model, adding a significant margin of safety (Chart 19, right panel). While we still like this position, the dismal trading in the USD this week underscores that USD/JPY still offers plenty of downside as well. Chart I-19ARisks To EUR/JPY (I) Risks To EUR/JPY (I) Risks To EUR/JPY (I) Chart I-19BRisks To EUR/JPY (II) Risks To EUR/JPY (II) Risks To EUR/JPY (II) We are also very negative on commodity currencies versus the yen. Weakness in EM growth and in EM bonds should be particularly unkind to AUD/JPY and NZD/JPY. Additionally, from a valuation perspective, these two crosses represent attractive shorting opportunities (Chart I-20). Of the two, shorting AUD/JPY should be the most profitable bet. As we wrote three weeks ago, the Australian dollar seems especially vulnerable right now because nominal growth is set to fall and the labor market continues to be weak. Moreover, Australia's terms of trade is more exposed to a fall in the share of capex in China than in New Zealand.6 Chart I-20ACommodity Currencies Look Especially ##br##Vulnerable Against The Yen (I) Commodity Currencies Look Especially Vulnerable Against The Yen (I) Commodity Currencies Look Especially Vulnerable Against The Yen (I) Chart I-20BCommodity Currencies Look Especially##br## Vulnerable Against The Yen (II) Commodity Currencies Look Especially Vulnerable Against The Yen (II) Commodity Currencies Look Especially Vulnerable Against The Yen (II) Bottom Line: While shorting EUR/JPY remains a safe way to play a continuation of the tactical rebound in the yen, shorting USD/JPY may offer a potential higher reward, but at higher risk. Shorting commodity currencies versus the yen, especially the AUD, still remain the vehicles with the highest potential payoffs. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Yen: QQE Is Dead! Long Live YCC!", dated January 12, 2018, available at fes.bcaresearch.com 2 Based on output prices, overall business conditions, and consumer confidence. 3 Please see Foreign Exchange Strategy Weekly Report, titled "A Cold Snap Doesn't Make A Winter", dated January 5, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, titled "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report, titled "From Davos To Sydney, With a Pit Stop In Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Inflation beat expectations, coming in at 2.1% for the headline measure and 1.8% for the core measure; Retail sales contracted by 0.3% on a monthly rate, with the core measure experiencing no growth; In line with expectations, initial jobless claims increased to 230,000; Capacity utilization came down a little at 77.5%;as Industrial production contracted by 0.1% on a monthly pace; Not even a strong inflation report was able to lift the greenback, which is a very negative sign. This could indicate that the dollar is experiencing a capitulation. A rebound in the USD is likely in the coming quarter, but this is likely to require a slowdown in global growth. Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German 2017 Q4 GDP growth mixed expectations of 3%, coming in at 2.9%; German CPI was in line with expectations at 1.6%; European GDP in Q4 of 2017 grew by 2.7% annually, as expected; Industrial production increased by 5.2%, beating expectations; While the euro had a strong week, the long euro trade is very overcrowded. Early signs of weakening in various indicators reflect signs that tightening financial conditions could start hurting growth. The most recent selloff in risky assets further proves this point. A short-term correction is likely to come in the following months, but the euro's cyclical bull market remains intact. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: The leading economic indicator surprised to the downside, coming in at 107.9. This measure also declined from the previous month. Moreover, annualized gross domestic product growth also underperformed expectations coming in at 0.5%. Finally, machinery orders yearly growth underperformed expectations substantially, coming in at -5%. This growth rate declined from 4% in the previous month. USD/JPY has depreciated by more than 2.5% this past week. This cross is now at its lowest point since Trump's election in late 2016. Overall we think that USD/JPY has more downside, as the rise in yields, coupled with a potential slowdown in global trade, and reduced industrial activity in China should continue to weigh on EM assets. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Both core and headline inflation surprised to the upside, coming in at 2.7% and 3% respectively. However, the retail price index yearly growth underperformed expectations, coming in at 4%. This measure also declined from last month's number. Moreover, industrial production yearly growth also underperformed expectations, coming in at 0%. This measure also declined from 2.6% the previous month. GBP/USD has rallied by nearly 1% this week. This has been mostly due to the weakness in the dollar as the trade-weighted pound continued to depreciate since it texting the upper-bound of its range on tk. Overall, we expect that inflation should ease from here on out, as the pound strength should start to translate into lower prices from imported goods, this will limit the number of hikes currently priced into the SONIA curve. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - ­February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Data out of Australia was mixed: NAB Business Confidence and Business Conditions both outperformed expectations, coming in at 12 and 19, respectively; The Westpac Consumer Confidence declined to -2.3% from 1.8%. The unemployment rate declined to 5.5%, in line with expectations; Part-time employment increased by 65,900, while full-time employment declined by 49,800. At a speech on Monday, RBA Assistant Governor Luci Ellis brought forward important arguments regarding the macroeconomic situation of Australia. She highlighted the lack of wage growth and high household debt, and pointed specifically to the low household consumption growth which stand in sharp contrast to the experience of other developed countries. Recent data continues to highlight the slack in the Australian labor market, and the AUD is likely to suffer this year due to these factors and its large overvaluation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been positive: The participation rate outperformed expectations, coming in at 71%. Moreover, the unemployment came below expectations, coming in at 4.5%. It also declined from last quarter number. Finally, RBNZ inflation expectations also increased from 2% in Q3 to 2.1% in Q4. On February 8th, the RBNZ elected to keep the policy rate unchanged. In its projections, the RBNZ expects that the trade weighted exchange rate will ease over the projection period. Overall, we expect that the New Zealand dollar will outperform the Australian dollar, given that New Zealand's economy is in a much better footing to sustain rate hikes than Australia. Moreover, a slowdown in the Chinese industrial sector would affect Australia much more than New Zealand, given that New Zealand exports are geared more towards the Chinese consumer. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD strengthened against the greenback by almost 1% this week. This was largely a result of the setback in the USD, and we remain neutral on the CAD for the year. That being said, Canada's superior growth position relative to most other DM commodity producers mean that the CAD is set to appreciate against the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Producer and import price yearly growth outperformed expectations, coming in at 1.8%. Moreover, the unemployment rate came in line with expectations at 3%. However, headline inflation underperformed expectations, coming in at 0.7%. EUR/CHF has been relatively flat this past week. The recent negative inflation release is a prime example of the entrenched deflationary pressures in Switzerland in spite of a weak franc. Overall, we believe that the SNB will be maintain their ultra-dovish monetary policy as well as their currency interventions, as long as prices remain contained. This means that while bouts of risk-off sentiment will cause temporary corrections in EUR/CHF, the primary trend for this cross still points upward. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Core inflation underperformed expectations substantially, coming in at 1.1% against anticipations of 1.5%. It also declined from 1.4% on the previous month. However, manufacturing production outperformed expectations After rallying by more than 5% in the first week of February, USD/NOK has given up some of those gains, falling by nearly 3% last week. Overall we expect that the Norwegian krone should outperform other commodity currencies, given that a slowdown in industrial activity in China will cause oil to outperform metals. Moreover, the market is only expecting roughly one rate hike in the next year by the Norges Bank, while anticipating nearly three hikes in Canada. We expect this spread in expectations to converge, putting downward pressure on CAD/NOK. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The Riksbank's monetary policy meeting on Wednesday contradicted remarks by officials earlier this year regarding a possible policy move in early 2018. In a mild volte face, Riksbank deputy governor Per Jansson pointed to Sweden's "problem with underlying price" pressures to argue in favor of a summer hike. Riksbank officials fear that tightening ahead of the ECB may lead to too strong a currency and depress prices. They also pointed to falling wage growth despite the increasingly tightening labor market. While we are optimistic on Sweden's growth prospects, this development was highlight that Ingves' dovish inclinations still linger within the walls of this central bank. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The trajectory of EM bank profits and share prices will be critical to sustain the EM equity rally. Rising U.S. bond yields will push up EM local bond yields. This, along with poor quality of banks' earnings, will likely halt EM banks' stock rally. We reiterate our strategic equity position: short EM banks / long U.S. banks. The same strategy can be replicated in credit markets. In China, bank loan data are no longer indicative of aggregate lending to all segments of the economy. Banks' total claims, total assets, and money aggregates have all slowed. The Korean won is making a major top. Short it against an equal-weighted basket of the U.S. dollar and yen. Feature Chart I-1Rising U.S. Bond Yields = Higher EM Local ##br##Bond Yields And Lower Bank Stocks Rising U.S. Bond Yields = Higher EM Local Bond Yields And Lower Bank Stocks Rising U.S. Bond Yields = Higher EM Local Bond Yields And Lower Bank Stocks The key financial market variables with respect to the outlook for emerging markets (EM) are commodities prices, the U.S. dollar and EM bank share prices. We have written extensively on the former two, and today we elaborate on the third pillar: the importance of banks/financial stocks to the EM aggregate equity index. First, surging U.S. Treasurys yields point to higher EM local currency bond yields (Chart I-1, top panel). In turn, EM banks' share performance inversely correlates with EM local bond yields (Chart I-1, bottom panel). Altogether, this heralds lower EM bank share prices. Second, financials make up 24.4% of the MSCI EM equity market cap, with banks accounting for 18% out of the 24.4%. Hence, financials/banks' price fluctuations are critical to the EM equity benchmark. Importantly, financials' earnings accounts for 33.6% of EM listed companies earnings. By contrast, technology accounts for 27.6% of the EM market cap, but only 23.3% of EM total earnings (Table I-1). As to the EM technology sector, it is heavily skewed toward four large companies: Tencent, Alibaba, Samsung and TSMC. The latter two have already shown considerable weakness, with Samsung breaking down below its 200-day moving average (Chart I-2). Analyses on the former two companies are beyond the realm of macro research. What's more, these stocks are extremely overbought and probably expensive. If the rest of EM goes down, these two stocks are not likely to preclude it from happening. Third, banks in China, Turkey, Indonesia, Malaysia and Brazil have been boosting their reported EPS by reducing their provisions outright or the pace of provisioning. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM Bank Stocks Hold The Key EM Bank Stocks Hold The Key Chart I-2Is EM Tech Hardware Breaking Down? Is EM Tech Hardware Breaking Down? Is EM Tech Hardware Breaking Down? For various reasons, we believe these reductions in provisions are unjustified. In China, Turkey and Malaysia, NPLs are too low to begin with: the more accurate measures of NPLs are probably much higher in these banking systems given the magnitude and duration of the preceding credit boom (Chart I-3 and Chart I-4). Chart I-3China: Banks' Provisions Are Inadequate bca.ems_wr_2018_02_14_s1_c3 bca.ems_wr_2018_02_14_s1_c3 Chart I-4Turkey And Malaysia: ##br##Falling Provisions Are Untenable Turkey And Malaysia: Falling Provisions Are Untenable Turkey And Malaysia: Falling Provisions Are Untenable In Brazil and Indonesia, the recent weakness in nominal GDP growth - shown inverted on the chart - does not justify the outright reduction in the level of net new NPL provisions (Chart I-5). In short, some EM banks have inflated their EPS in recent quarters by reducing provisioning for bad loans. This suggests that their EPS quality is poor, and their profit recovery is unsustainable. Bottom Line: EM bank share prices have reached their previous high but are unlikely to break above that level, in our opinion (Chart I-6). Chart I-5Brazil And Indonesia: Declining ##br##Provisions Are Unsustainable Brazil And Indonesia: Declining Provisions Are Unsustainable Brazil And Indonesia: Declining Provisions Are Unsustainable Chart I-6EM Bank Share Prices ##br##Are Facing Resistance EM Bank Share Prices Are Facing Resistance EM Bank Share Prices Are Facing Resistance We reiterate our strategic call of being short EM banks and long U.S. bank stocks. The relative share price performance of EM versus U.S. banks has been inversely correlated with U.S. bond yields (Chart I-7). Chart I-7Rising U.S. Bond Yields = ##br##EM Banks Underperformance Rising U.S. Bond Yields = EM Banks Underperformance Rising U.S. Bond Yields = EM Banks Underperformance If our view on higher U.S. bond yields materializes, odds are that EM bank share prices will relapse considerably versus U.S. banks. Traders should consider implementing this trade. Credit investors can replicate the same strategy in credit markets. Strategy Considerations Investor sentiment remains bullish on risk assets in general and emerging markets in particular. The buy-on-dips mentality is well entrenched. Amid such investor consensus, it is important to consider alternative scenarios. Presently, the relative performance of Swiss versus global non-financial stocks is sitting on its long-term moving average (Chart I-8). Odds of a rebound in the relative performance of Swiss non-financial stocks from such oversold levels are fairly high. As and when the latter begin outperforming their global peers, it might entail a negative outlook for global bourses in general and cyclical equity sectors in particular. The basis is that Swiss non-financial stocks are defensive in nature, as pharmaceuticals and consumer staples account for a large portion of the total market cap. Not surprisingly, the previous bottoms in Swiss non-financials' relative performance versus global non-financials coincided with major tops in global equity bull markets. For now, the risk-reward for global stocks is unattractive, and the outlook for EM relative performance is extremely poor. Notably, relative manufacturing PMI trends favor DM over EM stocks (Chart I-9). Chart I-8Swiss Stocks Are At Critical Juncture: ##br##What Does It Mean For Global Equities? Swiss Stocks Are At Critical Juncture: What Does It Mean For Global Equities? Swiss Stocks Are At Critical Juncture: What Does It Mean For Global Equities? Chart I-9EM Relative To DM: PMIs And Share Prices EM Relative To DM: PMIs And Share Prices EM Relative To DM: PMIs And Share Prices Besides, as we discussed at great length in our recent report,1 EM equity valuations are on par with DM when adjusted for sector weights and sub-sectors with outlier valuation ratios. Our stance remains that EM risk assets will face a perfect storm this year for two reasons: Strong U.S. growth will cause U.S. inflation to rise, and the selloff in U.S. bonds has further to run. Higher U.S. interest rates should support the U.S. dollar and weigh on EM risk assets that have benefited disproportionally from the search for yield; While China's growth has slowed only moderately, our forward-looking leading indicators continue to point to further deceleration. A combination of these two tectonic shifts will amount to a perfect storm for EM risk assets in 2018. We explore these two issues in greater detail below. U.S. Inflation, The Fed And The U.S. Dollar We have the following observations on current U.S. economic dynamics: Fiscal stimulus is arriving at a time when growth is already robust, and the labor market is tight. This will likely produce higher inflation. Inflation does not need to surge to make a difference in financial markets. It would be fair to say investors have become complacent and financial markets are still pricing in a goldilocks scenario. Therefore, even a moderate rise in core inflation readings along with some anecdotal evidence that companies are able to raise prices will lead to further re-pricing in U.S. interest rate expectations. Higher U.S. interest rates pose a risk to EM, which have benefited considerably from the search for yield. EM currencies, domestic bonds and credit markets have so far held up well, despite the considerable rise in U.S. bond yields (see Chart I-1 on page 1). Based on this, it is tempting to argue that EM will be immune to rising U.S. interest rate expectations. Nevertheless, we believe this EM resilience has occurred because fund flows to EM remain very robust. These flows are often backward looking. Odds are that 10-year U.S. Treasury yields will move well north of 3%. Such a considerable rise in yields will weigh on EM risk assets. It is essential to realize that the positioning in EM stocks, local bonds and credit is more elevated today than it was before the 2015 downturn. Finally, Chart I-10 illustrates that U.S. banks' excess reserves at the Federal Reserve have started to drop. In recent years the periods of reserve declines have coincided with a strong U.S. dollar, yet the latest drop in banks' excess reserves has not yet produced a meaningful rally in the greenback (the dollar is shown inverted in Chart I-10). The Fed's ongoing tapering efforts and the U.S. Treasury's replenishment of its account at the Fed are bound to produce further reductions in banks' excess reserves. Based on the latter's correlation with the exchange rate, this should support the greenback. Notably, the U.S. dollar is fairly valued, according to our most favored valuation measure: the unit labor cost-based real effective exchange rate (Chart I-11). This takes into account both wages and productivity, and hence gauges competitiveness much better than real effective exchange rate measures that rely on consumer and producer prices. Chart I-10Shrinking U.S. Banks Excess ##br##Reserves = Stronger U.S. Dollar Shrinking U.S. Banks Excess Reserves = Stronger U.S. Dollar Shrinking U.S. Banks Excess Reserves = Stronger U.S. Dollar Chart I-11The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive The U.S. Dollar Is Not Expensive Finally, tax cuts are supply side reforms, and they are typically bullish for the currency. Bottom Line: A combination of stronger growth, rising interest rate expectations, neutral valuations and oversold conditions should help the U.S. dollar to rebound. The rally in the U.S. exchange rate versus EM currencies will be pronounced if China's growth slows, as we expect it to. Making Sense Of Chinese Data China's slowdown has so far been moderate. However, in any economy a downturn almost always begins with a moderation in growth. That, however, is not sufficient reason to conclude that the growth slump will be benign or short-lived. Judgement on the duration and magnitude of a slowdown should be based on the existence of major macro imbalances, or lack thereof. Given that China has enormous money, credit and property market excesses/imbalances and policy has been tightening, we believe that growth disappointments will be non-trivial and more substantive than the market consensus currently expects. The following corroborate the case for a deepening growth slump ahead: The annual change in the manufacturing new orders-to-inventory ratio from the National Bureau of Statistics points to a relapse in Caixin's manufacturing PMI as well as steel, iron ore and coal prices (Chart I-12). This indicator also heralds a decline in analysts' EPS net revisions for all Chinese stocks (Chart I-13). Chart I-12China: An Impending Slowdown China: An Impending Slowdown China: An Impending Slowdown Chart I-13China: EPS Net Revisions Have Peaked China: EPS Net Revisions Have Peaked China: EPS Net Revisions Have Peaked While some economic data like imports for January were strong, it is important to realize that this January had a few more working days compared with January 2017 due to the Chinese New Year falling in February this year. Although the same seasonal adjustment should be applied to money and credit data, there are other critical dimensions specific to the credit data that investors should be aware of. Banks' loans to companies and households - widely watched by the investment community - was very strong in January relative to the previous month. However, loan and most of other data in China should be seasonally adjusted. The annual growth rate in RMB bank loans is still very robust at 13.2% (Chart I-14, top panel). However, the growth rates of banks' total assets, total claims and broad money have all dropped close to 10% or below (Chart I-14). The disparity between bank loans on the one hand and their claims and assets on the other is due to the following: In China's banking statistics, banks' loans to non-bank financial institutions - such as financial trusts, investment corporations, insurance, financial leasing companies and auto-financing companies, and loan companies - are not included in banks' loan data. Hence, bank loan data do not reveal the banks' full impact on the economy. By extending credit to non-bank financial institutions, banks have expanded their balance sheets without exceeding their loan quotas. In short, banks have funded shadow banking and by extension the real economy and speculative investment schemes but have done so via non-bank financial institutions. In addition, banks have also bought a lot of corporate and local government bonds that are not considered loans. Overall, bank loans have been understating the degree of the banking system's credit expansion. In the past year, regulators have been forcing banks to reduce their lending to non-bank financial institutions. With this channel of balance sheet expansion restricted (Chart I-15, top panel), banks are probably resorting to more traditional loans to expand their balance sheets and earn income. Chart I-14China: Bank Loans, ##br##Assets And Total Claims China: Bank Loans, Assets And Total Claims China: Bank Loans, Assets And Total Claims Chart I-15China: Bank Lending To Shadow ##br##Banking Is Being Curtailed China: Bank Lending To Shadow Banking Is Being Curtailed China: Bank Lending To Shadow Banking Is Being Curtailed In short, one needs to look at banks' aggregate claims on all entities - companies, households, non-bank financial institutions and governments - to assess whether their lending to the economy is slowing or accelerating. Chart I-16China: Structure Of Bank Assets China: Structure Of Bank Assets China: Structure Of Bank Assets Consistent with the ongoing regulatory clampdown, banks' claims on non-bank financial institutions - so called shadow banking - have plummeted in the past 12 months after expanding 50-70% annually for several years in a row (Chart I-15, top panel). The bottom three panels of Chart I-15 indicate that the annual growth rates of banks' claims on companies, household and the government have either already decelerated or are slowing now. Their respective shares in banks' total assets are displayed in Chart I-16. While banks' RMB loans remain the largest category of assets, the importance of other claims has risen. Bottom Line: Several leading indicators continue pointing to an impending slowdown in the mainland's economy. Bank loan data is no longer indicative of total bank assets expansion/aggregate lending to all segments in the economy. Broader measures - such as banks' total claims, assets and money aggregates - have decelerated considerably. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Korea: A Major Top In The Won The Korean won is vulnerable on several fronts: Its real effective exchange rate based on unit labor costs is well above its historical mean (Chart II-1, top panel). Importantly, based on this same measure, the won is very expensive versus the Japanese yen (Chart II-1, bottom panel). The manufacturing cycle has already weakened in Korea (Chart II-2). Chart II-1The Won Is Expensive The Won Is Expensive The Won Is Expensive Chart II-2Korea's Manufacturing Is Weakening Korea's Manufacturing Is Weakening Korea's Manufacturing Is Weakening Japanese exports in U.S. dollar terms are starting to outperform Korean ones (Chart II-3), suggesting that Korean exporters might be losing market share to their Japanese rivals. Furthermore, manufacturing inventories are rising sharply in Korea but not in Japan (Chart II-4). Relative manufacturing inventory trends also favor the yen versus the won (Chart II-4, bottom panel). Chart II-3Relative Exports: Korea Versus Japan Relative Exports: Korea Versus Japan Relative Exports: Korea Versus Japan Chart II-4Manufacturing Inventories: Korea And Japan Manufacturing Inventories: Korea And Japan Manufacturing Inventories: Korea And Japan The won's appreciation has depressed Korea's export prices in local-currency terms. In Japan, on the other hand, local-currency export prices are holding better. Interestingly, the relative export price trend in U.S. dollars points to the won's depreciation versus the yen (Chart II-5). Korean non-financial stocks have broken below their 200-day moving average, which corroborates that corporate profitability is deteriorating (Chart II-6). Korean equities have been among the world's worst-performing bourses year-to-date. Chart II-5Export Prices: Korea And Japan Export Prices: Korea And Japan Export Prices: Korea And Japan Chart II-6Korean Non-Financial Stocks Are Cracking Korean Non-Financial Stocks Are Cracking Korean Non-Financial Stocks Are Cracking In addition, the correction in Korean stocks commenced before the recent plunge in the S&P 500. This highlights that the relapse in Korean share prices was not only due to the contagion from the U.S. equity selloff. Finally, the technical profile of the won points to a major top. Chart II-7 shows that the won is facing multi-year technical resistance versus the U.S. dollar. Chart II-7KRW/USD Exchange Rate: ##br##A Long-Term Technical Profile KRW/USD Exchange Rate: A Long-Term Technical Profile KRW/USD Exchange Rate: A Long-Term Technical Profile Investment Conclusions We have been short the Korean won versus the Thai baht since October 19, 2016 and this trade has produced a 7.3% gain. We recommend closing this trade and shorting the won versus an equally-weighted basket of the U.S. dollar and yen. The rationale to short the KRW versus this basket is to hedge against a possible near-term U.S. dollar selloff if China is forced to revalue the RMB further, as we discussed in February 7, 2018 report.2 In regards to equities, we are closing our long KOSPI / short Nikkei trade with a 1% loss since April 26, 2017. Within the EM universe, we continue recommending a neutral allocation to Korean stocks excluding technology. Despite their recent underperformance, EM-dedicated managers should continue overweighting Korean tech stocks. The reasoning behind this is that the potential currency depreciation will help their corporate profitability as tech shipments are not exposed to Chinese capital spending. The latter will be the epicenter of negative growth surprises in our opinion. Finally, Korean local bond yields will soon top out as the deflationary pressures from a stronger currency become more evident in the economy. Korean bonds will outperform U.S. Treasurys on a currency-hedged basis. 1 Please refer to Emerging Markets Strategy Special Report, titled "EM Equity Valuations (Part I)," dated January 24, 2018, the link is available on page 19. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "A Regime Shift?," dated February 7, 2018, the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Wednesday, we sent you a Special Report by our Global Investment Strategist, Peter Berezin titled: The Return of Vol, which fleshed out BCA's view on the recent volatility spike and the associated market selloff. BCA believes that markets are realizing that U.S. inflation is not forever dead. As such, market volatility is set to rise, even if global equities can make new highs. From an FX perspective, a rise in U.S. inflation, especially when accompanied by the kind of spending programs announced this week in Washington DC, could result in a period of strength for the U.S. dollar. Additionally, since financial markets tend to experience clusters of volatility, the recent bout of volatility can stay in place for a while. High volatility tends to be negative for carry trades, hence EM currencies could suffer this quarter. The Australian dollar and the euro could also decline under this scenario. However, the yen and CHF may experience upside, but mostly against other currencies than the greenback. In this present report, we are updating our views on the G10 central banks. Best regards, Mathieu Savary Feature In our Special Report published last summer titled "Who Hikes Next?" we examined which of the G10 central banks would be next to join the Federal Reserve on its tightening path.1 Seven months later, we now know that the Bank of Canada and, to a lesser extent, the Bank of England, were respective second and third to begin raising their own policy rates. It is now time to revisit the topic and see which central banks are most likely to adjust their policy further. As Chart 1 shows, global goods prices have picked up steam, which has been translated in an ebbing of global deflationary forces. A few factors lie behind this improvement. First, China is not exporting deflation around the world anymore because the trade-weighted yuan has been stable and producer price inflation, which currently stands at 5%, has been in positive territory for 15 straight months. Second, thanks to ebullient global growth, global capacity utilization has grown significantly. Third, oil prices have climbed further. This development has been particularly meaningful as it has contributed to a significant pick-up in market-based inflation expectations. But as in every economic cycle, some risks are worth monitoring. As we have highlighted before, global money growth has slowed, Chinese monetary conditions have tightened meaningfully and Asian manufacturing activity has decelerated in a wide swath of countries. Even BCA's Global Capex Indicator (Chart 1, bottom panel), which flashed an unabashed green light last June, has begun to roll over. The recent market shakeup has also reminded investors that higher bond yields do have an impact on asset prices and economic growth. Despite these worries, we expect more central banks to join the fray this year and begin removing accommodation one way or another. Others will shy away, but they will guide markets toward expecting less monetary accommodation next year. Finally, some central banks will likely stand pat, and will leave their policy settings unchanged. Chart 2 illustrates where we think G10 central banks stand in their respective hiking cycles. Chart 1The Reasons Why Central Banks Are Tightening The Reasons Why Central Banks Are Tightening The Reasons Why Central Banks Are Tightening Chart 2G10 Central Banks Map Who Hikes Again? Who Hikes Again? The Hikers 1) The U.S. Chart 3U.S. U.S. U.S. The Federal Reserve will continue to tighten policy this year. To begin with, its communications on the topic have been extremely clear: the Federal Open Market Committee wants to increase interest rates three times in 2018. The Fed has good reasons for this hawkish stance. The gap between the real policy rate and the recent average of real GDP growth remains in stimulative territory (Chart 3). Meanwhile, U.S. financial conditions have rarely been easier, yet the economy is receiving a boost thanks to tax cuts and spending increases. There is, therefore, little mystery as to why survey data point to healthy GDP growth for the first half of 2018. In fact, the Atlanta Fed GDPnow model currently forecasts a growth rate of 4.0% for the first quarter of this year. This is an inflationary combination. It is not just growth conditions that are creating tailwinds for the Fed. Resource utilization is also elevated. According to the CBO, the U.S. output gap closed last year, and the unemployment rate not only stands at its lowest level in 17 years, but it is also well below equilibrium. We are already seeing the symptoms of this state of affairs: the employment cost index is growing at 2.6%/annum, its highest rate in three years; the growth of average hourly earnings just hit 2.9%/annum, and even core inflation is bottoming. These developments will give comfort to the Fed that hiking rates three times this year is the right strategy. The Hikers 2) Canada Chart 4Canada Canada Canada The Bank of Canada has already increased rates three times since we first explored this topic last summer. Like the Fed, the BoC has strong justification behind its hawkish stance. While the policy rate is not as stimulative as it was last year, capacity utilization has become much tighter (Chart 4). The unemployment rate is now back in line with its underlying equilibrium, and the BoC's Business Outlook Survey shows that the quantity and intensity of labor shortages have become elevated, which has historically led to higher wages. Additionally, the OECD's approximation of the output gap has closed, something also acknowledged by the BoC's models. Core inflation has begun to respond, rising to 1.5% in December. The current backdrop suggests this trend has further to go. Moreover, as exports to the U.S. represent 20% of Canada's GDP, the economic vigor south of the border will only translate into further inflationary pressures up north. Based on these factors, we expect the BoC to increase rates as much as the Fed in 2018. This view is not without risks. NAFTA negotiations remain rocky, and the uncertainty emanating from trade policy could hurt Canadian capex. Additionally, Canadian house prices remain 31% above fair value, Canadians sport a debt load of 170% of disposable income, and a growing array of macro-prudential measures are being implemented to slow the housing market. If this combination bites deeply - which remains to be seen - the BoC may be forced to, at least, pause its tightening policy faster than anticipated. Still Hiking? 3) The U.K. Chart 5U.K. U.K. U.K. On many metrics, the Bank of England looks set to hike again in 2018. There is no denying that British monetary policy remains extremely easy, as the gap between the real policy rate and real GDP growth is still in massively stimulative territory (Chart 5). Moreover, according to the OECD, the output gap stands at 0.4% of potential GDP. This observation seems to be corroborated by the fact that the unemployment rate remains nearly 1% below its equilibrium value. Adding credence to these assertions, U.K. core inflation spiked as high as 2.9% one month ago. However, make no mistake: the spike in inflation, while facilitated by tight supply conditions, is still mostly a consequence of the pass-through created by the pound's collapse in 2016. Because the rate of change of the pound has stabilized, the U.K.'s inflation rate will fall back to earth. Moreover, the outlook for British consumption is murky as the household savings rate has plunged to a mere 5.2% of disposable income, and debt growth is peaking. Corporations too have curtailed their borrowings, pointing to a weak capex outlook. While the MPC would like to hike once or twice this year, since a policy tightening is contingent on elevated inflation, the central bank may once again disappoint. For now, rate hikes look likely, but this may change if inflation decelerates sharply. In The Starting Blocs For 2018 4) Sweden Chart 6Sweden Sweden Sweden The December policy statement by the Riksbank highlighted that while the world's oldest central bank will reinvest the proceeds from redemptions and coupon payments from its large bond portfolio, it still expects to begin lifting its benchmark rate in the middle of 2018. This is not a minute too soon. Swedish monetary conditions are incredibly easy: Real interest rates are 6% below the average real GDP growth of the past three years (Chart 6). Moreover, Sweden is facing growing capacity constraints. The unemployment rate is nearly 1% below equilibrium, and according to the OECD, the output gap stands at 1.5% of GDP, the most positive number among the G10. The Riksbank's own capacity utilization measure - an excellent leading indicator of inflation - is at a 10-year high, pointing to further acceleration in a core inflation that is already very close to 2%. Additionally, Sweden is in the thralls of a massive real estate bubble, a byproduct of extremely loose monetary policy. The external environment will remain the main source of risk to this hawkish outlook. On the plus side, the European Central Bank has begun tapering its QE program and should end new purchases in September 2018. This limits how high the SEK can spike against the euro - the currency of Sweden's main trading partner - if the Riksbank tightens policy. However, Asian industrial production has slowed sharply, and Swedish PMIs are already buckling. Any deepening of the recent selloff in risk assets, especially if it spreads further into commodities, could cause Riksbank Governor Stefan Ingves to retreat to his dovish safe place. In The Starting Blocs For 2019... Or 2018 5) New Zealand Chart 7New Zealand New Zealand New Zealand The Reserve Banks of New Zealand is slated to hike rates by mid-2019. However, risks are growing that the RBNZ could be forced into an earlier first hike. Policy is currently massively accommodating as the real official cash rate stands nearly 4% below the average real GDP growth of the past three years (Chart 7). At 1.4%, core inflation remains below the RBNZ's target, but it is on a rising trend, especially as the Kiwi economy is beyond full employment and the OECD's measure for New Zealand's output gap is at 0.8% of potential GDP. Moreover, GDP growth remains robust, and terms of trade have been improving as dairy prices are still firm, thus a further overheating in this economy is likely. The political front could also give impetus for the RBNZ to hike earlier than it recently suggested. The Ardern government has proposed increasing the minimum wage to NZ$20/hour by 2021, starting in April 2018. This could fuel already improving wages, and thus fan inflation. This government also plans to increase fiscal spending, which tends to exacerbate inflationary pressures when an economy is at full capacity. Thus, inflationary risks in New Zealand are skewed to the upside. In The Starting Blocs For 2019... Or 2018 6) Norway Chart 8Norway Norway Norway The Norges Bank anticipates it will begin to increase rates toward the middle of 2018. The Norwegian central bank is facing an interesting cross current. On the one hand, when compared with other nations on the list, the Norwegian economy seems less ripe to withstand higher rates. To begin with, because Norwegian core inflation has fallen precipitously in recent years, the gap between real interest rates and the average real GDP growth of the past three years has narrowed considerably (Chart 8). Moreover, the unemployment rate remains 0.9% above equilibrium, while a more broad-based measure of slack, the output gap, stands at -1.6% of potential GDP, at least according to the OECD. Moreover, core inflation only hovers near a 1.2% annual pace and is expected to stay below 2.5% in the coming years. Despite these negatives for Norway, some important positives also exist, which explains the Norges Bank's optimism. The Norwegian economy did not go through much of a financial crisis this cycle; as a result, Norwegian banks are healthy, and the Norwegian money multiplier never imploded as it did in other G10 countries. Also, the Norwegian krone is very cheap, adding a further reflationary impulse beyond low rates. Moreover, Norwegian GDP growth has experienced a rebound on the back of rallying oil prices. However, oil prices are nearing the top end of our energy strategists' forecasts, suggesting this tailwind is receding. Altogether, this confluence of factors suggests that similar to the RBNZ, the Norges Bank is likely to hike rates in early 2019 or late 2018. 2019 Take Off 7) Australia Chart 9Australia Australia Australia The Reserve Bank of Australia may well begin increasing interest rates in early 2019. Many factors would argue that the RBA could in fact increase interest rates earlier. Even though it is less accommodative than Sweden's or New Zealand's, Australian monetary policy is quite easy as the gap between the real policy rate and the average real GDP growth rate of the past three years is well into negative territory (Chart 9). Additionally, core inflation has rebounded hitting 1.9% recently, while trimmed-mean CPI stands at 1.8%. Among additional positives, Australia's national income is growing at a robust 4.3% annual pace and job creation is brisk, with payrolls expanding at an impressive 3.6% rate on a yearly basis. These positives mask some stiff headwinds. Rapid national income growth will likely peter out. It was the result of the very large rebound in the RBA's commodity price index, however, this benchmark, which was growing at a 53% annual rate in February 2017, is now contracting at a 1% annual rate. Additionally, the OECD's measure for the Australian output gap stands at -1.5%. While it is true that the unemployment rate is below its equilibrium rate, the RBA's labor underutilization measure remains near 25-year highs. This explains why robust job creation is not being translated into wage gains, and suggests that the RBA is right to expect trimmed-mean inflation to durably be at 2-2.25% only by the end of 2019. Moreover, the recent strength in the AUD will also weigh on inflation going forward. Netting out pros and cons suggests that the most likely first hike by the RBA will be in early 2019. 2019 Take Off 8) Euro Area Chart 10Euro Area Euro Area Euro Area The European Central Bank has begun tapering its QE program, and if the global economy does not experience any meaningful relapse, the ECB will end new purchases this September. However, a rate hike is not in the offing this year. To begin with, the ECB's communications on the topic have been rather clear: At its latest press conference, President Mario Draghi once again rejected any possibility of a move this year, and even Jens Weidmann, the Bundesbank's head, acknowledged that the current market pricing - a hike in the summer of 2019 - is about right. While it is true that the ECB's monetary policy setting is still very accommodative, the unemployment rate remains 0.8% above equilibrium, and outside of Germany, labor underutilization is still high. Moreover, the OECD's estimate of the euro area's output gap still stands at -0.5% of potential GDP (Chart 10). Another hurdle is core CPI which remains well below the ECB's objective; in fact, after hitting 1.2% in May, inflation excluding food and energy has now relapsed to 0.9%. Peripheral nations are experiencing even weaker inflation readings. With the ECB's inflation forecast still well below target until 2020, a rate hike will have to wait until next year. The Laggards 9) Switzerland Chart 11Switzerland Switzerland Switzerland The Swiss National Bank remains firmly among the lagging central banks within the G10. Because inflation is still at only 0.7%, the gap between real interest rates and average real GDP growth of the past three years is among the least stimulative in the G10 (Chart 11). Corroborating this observation, loan growth has averaged a paltry 4% over the course of the past three years. Moreover, the Swiss economy is still replete with excess capacity. The unemployment rate may be a low 3%, but it still stands 1.3% above equilibrium, and Swiss wage growth remains very depressed. Moreover, the OECD pegs the Swiss output gap at -1.2% of potential GDP. On a PPP basis, the Swiss franc remains 5% overvalued against the euro, Swiss core inflation was only 0.7% in December, but better than the -1% posted in early 2016. The SNB is likely to officially abandon its foreign asset purchases this year. The Swiss economy has recovered from its doldrums of the past several years, and most importantly, the euro crisis is now fully in the rearview mirror. This means that safe-haven flows out of the euro area, which were pushing the CHF to nosebleed valuation levels, have dried up. In fact, this year's weakness in the franc versus the euro was not accompanied by much increases in SNB sight deposits, suggesting this depreciation has been organic and not manufactured in Bern and Zurich. However, until core CPI moves closer to 2% and Swiss wages pick up, the SNB will likely lag the ECB when it comes to actual interest rate increases amid fears that the Swiss franc will rebound and tighten policy again. A late 2019 or early 2020 hike remains the most likely scenario. The Laggards 10) Japan Chart 12Japan Japan Japan The Bank of Japan is also faraway from increasing policy rates. This is not because the Japanese economy is replete with excess slack. It is not. The active job openings-to-applicants ratio stands at a whopping 44-year high, the unemployment rate is 0.8% below equilibrium and the OECD's estimate of the output gap is in positive territory (Chart 12). However, despite this very inflationary backdrop, inflation excluding food and energy remains a paltry 0.3%/annum. The BoJ has rightfully identified moribund inflation expectations as the key to unlocking this mystery. Decades of deflation have created a deflationary mindset among Japanese economic agents. As a result, wages and inflation itself are not experiencing much of a lift. The BoJ is tackling this issue head on, and has made it clear that it will not abandon its yield curve control strategy until inflation is well above its 2% target. In the BoJ's view, an inflationary overshoot is now necessary to shock deflationary mentalities, which will be the keystone to let inflation take off in durable fashion. For now, the tight negative relationship between Japanese financial conditions and inflation suggests the BoJ will do its utmost to contain the yen, which would undermine the progress made in recent quarters. As such, we do not foresee any rate hikes until well into 2019. QQE is likely to be abandoned first, as in practice the BoJ has not hit its JGB purchases target since the first half of 2016. Investment Implications The dollar could experience a further lift in the first half of 2018. Investors plunked the greenback last year and in the opening weeks of 2018 because they had been focusing on the far future - a future in which the ECB hikes rates faster than the Fed. But the reality remains that this year and next, the Fed will lift interest rates much more than the ECB. This means the euro is vulnerable to a pullback as it is very expensive relative to differentials at the front end of the curve. The outlook for EUR/USD will improve again once we get closer to 2019. The CAD has niether much upside nor downside. Interest rate markets are pricing in as many interest rate increases as we are. The key for the CAD will once again be oil prices, but keep in mind that Brent prices are not far off from our energy strategists' target of US$67/bbl. The SEK and the NOK will likely experience upside versus the euro. Their central banks are also set to pull the trigger before the ECB. Moreover, these two currencies are very cheap. However, the ride is unlikely to be a smooth one. The budding slowdown in Asian manufacturing could generate temporary hiccups before yearend that will cause these extremely pro-cyclical currencies to swoon. The picture for the pound remains as murky as ever. On one hand, the BoE has begun to increase rates. However, this progress could run astray very easily if, as we expect, British inflation weakens anew. Moreover, Brexit negotiations with the rest of the EU are far from fully settled. Further, the trade-weighted pound is moving toward the top end of its post-Brexit range, making it highly vulnerable to even a modest disappointment. The Australian dollar is likely to experience a poor 2018, as the RBA is a long way from increasing interest rates, and on all the long-term metrics we track, the AUD is one of the most expensive currencies. A continuation of the recent spat of asset market volatility could prove to be unkind to the Aussie. The kiwi will likely outperform its antipodean brethren as we see upside risk for interest rates in New Zealand. Finally, Swiss and Japanese interest rates will remain near current levels for a few more years. This suggests that the Swiss franc and the yen have little durable upside this year. The same holds true for the first half of 2019. However, since Switzerland and Japan still sport hefty current account surpluses and supersized positive net international investment positions, the CHF and JPY will continue to behave as safe-haven currencies, rallying when global asset prices weaken. This means that since markets tend to experience volatility clusters, the recent bout of market volatility could continue, which will help both the Swiss franc and the yen over the coming weeks. This will be especially true if the CHF and JPY are bought against the EUR, AUD, CAD, and NZD. But beware: the yen is especially cheap, so any signs that inflation expectations of Japanese agents pick up could be associated with a sharp rally in the yen, as it will spell imminent doom for the BoJ's YCC strategy. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades

Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Oil Prices Caught Up In Equities Sell-Off Oil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation Fundamentals Support Backwardation Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Strong Fundamentals Force Inventories Lower Strong Fundamentals Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Stakes Are High For OPEC 2.0 If No Post-2018 Strategy Emerges Stakes Are High For OPEC 2.0 If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Long-Term Inverse Correlation Between USD TWIB And Crude Prices Long-Term Inverse Correlation Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices Backwardated Forward Curves Limit USD's Effect On Oil Prices Backwardated Forward Curves Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Tighter Inventories Limit USD's Effect On Oil Prices Tighter Inventories Limit USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves Lower Imports Of Petroleum Help Insulate USD From Oil Price Moves Lower Imports Of Petroleum Help Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Vs. The Fed OPEC 2.0 Vs. The Fed Trades Closed in 2018 Summary of Trades Closed in 2017 OPEC 2.0 Vs. The Fed OPEC 2.0 Vs. The Fed

Highlights The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally Rising Volatility Coincides With A U.S. Dollar Rally Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar U.S. Relative Equity Outperformance Warrants A Stronger Dollar U.S. Relative Equity Outperformance Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? Will Beijing Tolerate A Stronger RMB? Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar May 2006 And Now: EM Stocks, U.S. Bond Prices And U.S. Dollar May 2006 And Now: EM Stocks, U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise U.S. Core Inflation Set To Rise U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up U.S. Bond Yields: The Path Of Least Resistance Is Up U.S. Bond Yields: The Path Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential U.S. Bond Yields: The Path Of Least Resistance Is Up EM Local Currency Bonds Over U.S. Treasurys: Yield Differential U.S. Bond Yields: The Path Of Least Resistance Is Up EM Local Currency Bonds Over U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Asia's Manufacturing Production Growth Is Slowing Asia's Manufacturing Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Global Energy and Steel Stocks: A Technical Resistance Global Energy and Steel Stocks: A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Select EM Equity Markets Are Facing A Critical Test Select EM Equity Markets Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations