Currencies

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps It's Not My Cross To Bear It's Not My Cross To Bear The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). Chart 2A Bigger Funding Gap Equals##BR##A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread A Bigger Funding Gap Equals A Wider Basis Swap Spread In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad It's Not My Cross To Bear It's Not My Cross To Bear Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Chart 4The Structural Gap In The Basis Swap##BR##Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation The Structural Gap In The Basis Swap Spread Reflects Regulation Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads 1. Global Banks Health Chart 5Banks Perceived Health##BR##Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads Banks Perceived Health Determines Basis Swap Spreads The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. 2. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. 3. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding##BR##= Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads More Expensive Bank Funding = Wider Basis Swap Spreads In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead##BR##To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads More Bank Loans Lead To Wider Swap Spreads Chart 8More Debt Equals Less##BR##Securities In Bank Credit More Debt Equals Less Securities In Bank Credit More Debt Equals Less Securities In Bank Credit 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 Chart 9When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen When U.S. Inflation Increases, Swap Spreads Widen 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 10Smaller Fed Balance Sheet Leads##BR##To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Smaller Fed Balance Sheet Leads To Wider Basis Swap Spreads Chart 11Fed Runoff Could Widen##BR##Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads Fed Runoff Could Widen Basis Swap Spreads 4. U.S. Repatriations Chart 12U.s. Repatriations Support Wider##BR##Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads U.s. Repatriations Support Wider Basis Swap Spreads The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. Chart 13Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol Wider Basis Swap Spreads Equals Higher Vol On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017, available at fes.bcaresearch.com. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017, available at gps.bcaresearch.com. Appendix Implications For The Global Fixed Income Investor Chart A1FX Basis Swaps Boosting##BR##Hedged European Yields FX Basis Swaps Boosting Hedged European Yields FX Basis Swaps Boosting Hedged European Yields The outlook for cross-currency basis swap spreads has important implications for global fixed income investors. Chiefly, a wider (more negative) basis swap spread makes it more profitable for U.S. investors to lend U.S. dollars. For example, the top panel of Chart A1 shows that if a U.S.-based investor swaps dollars for euros on a 3-month horizon, and then invests those euros in 10-year German bunds, they will earn a hedged yield of 2.5% (annualized). This compares to a current yield of 2.3% on the 10-year U.S. Treasury note. If the basis swap spread were zero, then the U.S. investor would face a hedged German 10-year yield of only 2.1%. Conversely, a deeply negative basis swap spread works against non-U.S. investors looking to gain exposure to the U.S. bond market. If a Eurozone-based investor swaps euros for dollars on a 3-month horizon and then invests those dollars in 10-year U.S. Treasuries, he will earn a hedged yield of 0.1% (annualized). This compares to a current yield of 0.4% on 10-year German bunds. If the basis swap spread were zero, then the European investor would face a more enticing hedged U.S. 10-year yield of 0.6%. The middle three panels of Chart A1 show the 10-year yields in other Eurozone bond markets from the perspective of a U.S.-based investor who has hedged his currency risk on a 3-month horizon, as per the strategy explained above. The bottom panel of Chart A1 shows that the deviation of the EUR/USD basis swap spread from zero currently adds 42 basis points to the hedged yields faced by a U.S. investor. Charts A2, A3, A4 and A5 present the same analysis for other major bond markets, again from the perspective of a U.S. based investor.5 Chart A2FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields FX Basis Swaps Boosting Hedged Gilt Yields Chart A3FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields FX Basis Swaps Boosting Hedged JGB Yields Chart A4FX Basis Swaps Boosting##BR##Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields FX Basis Swaps Boosting Hedged Canadian Yields Chart A5FX Basis Swaps Are NOT Boosting##BR##Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields FX Basis Swaps Are NOT Boosting Hedged Australian Yields The Impact Of Hedging Costs On Returns Of course, the basis swap spread is only one input to hedging costs. Once again, using the example of a U.S.-based investor looking for exposure in European bond markets, we calculate the hedging cost as: (1 + Hedging Cost) = (1 + 3-month EUR LIBOR + basis swap spread) / (1 + 3-month USD LIBOR) Right now the hedging cost in the above example is below zero. This is why German bund yields actually appear more attractive to U.S. investors after taking hedging costs into account. But what's more interesting is that total returns in 7-10 year German bunds (hedged into USD) relative to total returns in 7-10 year U.S. Treasury notes track hedging costs very closely over time (Chart A6). Chart A6Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates Hedging Costs Will Continue To Boost Hedged German Bond Returns As The Fed Hikes Rates This is highly logical. As hedging costs become more negative, it means that U.S.-based investors make more money swapping U.S. dollars for euros. Therefore, a strategy of swapping dollars for euros, and then placing the proceeds in 7-10 year German bunds should continue to be a profitable one for U.S. investors as long as hedging costs continue to decline. Fortunately for U.S. investors, hedging costs should become even more negative during the next 12 months. In our base case scenario, we assume that the Federal Reserve will lift rates by 100bps by the end of 2018. We also assume that the ECB will not lift rates during this timeframe. That divergence in policy rates on its own will drive hedging costs further into negative territory, and it will only be exacerbated if the cross-currency basis swap spread widens as we anticipate. We illustrate the impact of the cross-currency basis swap spread on hedging costs in the bottom panel of Chart A6. The panel shows where hedging costs will go between now and the end of 2018, assuming policy rates move as we described above, and that the basis swap spread either widens to -100 bps or tightens back to zero. It is evident that a sharp widening in basis swap spreads would be a boon for U.S. investors in foreign bond markets. Bottom Line: Deeply negative basis swap spreads make it more profitable to lend dollars on a short-term horizon. This presents an opportunity for U.S. investors to swap dollars for foreign currencies and invest in non-U.S. bond markets. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 5 While the basis swap spread between the U.S. and most countries is negative, it is actually positive between the U.S. and Australia. So in this case the basis swap spread makes Australian bonds look less attractive to U.S. investors. Conversely, the basis swap spread makes U.S. bonds look slightly more attractive to Australian investors.

Highlights The three deflationary anchors of the global economy have abated: The U.S. private sector deleveraging is over, the euro area economy is escaping its post crisis hangover, and the destruction of excess capacity in China is advanced. This means that global central banks are in a better position than at any point this cycle to normalize policy, pointing to higher real rates. As a result, gold prices will suffer significant downside. The populist wave in New Zealand is based on inequalities and is here to stay. This will hurt the long-term outlook for the Kiwi. However, short-term NZD has upside, especially against the AUD. The BoE hiked rates, but upside surprises to policy is unlikely now. The pound remains at risk from Brexit negotiations. Feature Chart I-1Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold Is Setting Up For A Big Move Gold is at an interesting juncture. Gold prices, once adjusted for the trend in the U.S. dollar, have been forming a giant tapering wedge since 2011 (Chart I-1). This type of chart formation does not necessarily get resolved by an up-move, nor does it indicate a clear bearish pattern either. Instead, it points toward a potential big move in either direction. For investors, the key to assess whether this wedge will be resolved with a rally or a rout is the trend in global monetary conditions and real rates. In our view, the global economic improvement witnessed in 2017 suggests the world needs less accommodation than at any point since the onset of the great financial crisis. Thus, global accommodation will continue to recede, global real rates will rise and gold will suffer. The Exit Of The Great Deflationary Forces Since the financial crisis, in order to generate any modicum of growth, global monetary authorities have been forced to maintain an incredible degree of monetary accommodation in the global financial system. Central banks' balance sheets have expanded massively, with the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and the Swiss National Bank all increasing their asset holdings by 16% of GDP, 26% of GDP, 70% of GDP, 17% of GDP and 97% of GDP respectively. Real rates too have been left at unfathomable levels, with average real policy rates in the U.S., the euro area, Japan and the U.K. standing at 0.13%, -1.15%, -0.19%, and -2.12%, respectively. Despite all this easing, core inflation in the OECD has only averaged 1.68% since 2010, and real growth 2.05% - well below the averages of 2.3% and 2.44%, respectively, from 2001 to 2007. Explaining this extraordinary situation have been three key anchors that have conspired to create strong deflationary forces that have necessitated all this stimulus: the first was U.S. private sector deleveraging, with at its epicenter the rebuilding of household balance sheets. The second was the euro area crisis, which also caused a forced deleveraging in the Spanish and Irish private sector as well as in the Greek and Portuguese public sectors. The third was China's purging of excess capacity in the steel and coal sectors, as well as various heavy industries. These three deflationary anchors seem to have finally passed. In the U.S., nonfinancial private credit is slowly showing signs of recovering. Households have curtailed their savings rate, suggesting a lower level of risk aversion. Even more importantly, the growth in savings deposits is sharply decelerating, which historically tends to be associated with a re-leveraging of the household sector and increasing consumption (Chart I-2). Strong new home sales point toward these developments. The corporate sector is also displaying an important change in behavior. Share buybacks are declining, and both capex intentions and actual capex are recovering smartly - powered by strong profit growth (Chart I-3). This is crucial as it suggests firms are not recycling the liquidity they generate through their operations or their borrowings in the financial markets. Thus, with banks easing their lending standards, additional debt accumulation by firms is likely to support aggregate demand, eliminating a key deflationary force in the global economy. Chart I-2Household Deleveraging Is Over Household Deleveraging Is Over Household Deleveraging Is Over Chart I-3Companies Are Borrowing To Invest Companies Are Borrowing To Invest Companies Are Borrowing To Invest Moreover, Jay Powell's nomination to helm the Fed is also important. He is a proponent of decreasing bank regulation, especially for small banks that greatly rely on loan formation for their earnings. A softening in regulatory stance on these institutions could contribute to higher credit growth in the U.S. With aggregate liquidity conditions of the private sector - shown by the ratio of liquid assets to liabilities - having already improved, and indicating that a turning point in U.S. inflation will soon be reached, more credit growth could further stoke inflation (Chart I-4). Europe as well is also escaping its own morose state. ECB President Mario Draghi's fateful words in July 2012 resulted in a compression of peripheral spreads as investors priced away the risk of a breakup of the euro area (Chart I-5). As a result, the massive policy easing associated with negative rates and the ECB's expanded asset purchase program was transmitted to the parts of the euro area that really needed that easing: the periphery. Now, Europe is booming: Monetary aggregates have regained traction, real GDP growth is growing at a 2.3% annual pace, PMIs are growing vigorously, and even the unemployment rate has fallen back below 9%. European inflation remains low, but nonetheless the nadir of -0.6% hit in 2015 has also passed (Chart I-6). Chart I-4Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Liquid Private Balance Sheet Point To Inflation Chart I-5Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Draghi Held The Key To Help Europe Chart I-6Europe Past The Worst Europe Past The Worst Europe Past The Worst In China too we have seen important progress. Curtailment to excess capacity in the steel and coal sectors as well as across a wide swath of industries are bearing fruit (Chart I-7). China is not the source of deflation that it was as recently as 2015. Industrial profits have stopped contracting, industrial price deflation is over, and even core consumer prices are showing signs of vigor, growing at a 2.28% pace, the highest since the 2010 to 2011 period (Chart I-8). Thanks to these developments, global export prices have stopped deflating and are now growing at a 4.64% annual pace. With the three deflationary anchors having been slain, global growth is now able to escape its lethargy, with industrial activity at its strongest since 2003, while global capacity utilization has improved (Chart I-9). This is giving global central banks room to remove their easing. The Fed has already hiked rates four times and is embarking on decreasing its balance sheet; the Bank of Canada has followed suit two times, and the BoE, one time. Even the ECB is now beginning to taper its own asset purchases. We do anticipate this trend to continue with more and more central banks, with potentially the exception of the BoJ, joining the fray as the global environment remains clement. Even the People's Bank of China is likely to keep tightening policy due to the increasingly inflationary environment being experienced. Chart I-7Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chinese Excess Capacity Purge Chart I-8China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore China Doesn't Export Deflation Anymore Chart I-9Central Banks Can Normalize Central Banks Can Normalize Central Banks Can Normalize Bottom Line: The three anchors of global deflation have been slain. Private sector deleveraging in the U.S. is over, the euro area has healed and Chinese excess capacity has declined. As a result, global economic activity is at its strongest level in 14 years, and deflationary forces are becoming more muted. This is giving global central banks an opportunity to normalize policy without yet killing the business cycle. Implications For Gold Gold is likely to fare very poorly in this environment. Gold can be thought of as a zero coupon, extremely long-maturity inflation-indexed bond. This means that gold is a function of both inflation and real rates. Currently, gold offers little protection against outright inflation, having moved out of line with prices by a very large margin (Chart I-10). This leaves gold extremely vulnerable to development in real rates and liquidity. Saying that central banks can begin to normalize policy is akin to saying that central banks are in a position where letting real rate rise is feasible. As Chart I-11 illustrates, there has been a strong negative relationship between TIPS yields and gold prices. Moreover, when one looks beyond the price of gold in U.S. dollars, one can see that gold has been negatively affected by higher bond yields (Chart I-11, bottom panel). BCA currently recommends an underweight stance on duration, one that is synonymous with lower gold prices.1 Chart I-10Gold Is Expensive Gold Is Expensive Gold Is Expensive Chart I-11Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Higher Interest Rates Equal Lower Gold Moreover, the Fed's own research suggests that its asset purchases have curtailed the term premium by 85 basis points. The balance sheet run-off that the U.S. central bank is engineering will weaken that impact to a more meager 60 basis points by 2024. This also points to lower gold prices, as gold prices have displayed a negative relationship with the term premium (Chart I-12). An outperformance of financials in general but banks in particular is also associated with poor returns for gold (Chart I-13). Strong financials are associated with growing loan volumes, which mean a lesser need for policy easing, which puts upward pressure on the cost of money. Anastasios Avgeriou, who heads BCA's sectoral research, has an overweight on banks both globally and in the U.S. on the basis of the stronger loan growth we are beginning to see around the world.2 This represents a dangerous environment for gold. Chart I-12Normalizing Term Premium ##br##Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Normalizing Term Premium Is Dangerous For Gold Chart I-13Bullish Banks Equals ##br##Bearish Gold Bullish Banks Equals Bearish Gold Bullish Banks Equals Bearish Gold Finally, there is an interesting relationship between real stock prices and real gold prices. When stocks are in a secular bull market, gold prices are typically in a secular bear market (Chart I-14). A secular bull market in stocks tends to happen in an environment where there is more confidence that growth is becoming more durable, where there is less fear that currencies will have to be debased to support economic activity, or where inflation is not a destructive force like it was in the 1970s. These are environments where real rates tend to have upside. The continued strength in global equity prices, which are again in a secular bull market, would thus contribute to an increase in currently still-depressed global real yields, and thus, create downside in gold. One key risk to our view is that the Fed falls meaningfully behind the curve and lets inflation rise violently, which would put downward pressure on real rates and cause a violent correction in global equity prices - prompting investors to price in an easing in monetary policy. Geopolitics are another key risk, particularly a ratcheting up in North Korea tensions. With our bullish stance on the dollar, we are inclined to short the yellow metal versus the greenback. Moreover, for the past eight years, when net speculative positions in gold have been as elevated as they are today relative to net wagers on the DXY, gold in U.S. dollar terms has tended to weaken (Chart I-15). However, the analysis above suggests that gold could weaken against G10 currencies in aggregate. Thus investors with a more negative dollar view than ours could elect to sell gold against the euro. Agnostic players should short gold equally against the USD and the EUR. Chart I-14Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Gold And Stocks Don't Like Each Other Chart I-15Tactical Risk To Gold Tactical Risk To Gold Tactical Risk To Gold Bottom Line: The outlook for gold is negative. As the global economy escapes its deflationary funk and global central banks begin abandoning emergency easing measures, real interest rates will rise and term premia will normalize, which will put downward pressure on gold prices. Additionally, BCA's positive stance on banks is corollary with a negative outlook on gold. The continued bull market in stocks is an additional hurdle for gold. New Zealand: A New Hot Spot Of Populism The formation of the Labour/NZ First/Green coalition has sent ripples through the kiwi. The reaction of investors is fully rational, as the Adern government is carrying a very populist torch, sporting a program of limiting foreign investments in housing, limiting immigration, increasing the minimum wage and creating a dual mandate for the Reserve Bank of New Zealand. The key question is whether this is a fad, or whether something more profound is at play in New Zealand. We worry it is the latter. New Zealand has suffered from a profound increase in inequality since pro-market reforms were implemented in the 1980s. New Zealand's gini coefficient is very elevated, but even more worrisome has been the deteriorating trend. As Chart I-16 illustrates, the ratio of income of the top 20% of households relative to the bottom 20% has been in a steady uptrend. Additionally, this trend is sharper once the cost of housing is incorporated into the equation. Moreover, as Chart I-17 shows, New Zealand has experienced one of the most pronounced increases in housing costs among the G10. Chart I-16Growing Inequalities In New Zealand Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-17Kiwi Housing Is Expensive Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead It is undeniable that the impact of immigration has been real. Net migration has averaged 24 thousand a year since 2000, on a population of 4.8 million. Moreover, the labor participation rate of immigrants has been higher than that of the general population, reinforcing the perception that immigration has contributed to keeping wage growth low (Chart I-18). The effect of low wage growth - whether caused or not caused by the increase in the foreign-born population - has been to boost household credit demand, pushing the national savings rate into negative territory, something that was required if households were to keep spending. These developments suggest that kiwi populism is not a fad, and is in fact a factor that will remain present in New Zealand politics. It also implies that policies designed to limit foreign investments into housing as well as immigration are indeed popular and will be implemented. What are the economic implications of these developments? Immigration was a key source of growth for New Zealand. As Chart I-19 shows, the growth of the kiwi economy since 1985 has been driven by an increase in the labor force. In fact, over the past five years, 86% of growth has been caused by labor force growth, with a very limited contribution from productivity gains. More concerning, as Chart I-20 shows, 44% of the increase in the population growth since 2012 has been related to immigration. Chart I-18The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs The Narrative: Foreigners Steal Our Jobs Chart I-19Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Kiwi Growth: Labor Force Is Key Chart I-20Labor Force Growth Could Halve Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Additionally, according to the IMF's Article IV consultation for New Zealand, immigration has boosted output significantly, contributing to total hours worked as well as forcing an increase in the capital stock, which has boosted capex (Table I-1). Hence, lower intakes of foreign-born workers is likely to push down the country's potential growth rate. Limiting immigration in New Zealand could therefore have a significantly negative impact on the country’s neutral rate. As Chart 21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential growth rate would push down the equilibrium policy rate in New Zealand, limiting how high the RBNZ's terminal policy rate will rise in the future. This points toward downward pressure on the NZD on a long-term basis. Shorting NZD/CAD structurally makes sense at current levels, especially as Canada remains open to immigration and immune to populism, as income inequalities are much more controlled there (Chart I-22). Table I-1Impact Of Immigration On Growth Reverse Alchemy: How To Transform Gold Into Lead Reverse Alchemy: How To Transform Gold Into Lead Chart I-21Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Kiwi Neutral Rate Has Downside Chart I-22NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy NZD/CAD: Long-Term Heavy Limiting immigration in New Zealand could therefore have a significantly negative impact on the country's neutral rate. As Chart I-21 demonstrates, the real neutral rate for New Zealand, as estimated using a Hodrick-Prescott filter, is around 2%. A falling potential Shorter-term, the picture is slightly brighter for the NZD. Credit growth is strong, and is pointing toward an increase in the cash rate next year. Additionally, consumer confidence is high, and the labor market is showing signs of tightness, especially as the output gap stands at 0.87% of GDP (Chart I-23). This tightness in the labor market could easily be catalyzed into higher wage growth, especially as the new government is tabulating a 4.76% increase in the minimum wage in the coming quarters. Thus, BCA continues to expect an uptick in kiwi inflation and higher kiwi rates, even if a dual mandate for the RBNZ is implemented. Our favored way to play this strength in the kiwi remains going short the AUD/NZD. Our valuation model points to a strong sell signal in this cross (Chart I-24). Moreover, speculators are very long the AUD relative to the NZD, which historically has provided a contrarian signal to short it. Additionally, the concentration of power around Chinese President Xi Jinping points towards more reform implementations in China - reforms that we estimate will be targeted at decreasing the reliance of growth on debt-fueled investment while increasing the welfare of households, which should help Chinese consumption. As a result, metals could suffer relative to consumer goods. With New Zealand being a big exporter of foodstuffs and dairy products, this should represent a positive terms-of-trade shock for the kiwi relative to the Aussie. Chart I-23Short-Term Positives In New Zealand Short-Term Positives In New Zealand Short-Term Positives In New Zealand Chart I-24Downside Risk To AUD/NZD Downside Risk To AUD/NZD Downside Risk To AUD/NZD Bottom Line: The increase in populism in New Zealand is being fueled by a sharp increase in inequalities and rising housing costs. Immigration, rightly or wrongly, has been blamed in the public narrative for these ills. The measures announced by the Adern government target these issues head on, and we expect they will be implemented. This hurts New Zealand's long-term growth profile, and thus the terminal rate hit by the RBNZ this cycle. This could hurt the NZD on a structural basis. Tactically, it still makes sense to be short AUD/NZD. A Word On The BoE The BoE increased rates this week for the first time in a decade, but now acknowledges that current SONIA pricing is correct, removing its mention that risks are skewed toward higher rates than anticipated by the market. The pound sold off sharply on the news. Consumer confidence and retailer orders point to further slowdown in consumption. Thus, we think the British OIS curve is currently well priced, limiting any potential rebound in the GBP. Brexit continues to spook markets, rightfully. The political theater is far from over, and the continued uncertainty is likely to weigh further on the U.K. economy. This is likely to generate additional downside risk in the pound over the coming months. Thus, on balance, our current assessment is that the risks are too high to make a bullish bet on the GBP for now. A progress in the negotiations between the U.K. and the EU is needed before investors can buy the GBP, a currency that is cheap on a long-term basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Please see Global Fixed Income Strategy Weekly Report, titled "Follow The Fed, Ignore The Bank Of England" dated September 19, 2017, available at gfis.bcaresearch.com 2 Please see Global Alpha Sector Strategy Weekly Report, titled "Buy The Breakout" dated May 5, 2017, available at gss.bcaresearch.com and U.S. Equity Strategy Weekly Report, titled "Girding For A Breakout?" dated May 1, 2017, available at uses.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: Core PCE was unchanged at 1.3%, and in line with expectations; Headline PCE was also unchanged at 1.6%; ISM Prices Paid came in at 68.5, beating expectations of 68; ISM Manufacturing came in weaker than expected. In other news, Jerome Powell is President Trump's pick as the next Fed chairman to replace Janet Yellen. Market reaction was muted as Powell is expected to continue in Yellen's footsteps and hike rates at a similar pace. While the Fed decided to leave rates unchanged this month, the probability of a December rate hike went up to 98%. We expect the USD bull market to strengthen next year when inflation re-emerges. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 Data out of Europe was mixed: German and Italian inflation underperformed expectations and weakened compared to last month, while French inflation beat expectations; Overall European headline and core inflation also mixed expectations, coming in at 1.4% and 1.1% respectively; European preliminary GDP, however, beat expectations of 2.4%, coming in at 2.5%; The unemployment rate dropped to 8.9% for the euro area; The euro was up on Thursday after the nomination of Jerome Powell as Fed chair. His nomination represents a continuity of monetary policy. Despite this, we believe the re-emergence of inflation will cause the Fed to continue hiking after the December hike, deepening downward pressure on the euro next year. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has been mixed: Housing starts yearly growth came above expectations, coming in at -2.9%. However, housing starts did accelerate their contraction from August, when they were falling by 2% year-on-year. Industrial Production yearly growth came in above expectations, at 2.5%. However the jobs-to-applicants ratio came below expectations, staying put at 1.52. On Tuesday the BoJ left rates unchanged. Additionally the committee vowed to keep 10-year government bond yield around 0% and to continue their ETF purchases. More importantly, however, was the Bank of Japan's change to its outlook for inflation, which was decreased for this year. We continue to believe that deflation is too entrenched in Japan for the BoJ to change its policy stand. Thus, we expect USD/JPY to keep grinding higher, as U.S. monetary policy becomes more hawkish vis-à-vis Japan. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 surprised to the upside: Mortgage Approvals also outperformed expectations, coming in at 66.232 thousand. Moreover Nationwide house price yearly growth also outperformed, coming at 2.5% Both Markit Manufacturing PMI and Construction PMI outperformed, coming in at 56.3 and 50.8 respectively. The BoE hiked rates yesterday by 25 basis points as expected. Moreover, the committee also voted unanimously to maintain the stock of UK government bond purchases. However, the committee also acknowledged that inflation was not be the only effect of Brexit on the economy. They highlighted that uncertainty about the exit from the European Union was hurting activity despite a positive global growth backdrop. Overall, we think that the BoE will not deviate from the interest rate path priced into the OIS curve. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 Australian data was mixed: HIA New Home Sales contracted by 6.1%; AiG Performance of Manufacturing Index came in at 51.1, less than the previous 54.2; Exports increased by 3%, while imports stayed flat at 0%; The trade balance increased to AUD 1.745 bn, compared to the expected AUD 1.2 bn, and above the previous AUD 873 mn. The AUD was up on the release of the trade balance. But underlying slack in the economy, which worries RBA officials, points to a low fair value for the AUD. The AUD will be the poorest performer out of the commodity currencies, due to the relative strength of those economies and of oil relative to metals. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 unemployment rate came below expectations at 4.6%, it also decreased from last quarter's 4.8% reading. The participation rate came above expectations, at 71.1%. It also increased from 70% on the previous quarter. The Labour cost Index came in line with expectations at 1.9% yearly growth. However it increased from 1.6% in the previous quarter. Overall the New Zealand economy looks very strong. This should warrant a hike by the RBNZ. However the new government create a new set of long-term risks. The elected government is a response to the high inequality and high migration that the country had experienced in the recent years. Overall the plans to reduce immigration and install a double mandate to the RBNZ are bearish for the NZD, as the neutral rate of New Zealand would be structurally lowered. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 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 Canadian data has been weak recently: The raw material price index contracted by 0.1%; Industrial product prices contracted at a 0.3% monthly rate; GDP also contracted at a 0.1% monthly pace; Manufacturing PMI came out at 54.3, lower than the previous 55. In addition to this, Poloz identified several issues with the Canadian economy in his speech on Tuesday. These included the deflationary effects of e-commerce, slack in the labor market, subdued wage growth, and the elevated level of household debt. The probability of a rate hike has fallen to 22% for December, and it only rises above 50% in March next year. The CAD has lost a lot of its value since the BoC began hiking, but we believe it will resume hiking next year. Increasing oil prices will also mean that that CAD will outperform other G10 currencies. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 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 positive: The SVME Purchasing Manager's Index came above expectations at 62 in October. It also increased from the September reading. The KOF leading indicator also outperformed expectations significantly, coming at 109.1. EUR/CHF continues to climb unabated and is now only 3% from where it was before the SNB let the franc appreciate in January of 2015. Overall we see little indication that the SNB would let the franc appreciate again in the near future. On Wednesday, SNB Vice President Zurbruegg continued to talk down the franc by stating that a stronger CHF would cause a growth slowdown and that the CHF is still highly valued. Thus we expect downside in EUR/CHF to be limited for the time being. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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: Retail sales growth underperformed expectations, as they contracted by 0.8% in September. However Norway's credit indicator surprised to the upside, coming in at 5.8%. Since September USD/NOK has appreciated by nearly 6%. This has been in an environment where oil has rallied by nearly 20%. Although this divergence might seem counterintuitive, it confirms our previous findings: USD/NOK is much more sensitive to real rate differentials than to oil prices. Inflationary pressures are still very tepid in Norway, while inflation is set to go higher in the U.S. These factors will further amplify the monetary policy divergences between these 2 countries, and consequently propel USD/NOK higher. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish Manufacturing PMI decreased to 59.3 from 63.7, below the expected 62. EUR/SEK has appreciated to June levels, implying that markets have priced out any potential hawkishness by the Riksbank. Similarly, USD/SEK has risen by 6.2% from September lows. This is due to the re-chairing of Stefan Ingves, known for negative rates and quantitative easing. On the opposite side of the trade, President Trump elected Jerome Powell as the next Fed chair who will most likely continue the rate hike path highlighted by Janet Yellen. This will add further upward pressure on USD/SEK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Closed Trades

Dear Clients, Please note there was an error in the Recommend Asset Allocation table published on November 1, 2017. This has now been amended. We apologize for the confusion and any inconvenience it may have caused. Best Regards, Garry Evans Senior Vice President Global Asset Allocation Reflation Trade Returns Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The market mood has shifted remarkably quickly over the past couple of months. The probability of a December Fed rate hike has moved up from 20% in early September to close to 100%, pushing the 10-year Treasury bond yield from 2.0% to 2.4% and causing the trade-weighted U.S. dollar to appreciate by 2%, and Emerging Market equities to underperform. We expect this trend to continue. Global growth continues to surprise to the upside (Chart 1). The softness in U.S. inflation this year is likely to reverse over coming quarters - an argument supported by the New York Fed's new Underlying Inflation Gauge, which indicates that sustained movements in inflation continue to trend higher (Chart 2). This makes it likely that the Fed will move ahead with its forecast three rate hikes in 2018, which the market has not yet priced in (Chart 3) - the implied probability of this is only 10%. Consequently, rates have further to rise: our fair value for the U.S. 10-year Treasury yield currently is 2.7%. And the increasing gap between U.S. and euro zone interest rates suggests that the dollar can appreciate further (Chart 4). All this supports our view that risk assets (equities and corporate credit) should outperform over the next 12 months, with developed government bonds producing a negative return, and emerging markets lagging because of rising rates and the stronger dollar (and a possible slowdown in China, as it focuses on reforming its economy and cleaning up the debt situation). Chart 1Growth Surprising To The Upside Growth Surprising To The Upside Growth Surprising To The Upside Chart 2Underlying Inflation Still Trending Up Underlying Inflation Still Trending Up Underlying Inflation Still Trending Up Chart 3Market Expects Fed To Move Only Slowly Market Expects Fed To Move Only Slowly Market Expects Fed To Move Only Slowly Chart 4Rate Gap Suggests Dollar Appreciation Rate Gap Suggests Dollar Appreciation Rate Gap Suggests Dollar Appreciation The key question, though, is how long this positive scenario can continue. With stock market valuations expensive (Chart 5) and investors fully invested, though not yet euphoric (Chart 6), we are clearly in late cycle. Rising rates could put a dampener on growth. Chart 5 Equities Close To Extremely Overvalued Equities Close To Extremely Overvalued Equities Close To Extremely Overvalued Chart 6Investors Are Fully Invested, But Cautious Investors Are Fully Invested, But Cautious Investors Are Fully Invested, But Cautious We find the Fed policy cycle a useful tool for thinking about probable investment returns from different assets (Chart 7). The best quadrant for risk assets is when the Fed is easing and policy is easy (with the Fed Funds Rate below the neutral rate). Currently we are in the bottom-right quadrant (Fed tightening, but not yet in the tight zone), which also has produced attractive returns for equities and credit. But once the Fed Funds Rate (FFR) moves above the neutral rate, returns from risk assets are on average poor and, historically, recession often followed quite quickly. How much longer do we have before Fed policy moves into the top-right quadrant? The Fed's own estimate of the neutral rate, in real terms, is 0.3%. The current real FFR (using core PCE inflation, 1.3%, as the deflator) is -0.17 (Chart 8). This implies that it will take only two further Fed hikes to move into the tight zone, which could happen as soon as March. This is why the outlook for inflation is critical. If, as the Fed forecasts and we also expect, core PCE inflation rises to 2%, it will be another five hikes before policy turns tight - we are unlikely to get there until early 2019. Chart 7The Fed Policy Cycle Monthly Portfolio Update Monthly Portfolio Update Chart 8How Far From The Tight Zone? How Far From The Tight Zone? How Far From The Tight Zone? For now, therefore, we continue to recommend an overweight on risk assets and pro-cyclical portfolio tilts. Global monetary policy remains easy and we see no indicators that suggest growth is slowing or that the risk of recession over the next 12 months is rising. The risks to this optimistic scenario (a hawkish Fed, over-eager structural reform in China, provocation from North Korea) seem limited. But we also continue to warn of the possibility of a recession in 2019 or 2020 caused, as so often, by excessive Fed tightening. We see, therefore, the possibility of our turning more defensive somewhere in mid-2018. Equities: We prefer developed over emerging market equities. Rising interest rates and an appreciating dollar will be headwinds for EM. Moreover, Xi Jinping's speech at the Communist Party Congress hinted at supply side structural reforms, overcapacity reduction, and deleveraging efforts. A renewed reform effort could dampen Chinese growth somewhat which, as in 2013-15, would negatively impact EM equities (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which are higher beta, have stronger earnings momentum, and benefit from looser monetary policy. Fixed Income: We expect bonds to underperform over coming quarters, as U.S. inflation picks up and the Fed moves raises rates in line with its "dots". Corporate credit still has some attractions, provided the economic expansion continues. U.S. sub-investment grade bonds, in particular, have an attractive default-adjusted yield, as long as a strong economy keeps the default rate over the next 12 months to the historically low 2% our model suggests (Chart 10). The pick-up in inflation we expect would mean inflation-linked bonds outperform nominal bonds. Chart 9Slowing China Would Hurt EM Equities Slowing China Would Hurt EM Equities Slowing China Would Hurt EM Equities Chart 10Junk Attractive If Defaults Stay This Low Junk Attractive If Defaults Stay This Low Junk Attractive If Defaults Stay This Low Currencies: The ECB delivered a dovish tapering last month, extending its asset purchases until at least September 2018 and emphasizing that its current low interest rates will continue "well past the horizon of our net asset purchases". Given this, and the gap between U.S. and euro zone interest rates (Chart 4), we expect moderate further euro weakness over coming months. The dollar is likely to appreciate even more against the yen. There are the first tentative signs of inflation emerging in Japan (Chart 11) which, combined with the Bank of Japan sticking to its 0% 10-year JGB target and rising global interest rates, could push the yen to 120 against the dollar over coming months. Commodities: BCA's energy strategists recently revised up their crude oil forecasts on the back of strong demand, a likely extension of the OPEC agreement until at least end-2018, and possible supply disruptions in Iraq, Venezuela and other troubled regions.1 They see inventories continuing to draw down until at least 2H 2018 (Chart 12). Accordingly, they forecast $65 a barrel for Brent and $63 for WTI and flag upside risk to those projections. The outlook for industrial and precious metals, however, is less positive. A stronger dollar and a shift in the growth drivers in China will depress prices for base metals. Rising real interest rates will hurt gold, although we still like precious metals as a long-term hedge. Chart 11First Signs Of Inflation In Japan? First Signs Of Inflation In Japan? First Signs Of Inflation In Japan? Chart 12Oil Inventory Drawdowns Support Higher Price Oil Inventory Drawdowns Support Higher Price Oil Inventory Drawdowns Support Higher Price Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "Oil Forecast Lifted As Market Tightens," dated 19 October 2017, available at ces.bcaresearch.com GAA Asset Allocation

Feature This week we are sending you a shorter-than-usual market update, as we are also publishing a Special Report exploring the outlook for USD cross-currency basis swap spreads. This report argues that USD basis swap spreads should widen over the next 12 months. Being a phenomenon associated with higher FX vols, this should hurt carry trades, including EM and dollar bloc currencies. It will also potentially create additional support for the USD. Also, next week, we will provide a deeper analysis of the fallout from the New Zealand government's dynamics. ECB Tapers? European Central Bank President Mario Draghi refused to call it "tapering," but he nonetheless announced that the ECB will be cutting back its asset purchases to EUR30 billion per month until at least September 2018. However, because the ECB will continue to proceed with re-investment of the stock of assets it holds, the monthly total presence of the ECB in European bond markets will stay above EUR 30 billion. Moreover, the ECB is keeping the door open to leaving its purchases in place beyond September 2019, if inflation does not keep track with the central bank's forecasts, and thus referred to the adjustment as being open-ended. Ultimately, the ECB does think that the recent rebound in inflation has been and remains a function of maintaining a very accommodative monetary setting. We think this option to keep the asset purchases in place beyond September 2018 is just this: an option. However, we do believe that yesterday's change in policy means the ECB will not increase interest rates until well into 2019. We also anticipate U.S. core inflation to begin outperforming euro area core inflation as U.S. financial conditions have eased significantly relative to the euro area - a key factor to redistribute inflationary pressures among these two economies (Chart I-1). As a result, because we anticipate that the Federal Reserve will increase the fed funds rate by more than the 67 basis points currently expected over the next two years, there could be some downside risk in EUR/USD. This downside risk is already highlighted by the large gap that has recently emerged between the 1-year/1-year forward risk-free rate spread between Europe and the U.S. versus the euro itself (Chart I-2). Chart I-1U.S. Inflation Set To Outperform Euro Area Prices U.S. Inflation Set To Outperform Euro Area Prices U.S. Inflation Set To Outperform Euro Area Prices Chart I-2Forward Interest Rates Point To A Lower Euro Forward Interest Rates Point To A Lower Euro Forward Interest Rates Point To A Lower Euro Moreover, the elevated long positioning right now further highlights the downside risk present in the euro (Chart I-3), probably explaining the European currency's rather violent reaction to what was a well-anticipated policy move. This means that EUR/USD could end 2017 in the 1.15 neighborhood, and fall further in 2018. Chart I-3Positioning Risk In EUR/USD Positioning Risk In EUR/USD Positioning Risk In EUR/USD Bottom Line: The ECB delivered exactly what was anticipated, yet the euro sold off. The ECB is unlikely to increase interest rates until well into 2019, suggesting the first anticipated rate hike in Europe is fairly priced. Thus, in order to justify any downside in the euro, one needs to be more positive on the Fed than what is currently priced into the U.S. interest rate curve. We fall into this camp. Moreover, positioning remains too long the euro. We expect EUR/USD to fall toward 1.15 by year end, and display more downside in 2018. Bank Of Canada The Bank of Canada (BoC) surprised the market this week by expressing a reversing of its recent pronounced hawkish bias, instead expressing a much more cautious tone. Where a closed output gap was once driving the need for tighter policy, residual labor market slack now warrants a more restrained approach to tightening. What has changed? NAFTA. The most recent and tenuous NAFTA negotiation round raised the specter of an end to the North American FTA. While NAFTA is still not dead, the rising probability that Canada-U.S. trade falls backs under the umbrella of the previous CUSFTA or even maybe something worse is causing a headache for Canadian policymakers. Some 20% of Canadian GDP is made up of products destined to be exported to the U.S., and this large chunk of GDP could be under some risk. Additionally, as the BoC highlighted, future investment decisions by firms in Canada may become investments in the U.S. to bypass regulatory uncertainty. Ultimately, if the Canada / U.S. trade relationship falls back under the CUSFTA umbrella, the impact on Canadian growth will be limited. Nonetheless, we think the BoC is correct to play its hand carefully, especially as the Canadian housing market is cooling. Moreover, a recent IPSOS survey revealed that around 40% of Canadian households would face financial difficulties if rates moved up significantly, which may justify a slower pace of hiking. With all this uncertainty looming, it is logical for the BoC to take its time before tightening policy anew. But in the end, we do anticipate the Canadian central bank to increase rates around two times next year, which is in line with the market's assessment: Canada's output gap is closing, and inflation is moving in the right direction. Thus, the outlook for the CAD is likely to be dominated by the outlook for oil. Robert Ryan, who runs BCA's Commodity And Energy Strategy service, expects WTI to move toward US$63/bbl next year, with upside risk to his forecast.1 This could help the CAD. However, the CAD does not seem particularly cheap against the USD when Canada's poor productivity performance is taken into account (Chart I-4), and speculators are now quite long the CAD (Chart I-5). As a result, our preferred medium to express positive views on the CAD is to be short AUD/CAD, where a valuation advantage is still present for the loonie (Chart I-6). Moreover, the AUD is more likely to suffer from China moving away from its investment-led growth model, while the CAD is less exposed to this risk. Chart I-4The CAD Is Not That Cheap The CAD Is Not That Cheap The CAD Is Not That Cheap Chart I-5Speculators Are Very Long The CAD Speculators Are Very Long The CAD Speculators Are Very Long The CAD Chart I-6Short AUD/CAD Short AUD/CAD Short AUD/CAD Bottom Line: The BoC is rightfully concerned that a breakdown of NAFTA would negatively affect the Canadian economy. While a return to CUSFTA would minimize any impact, the current high degree of uncertainty warrants that the BoC takes a more cautious stance. Ultimately, the BoC will increase rates next year, potentially two times. We continue to prefer to short AUD/CAD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, titled "Upside Risks Dominate BCA's Oil Price Forecast", dated October 26, 2017, available at ces.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 has been strong: Manufacturing PMI came out at 54.5, stronger than expected; Services PMI came out at 55.9, also stronger than expected; Durable goods orders increased by 2.2%; New home sales increased by 18.9% monthly, the highest growth rate in 25 years; Initial jobless claims declined and beat expectations. Crucially, the DXY is above its 100-day moving average and has broken the reverse head-and-shoulders neckline, with momentum in the greenback's favor. The ECB's tapering weakened the euro by 1.4%. Further weakness in commodity currencies also allowed the dollar to gain momentum. We expect this momentum to continue as inflation in the U.S. re-emerges over the next six to twelve months. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 The ECB's decision was largely in line with market consensus, but the euro nonetheless fell significantly. The ECB will halve its rate of purchases to EUR 30 bn a month starting next year until at least September 2018. However, President Mario Draghi stated that this could be extended beyond September, or even increased, if conditions warrant it. Draghi noted that "domestic price pressures are still muted overall and the economic outlook and the path of inflation remain conditional on continued support from monetary policy", also stating that rates would remain low for an extended period of time, and possibly even "past the horizon of the net asset purchases". Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The Leading Economic Index increased from 105.2 to 107.2 in the month of August. Nikkei Manufacturing PMI surprised to the downside, coming in at 52.5, declining from 52.9 the month before. However, corporate service prices year-on-year growth came in at 0.9%, against expectations of 0.8%. Following the overwhelming victory of Prime Minister Shinzo Abe, the USD/JPY traded above 114, before stabilizing just below later in the week. Now that Abe has won the election, he is freer to implement loose fiscal policy in order to increase his chances to amend the pacifist Japanese constitution. This, accompanied by 10-year JGB rates anchored around zero, and a Federal Reserve that is likely to hike more than expected, should push USD/JPY higher. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 Britain has been mixed: Gross Domestic product yearly and quarterly growth surprised to the upside, coming in at 1.5% and 0.4% respectively. Moreover, public sector net borrowing was also lower than expected coming in at 5.236 billion pounds for the month of September. However, BBA mortgage approvals came below expectations, coming in at 41.584 thousand, which is lower than the month before. The pound has gone up following the positive GDP reading. As of now the market considers there is a 91% probability that the Bank of England hikes rates in November. However any hikes beyond that would require a significant improvement in economic activity. Thus, we would tend to fade any strength in GBP/USD, as the Fed is more likely to hike rates than the BoE on a sustainable basis. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 The AUD declined on weak consumer price numbers. The trimmed mean CPI remained steady at 1.8% annually, below the expected 2% rate, and weakened to 0.4% quarterly, down from 0.5%. The largest yearly decline was in communication (services or equipment) of 1.4%, although declines in food prices and clothing were also substantial at 0.9%. This is largely in line with our view that the consumer sector is handicapped with poor wage growth. We believe inflation is unlikely to move much higher; this will keep the RBA at bay. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 negative: Imports surprised to the upside, coming in at 4.92 billion dollars. This figure also increased form last month's reading. However exports underperformed expectations, coming in at 3.78 billion dollars for the month of September. Finally the trade balance, also underperformed expectations, coming in at -1.143 billion dollars. After the election of new Prime Minister Jacinda Ardern the kiwi has plunged, and now has a negative return year-to-date. The government is trying to implement three measures which significantly affect the value of the kiwi: a dual central bank mandate, restrictions on immigration, and a stop to foreign real estate purchases. All these measures lower the terminal rate for the RBNZ. With this being said, we are still shorting AUD/NZD given that commodity dynamics will dominate the movements of this cross. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 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 CAD had an eventful week as the Bank of Canada came out with a monetary policy decision. The decision was in line with the consensus, but the statement was not. The Bank was particularly concerned "about political developments and fiscal and trade policies, notably the renegotiation of the North American Free Trade Agreement". Additionally, it was also noted that "because of high debt levels, household spending is likely more sensitive to interest rates than in the past". The Bank also made a U-turn in its view of the labor market, stating that "wage and other data indicate that there is still slack in the labor market". These unexpected remarks dropped the CAD's value by 1% against USD. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 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 The Franc continues to depreciate against the Euro, even as EUR/USD has gone down more than 2.5% since peaking early in December. Meanwhile, as the franc has depreciated, economic variables have improved. The KOF Industry Survey Business Climate indicator is now positive for the first time since 2011. Meanwhile, core inflation has reached 2011 highs as well. Additionally multiple components of PMI are at their highest level in the past 6 years. All of these factors bode well for the Swiss economy, and prove that the SNB's ultra-loose monetary policy and currency intervention is working. That being said, we would like to see more strength from key economic variables to consider shorting EUR/CHF, given that the recovery is still too fragile for the SNB to change policy. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 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 The Norges Bank left their key policy rate unchanged at 0.5% yesterday. The central bank highlighted that capacity utilization was below normal levels and that inflation was expected to be below 2.5% in the coming years. Furthermore, the comittee highlighted that although the labor market appears to be improving, inflation has been lower than expected, while the krone is also weaker than projected. The bank has reassured our view that even in the face of strong oil prices, slack is still too big in the Norwegian economy for the Norges Bank to start raising rates. Furthermore, a hawkish fed will further put upward pressure on USD/NOK. Than being said, EUR/NOK should depreciate, given that this cross is much more sensitive to oil than it is to rate differentials. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 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 SEK has depreciated considerably in recent weeks owing to somewhat weaker inflation figures. It has weakened particularly against the EUR, as markets are expecting the Riksbank to follow the ECB in its rate path. This was confirmed by a particularly dovish tone from the recent monetary policy statement which exacerbated this decline, with the board expecting to maintain the current monetary policy until mid-2018, and even discussed a possible extension of asset purchase programs beyond December. The Board has "also taken a decision to extend the mandate that facilitates a quick intervention in the foreign exchange market". Finally, they lowered their inflation forecasts for both 2017 and 2018. Stefan Ingves is firmly in control. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. Feature Three factors point to stable or narrower USD cross-currency basis swap spreads: the improving health of global banks, the end of the adjustment to the regulatory change affecting prime-money market funds, and the relaxation to the Supplementary Leverage Ratio rules by the U.S. Treasury. Four factors point to wider basis swap spreads: BCA's forecast that U.S. loan growth will pick up, our view on U.S. inflation, the coming decline in the Federal Reserve's balance sheet, and the potential for U.S. repatriation. We expect USD basis swap spreads to widen again, which suggests increasing FX vol. This would hurt carry trades, EM currencies and dollar bloc currencies. The rather arcane topic of cross-currency basis swap spreads has periodically surfaced in the news in the past few years. The widening in cross-currency basis swap spreads has been highlighted as one of the key factors explaining why covered interest rate parity relationships (the link between the price of FX forward, spot prices and interest rate differentials) have not held as closely after the Great Financial Crisis (GFC) as before. The widening of cross-currency basis swap spreads has also been highlighted as a factor behind the strength in the U.S. dollar in 2014 and 2015. Similarly, the recent narrowing in the cross-currency basis swap spread has been highlighted as a factor behind the weakness in the USD this year. This week we delve a little deeper into what cross-currency basis swap spread measures, and what some of its major determinants are. We ultimately expect the USD cross-currency basis swap spread to widen again, which should contribute to a stronger dollar and increased global FX volatility. What Is A Cross-Currency Basis Swap? To examine what drives cross-currency basis swap spreads, one first needs to understand what these instruments are. Let's begin with a regular FX swap. An FX swap in EUR/USD is a contract through which two counterparties agree to exchange EURs for USDs today, with a reversal of that exchange at the maturity of the contract - a reversal set at a predetermined exchange rate simply equal to the forward value of the EUR/USD. So, if counterparty A lends X million EURs to counterparty B, the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. The transaction does not end there. Simultaneously, the FX swap forces B to give back the X million EURs to counterparty A at maturity, while counterparty A gives back X million EUR times the EUR/USD forward rate in U.S. dollars to counterparty B. This forward rate is the rate prevalent when the contract was agreed upon. The transactions are illustrated in the top panel of Chart 1. Chart 1FX Swaps Vs. Cross Currency Basis Swaps It's Not My Cross To Bear It's Not My Cross To Bear The problem with regular FX swaps is that they offer little liquidity at extended maturities. If market players want to hedge long-term liabilities and assets, they tend to do so using a cross-currency basis swap, where much more liquidity is available at long maturities. Chart 2A Bigger Funding Gap = ##br##A Wider Basis Swap Spread It's Not My Cross To Bear It's Not My Cross To Bear A EUR/USD cross currency basis swap begins in the same way as a regular FX swap: counterparty A lends X million EURs to counterparty B, and the former receives in U.S. dollars the equivalent of X million EURs times the prevalent EUR/USD spot rate from counterparty B today. However, this is where the similarities end. A cross-currency basis swap has exchanges of cash flows through its term. Counterparty B, which provided USDs to counterparty A, receives 3-month USD Libor, while counterparty A, which provided EURs to counterparty B, received 3-month EUR Libor + a (alpha being the cross-currency basis swap spread). At the maturity of the contract, counterparty A and B both receive their regular intermediary cash flows, and also re-exchange their respective principal - but this time at the same spot rate as the one that existed at the entry of the contract (Chart 1, bottom panel). In both regular FX and cross-currency basis swaps, counterparties have removed their FX risks, except that in the latter, the interest differentials have been paid during the life of the contract instead of being factored through the forward premium/discount. This is fine and dandy, but it leaves a unexplained. The cross currency basis swap spread (a), is a direct function of the relative supply and demand for each currency. If investors demand a lot of EUR in the swap market relative to its supply, a will be positive. If they demand more USDs, a will be negative. A good example of this dynamic is the funding gap of banks. Let's take the Japanese example. Japanese banks have a surplus of domestic deposits (thanks to the massive savings of the Japanese corporate sector) relative to their yen lending. As a result, they have large dollar lending operations. To hedge their dollar assets, Japanese banks borrow USD in large quantities in the cross-currency swap market. This tends to result in a negative swap spread in the yen (Chart 2). This is particularly true if both the banking sector and the other actors in the economy (institutional investors and non-financial firms) also borrow dollars in the swap market to hedge dollar assets, which is the case in Japan (Chart 3). Chart 3Japanese Investors Are Accumulating Assets Abroad It's Not My Cross To Bear It's Not My Cross To Bear Additionally, if there are perceived solvency risks in the European banking sector, this should further weigh on the cross-currency basis swap spread, pushing it deeper into negative territory, as the viability of the main EUR counterparties becomes at risk. The same dance is true for any currency pair. Chart 4The Structural Gap In The Basis Swap Spread##br## Reflects Regulation It's Not My Cross To Bear It's Not My Cross To Bear The other factor that affects USD cross-currency basis swap spreads is the supply of U.S. dollars, especially the room on large banks' balance sheets to service these markets. The cross-currency basis swap spread could be close to zero if large arbitrageurs take offsetting positions to arbitrage the spread away, doing so until the spread disappears. However, with the imposition of Basel III and Dodd-Franks, banks have been constrained in their capacity to do this. Indeed, increased leverage ratio requirements (now banks need to post more capital behind repo transactions as well as collateralized lending and other derivatives) mean that arbitraging cross-currency basis swap spreads and deviations from covered interest rate parity has become much more expensive. Furthermore, the increase in Tier 1 capital ratios associated with these regulations has forced banks to de-lever; however, engaging in arbitrage activities still requires plenty of leverage (Chart 4). Economic Factors Driving The Spread The factors that we look at essentially relate to the supply of USD available for lending in offshore markets, as well as determinants of relative counterparty risks between the U.S. and the rest of the world. Factors Arguing For Narrower Cross-Currency Basis Swap Spreads Global Banks Health The price-to-book ratio of global banks outside the U.S. has been largely correlated with USD cross-currency swap spreads. When global banks get de-rated, spreads widen, and it becomes more expensive to hedge USD positions in the swap market (Chart 5). This is because as investors perceive the solvency of global banks deteriorating, they impose a penalty as the Herstatt risk increases. Additionally, solvency problems can force banks to scramble to access USD funding, prompting deeper spreads. Chart 5Banks Perceived Health Determines ##br##Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear BCA is positive on global financials and sees continued improvement in European NPLs. This means that solvency risk concerns are likely to remain on the backburner for now, pointing to narrower basis swap spreads. Supplementary Leverage Ratio Changes In June, the U.S. Treasury announced a relaxation of some of its rules on supplementary leverage ratios, lowering the amount of capital required to support activity in the repo market behind initial margins for centrally cleared derivatives, and behind holdings of Treasurys. This means that commercial banks in the U.S. can have bigger balance sheets and more room to engage in arbitrage activity, implying a greater supply of dollars in the USD cross-currency basis swap market. In response to last June's proposal, basis swap spreads narrowed by 11 basis points. BCA believes these changes will continue to support dollar liquidity, and will further help in narrowing cross-currency basis swap spreads. Prime Money-Market Funds Debacle Is Over Chart 6More Expensive Bank Funding Equals ##br##Wider Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear In October 2016, regulatory changes were implemented that allowed prime money market funds to have fluctuating net asset values. Obviously, this meant that prime money-market funds would be not-so-prime anymore. As a result, to remain the ultra-safe vehicles that they once were, prime money-market funds de-risked. As a result, they cut their exposure to risky activities in anticipation of these changes. In practice, a key source of short-term funding for banks evaporated from the market, putting upward pressure on bank financing costs. As the LIBOR-OIS spread increased, so did basis-swap spreads (Chart 6): as it became more expensive for banks to finance themselves, they had to curtail the supply of USDs provided to the swap market, an activity normally requiring intense demand on banks' balance sheets. This adjustment is now over, suggesting limited potential widening in USD basis swap spreads. Factors Arguing For Wider Cross-Currency Basis Swap Spreads 1. U.S. Loan Growth When U.S. banks increase their loan formation activity, USD cross-currency basis swap spreads widen (Chart 7). As banks increase their extension of credit through loans, they decrease the amount of securities they hold on their balance sheets (Chart 8). This means there is less supply of liquidity available for balance sheet activities, particularly providing dollar funding in the offshore market. In the Basel III / Dodd-Frank world, less-liquid bank balance sheets are synonymous with wider USD basis-swap spreads. As we argued last week, increasing U.S. capex, easing lending standards for firms and rising household income levels should result in increasing loan growth in the U.S. which will result in lower abundance of liquid assets and a widening basis swap spreads.1 Chart 7More Bank Loans Lead To Wider Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear Chart 8More Debt Equals Less Securities In Bank Credit It's Not My Cross To Bear It's Not My Cross To Bear 2. U.S. Inflation There is a fairly close relationship between U.S. inflation and the USD basis swap spread, where a higher core CPI tends to lead to a wider spread (Chart 9). The fall in U.S. inflation this year likely contributed to the narrowing in basis swap spreads. Our take on this is that as inflation falls, it gives an incentive for banks to hold low-yielding liquidity on their balance sheets as real returns on cash improve. This fuels a gigantic carry trade through the basis-swap market. We expect inflation to pick up meaningfully by mid-2018, which should widen cross-currency basis swap spreads.2 3. Central Bank Balance Sheets When the Federal Reserve increases the size of its balance sheet relative to other balance sheets, this tends to lead to a narrowing of the USD basis swap spread as the global supply of dollars relative to other currencies increases. The opposite is also true. This relationship did not work after late 2016 (Chart 10). However, during that episode, as the change in prime money-market funds caused a dislocation in banks' funding, commercial banks exhibited cautious behavior and increased their reserves with the Fed. As Chart 11 illustrates, there is a tight relationship between the change in commercial banks' reserves held at the Fed and cross-currency basis swap spreads. Going forward, as the Fed lets it balance sheet run off, we expect to see a decrease in commercial banks' excess reserves. This could contribute to upward movement in the basis swap spread. Chart 9When U.S. Inflation Increases, ##br##Swap Spreads Widen It's Not My Cross To Bear It's Not My Cross To Bear Chart 10Smaller Fed Balance Sheet Leads To##br## Wider Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear Chart 11Fed Runoff Could##br## Widen Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear 4. U.S. Repatriations The most revealing relationship unearthed in our study was that when U.S. entities repatriate funds at home, this tends to put strong widening pressure on the USD cross-currency basis swap spread (Chart 12). U.S. businesses hold large cash piles abroad - by some estimates more than US$2.5 trillion. However, most of these funds are held in highly liquid, high-quality U.S.-dollar assets offshore. These assets are perfect collaterals for various transactions in the interbank market. The funds held abroad by U.S. firms are a source of supply for U.S. dollars in the offshore markets. When U.S. entities bring assets back home, the widening in the basis swap spread essentially reflects a decline in the supply of USD in offshore markets, and vice versa when Americans export capital abroad. Chart 12U.s. Repatriations Support Wider Basis Swap Spreads It's Not My Cross To Bear It's Not My Cross To Bear BCA's base case is that tax cuts are likely to hit the U.S. economy in 2018, even if the growing feud between Trump and the establishment Republican party members is a growing risk. BCA still views a tax repatriation as a higher-likelihood event, as it is the easiest way for the U.S. government to bring funds into its coffers. The 2004 tax repatriation under former President George W. Bush did result in substantial fund repatriation in the U.S. This time will not be different. We expect any such tax repatriation to cause a potentially large deficit of supply in the USD offshore markets, which could create a strong widening basis on the cross-currency basis swap spread in favor of the dollar. Bottom Line: Three factors argue for USD cross-currency basis swap spreads to stay at current levels, or even narrow further. These factors are the health of global banks, the easing in U.S. supplementary leverage ratios and the end of the adjustment of U.S. bank funding to new regulations affecting prime money-market funds. On the other hand four factors points to wider USD cross-currency basis swap spreads: BCA's positive outlook for U.S. credit growth; BCA's positive outlook on U.S. inflation; the run-off of the Fed's balance sheet; and the potential for U.S. entities repatriating funds from abroad. Potential Direction And Investment Implications We anticipate USD cross-currency basis swap spreads to widen over the coming 12 months. We think the easing in the Supplementary Leverage Ratios rules by the U.S. Treasury is the most important factor pointing to narrower USD cross-currency basis swap spreads. However, Basel III rules and most of Dodd-Frank are still in place, which suggest there remains large constraints on the balance-sheet activities of global banks, which will limit the potential for a narrowing of the USD basis swap spread as U.S. banks will remain constrained in their ability to supply U.S. dollars in the offshore market. On the other hand many factors support wider USD cross-currency basis swap spreads, most important of which is the potential for more credit growth. This is in our view a very strong force as it requires banks to ration the use of their balance sheets, limiting their activity in the offshore market. Moreover, we do foresee a high probability of tax repatriation, which would put strong widening pressure on the swap spreads. In terms of implications, wider USD basis swap spreads tend to be associated with rising FX vols (Chart 13). As we highlighted in a Special Report last year, higher FX vols are poison for carry trades.3 As such, we think that widening swap spreads could spur a period of trouble for traditional carry currencies. This means EM and dollar-block currencies are likely to suffer in this environment. Chart 13Wider Basis Swap Spreads Equals Higher Vol It's Not My Cross To Bear It's Not My Cross To Bear Additionally, in China, Xi Jinping is consolidating power and has taken control of the Politburo. This implies he now has more room to implement reforms. Removal of growth targets after 2020, removal of growth as a criterion for grading local officials, a focus on balanced growth, and a focus on combatting pollution all suggest that Chinese growth is unlikely to follow the same debt-fueled, capex-led model.4 This will weigh on Chinese imports of raw materials, and hurt export volumes and prices for many EM countries and commodities producers. This means these policies represent a headwind for many carry currencies. Moreover, historically, wider USD funding costs have been associated with a stronger dollar, as it makes it more expensive to hedge dollar assets. Thus, in an environment where U.S. interest rates are rising relative to the rest of the world - making U.S. assets attractive - wider basis swap spreads are an additional factor that could lift the dollar. Bottom Line: We anticipate the USD cross-currency basis swap spread to widen over the next 12 months. This will be associated with higher FX vols, which hurt carry trades, EM currencies and dollar-block currencies. Chinese reforms will reinforce these risks. Additionally, wider basis swap spreads will create support for the USD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "All About Credit", dated October 20, 2017, available at fes.bcaresearch.com. 2 Please see Foreign Exchange Strategy Weekly Report, titled "Conflicting Forces For The Dollar", dated September 8, 2017, and "Is The Dollar Expensive?", dated October 13, 2017. 3 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016. 4 Please see Geopolitical Strategy Weekly Report, titled "Xi Jinping: Chairman Of Everything", dated October 25, 2017 and Special Report, titled "How To Read Xi Jinping's Party Congress Speech", dated October 18, 2017.

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Valuation Today Is Very Stretched Vs. 1987 Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Upbeat Global Economic Indicators Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector Global Earnings By Sector Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP bca.bca_mp_2017_11_01_s1_c4 bca.bca_mp_2017_11_01_s1_c4 A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Broad-Based Growth Lower Implied Volatility Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked November 2017 November 2017 The Equity Risk Premium Chart I-7Still Some Value In High-Yield Still Some Value In High-Yield Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Measures Of Labor Market Slack (I) Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) Measures Of Labor Market Slack (II) Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Phillips Curve Still (Weakly) Operating Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag November 2017 November 2017 It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Room For U.S./Eurozone Spreads To Widen... Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift ...Giving The Dollar A Lift ...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Housing Affordability Outlook Housing Affordability Under Various Rate Assumptions Housing Affordability Outlook Housing Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators China: Healthy Growth Indicators China: Healthy Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Our Aging World Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Savings Over The Life Cycle Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult November 2017 November 2017 Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The Ratio Of Workers To Consumers Has Peaked The Ratio Of Workers To Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders November 2017 November 2017 Chart II-6Immigration Versus Income Distribution Immigration Versus Income Distribution Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe November 2017 November 2017 Chart II-8Immigration Is Straining Generous ##br##European Welfare States November 2017 November 2017 All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind November 2017 November 2017 Chart II-10Worries About Immigrant Assimilation November 2017 November 2017 Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population The Projected Expansion In Sub-Saharan Population The Projected Expansion In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart November 2017 November 2017 Chart II-13The Erosion Of Trust In Media November 2017 November 2017 It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? November 2017 November 2017 Chart II-15People Versus Companies November 2017 November 2017 The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? November 2017 November 2017 Table II-2Crime Rates Are Creeping Higher In Europe November 2017 November 2017 Chart II-17Homicides And Inflation Homicides And Inflation Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy November 2017 November 2017 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It 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 also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. 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 ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And 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 Chinese growth will slow next year, but underlying momentum remains strong. Jerome Powell is the most likely choice for Fed chair. However, no matter who is selected, the general thrust of monetary policy will not change radically next year. The transatlantic interest rate spread is not particularly wide considering that the output gap is larger in the euro area, while the neutral rate and expected inflation are lower. U.S. growth should surprise on the upside over the next few quarters, as already evidenced by the rebound in the economic surprise index. This will give the Fed greater scope to raise rates. We expect EUR/USD to reach $1.15 by the end of the year. Feature China: Let's Get This Party Congress Started China's 19th National Congress of the Communist Party of China kicked off this week. As widely expected, President Xi Jinping lauded the successes that China has enjoyed over the past few years in his opening speech, but cautioned that more must be done to reduce corruption, clean up the environment, and expedite market reforms.1 We expect Chinese growth to slow modestly in 2018 from the current above-trend pace, as the government pares back stimulus efforts. Nevertheless, the underlying trend in growth will remain reasonably solid. Chart 1 shows that real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at a healthy pace. Despite the introduction of some tightening measures this spring, the housing market remains resilient. The share of households planning to buy a new home is close to record high levels, while the amount of land purchased by developers - a good leading indicator for housing starts - has continued to accelerate (Chart 2). Chinese property developer stocks have been on a tear this year, outperforming even the red-hot tech sector. With housing inventory levels at multi-year lows, home prices should stay firm. In the industrial sector, rampant producer price deflation last year has given way to modest inflation this year. This has boosted industrial profits, which should support corporate spending in the months ahead (Chart 3). Chart 1Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Chart 2Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chart 3Boost In Industrial Profits Bodes Well For Corporate Spending Boost In Industrial Profits Bodes Well For Corporate Spending Boost In Industrial Profits Bodes Well For Corporate Spending Both money and credit growth surprised on the upside in September. As we have argued before, copious private-sector savings will forestall a credit crunch and, at least for the foreseeable future, permit the government to run large off-balance sheet budget deficits in an effort to support aggregate demand (Chart 4). Indeed, for all the talk about slowing credit growth, medium- and long-term bank lending to nonfinancial corporations - probably the best single measure of credit flows to the real economy - has continued to accelerate this year (Chart 5). Investors should continue to overweight Chinese stocks relative to the EM aggregate. Chart 4China's Fiscal Deficit Has Been Increasing China, The Fed, And The Transatlantic Interest Rate Spread China, The Fed, And The Transatlantic Interest Rate Spread Chart 5Credit To Real Economy Accelerating Credit To Real Economy Accelerating Credit To Real Economy Accelerating Musical (Fed) Chairs News reports indicate that President Trump has winnowed down the list of candidates for Fed chair to five individuals: Chief economic advisor Gary Cohn, current Fed Governor Jerome Powell, former governor Kevin Warsh, Stanford university economist John Taylor, and current chair Janet Yellen. We suspect that Cohn will not make the cut, given his apparent falling out with Trump following the President's remarks about the Charlottesville protests. Warsh and Taylor are likely to be seen as too hawkish. That just leaves Powell and Yellen. Chair Yellen's relatively dovish views on monetary policy would likely sit well with Trump, but she has two major strikes against her. One, she has generally been in favor of more financial sector regulation, which is anathema to Trump. Two, Trump accused her of abetting Hillary Clinton during the election campaign. Keeping her as Fed Chair (assuming she would actually want the job) might convey the message that he is no longer interested in shaking up the existing institutional order in Washington DC. This just leaves Powell as the default candidate, who reportedly has received the blessing of Treasury Secretary Steven Mnuchin. The prevailing wisdom is that Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. Such a potentially malleable mind may be exactly what Trump is seeking! Still, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. Thoughts On The Transatlantic Yield Spread I have been visiting clients in Europe this week and questions about the relative stance of monetary policy between the U.S. and the euro area have come up in almost every meeting. The gap between U.S. and euro area rate expectations has narrowed since the start of the year, helping to push the euro higher. Nevertheless, most interest rate spreads remain elevated by historic standards. This has led many commentators to speculate that they will continue to shrink, putting further upward pressure on EUR/USD. For example, the U.S. 5-year Overnight Index Swap rate currently stands at 1.82%. This compares to only 0.02% in the euro area. The current level of spreads can be partly explained by the fact that labor market slack is still substantially higher in the euro area than in the U.S. Outside of Germany, labor underutilization is still 6.3 percentage points higher across the euro area than in 2008 (Chart 6). In contrast, our work suggests that the U.S. labor market has returned to full employment.2 Chart 6Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany Euro Area: Labor Market Slack Still High Outside Of Germany This is not to say that transatlantic interest rate spreads won't narrow over the coming years. They will. But what matters for investors is how spreads evolve relative to market expectations. The market is already pricing in roughly 50 basis points of spread compression in five-year rates between now and 2022. If one looks further out to 2027, the spread in expected policy rates stands at 94 basis points.3 That may still seem like a lot, but keep in mind that inflation expectations in the euro area are well below those of the U.S. The CPI swap market is predicting that U.S. inflation will exceed euro area inflation by 67 basis points over the next decade. All things equal, lower inflation in the euro area implies that nominal interest rates should be lower there too. Moreover, many euro area government bond markets trade at a discount due to country-specific default/denomination risks. While these risks have faded, they have not gone away. As such, GDP-weighted euro area government bond yields - which are arguably what the ECB cares most about - are generally higher than swap rates of the same maturity. In Search Of Fair Value Chart 7The Neutral Rate Is Lower In The Euro Area The Neutral Rate Is Lower In The Euro Area The Neutral Rate Is Lower In The Euro Area A reasonable estimate is that the market currently sees the real terminal rate in the U.S. as being roughly 40 basis points higher than in the euro area. As it happens, this is almost identical to the gap in the neutral rate between the two regions that Williams, Laubach, and Holston have calculated (Chart 7). Does that mean that the current transatlantic spread is close to fair value? Not quite. One of things that has become apparent over the past eight years is that euro area membership comes at a high price. When countries such as Italy and Spain are hit by adverse economic shocks, they are limited in how they can respond. They cannot devalue their currency because they do not have a currency to devalue; and they cannot loosen fiscal policy for fear of being attacked by the bond vigilantes. All they can do is suffer from grinding deflation in the hopes of regaining competitiveness through weak wage growth. This means that over the long haul, unemployment in the euro area is likely to be above NAIRU more often than in the U.S. This, in turn, implies that euro area policy rates will, on average, be below their neutral value more often than in the U.S. Thus, even if the gap in the real neutral rate between the two regions were 40 basis points, the expected gap in policy rates should be larger than that. Modest Downside For EUR/USD The discussion above suggests that the transatlantic interest rate spread is not especially wide if one looks further out in time. If U.S. growth surprises on the upside over the coming months, while euro area growth flatlines, spreads will widen again. Such an outcome is, in fact, quite likely. U.S. financial conditions have eased significantly relative to those of the euro area since the start of the year (Chart 8). To the extent that changes in financial conditions lead growth by about 6-to-9 months, the U.S. could start outperforming the euro area as we enter 2018. The fact the Goldman's Sachs' U.S. Current Activity Indicator has hooked higher and the economic surprise index has rebounded smartly is early evidence that this process may have already begun (Chart 9). We see EUR/USD falling to 1.15 by the end of the year. Chart 8Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 9Early Evidence That U.S. May ##br##Outperform Euro Area Next Year Early Evidence That U.S. May Outperform Euro Area Next Year Early Evidence That U.S. May Outperform Euro Area Next Year Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy / China Investment Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017. 2 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and "What's the Matter With Wages?" dated August 11, 2017. 3 We estimate the expected policy rates ten years out by looking at one-month, 10-year forward OIS rates (i.e., the market's expectation of where one-month OIS rates will be ten years from today). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. credit growth is set to improve as capex has more upside and households benefits from a positive backdrop. The U.S. has substantially more room to increase leverage than the rest of the G10, pointing toward further monetary divergences. The euro is not very cheap and is trading at a significant premium to forward rate differentials. It is thus at risk if U.S. rates can rise vis-à-vis Europe. Chinese underlying inflation is becoming elevated, which could prompt additional tightening by the PBoC. Moreover, Xi Jinping's speech this week suggests a move away from the debt-fueled, investment-led growth model. The AUD is at risk. Feature A general lack of credit growth has been one of the key factors hampering both broader growth and inflation in the U.S. Not only has this muted activity and weak pricing pressure kept the Federal Reserve on the easier side of policy, the absence of lending growth has further depressed real rates as demand for loanable funds remains low. Can credit pick up from here, and what are the implications for the USD? Room For Optimism There are good reasons to lean a bit more on the positive side regarding the U.S. credit growth outlook. As Chart I-1 illustrates, U.S. commercial and industrial loan growth seems to be rebounding. Confirming that this impulse could gain momentum, it follows an easing in lending standards and a pick-up in durable goods orders - two leading indicators of business borrowings. Household debt is also showing some signs of revival. While the annual growth rate of household borrowings from banks has yet to trough, the annualized quarterly growth rate has picked up significantly - a development that tends to precede accelerations in the yearly measure. Moreover, this improvement is broad based among all the key components of household borrowings (Chart I-2). Chart I-1Upside For U.S. C&I Loans... Upside For U.S. C&I Loans… Upside For U.S. C&I Loans… Chart I-2... And For Household Debt As Well ... And For Household Debt As Well ... And For Household Debt As Well This has positive implications for U.S. nonfinancial private credit, which has been in the process of forming a shallow bottom relative to GDP. Moreover, based on the low level of debt servicing costs for both households and businesses, this trend has room to develop (Chart I-3). However, most of the increase in the debt-to-GDP since 1994 has been caused by financial engineering, with firms swapping equity for debt in their capital structure, and has therefore not lifted domestic demand nor created inflationary pressures. However, we posit that this phenomenon is toward its tail end, and that additional debt accretion could have a meaningful impact on growth. Why? On the business front, capex - an essential but volatile component of aggregate demand - is set to accelerate further. Business investment is led by firms' capex intentions, a series that has surged since the summer of 2016 (Chart I-4, top panel). Confirming the message from this indicator, profits from U.S.-listed businesses have also sharply rebounded, a signal that leads capex by a year, as highlighted last Monday by Anastasios Avgeriou, who heads BCA's U.S. Equity Sector Strategy service (Chart I-4, bottom panel).1 Chart I-3The U.S. Has Room To Relever The U.S. Has Room To Relever The U.S. Has Room To Relever Chart I-4Capex Outlook Looks Good Capex Outlook Looks Good Capex Outlook Looks Good On the household front, three factors support our assessment: First, household nominal and real wages and salaries should enjoy further upside as the labor market remains very healthy. This means more consumption and more capacity to accumulate debt, especially as household financial obligations remain near multi-generational lows (Chart I-5). In fact, U.S. real median household income already hit an all-time high in 2016. Chart I-5Supports To Household Consumption Supports To Household Consumption Supports To Household Consumption Second, household confidence is still near record-high levels, a factor which tends to lead credit growth and consumption. Optimistic households are more likely to spend their income gains and buy durable goods like houses or apartments, especially as the household formation rate has regained vigor. Third, U.S. net wealth has hit 430% of disposable income, a record, which will keep supporting consumption. As households see their net worth increase, they can boost consumption and debt as their leverage ratios improve, especially when financial obligation ratios are as low as they are today. These factors point toward a continued increase in the indebtedness of the U.S. private sector, one which this time we anticipate will add to demand through investments, real estate purchases and general consumption. This also means that real rates are likely to experience upside. More debt-fueled aggregate demand implies more demand for loanable funds, and thus higher real rates. In an economy operating near full capacity, it can also lift inflation. Tax cuts and fiscal stimulus would only be a bonus in this environment. This should give the Fed room to increase interest rates in line with its dot plot, or more than the two-and-a-half hikes priced into the OIS curve over the next two years. However, as 2017 has vividly demonstrated, movements in U.S. rates alone are not enough to make a call on the U.S. dollar. One needs to have a sense of how U.S. rates could evolve vis-à-vis the rest of the world. In the context of debt accumulation, we are optimistic that the U.S. could experience a re-leveraging relative to the rest of the G10, putting upward pressures on U.S. real rates relative to the rest of the world. To begin with, U.S. non-financial private credit stands at 150% of GDP, a drop of 20% of GDP since its peak in 2009. The rest of the G10 has not experienced the same extent of post-financial crisis deleveraging, and nonfinancial private credit there still hovers around 175% of GDP (Chart I-6). Today, the indebtedness of the U.S. relative to other advanced economies is near its lowest levels of the past 50 years. Debt levels are obviously not the only consideration; the ability to service that debt also must enter the equation to judge the capacity of an economy to accumulate debt relative to the rest of the world. Currently, according to the BIS, the debt-service ratios of the U.S. nonfinancial private sector still stand well below the GDP-weighted average of the rest of the G10 (Chart I-7). This also highlights that the U.S. has plenty of room to have both higher debt accumulation and higher real rates than the rest of the G10. Chart I-6U.S. Vs. G10: Debt Upside U.S. vs. G10: Debt Upside U.S. vs. G10: Debt Upside Chart I-7Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. Lower Private Sector Debt-Servicing Costs In The U.S. This should support the dollar in 2018. As Chart I-8 shows, 10-year bond yield differentials between the U.S. and other large advanced economies lead tops in the dollar by one year. To highlight this relationship, this chart de-trends the DXY by plotting it as a deviation from its 10-year moving average. Not only does the current trend in real rate differentials already point to a higher dollar, but room for more debt accumulation in the U.S. relative to the rest of the G10 supports the notion that the elevated level of spreads could even expand, implying the era of monetary divergence has yet to end. As we highlighted last week, the dollar may not be as expensive as seems at first glance. We have expanded on our 'modelization' exercise this week, using methods employed by the Swiss National Bank to incorporate the Balassa -Samuelsson effect.2, 3 This metric, which incorporates the relative price of manufactured goods in each economy, further confirm our assessment from last week that the dollar is not expensive enough to warrant a sell-signal (Chart I-9). Thus, with competitiveness a non-issue for the dollar for now, the USD is likely to be able to take advantage of potentially supportive real interest rate spreads. Chart I-8Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Real Rates Point To A Higher Peak For The USD Chart I-9U.S. Only Sightly Expensive U.S. Only Sightly Expensive U.S. Only Sightly Expensive On the technical side, our U.S. Dollar Capitulation Index hit very depressed levels earlier this year, but is now rebounding. Crucially, it has moved meaningfully back above its 13-week moving average, an event which normally characterizes uptrends in the dollar (Chart I-10). Chart I-10Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Dollar: From Bearish To Bullish Mood Bottom Line: The U.S. economy looks set to enjoy an episode of rising debt supporting increasing economic activity and higher rates as capex should grow further and a supportive backdrop continues to emerge for households - whether or not tax cuts happen. Because the U.S. private sector has comparatively healthy balance sheets relative to the rest of the G10, this means that U.S. re-leveraging should outpace the rest of the world. Even if this U.S. re-leveraging is only a cyclical phenomenon and not a resumption of the debt super-cycle, it would imply that monetary policy divergences have yet to reach their apex, and thus the dollar could experience additional upside. Even Against The Euro? We tend to view the euro as the anti-dollar. It is the main vehicle to play both uptrends and downtrends in the dollar and it is also the most liquid instrument, backed with an economy similarly sized as the U.S. Thus, the views expressed above would imply a negative slant on EUR/USD. Such a framework can give an impetus to a EUR/USD view, but is also not enough. Indeed, factors more specific to this pair argue that EUR/USD does have downside. When it comes to valuations, using the SNB's methodology, the EUR/USD is more or less the mirror image of the DXY. This pair is slightly cheap, essentially within the statistical definition of fairly valued (Chart I-11). Thus, valuations alone are fully neutral for the euro. This means EUR/USD remains prisoner to relative interest rate dynamics. On this front, a key driver of this pair paints a risky picture for euro bulls. The 1-year/1-year forward risk-free rate spread between the euro area and the U.S. has been a reliable guide of the EUR/USD's trend for the past 12 years. Yet, the euro's rally has not been matched by a similar move in this spread. As a result, the gap between the currency pair and its rates-implied fair value is at its highest since the summer of 2014 (Chart I-12). Chart I-11Euro: Not That Cheap Euro: Not That Cheap Euro: Not That Cheap Chart I-12Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk Forward Interest Rates Point To Euro Risk But then again, the differential between the European and U.S. 1-year/1-year forward risk-free rate is at its lowest ever over the time frame of this chart. However, it was even lower than current levels in 1999 and 1997. This suggests that if the U.S. can re-leverage relative to the rest of the G10, the spread could grow as negative as it was in these two previous instances. Supporting this assessment, we anticipate U.S. inflation to outperform euro area measures going forward. Last week, we explored the reasons why we see an upcoming uptick in U.S. inflation next year: U.S. financial conditions have eased, American velocity of money has increased, pipeline inflationary pressures are growing and underlying wage growth seems to be improving.4 Meanwhile, European financial conditions have tightened, especially against the U.S., which historically leads to an underperformance of European inflation measures. Very importantly, the euro area core CPI diffusion index has rolled over and is now below 50%, suggesting that euro area core CPI has limited upside (Chart I-13). This means potential downside vis-à-vis the U.S. and room for upside in U.S. rates relative to the euro area, especially as the European Central Bank is likely to craft its message carefully next week when it announces the tapering of its asset purchases, to prevent quick upward movement in interest rate expectations. Additionally, the dollar is still quite under-owned by speculators relative to the euro. Our favorite positioning measure, which sums long bets in the euro with short bets on the DXY - two equivalent wagers - continues to hover near record-high levels, suggesting potential downside in EUR/USD (Chart I-14). This continues to highlight the risks to the euro created by a repricing of the Fed. Chart I-13Euro Area CPI Peaking? Euro Area CPI Peaking? Euro Area CPI Peaking? Chart I-14Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Excess Bullishness In Euro Intact Bottom Line: The euro is obviously at risk if the dollar gets lifted by rising economic activity and indebtedness in the U.S., even if this cyclical upswing in debt does not represent a resumption of the debt super-cycle. Moreover, 1-year/1-year forward rates differentials point to heightened EUR/USD vulnerability, especially if U.S. inflation bottoms relative to the euro area. Moreover, long euro bets have yet to be washed out, deepening the EUR/USD's vulnerability. A Few Words On China Chart I-15China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening China: Good Reasons For Policy Tightening Despite a marginal slowdown in Chinese real GDP growth and slightly disappointing industrial production and fixed asset investment numbers for the third quarter, some key Chinese economic activity metrics have been very robust. Imports are growing at a 19% annual pace, credit growth continues to outperform expectations and electricity production and excavator sales remain robust. Should this make investors bullish on China plays? In our view, two key risks lurk on the horizon. The first is monetary tightening. Pricing pressures in China are growing and are looking increasingly genuine. As Chart I-15 shows, core CPI is clocking in at 2.3%, the highest level since 2010-2011, a level which in the past prompted monetary tightening by the Chinese authorities. Additionally, services inflation - a purely domestic sector and thus one reflective of domestic inflationary pressures - is now above 3% and accelerating. Also, PPI has re-accelerated to 6.9%, pointing to a paucity of deflationary forces in the Chinese economy that could potentially give the People's Bank of China the green light to tighten further. We would expect the rise in the Shibor 7-day rate to continue and monetary conditions, which have been tightening since the end of 2016, to become an even bigger handicap in the future. The second risk lies around the Communist Party Congress underway in Beijing. Xi Jinping's marathon speech highlighted his vision for Chinese socialism in a new era. Xi is very clearly dedicated to the primacy of the Chinese communist party. He did highlight, however, that the new principal problem for the Chinese population is the need for a better life, with less imbalances, less inequalities. This fits with his previously revealed policy preferences. As Matt Gertken, who heads the Asian efforts on our Geopolitical Strategy team, has shown, Xi's administration has massively increased spending to protect the environment and increased financial regulation (Table 1).5 These preferences fit in the optic of addressing China's new principal problems: too much pollution and too much debt. Table 1Fiscal Priorities Of Recent Chinese Presidents All About Credit All About Credit Moreover, the continued fight against corruption also fits into that mold. It is a key tool to maintain the legitimacy of the Communist party, and a popular way to address some of the inequalities and imbalances plaguing China today. What does this mean? China has continued to accumulate debt over the past 10 years, with debt to GDP increasing by nearly 120% between 2008 and 2017 (Chart I-16). If a window is opening to tighten monetary policy because inflationary pressures are growing while there is political will to combat inflation and imbalances, it is likely that investment - which pollutes heavily - and debt - a byproduct of large capex programs - could be curtailed. Moreover, the Chinese government still has the wherewithal to support aggregate economic activity through fiscal stimulus. In addition, in the context of the above, much fiscal stimulus could be deployed to fight pollution and decrease inequalities by supporting households. This means that while Chinese GDP growth is unlikely to weaken substantially, the capex intensity of the economy could decrease. So would imports of raw materials and capital goods. As a result, this could be a very negative environment for metals. Metals prices have rebounded sharply since 2016 as Chinese investment has increased. But now that policy could be tightened further and that Xi's new administration has more freedom to move away from an investment-heavy, deeply polluting growth model, the rally in metals could be at risk. Copper, a bellwether for the metals complex, has surged nearly 70% since 2016, and bullish sentiment on the red metal is now at levels historically associated with imminent corrections (Chart I-17). Chart I-16Is This What Deleveraging Looks Like? All About Credit All About Credit Chart I-17Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk Tighter Policy And A Reform Push Put Metal At Risk This means that currencies for which metals prices are a key driver of terms of trade are at great risk, specifically the BRL, the CLP and the AUD. Moreover, the latter is expensive, having recently been buoyed by some positive economic numbers, and is now widely owned by very bullish investors. We have a short sell AUD/USD at 0.79 and our short AUD/NZD trade at 1.11 was triggered following the Labor/NZ First/Green coalition announced Thursday in New Zealand. Bottom Line: Chinese authorities are set to tighten monetary conditions further as domestic inflationary pressures are growing. Moreover, while short on details, this week's speech by Xi Jinping at the opening of the 19th Communist Party Congress in Beijing seemed to confirm that addressing imbalances, inequalities, and environmental problems will be a key objective of this administration. This points toward a less debt-/investment-driven economic model - at least until deflationary problems re-emerge. While overall GDP growth could be supported by targeted fiscal support, investment plays linked to Chinese capex and real estate could suffer. The AUD is at risk, and we are entering our proposed short AUD/NZD trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Strategy Special Report, titled “Top 5 Reasons To Favor Cyclicals Over Defensives” dated October 16, 2017, available at uses.bcaresearch.com 2 The Balassa Samuelson effect is an empirical observation that countries with higher productivity tend to experience an appreciating trend in there real exchange rate. Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 3 Samuel Reynard, “What Drives the Swiss Franc?” Swiss National Bank Working Papers (2008 – 14). 4 Please see Foreign Exchange Strategy Weekly Report, titled “Is The Dollar Expensive?”, dated October 13, 2017, available at fes.bcaresearch.com 5 Please see Geopolitical Strategy Weekly Report, titled “How To Read Xi Jinping’s Party Congress Speech”, dated October 18, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1 USD Technicals 1 USD Technicals 1 Chart II-2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Last week's CPI releases showed that inflation disappointed in September, with headline CPI increasing by only 2.2%, below the expected 2.3%; and Core CPI coming in at 1.7%, in line with expectations; However, long-term TIC data showed a large inflow of funds of USD 67.2 bn, much larger than the expected USD 14.3 bn. The labor market continues to tighten with initial jobless claims and continuing claims dropping to 222,000 and 1.888 million respectively. The DXY has rebounded this week on this news, and also helped by a somewhat disappointing ZEW survey from the euro area, but pared its gains on Wednesday. Regardless, positive developments in the U.S. fiscal space and disappearing slack will provide a tailwind for the greenback. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 The Euro Chart II-3 EUR Technicals 1 EUR Technicals 1 Chart II-4 EUR Technicals 2 EUR Technicals 2 Data from the euro area has been mixed: Industrial production grew at an annual rate of 3.8% in August; The trade balance contracted to EUR 16.1 bn from EUR 23.2 bn on a non-seasonally-adjusted basis, but improved on a seasonally-adjusted basis. The final estimate for core CPI hit 1.1%, in line with expectations; The ZEW Survey dropped and underperformed expectations; Despite largely weak data, the euro has pared all of last week's losses. Markets may be pricing in Catalan developments as a bullish case. The Spanish government has threatened to enact Article 155 of the constitution if Catalonia does not comply, which will give Spain the authority to take measures to ensure compliance by the rogue region. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 The Yen Chart II-5 JPY Technicals 1 JPY Technicals 1 Chart II-6 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Bank lending outperformed expectations, growing at a 3% year-on-year pace. Machinery orders yearly growth also outperformed to the upside, coming in at 4.4% However, the annual growth of both imports and exports underperformed expectations and declined significantly from last month, coming in at 12% and 14.1% respectively. The yen has remained relatively flat these past two weeks. Overall, we expect USD/JPY to have additional upside, given that the U.S. OIS curve is not pricing in enough rate hike over the next 2-years. Ultimately, the driver of USD/JPY will simply be U.S. rates as Japanese 10-year rates are capped near 0%. This situation is not likely to change any time soon, as the Japanese economy is still hampered by very low inflation. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7 GBP Technicals 1 GBP Technicals 1 Chart II-8 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Average hourly earnings outperformed expectations, growing at a 2.2% pace from a year ago. Both headline and core inflation came in line with expectations at 3% and 2.7% respectively. However, both retail sales and retail sales ex-fuel growth underperformed expectations, coming in at 1.2% and 1.6% respectively. Overall, we do not expect much more upside for the pound relative to the U.S. dollar, given that there is already a hike priced for November. At this point, the economic situation does not warrant any more hikes beyond just removing the emergency measures implemented after the Brexit fallout. Furthermore inflation has stopped climbing, and could start to come down in the coming months as the effects of the currency dissipate. Finally, Brexit negotiations have hit a bit of a temporary impass. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Australian Dollar Chart II-9 AUD Technicals 1 AUD Technicals 1 Chart II-10 AUD Technicals 2 AUD Technicals 2 The AUD has not seen much action this week. The RBA minutes highlighted that "slow growth in real wages and high levels of household debt were likely to be constraining influences". This is largely in line with our argument that spare capacity is limiting wage growth and inflation in the economy. Going forward, China remains a risk to our view, with the most recent import figures having provided a welcomed fillip to the AUD. Nevertheless, remarks by RBA Governors will limit the upside in the AUD. Expectations of a rate hike by the RBA depend upon growth numbers, which are unlikely to be achieved given the current trajectory of wages and consumer spending. Furthermore, high underemployment in the economy also remains a drag on spending, dampening the positive effect of a strong job report. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11 NZD Technicals 1 NZD Technicals 1 Chart II-12 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales year-on-year growth declined form 4.4$ to 2.9%. Business NZ PMI softened from 57.9 to 57.5. However, headline inflation came in at 1.9%, rising from the previous month reading of 1.7% and outperforming expectations. The kiwi sold off by almost 2% yesterday, as Jacinda Ardern was elected as the new prime minister of New Zealand. The market is now pricing the risk that the Labor party, which Ardern leads, could change the mandate of the central bank from just targeting inflation to also seeking full employment. Moreover, Labor and its coalition partner, NZ First, want to curtail immigration, one of the tailwind to New Zealand growth. These development would structurally limit the upside for kiwi rates, acting as a headwinds to the New Zealand dollar. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Bad Breadth - July 7, 2017 Canadian Dollar Chart II-13 CAD Technicals 1 CAD Technicals 1 Chart II-14 CAD Technicals 2 CAD Technicals 2 The CAD has been somewhat strong recently due to developments in the oil market. KSA-Russia support for an extension of supply cuts to OPEC 2.0, as well as developments in Iraq, have pointed to an increase in prices. While the path for Canadian interest rates seem fairly priced, oil prices could buoy the CAD. Risks surrounding NAFTA remain, as President Trump stays inflexible with regards to tariffs, although this is likely to have a greater effect on Mexico than on Canada. Furthermore, albeit still in its infancy Morneau's tax plan, which is anticipated to mostly affect the richest of small business, could have an effect on investment intentions. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Swiss Franc Chart II-15 CHF Technicals 1 CHF Technicals 1 Chart II-16 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has surprised to the upside: The unemployment rate decreased from 3.2% and 3.1%, outperforming expectations. Producer and import prices yearly growth came in at 0.8%, also surprising to the upside. Finally, the trade balance also outperformed, coming in at 2.918 billion dollars for September. It seems that the fall in the franc has been very positive to the Swiss economy. Overall, it would be difficult to see much more upside in EUR/CHF, as the euro already reflects euro area positives. That being said, we are reticent to be outright bearish on this cross as the economic data is still too weak for the SNB to change its monetary policy stance. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17 NOK Technicals 1 NOK Technicals 1 Chart II-18 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Manufacturing yearly output growth underperformed expectations, contracting at 5.7%. Both core and headline inflation also surprised to the downside, coming in at 1% and 1.6% against expectations of 1.2% and 1.7% respectively. Finally, the Norwegian trade balance declined from 12.4 billion dollars to 9.2 billion dollars USD/NOK has risen 3% since September, even as oil prices have continued their path upward. This was first and foremost reflective of the higher probability of rate hikes in the U.S. in December. Additionally, the recent Norwegian inflation and trade balance numbers are showing that the krone rebounds has tightened monetary conditions in this Scandinavian economy. Overall, we remain bullish on USD/NOK and bearish on EUR/NOK. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19 SEK Technicals 1 SEK Technicals 1 Chart II-20 SEK Technicals 2 SEK Technicals 2 The most recent inflation data was slightly weak, with CPI increasing by 0.1% monthly, and 2.1% yearly. Unemployment worsened as the rate rose to 6.2% from 6%. The krona depreciated against the euro on the news, but was flat against the dollar. Despite this temporary setback, PMIs are still perky across the board, and credit is hooking up. China and Europe's recent performance has likely provided a tailwind for growth, which should translate into higher inflation as capacity utilization is extremely tight. Furthermore, the depreciation of the SEK since the beginning of September has eased monetary conditions, making way for the central bank to begin a tightening process in the wake of the ECB's tapering program. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades