Currencies

Highlights Recommended Allocation Quarterly - July 2017 Quarterly - July 2017 Risk assets have continued to outperform, despite soft inflation data and falling interest rates. Either inflation will pick up again, amid decent growth, and the Fed (and, to a degree, other central banks) will tighten, or the Fed will capitulate and stay on hold. Either scenario should be good for risk assets. No indicator signals a recession on the horizon, and so we continue to expect equities to outperform bonds over the next 12 months. Within equities, we favor DM over EM; we maintain a pro-cyclical sector tilt, but rotate out of Tech into Financials, which are cheaper and should benefit from steeper yield curves. In fixed income, we prefer credit to government bonds, but trim our overweight in investment grade credit as spreads are unlikely to contract further. We are overweight TIPS and Japanese inflation-linked bonds. Feature Overview How To Square Lower Rates And Rising Equities One of the basic principles of BCA's Global Asset Allocation service is that it is highly unusual for equities to underperform bonds for any extended period except in the run-up to, and during, recessions (Chart 1). After the recent decline in long-term interest rates and softness in inflation, we find investors worldwide becoming increasingly nervous about the outlook. We see nothing in the data, however, to indicate a recession in the coming 12 months. Of the three historically most reliable recession indicators - PMIs, credit spreads, and the yield curve (Chart 2) - only the last raises some concerns, but it is still far from inverting, which is the requirement for a recession signal. None of the formal recession models is flashing a warning signal either (Chart 3). Chart 1Stocks Outperform Except Ahead Of Recession Stocks Outperform Except Ahead Of Recession Stocks Outperform Except Ahead Of Recession Chart 2Usual Recession Signals Still Absent Usual Recession Signals Still Absent Usual Recession Signals Still Absent Chart 3Recession Risk Models Not Rising Either Recession Risk Models Not Rising Either Recession Risk Models Not Rising Either Nonetheless, market action in recent months has been unusual. Bond yields have fallen (with the 10-year U.S. Treasury yield slipping to 2.2% from 2.6%), and the dollar has weakened, but risk assets have continued to perform well, with global equities giving a total return of 13% year to date and 4% in Q2. Can this desynchronization continue? We see three possible scenarios:1 Chart 4Market Expects Fed To Be Dovish Market Expects Fed To Be Dovish Market Expects Fed To Be Dovish Reflation returns. The Fed proves to be right that the recent weak inflation data is temporary. Inflation picks up and the Fed raises rates more quickly than the market is currently pricing in (which is only 25 bps over the next 12 months, Chart 4). Initially, the rebound in inflation might be a shock for risk assets but, as long as the Fed is tightening because it is confident about growth and unconcerned about global risk, over 12 months risk assets such as equities should continue to outperform. The Fed capitulates. Inflation fails to rebound and the Fed tightens only in line with what the market is currently pricing in. This could be good for risk assets, as long as the soft inflation is not accompanied by disappointing data on growth. The U.S. dollar would probably weaken further, which should be positive for EM assets and commodities. A policy mistake. The Fed pushes stubbornly ahead with tightening even though inflation fails to rebound. Bond yields fall and the yield curve moves closer to inverting. This would be negative for risk assets, which would start to price in the risk of recession. We think the first scenario is the most likely. Leading indicators of employment suggest the recent sluggish wage growth should prove temporary (Chart 5). The softness in U.S. PCE inflation probably reflects mostly the weak economic growth last year and the recent fall in commodity prices (as well as special factors in telecoms, healthcare and autos). Even if reflation pushes the Fed to tighten more quickly - followed by central banks in the euro area, U.K, and Canada, which have also sounded more hawkish recently - this should not fundamentally undermine the case for risk assets, given how easy monetary policy remains everywhere (Chart 6). It would represent merely a step towards "normalization". Chart 5Sluggish Wage Growth Should Be Temporary Sluggish Wage Growth Should Be Temporary Sluggish Wage Growth Should Be Temporary Chart 6Real Rates Still Negative Everywhere Real Rates Still Negative Everywhere Real Rates Still Negative Everywhere While scenario (2) would also probably be generally positive for risk assets, the correct portfolio allocation would be different. Under scenario (1) - our central view - the dollar would appreciate, causing commodities and EM assets to underperform, higher beta markets (such as the euro area and Japan) and cyclical sectors would perform the best, and in bond markets investors should be underweight duration and overweight TIPS. Scenario (2) would suggest a less aggressive positioning in equities, with income-generating assets outperforming as bond yields stay low at around current levels. Scenario (3), which we see only as a tail risk, would point to an outright defensive stance. What should investors watch for over the coming months? Besides the trends in inflation and wages discussed above, we would be concerned to see any slippage in global growth expectations, which have so far continued to rise despite the softness in inflation and wages (Chart 7). The most likely cause of this would be a Chinese slowdown, though recent comments by Premier Li Keqiang ("we continue to implement a proactive fiscal policy and prudent monetary policy....[but] will not resort to massive stimulative measures") seem to confirm our view that Chinese growth may slow a little further, but that the authorities will not allow it to collapse ahead of the Party Congress in the fall. As potential upside catalysts for risk assets we see: a rebound in crude oil prices (driven by a drawdown in inventories over coming months as the OPEC production cuts reduce supply, Chart 8), progress on a U.S. tax cut (which BCA's Geopolitical Strategy still expects to come into effect from early 2018), and further surprises in earnings growth (where analysts continue to revise up their forecasts, Chart 9). Chart 7No Signs Of Global Growth Slipping No Signs Of Global Growth Slipping No Signs Of Global Growth Slipping Chart 8Oil Inventories To Draw Down Oil Inventories To Draw Down Oil Inventories To Draw Down Chart 9Earnings Continue To Be Revised Up Earnings Continue To Be Revised Up Earnings Continue To Be Revised Up Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Why Haven't Inflation And Wages Picked Up? Chart 10Just A Temporary Phenomenon? Just A Temporary Phenomenon? Just A Temporary Phenomenon? Eight years into an expansion, U.S. inflation remains stubbornly below 2% on every measure and has even slowed in recent months (Chart 10, panel 1). And, despite headline unemployment of only 4.3% (below the Fed's estimate of 4.6% for the Nairu), wage growth also remains sluggish (panel 3). The Fed's view is that inflation has been pulled down by special factors: weak auto sales, the introduction of unlimited cell phone data packages (which lower hedonically-adjusted prices), and drugs companies which raised prices before last year's U.S. presidential election (panel 2). We agree that these factors are likely to be temporary. But the recent weak wage growth is more puzzling. Wages have trended up since 2012, suggesting that the Phillips Curve is not dead. But the relationship seems to have weakened. With U6 unemployment (which includes marginally attached workers and those working part-time who would like full-time jobs) currently at only 8.4%, one would have expected wage growth to be 1 ppt higher than it is (panel 4). Changes in the structure of the workforce may partly explain this (the growing proportion of low-wage service jobs, the "gig economy"). Last year's weak corporate profits may also be a factor. But, with the labor market clearly very tight, we expect wages - and therefore core inflation - to pick up again over the next 12 months. What To Do When VIX Is So Low? After two brief spikes earlier in the year, VIX has declined to 11.4, closer to the historical low of 9.3 reached in 1993, than the historical average of 19.5. In fact, asset price volatilities have been low across the board in fixed income, currencies and commodities, even though the latter two are not at the same extreme low levels as equities and fixed income (Chart 11). However, the VIX futures curve is still in steep contango, which means that getting the timing wrong would make it very costly to go long the volatility index. In addition, correlation among the index members of the S&P 500 is very low, and so are cross-market equity correlations. We do not forecast a recession until 2019, so a sharp reversal in VIX is unlikely, but brief spikes are possible, implying possible corrections in S&P 500 given the inverse correlation between the two. As such, we recommend four strategies for investors who are concerned that markets are too complacent: Focus on security selection, and rotate into cheaper sectors from expensive ones without altering the pro-cyclical bias. Our preferred way is to buy the much cheaper Financials by selling the more expensive Tech; Allocate a portion of funds to the minimum volatility style as it has been relatively oversold; Raise cash and buy a call spread on the S&P 500; Buy longer-dated VIX futures and sell shorter-dated futures to mitigate the rolling cost. Chart 11Are Investors Too Complacent? Are Investors Too Complacent? Are Investors Too Complacent? Chart 12Overweight To Neutral Overweight To Neutral Overweight To Neutral Have Technology Stock Run Too Far? Technology stocks have outperformed the broad market by 33% since April 2013 and investors are increasingly skeptical about whether the run-up can continue. In this Quarterly, we cut our weighting in the Tech sector from Overweight, but we believe it deserves no lower than a Neutral weighting for the following reasons: Sales & Earnings: New order growth is improving alongside rising consumer spending on technology (Chart 12, panel 2). Sales are growing at 5% YoY and this is likely to continue. Pricing power has also recovered over the past year. These factors should support margins and earnings growth. Valuations: Investors are worried about valuation. However, the recent rally has not led to an expansion of relative forward P/E, which is below the historical average (panel 4). Sector relative performance over the past four years has moved in line with its superior return on equity. Breadth: Improving breadth suggests that relative outperformance should be sustainable. An increasing number of firms are participating in the rally, as seen by the improving advances/declines ratio (panel 3). However, we also have some concerns. For example, a handful of large-cap technology firms have generated the bulk of the stock price performance. However, these firms currently trade at 23x.2 earnings compared to 60x.3 for the top firms at the peak of the TMT bubble in 2000. Additionally, the five largest stocks in the sector comprise only 13% of the index, compared to 16% at the peak of the 2000 bubble. Our recommendation, then, is that investors should hold this sector in line with benchmark. Are Canadian Banks At Risk Due To The Housing Bubble? Chart 13Canadian Housing Puzzle Canadian Housing Puzzle Canadian Housing Puzzle The recent problems at Home Capital Group have drawn investors' attention to the Canadian housing market. Home Capital's shares fell by 70% in April after regulators accused the mortgage lender of being slow to disclose fraud among its brokers. However, the issue is unlikely to have wider consequences: the event took place two years ago and had no impact on the lender's assets. Home Capital lends only to individuals with reliable collateral, and accounts for only 1% of total mortgage loans. We don't see imminent risks to the housing and banking sectors, since the economy is recovering and monetary policy remains loose. Vancouver and Toronto home prices have surged for almost a decade (Chart 13, panel 1). After Vancouver introduced a 15% foreign buyer tax in July 2016, house prices initially pulled back but quickly recovered. A similar tax in Ontario this April is also likely to have limited impact. Cautious macro-prudential rules should ensure banks' health: mortgage insurance is required for down-payments under 20%, and the gross debt service ratio (total housing costs over household income) cannot exceed 32%. However, the rise in house prices has caused household debt to run up (Chart 13, panel 2). Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, hinted in a speech in June that the central bank may soon raise rates. Tighter monetary policy could hurt mortgage borrowers who have enjoyed low interest payments for years (Chart 13, panel 3). Over the longer-term, therefore, we are concerned about the level of household debt, and recommend a cautious stance toward Canadian bank stocks. Global Economy Overview: Goldilocks continues, with global growth prospects still good (PMIs in developed economies generally remain around 55 - see Chart 14 panel 2 and Chart 15 panel 1), but inflation surprising on the downside in recent months. The wild card is China, where growth has slowed since Q1, when GDP reached 6.9%, and it is unclear whether the authorities will ease fiscal and monetary tightening to cushion the slowdown. Chart 14Growth Prospects Generally Remain Good Growth Prospects Generally Remain Good Growth Prospects Generally Remain Good Chart 15But Inflation Expectations Have Fallen But Inflation Expectations Have Fallen But Inflation Expectations Have Fallen U.S.: Growth has been weaker than the over-heated consensus expected, pushing down the Citigroup Economic Surprise Indexes (CESI) sharply (Chart 14, panel 1). However, prospects remain positive for the next 12 months: the Manufacturing ISM is at 54.9, retail sales are growing at 3.8% YoY, and capex has begun to reaccelerate (Chart 14, panel 5). The Fed's Nowcasts point to Q2 GDP growth at 1.9%-2.7% QoQ annualized. With expections now lowered, the CESI is likely to bottom around here. Euro Area: Growth has been stronger than in the U.S, with the PMI continuing to accelerate to 57.3. However, this is largely due to the euro area's strong cyclicality and exposure to global growth. Domestic momentum remains weak in most countries, with region-wide wage growth only 1.4% YoY. European PMIs are likely to roll over in line with the U.S. ISM. But GDP growth for the year is not likely to fall much from the 1.9% achieved in Q1. Japan remains a dual-paced economy, with international sectors doing well (exports rose by 14.9% YoY in May and industrial production by 5.7%) but domestic sectors stagnating, as wage growth remains sluggish (up just 0.5% YoY). Bank of Japan policy will remain ultra-easy, but there is scant sign of fiscal stimulus or structural reform. Emerging Markets: China is showing clear signs of slowdown, with the Caixin Manufacturing PMI falling below 50 (Chart 15, panel 3). The PBoC has tightened monetary policy, causing corporate bond yields to rise by 100 bps since the start of the year and the yield curve to invert. However, with the 19th Communist Party Conference scheduled for the fall, the authorities will prioritize stability: there are signs they are increasing fiscal spending. Elsewhere, many emerging markets are characterized by sluggish growth but falling inflation, which may allow central banks to cut rates. Interest rates: Inflation has softened recently, with U.S. core PCE inflation slowing to 1.4% and euro zone core CPI to 1.1%. We agree with the Fed that the recent weak inflation was caused by temporary factors and, with little slack in the labor market, core PCE will rise to 2% by next year, causing the Fed to hike in line with its dots. In the euro zone, however, the output gap remains around -2% of GDP and countries such as Italy could not bear tightening, so the ECB will taper only gradually next year and not raise rates soon. Chart 16Powered by Earnings and Margin Improvement! Powered by Earnings and Margin Improvement! Powered by Earnings and Margin Improvement! Global Equities In Q2 2017 the price gain in global equities was driven entirely by earnings growth, as forward earnings grew by 3.5% while the forward PE multiple barely changed. This is distinctively different from the equity rally in 2016 when multiple expansion dominated earnings growth (Chart 16). The scope of the improvement in earnings so far in 2017 has been wide. Not only are forward earnings being revised up, but 12-month trailing earnings growth has also come in very strong, with 90% of sectors registering positive earnings growth. Margins improved in both DM and EM. Equity valuation is not cheap by historical standards but, as an asset class, equities are still attractively valued compared to bonds given how low global bond yields are. We remain overweight equities versus bonds even though we are a little concerned about the extremely low volatility in all asset classes (see "What Our Clients Are Asking" on page 8). Within equities, we maintain our call to favor DM versus EM despite the 7% EM outperformance year-to-date, which was supported by attractive valuations and the weak U.S. dollar. BCA's house view is that the USD will strengthen versus EM currencies over the coming 12 months. Within EM, we have been more positive on China and remain so on a 6-9 month horizon, in spite of China's 6.7% outperformance versus EM. Our upgrade of euro area equities to overweight at the expense of the U.S. in our last Quarterly Portfolio Outlook proved to be timely as the euro area outperformed the U.S. by 641 bps in Q2. We continue to like Japan on a currency hedged basis (see next page). Sector-wise, we maintain a pro-cyclical tilt. However, we are taking profit on our overweight in Technology (downgrade to neutral) and upgrading Financials to overweight from neutral. Japanese Equities: Maintain Overweight, With Yen Hedge We upgraded Japanese equities to overweight in June 2016 (please see our Quarterly Report, dated June 30, 2016 and our Special Report, dated June 8, 2016) on a currency hedged basis. These positions have worked very well as the yen is down by 10% and MSCI Japan has gained 32% in yen term, outperforming the global benchmark by 12% in local currency terms, but in line with benchmark in USD (Chart 17). Going forward, we recommend clients continue to overweight Japanese equities in a global portfolio and hedge the JPY exposure. Reasons: First, since December 2012 when Abenomics started, MSCI Japanese equities have gained 82% in yen terms, but earnings have risen by much more, with a 180% increase. Valuation multiples have contracted, in stark contrast to other major equity markets where multiple expansion has led to stretched valuations. Second, divergent monetary policy between the BOJ and the Fed will put more downside pressure on the JPY. More importantly, weak fundamentals, as evidenced by falling inflation and a slowing in GDP growth, are likely to push the BOJ to resort to more extraordinary policy measures, such as debt monetization, which would further weaken the JPY, boosting exports and therefore the export sector dominated Japanese equity market. Note that our quant model is still underweight Japan, but has become slightly less so compared to six months ago. We have overridden the model because 1) the model is unhedged in USD terms and, more importantly, 2) the model cannot capture potential policy action such as debt monetization. Chart 17Japanese Equities: Remain Overweight Japanese Equities: Remain Overweight Japanese Equities: Remain Overweight Chart 18Financials Vs Tech: Trading Places Financials Vs Tech: Trading Places Financials Vs Tech: Trading Places Sector Allocation: Upgrade Financials to Overweight by Downgrading Tech to Neutral. We have been overweight Technology since July 2016 (please see our Monthly Update, July 29, 2016) and the sector has outperformed the global benchmark by 11.8%, of which 9% came this year. In line with our general concern on asset valuations, we are taking profit on the Tech overweight and use the proceeds to fund an overweight in the much cheaper Financials sector. As shown in Chart 18, the relative total return performance of Financials vs. Technology is back to extreme levels (panel 1), while the relative valuation of Financials measured by price to book has reached an extremely cheap level (panel 2). Also, Financial shares offer a good yield pick-up over Tech even though this advantage is in line with the historical average (panel 3). BCA's house view calls for higher interest rates and steeper yield curves over the next 9-12 months. Financial earnings benefit from a steepening yield curve. If history is any guide, we should see more aggressive analysts' earnings revisions going forward in favor of Financials (panel 4). Overall, our sector positioning retains its tilt towards cyclicals vs. defensives. (Please see Recommended Allocation table on page 1), in line with the tilt from our quant model. Within the cyclical sectors, however, we have overridden the model on Financials and Tech since the momentum factor is a major driver in the model and we judge that momentum has probably run too far. Chart 19MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance MSCI ACW: Factor Relative Performance Smart Beta Update: In Q2, an equal-weighted multi-factor portfolio outperformed the global benchmark (Chart 19, top panel). Among the five most enduring factors - size, value, quality, minimum volatility, and momentum - quality and momentum factors continued the Q1 trend of outperformance, while value continued to underperform. It's worth noting that the underperformance of minimum volatility stabilized in the last two months of the quarter, indicating that the extremely low market vol has caught investor attention and some investors have started to seek protection by moving into the low vol space, albeit gradually. Value has continued to underperform growth, and small caps to underperform large caps. We maintain our neutral view on styles and prefer to use sector positioning to implement the underlying themes given the historically close correlation between styles and cyclicals versus defensives (bottom two panels). As show in Table 1, however, even though value has underperformed growth across the globe, small caps in Japan and the euro area have consistently outperformed large caps year-to-date, the opposite to that in the U.S., in line with the higher beta nature of these two markets. Table 1Divergence In Style Quarterly - July 2017 Quarterly - July 2017 Government Bonds Maintain Slight Underweight Duration. U.S. bond yields declined significantly in Q2 to below fair value levels in response to weaker "hard data" (Chart 20, top panel). But weakness in Q1 U.S. GDP was concentrated in consumer spending and inventories, both of which are likely to strengthen in the months ahead. In addition, after the June rate hike, we expect the Fed to deliver another rate hike by year end, while the market is pricing in only 14 bps of rate rise. Maintain overweight TIPS vs. Treasuries. As the nominal 10-year yield fell, so did 10-year TIPS breakeven inflation. In terms of relative valuation, now TIPS is fairly valued vs. the nominal bonds (panel 2). However, our U.S. Bond Strategy's core PCE model, which closely tracks the 10-year TIPS breakeven rate (panel 3), is sending the message that inflationary pressures are building in the economy and that core PCE should reach the Fed's 2% target later this year. This suggests that the bond markets are not providing adequate compensation for the inflationary economic backdrop. Overweight Inflation-linked JGBs (JGBi) vs. Nominal JGBs. Inflation in Japan has been falling despite strong GDP growth. However, the labor market has not been this tight since the mid-1990s, with the unemployment rate at 3.1% and jobs-to-applicants ratio at 1.49, both post-1995 extremes (Chart 21, panel 2). BCA Foreign Exchange Strategy service believes that wage pressures, in addition to the inflationary effect of a weakening yen, could lead inflation higher. Accordingly, inflation-linked JGBs offer good value relative to nominal JGBs (Chart 21, panel 1). Chart 20Inflationary Pressures Are Building Inflationary Pressures Are Building Inflationary Pressures Are Building Chart 21Overweight JGBi Vs JGB Overweight JGBi Vs JGB Overweight JGBi Vs JGB Corporate Bonds Given our expectations that global growth will remain robust over the coming 12 months, pushing the U.S. 10-year Treasury yield above 3%, we continue to favor credit over government bonds. However, U.S. corporate health has deteriorated further in the past two quarters (Chart 22) and so, when the next recession comes, returns from corporate credit may be particularly bad. We cut our double overweight in investment grade debt to single overweight. The spread over Treasuries of U.S. IG credit has fallen to around 100 bps. Given high U.S. corporate leverage currently, it is unlikely that the spread will tighten any further to reach previous lows (Chart 23), so investors will benefit only from the carry. Moreover, the ECB is likely to reduce its bond buying from January 2018 and, though it is unclear whether it will taper corporate as well as sovereign purchases, this represents a potential headwind for European credit. Remain overweight high yield debt. U.S. junk bonds have been remarkably resilient in the face of falling oil prices and the subsequent blowout in energy bond spreads. The default-adjusted spread is just over 200 bps (Chart 24), based on Moody's default assumption of 2.7% over the next 12 months and a recovery rate of 47%. Historically, a spread of this size has produced an excess return over the following year 74% of the time, for an average of 84 bps. Chart 22U.S. Corporate Health Deteriorating U.S. Corporate Health Deteriorating U.S. Corporate Health Deteriorating Chart 23IG Spreads Unlikely To Tighten Further IG Spreads Unlikely To Tighten Further IG Spreads Unlikely To Tighten Further Chart 24Junk Spreads Give Sufficient Reward Junk Spreads Give Sufficient Reward Junk Spreads Give Sufficient Reward Commodities Chart 25Mixed Feelings Towards Commodities Mixed Feelings Towards Commodities Mixed Feelings Towards Commodities Secular Perspective: Bearish: We continue to hold a negative secular outlook for commodities (Chart 25). A gradual shift towards a service-led economy in China, combined with sluggish global growth, will prevent demand from rising further. This lack of demand, together with record high inventory levels for major commodities, keep us from turning bullish. Cyclical Perspective: Neutral We are positive on oil because we believe that inventories will continue to draw. We are negative on base metals due to weak demand and excess supply. We are somewhat bullish on precious metals based on the political uncertainties ahead. Energy: Bullish OPECextended its production cuts for another nine months, carrying the cuts through to Q1, when the oil price is typically seasonally weak. We expect demand growth will increasingly outpace production growth in 2017, producing inventory drawdowns. The current weakness in the crude price is largely due to investors' concerns over shale production. However, the OPEC cut of 1.2 MMb/d, supplemented by an additional 200,000 - 300,000 b/d of voluntary restrictions on non-OPEC oil, are enough to offset any spurt in shale production. Base metals: Bearish China is slowly tightening monetary policy and, following the 19th Communist Party Congress later this year, reflationary stimulus will probably continue to wind down. We have seen a cooling in the Chinese property market along with a slowdown in the manufacturing sector. The Caixin manufacturing PMI, a key indicator for metals demand, fell below 50 in May for the first time in 11 months. At the same time, inventories for copper and iron ore have risen. Precious metals: Long-term Bullish Inflation has not picked up as we expected, which may prevent the gold price from rising further in 2017. However, we expect inflation to move higher going into 2018. As a safe haven, gold is also a good hedge against geopolitical risks. We believe that the political risks in 2018 are underestimated, especially the Italian general election (probably in March or April). Currencies Chart 26Fed Will Support The Dollar Fed Will Support The Dollar Fed Will Support The Dollar In 2017, the U.S. dollar (Chart 26) has weakened by 5% on a trade-weighted basis. However, we believe that the soft patch in inflation and wage data that caused this weakness is temporary and that underlying economic momentum remains strong. Following its rate hike in June, the Fed kept its forecast for core PCE in 2018 and 2019 at 2%. As inflation and wage pressures return, market expectations will converge with the Fed's forecast. The subsequent improvement in relative interest rates will support the dollar. Euro: The euro is up by 8% versus the dollar so far this year. The ECB is likely to continue to set policy for the weakest members of the euro zone, in the absence of a major pickup in inflation. While economic activity has improved, inflation has recently fallen back again, along with the oil price. The ECB is particularly sensitive to political uncertainty surrounding the upcoming Italian elections and the fragility of the Italian banking system. This suggests that the ECB will only gradually taper its asset purchases starting early next year, but will not move to raise rates until at least mid-2019. This is likely to cause the euro to weaken over the coming months. Yen: The yen has strengthened by 4% versus the dollar year to date. With core core inflation in Japan struggling to stay above 0%, we think it highly likely that the BOJ will continue its yield curve control policy. If, as we expect, U.S. long-term interest rate trend up in the coming months, relative rates will put downward pressure on the yen. Our FX strategists expect the USD/JPY at 125 within 12 months. EM Currencies: With Chinese growth likely to remain questionable over the coming months, emerging market currencies will lack their biggest tailwind. Terms of trade will continue to turn negative as commodity prices weaken. EM monetary authorities will mostly be easing policy in order to support growth. With rates kept low, relative monetary policy is likely to will force EM currencies, especially those for commodity exporters, to depreciate from current levels. Alternatives Chart 27Attractive Risk-Return Profile Attractive Risk-Return Profile Attractive Risk-Return Profile Return Enhancers: Favor private equity vs. hedge funds In 2016, private equity returned 9%, whereas hedge funds managed only a 3% return (Chart 27). Strong performance led to private equity funds raising $378 bn last year, the highest level of capital secured since the Global Financial Crisis. By contrast, hedge funds have underperformed global equities and private equity since the financial crisis of 2008-09. However, investors have become increasingly concerned with valuation levels in private markets. Our recommendation is that investors should continue to overweight private equity vs hedge funds, since we do not see a recession as likely over the next 12 months. Within the hedge fund space, we would recommend overweighting event-driven funds over the cycle, and macro funds heading into a recession (please see our Special Report, dated June 16, 2017). Inflation Hedges: Favor direct real estate vs. commodity futures In 2016, direct real estate returned 9%, whereas commodity futures achieved 12%. Given the structural nature of this recommendation, investors need to look past recent short-term moves in commodity prices. Low interest rates will keep borrowing cheap, making the spread between real estate and fixed income yields continue to be attractive. Moreover, with 48% of institutional investors currently below their target allocation for real estate, there is a lot of potential for further capital allocations to the asset class. With regards to the commodity complex, the long-term transition of China to a services-based economy will lead to a structural decline in commodity demand. Investors should continue to overweight direct real estate vs commodity futures on a 3-5 year target horizon. Volatility Dampeners: Favor farmland & timberland vs. structured products In 2016, farmland and timberland returned 9% and 3% respectively, whereas structured products returned 2%. Farmland and timberland will continue to benefit from favorable global demographic trends, as a growing population and improving prosperity in the developing world increase food consumption. However, increased volatility in lumber and agriculture prices have made investors concerned about cash flows. With regards to structured products, increasing rates and deteriorating credit quality in the auto loan market will slow credit origination. Given that the Fed will start unwinding its balance sheet this year, increased supply will put upward pressure on spreads. Investors can reduce the volatility of a multi-asset portfolio with the inclusion of farmland and timberland. Risks To Our View We explained the two alternative scenarios to our main view in the Overview section of this Quarterly. There are three other specific areas where our views differ notably from the consensus: Strong dollar. Our view is predicated on the Fed tightening policy more than the market currently expects, and the ECB less. Interest rate differentials (Chart 28) certainly point to a stronger USD, and speculative positions have reversed from being very dollar-long at the start of the year. But the euro momentum could continue for a while, especially given mixed messages from Mario Draghi, for example when he said in late June that "the threat of deflation is gone and reflationary forces are at play." Crude oil back at $55. Our Energy strategists believe that the oil price is currently being driven by supply, not demand. They argue that OPEC production cuts will hold and cause inventories to draw down rapidly over the coming six months. However, speculative positioning in oil has shifted from very long to significantly short since the start of the year. The risk is that U.S. oil production continues to accelerate (Chart 29), as fracking technology improves and availability of capital for oil producers remains easy. Negative on EM. Our 12-month EM view is predicated on a stronger dollar, higher U.S. interest rates, slowing Chinese growth, and falling commodity prices. We could be wrong about these drivers. Falling inflation in emerging markets such as Brazil (Chart 30) could allow central banks to cut rates aggressively, which might temporarily boost growth. Chart 28Rate Differentials Suggest Strong Dollar Rate Differentials Suggest Strong Dollar Rate Differentials Suggest Strong Dollar Chart 29Oil Bears Point To U.S. Output Oil Bears Point To U.S. Output Oil Bears Point To U.S. Output Chart 30Sharp Fall In Brazilian Inflation Sharp Fall In Brazilian Inflation Sharp Fall In Brazilian Inflation 1 Our U.S. Bond Strategists explain the detailed thinking behind these three scenarios in their Weekly Report "Three Scenarios for Treasury Yields In 2017," dated June 20, 2017, available at usbs.bcaresearch.com 2 Market-cap weighted average of Apple, Alphabet, Microsoft, Amazon and Facebook. 3 Market-cap weighted average of Microsoft, Cisco Systems, Intel, Oracle and Lucent. Recommended Asset Allocation

Feature Chart 1Global Growth Pick Up Global Growth Pick Up Global Growth Pick Up As a whole, G10 economies have been in expansion for more than seven years now. Moreover, after a near-recessionary episode in late 2015 / early 2016, the global economy is on a renewed upswing, with global trade and capex having regained vigor (Chart 1). Similar upswings in aged economic expansions have historically been the ideal breeding ground for global monetary tightening. However, the world economy is still dealing with two deflationary anchors: two decades of over-investment in emerging markets that have led to chronic overcapacity globally, and a strong preference for savings - a legacy of the great financial crisis (GFC) in the West and of financial repression in China. Thanks to this confluence of forces, global central banks have been fearful of tightening policy, hence, global policy rates continue to hover near multi-generational lows. Yet, now that the Federal Reserve has opened Pandora's box and raised rates four times, the question on every investor's mind is who is next. In this piece, we examine a few key domestic indicators for each G10 central bank (CB), and try to categorize CBs according to their likelihood of being the next one to tighten policy. We find three groups. The first one with the highest likelihood of hiking includes New Zealand, Sweden, and Canada. We place Australia, the U.K., and the Euro Area in the somewhat-likely-to-tighten camp. Finally, among the economies where we see little scope for tighter policy are Norway, Switzerland, and Japan. Using this ranking, we examine the implications for these countries' respective currencies and equity markets' relative performance. In this optic, it is important to remember that while conventional wisdom dictates that the stock market needs a depreciating currency in order to advance, empirically, countries with appreciating exchange rates have tended to outperform the global equity benchmark, reflecting the effect of international flows into these economies and markets.1 Finally, we look forward to publish in the coming months a quantitative model based on the indicators used in this report. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com Most Likely To Increase Rates First: 1) New Zealand Chart 2New Zealand New Zealand New Zealand The real Official Cash Rate has never been at such a discount to trend real GDP growth (Chart 2). As a result, nominal GDP is growing at a strong 6% a year, and core inflation is moving back toward 2%. Additionally, nominal retail sales are expanding at nearly 8% per year, the highest pace since 2007. According to the OECD, GDP is now nearly 2% above trend, which highlights the inflationary nature of New Zealand's economy. Supporting that, capacity constraints are becoming rampant, despite strong immigration into the country, unemployment is now nearly 1% below equilibrium, further confirming that the Reserve Bank of New Zealand is keeping policy at too-stimulative levels. This time around, hiking rates will not be a policy mistake as it was in both 2010 and 2014. In 2010, the difference between real rates and trend real GDP growth was much narrower than today, and the output gap was still very negative. In 2014, measures of slack were also not supportive of higher rates, and a rollover in core inflation as well as muted retail sales growth created additional headwinds. Most Likely To Increase Rates First: 2) Sweden Chart 3Sweden Sweden Sweden The Riksbank's repo rate has been driven lower in response to the European Central Bank's own bias, resulting in a Swedish repo rate of -0.5%. The gap between the real policy rate in Sweden and trend GDP growth is hovering around record-low levels (Chart 3). Supported by such a stimulative policy setting, Swedish non-financial private credit has expanded massively, hitting 230% of GDP. Today, the output gap is in positive territory and the unemployment gap indicates that the labor market has tightened considerably. In fact, both measures are congruent with the levels recorded during prior rate-tightening cycles. Core inflation is still below the central bank's 2% target, but is accelerating higher. The Riksbank's resource utilization indicator is further confirming this trend and points toward much higher inflation in the second half of 2017.2 Retail sales have been soggy, but they are picking up anew, clearing the way for a rate hike. Crucially, under the tutelage of Stefan Ingves, the Riksbank has been extremely dovish, but his second term as head of the institution ends this year. For now, he does not look set to be re-appointed. His re-appointment constitutes the greatest risk to our Riksbank view. Most Likely To Increase Rates First: 3) Canada Chart 4Canada Canada Canada The gap between the real policy rate and trend real GDP growth is still very negative, much more so in fact than was the case in 2010, the last time the Bank of Canada (BoC) tried to hike interest rates. The output gap and the unemployment gap continue to point toward a small degree of slack in the Canadian economy (Chart 4). Nonetheless, the BoC expects the output gap to close in 2018. However, the amount of slack in the economy remains very low compared to what prevailed in 2010. Like in the U.S., core inflation has recently sagged, but retail sales continue to grow at a healthy pace. Canadian policy rates have rarely diverged from those in the U.S. for long as the Canadian economy is deeply integrated in the U.S. supply chain. This means that economic impulses in the U.S. are often transferred to Canada. The Fed increasing rates in the U.S. puts pressure on the BoC. If rates diverge for too long, the Loonie will weaken considerably, exacerbating inflationary pressures in Canada. Recent communications of the BoC's most senior staff indicate a very sharp move away from dovishness. Middle Of The Pack: 1) Australia Chart 5Australia Australia Australia The gap between real policy rates and trend real GDP growth is in stimulative territory, but it is not at the level seen in New Zealand, Sweden or Canada. While the unemployment gap suggests the labor market is becoming increasingly tight, the OECD's measure of the output gap still stands near record lows, suggesting that in aggregate there remains substantial slack in Australia (Chart 5). This paints a mixed picture rather than an indubitably good or bad one. Core inflation remains in a downtrend and nominal retail sales are growing at very low rates, further highlighting that monetary policy is not as accommodative as in New Zealand or Canada. Improvement in global trade continues to support the Australian economy, and strong real estate activity suggests that policy is too easy for domestic asset prices. These two forces are critical in preventing Australia from falling into the bottom basket of central banks. Even if a small deceleration in global activity emerges, so long as it does not degenerate into the kind of vicious commodity selloff experienced in the second half of 2015 and early 2016, the Australian economy will be able to avoid another deceleration. Middle Of The Pack: 2) The U.K. Chart 6U.K. U.K. U.K. On many fronts, the U.K. looks ripe for an imminent rate hike. The gap between the real policy rate and trend real GDP growth is as depressed as the levels recorded in the countries in the first bucket, suggesting that the Bank of England's policy stance is extremely accommodative (Chart 6). However, like in Australia, measures of economic slack paint a mixed picture. The unemployment gap points to an absence of slack, while the output gap remains negative and indicative of some slack in the U.K. Retail sales have been lifted by the recent surge in inflation, with core consumer prices now growing at a 2.6% annual rate. However, this picture is distorted. Real retail sales have massively decelerated, and the surge in inflation has had nothing to do with domestic conditions but has been entirely due to the pass-through associated with the near-20% collapse in the trade-weighted pound since November 2015. Beyond the negative output gap, the key reason why the BoE is not at the top of the list of potential hikers is because U.K. household inflation expectations remain well behaved, and the economy could continue to decelerate in the face of uncertainty associated with Brexit. This could even prompt Mark Carney to keep an even more dovish stance that we or the market currently anticipate. Middle Of The Pack: 3) The Euro Area Chart 7Euro Area Euro Area Euro Area The gap between the real policy rate and trend real GDP growth in the euro area is actually also at extremely stimulative levels (Chart 7), partly explaining why the European economy has been able to generate so many positive data surprises. However, the euro area economy still needs easy policy. The output gap remains very negative and unemployment is still below equilibrium. In fact, as we have argued, this latter indicator may even underestimate the amount of labor market slack in Europe, as measures of labor underutilization remain very elevated. Euro area core inflation has been moving up, but at around 1% remains well shy of the ECB's objective of close to but below 2%. True, officially the ECB targets headline inflation, but Draghi's emphasis on underlying domestic inflation trends belies a focus on core inflation. Ultimately, the combination of labor underutilization, simmering political risk in Italy and a still-negative output gap suggests the ECB in unlikely to lift interest rates until at least late 2018. The biggest risk to our view would be for the ECB to tighten policy more than we or even the market anticipate. This would put the ECB ahead of the BoE. The Laggards: 1) Norway Chart 8Norway Norway Norway The gap between Norway's real policy rate and trend real GDP growth is still indicative of an easy policy stance. However, the recent dip in core inflation has caused an inadvertent policy tightening, as illustrated by the gap's sharp narrowing (Chart 8). The OECD's measure of Norway's output gap is very negative, and the unemployment rate has not been this deeply above equilibrium in more than 20 years. As such, there seems to remain large amounts of slack in the Norwegian economy. Corroborating this assessment, Norwegian wages are contracting at a 4% annual pace. Norwegian retail sales have been very weak, and core inflation has collapsed from 4% to 1.5%. This easing in inflation is a blessing for the Norges Bank as this allows it to focus on the large amount of slack still present in the economy. The Laggards: 2) Switzerland Chart 9Switzerland Switzerland Switzerland Despite a deeply negative nominal policy rate and a continuously expanding central bank balance sheet, Switzerland monetary policy does not seem to be very easy, as the gap between the real policy rate and the trend real GDP growth rate is in neutral territory (Chart 9). The OECD's output gap and the difference between the headline unemployment rate and equilibrium unemployment rate both point toward plentiful slack in the Swiss economy. Swiss wage growth also remains quite tame, only hitting 0.1% last quarter. Core inflation remains well below target as it only modestly moved back into positive territory three months ago. The confluence of not-so-easy monetary policy and plentiful excess capacity suggests that despite the challenging conditions for Swiss pension plans and insurance companies created by deeply negative rates the Swiss economy is not yet ready to handle tighter monetary policy. The Laggards: 3) Japan Chart 10Japan Japan Japan Japan might be the most perplexing economy in the G10 right now, and the Bank of Japan is in the toughest position of all the major central banks in the advanced economies. Like Switzerland, despite negative nominal short-term interest rates and large asset purchases by the BoJ, the gap between Japan's real policy rates and trend real GDP growth suggests that policy is only at a neutral setting (Chart 10). This would seem appropriate given that both the output gap and the unemployment gap point to little spare capacity in Japan. However, this does not square with core inflation moving back into negative territory and barely expanding retail sales. Ultimately, Japan's problem is two-fold. First, the unemployment gap underestimates the amount of labor underutilization in Japan, as output per hour worked remains 11% and 34% behind that of the OECD and the U.S, respectively. Second, extremely depressed Japanese inflation expectations continue to result in an extraordinarily flat Philips curve. Due to these dynamics, we expect that it will take continued sustained efforts by the BoJ to overheat the economy before any signs of inflation emerge. FX Implications Based on our assessments, we would expect the RBNZ, the Riksbank and the BoC to be the first central banks to hike now that the Fed has blazed the trail. Within this group, the RBNZ is potentially the cleanest story, as all factors are aligned. We would expect the RBNZ to hike late summer / early fall 2017. Technically, the Riksbank seems in a better place to hike rates than the BoC. However, the leadership of the BoC is already preparing the market for higher rates. Canadian rates could also rise as soon as late summer / early fall 2017. Meanwhile, so long as Ingves remains head of the Riksbank, the Swedish central bank will likely stand pat. Thus, we would expect the first hike to materialize early next year, as soon as a new governor takes the helm, although, we believe markets will begin pricing in such a hike as soon as his replacement is announced. In the second group of central banks, we expect the RBA to be the first to increase rates. The BoE does face a much more inflationary environment than the RBA, but the U.K.'s economic uncertainty remains such that the BoE is likely to tread carefully and wait to see how the economy handles the new wave of political trauma unleashed by this month's election. The ECB is likely to begin tapering its own purchases at the end of 2017, but our base case anticipates that it will not touch policy rates until well into 2018. Among the laggards, the Norges Bank will most likely be the first to push up rates - something we do not anticipate until late 2018. While BCA expects oil prices to rebound, this is unlikely to boost the economy fast enough to close the output gap for at least 18 months. Switzerland and Japan need to do a lot of work before their respective economies generate any kind of inflationary pressures. We do not anticipate any tightening for Switzerland until well after the ECB has moved. The BoJ may not tighten policy for the remainder of this decade. This means that the CAD and the NZD are likely to prove to be the best-performing currencies in the dollar bloc. Investors should stay short AUD/NZD and AUD/CAD. CAD/NOK also possesses more upside. The SEK could prove to be the best performing European currency. Swedish money markets are pricing in only 40 basis points of hikes over the next 12 months, something that seems too low considering the inflationary risk in that country. Stay short EUR/SEK. The EUR/USD rebounded this week on the back of seemingly hawkish comments by Draghi. Even when the ECB somewhat backtracked and communicated that the market had misinterpreted the speech, EUR/USD looked the other way. This confirms our fear that the momentum in this pair is too strong to fight. EUR/USD should retest 1.15-1.16, the upper bound of its trading range put in place since March 2015. Based on our economics work, any move above 1.15 should be used to short the euro. The pound will continue to suffer from a political discount, however, because our base case expects the BoE to tighten policy before the ECB, we continue to recommend that investors use moves above 0.88 to begin shorting EUR/GBP. The SNB is unlikely to remove its cap on the Swiss franc, which means the natural upward pull created by the large net international position of Switzerland will be of little solace for investors. Finally, the JPY should be the worst performing currency in the G10 as the BoJ will not be able to lift rates - a great handicap when, as BCA expects, global bond yields are likely to enjoy more upside than downside over the next 12 months. Equity Implications U.S. Equities Chart 11U.S. U.S. U.S. Contrary to popular belief equities and the currency are joined at the hip especially during currency bull markets. A rising currency tends to attract flows and equities outperform in common and local currency terms. Keep in mind that domestic equity exposure dominates stock market weightings, further solidifying the positive currency and equity correlation. The top panel of Chart 11 shows that this relationship is extremely tight in the U.S. with equities outperforming the MSCI ACWI when the dollar advances and suffering a setback when the greenback depreciates. The Fed has raised rates three times since December 2015 and is slated to tighten monetary policy one more time later this year. This is well telegraphed to the markets, and thus the U.S. dollar has been in sell off mode for the past 6 months, weighing on relative equity performance. The relative economic surprise indexes also have an excellent track record in forecasting relative equity momentum, and the current message is grim for relative share prices. We expect the U.S. to continue to trail other G10 bourses in the coming months and the MSCI ACWI as other CBs have more scope to tighten monetary policy, and recommend an underweight stance in global equity portfolios. Bank/financials performance is also closely linked to monetary policy. While the yield curve flattening tends to suppress net interest margins (NIM), the recovery in loan volumes and drop in NPLs owing to a pickup in economic growth more than offsets the fall in NIMs. We continue to recommend overweight exposure in U.S. banks/financials both in global and U.S. only portfolios.3 New Zealand Equities Chart 12New Zealand New Zealand New Zealand The positive stock and currency correlation exists in New Zealand. Currently, the Kiwi has been rising, but relative equities have not followed suit. If our analysis proves prescient and the RBNZ becomes the next G10 CB to hike, then a playable relative equity catch up phase will materialize (Chart 12). The relative surprise index is firing on all cylinders and corroborates the bullish economic message from our macro analysis and hints that New Zealand equities are a buy. We recommend an overweight stance in New Zealand stocks in global equity portfolios. While all the rest of the G10 have a domestic banking sector, New Zealand is the exception. Australian banks dominate the banking scene in New Zealand, and thus serve as a good proxy. We are comfortable to have a modest Australian banks/financials exposure in New Zealand only portfolios. However, there is one caveat: the housing market is bubbly. While excesses are well documented, we doubt that the housing markets would burst either in Australia or in New Zealand in the coming 6-12 months and bring down the Australian banking sector. In such a time frame, both CBs will still be early in their respective tightening cycles. Swedish Equities Chart 13Sweden Sweden Sweden The Swedish krona moves in lockstep with relative share prices, a relationship that has been in place for the better part of the past two decades (Chart 13). Were the Riksbank to raise the policy rate from deeply negative territory, as our macroeconomic analysis pegs it as second most likely, then equities will outperform the MSCI ACWI, and we recommend an above benchmark allocation in global equity portfolios. Economic surprises in Sweden continue to outnumber the G10, heralding additional momentum gains in relative share prices (bottom panel). The elimination of NIRP would also benefit the banking sector. NIRP serves as a noose around banks' necks, as bankers cannot pass on NIRP to retail depositors weighing on NIMs. Chart 21 in the Appendix shows that Swedish financials comprise over 30% of the overall Swedish market and drive overall market performance. Thus, we are comfortable with an overweight stance in financials in Swedish only equity portfolios given the prospects of tighter monetary policy in the coming quarters. Canadian Equities Chart 14Canada Canada Canada The Loonie and relative equity performance also move in tandem (Chart 14). At the current juncture the bear market in oil prices has dampened both the currency and equities, as Canada is an excellent proxy for commodity prices in general and oil prices in particular. The BoC is the third most likely CB to raise interest rates in the coming months according to our analysis, raising the odds of a reversal of fortunes for Canadian equities. The relative economic surprise index is surging, opening a wide gap with relative share price momentum. If our thesis proves accurate and the BoC pulls the trigger soon, then Canadian equities will gain some traction. Under such a backdrop we recommend an overweight stance in global equity portfolios. In terms of financials, Canadian financials' market capitalization weight is the second largest in the G10, exerting significant influence in overall equity direction. If the commodity complex is healthy enough for the BoC to tighten monetary policy, then banks will outperform on the back of firming loan growth and receding commodity related NPLs. Nevertheless, the housing market poses a clear risk. Were a housing crisis to grip the Canadian economy, bank earnings and thus performance would suffer a sizable blow. Our sense is that such an outcome is highly unlikely in the next year, making us comfortable recommending overweight financials exposure in Canadian only equity portfolios. Australian Equities Chart 15Australia Australia Australia The positive correlation between FX rates and relative equity performance is prevalent in Australia (Chart 15). Currently, the Aussie has stayed resilient, but equities have given way suffering alongside commodities in general and iron ore prices in particular. The RBA sits in the middle of the pack in terms of hiking interest rates next according to our thesis, but still remains the fourth most likely CB in the G10 to pull the trigger ahead of the BoE and the ECB. As such, we recommend a neutral weight in global equity portfolios. While the relative economic surprise index has vaulted higher, the positive correlation with relative share price momentum seems to have broken down in recent years. Similar to Canada, Australian financials comprise a large chunk of the broad equity market (see Chart 21 in the Appendix on page 24), setting the tone for overall equity returns. If Canada's housing market is frothy, then Australia is a definite bubble and poses a significant risk to the banking sector. The APRA is breathing down banks' necks and that is reflected in recent bank underperformance. As we mentioned earlier, we doubt the Australian housing market blows up in the next 6-12 months as the RBA will be in the early innings of a tightening cycle. As a result, only a benchmark allocation is warranted in Australian banks in Australian only portfolios. U.K. Equities Chart 16U.K. U.K. U.K. Cable and relative U.K. equity performance also follow our currency/FX positive correlation playbook (Chart 16). Relative share prices have ticked up recently taking cue from the rebound in sterling. British economic surprises have been outnumbering the G10 post Brexit, and sport a positive correlation with relative share price momentum. Our U.K. macroeconomic analysis highlights that the BoE stands right in the middle of the CB pack. Importantly, the BoE is our "surprise risk" of staying easy for longer than the economic variables would suggest as the dust clears from the Brexit aftermath. Under such a backdrop we recommend a modest underweight in U.K. equities in global equity portfolios. Similarly, U.K. banks also warrant a slight underweight stance in U.K. only equity portfolios. Eurozone Equities Chart 17Euro Area Euro Area Euro Area Euro area stocks and the euro have been positively correlated especially since 2003. Year-to-date EUR/USD is up roughly 10% and Eurozone equities have been stellar outperformers. The catalyst for the euro's sizable gains has been the market's realization that the ECB passed its maximum easing in Q1/2017. Receding geopolitical uncertainty has also played a key role. In addition, the economy has responded well both to the extraordinarily easy monetary policy measures and move away from austerity. The bottom panel of the Chart 17 shows that relative economic surprises are probing 5-year highs pulling relative equity momentum higher. While our macro analysis suggests that the ECB stays pat for a while longer, our "surprise risk" is that the ECB moves earlier than we expect and removes some of the extreme monetary accommodation. As a result we continue to recommend above benchmark exposure both in Eurozone equities and banks/financials. Importantly, not only will euro area banks benefit from the eventual ECB's removal of NIRP and the related boost to NIMs, but also NPLs have peaked and will continue to drift lower along with the unemployment rate. More recently, the speedy and contained resolution of two Italian bank failures along with the absorption of two Spanish banks by Santander and Bankia are a giant step in the right direction. These moves also suggest that there is political will to overcome the banking issues in the euro area. Additional bank cleanup is likely and this is a welcome development in the Eurozone that should entice healthier banks to extend credit to the economy. Norwegian Equities Chart 18Norway Norway Norway Over the past two decades, the Norwegian krone and relative equity performance have moved in lockstep (Chart 18). Year-to-date, relative Norwegian equities have fallen to fresh cycle lows. Similar to Canada, the country's substantial oil dependency has weighed on relative share prices and also knocked down the krone. Our macro analysis concluded that the Norges Bank will be late in lifting interest rate and sits at the bottom of the G10 CBs. As a result, we recommend underweight exposure in Norwegian stocks in global equity portfolios. Financials in Norway comprise one fifth of the stock market's capitalization (Chart 21 in the Appendix on page 24) and have been on a nearly uninterrupted run since the end of the GFC and catapulted to multi-decade highs. Given our thesis of the Norges Bank staying late in raising rates we recommend lightening up on financials equities in Norwegian only equity portfolios. Swiss Equities Chart 19Switzerland Switzerland Switzerland Since the late 1990s relative Swiss share prices and the CHF have been enjoying an almost perfect positive correlation (Chart 19). At the current juncture Swiss stocks have been propelling higher versus the MSCI ACWI as the franc has been appreciating. There are extremely low odds that the SNB would move the needle in terms of normalizing interest rates any time soon, according to our analysis. Keep in mind that the SNB is conducting the ultimate QE experiment by purchasing U.S. stocks, underscoring that there are a lot of layers/levers of momentary policy easing that it will have to eventually to unwind. The implication is that we would lean against recent strength in the Swiss equity market and recommend a below benchmark allocation. Switzerland financials have the third lowest market cap weight in the G10 as UBS and CS are still licking their wounds from the aftermath of the GFC. Relative financials performance has been soft and taken a turn for the worse recently in marked contrast with global financials exuberance since Brexit. Our macro analysis suggests that a below benchmark allocation is warranted in financials in Swiss only portfolios. Japanese Equities Chart 20Japan Japan Japan The Japanese yen and relative equity performance were joined at the hip from the mid-1990s until 2009. From the end of the GFC until 2015 this correlation broke down as Japan has been in-and-out of recession. Since then however, there is tentative evidence that Japanese equities and the yen have resumed moving in tandem (Chart 20). Our macroeconomic analysis suggests that Japan will be the last G10 CB to lift interest rates. While our study would signal that investors should avoid Japanese equities, we do not have high confidence in that view. The break and resumption in the equity/currency correlation is worrisome and suggests that other more important factors are in play dictating relative share price performance. As a result, we would modestly overweight Japanese equities in global equity portfolios in line with BCA’s Global Investment Strategy service view.4 On the financials front, relative performance in Japan has fallen into oblivion. NIRP is anchoring NIMs. But, an extremely low unemployment rate suggests that NPLs will continue to probe multi decade lows and provide an offset to bank EPS. Thus, we would stick with a neutral weighting in Japanese financials.5 Appendix Chart 21G10 Financial Market Cap Weights Who Hikes Next? Who Hikes Next? 1 For a more detailed discussion on the correlation between equity prices and the currency market, please see Global Alpha Sector Strategy Special Report titled, "Can The S&P 500 Rise Alongside The U.S. Dollar?", dated October 7, 206, available at gss.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 16, 017, available at fes.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report titled, "Girding For A Breakout?", dated May 1, 2017, available at uses.bcaresearch.com 4 Please see Global Investment Strategy - Strategy Outlook "Third Quarter 2017: Aging Bull", June 30, 2017, available at gis.bcaresearch.com 5 Please see Global Alpha Sector Strategy Weekly Report titled "The Year Of The Letter "R"", January 13, 2017, available at gss.bcaresearch.com

Highlights Trade 1: An unwinding of the Trump reflation trade... has worked exactly as expected. Take profits and switch into Trade 5. Trade 2: Short pound/euro at €1.18 and simultaneously buy call options at €1.30... is up 4%. Take profits and add to long euro/dollar. Trade 3: Underweight French OATS... has worked well both in a European bond portfolio and in a global bond portfolio. Stick with this trade. Trade 4: Long euro/yuan... is up 6%. Stick with this trade. Trade 5 (New): Underweight emerging market equities. European equity investors should underweight Poland. Feature At the mid-point of the year, we are devoting this report to appraise our top investment ideas for 2017 - as recommended in our December 22 report Five Pressing Questions (And Four Trades) For 2017. Half-time is a good moment to review the thoughts we had at the start of 2017, establish how the ideas have performed in the first half, and assess whether to stick with them or make some changes in the second half. Chart of the WeekFor EM Equities, Excessive Groupthink Is Hitting Its Natural Limit For EM Equities, Excessive Groupthink Is Hitting Its Natural Limit For EM Equities, Excessive Groupthink Is Hitting Its Natural Limit Trade 1: An Unwinding Of The Trump Reflation Trade Chart I-2The Trump Reflation Trade Has Unwound The Trump Reflation Trade Has Unwound The Trump Reflation Trade Has Unwound Our thoughts at the start of 2017: "Can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? This publication believes that the tide has not turned... Rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now." How has the trade performed in the first half? Exactly as scripted, the Trump reflation trade - in its various guises - has unwound. Since our original report, the trade-weighted dollar is down 5%; the global bond yield is down 15bps (the 10-year T-bond yield is down 40bps); and banks have underperformed the market by 5% (Chart I-2). Our thoughts for the second half of 2017: Never forget that the financial markets are a complex ecosystem in which long-term investors jostle with short-term traders. The equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. In February, our prescient warning in The Contrarian Case For Bonds was that as emotional and impulsive short-term traders had been left unchecked to drive markets, excessive groupthink was hitting its natural technical limit. The 6-month sell-off in bonds had reached a point of instability. And sure enough, the trend broke (Chart I-3). Chart I-3For Bonds, Excessive Groupthink Hit Its Natural Limit In February For Bonds, Excessive Groupthink Hit Its Natural Limit In February For Bonds, Excessive Groupthink Hit Its Natural Limit In February At such tipping points of excessive groupthink, a good benchmark is that the preceding trend will reverse by one third. On this basis, a large part of the gains in the Trump trade unwind have now been made. Take profits and switch into new trade 5. Trade 2: Short Pound/Euro At €1.18 And Simultaneously Buy Call Options At €1.30 Our thoughts at the start of 2017: "2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive... The pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other." How has the trade performed in the first half? For U.K. politics, "especially unpredictable" could be the understatement of the year! An unpredicted general election generated an even more unpredicted result. With pound/euro now below €1.13, the directional position is up 5% in gross terms, and up around 4% in net terms allowing for the cost of the call options (Chart I-4). Chart I-4Pound / Euro Has Underperformed In 2017 Pound / Euro Has Underperformed In 2017 Pound / Euro Has Underperformed In 2017 Our thoughts for the second half of 2017: In a hung parliament, the minority Conservative government does not have the parliamentary maths to legislate for a hard Brexit in either the House of Commons or the House of Lords. Significantly, the so-called 'Salisbury Convention' - in which the House of Lords does not oppose the second or third reading of any government legislation promised in its election manifesto - does not necessarily apply in a hung parliament. This is because, by definition, the minority Conservative government's manifesto did not secure a majority in the House of Commons. With the hard Brexit tail-risk diminished, our current preference for currencies is euro first, pound second, dollar third, based on the evolution of interest rate expectations explained below. Hence, take profits in short pound/euro and add to long euro/dollar. Trade 3: Underweight French OATS Our thoughts at the start of 2017: "2016 was the year when QE peaked... The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero." How has the trade performed in the first half? French OATS have substantially underperformed both U.K. gilts (Chart I-5) and U.S. T-bonds (Chart I-6). So it has been correct to underweight French government bonds both in a European bond portfolio and in a global bond portfolio. Chart I-5French OATs Have Underperformed In##br## A European Bond Portfolio... French OATs Have Underperformed In A European Bond Portfolio... French OATs Have Underperformed In A European Bond Portfolio... Chart I-6...And A Global ##br##Bond Portfolio ...And A Global Bond Portfolio ...And A Global Bond Portfolio Our thoughts for the second half of 2017: Central banks' professed commitment to data-dependency means that their words - and ultimately actions - must acknowledge the hard data. No ifs, buts or maybes. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses, which lead activity, euro area hard data will continue to be among the best among the major economies. Combined with the supply shortages the ECB is now facing in buying German bunds, expect the ECB's words to continue becoming more hawkish. The recent relatively smooth winding down of three failing banks - Spain's Banco Popolare and Italy's Banca Popolare di Vicenza and Veneto Banca - will also hearten the ECB that the strategy for resolving its undercapitalised banks does not pose a systemic risk to the economy or markets. Hence, expect euro area interest rate expectations to continue converging with other developed economies. And stick with the underweight French OATS (or German Bunds) trade, especially in a global bond portfolio. Chart I-7Euro / Yuan Is Up 6% Euro / Yuan Is Up 6% Euro / Yuan Is Up 6% Trade 4: Long Euro/Yuan Our thoughts at the start of 2017: "The debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation... China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses." How has the trade performed in the first half? Euro/yuan is up 6% (Chart I-7). Our thoughts for the second half of 2017: The thoughts we expressed at the start of 2017 are still entirely valid and supported by the argument for trade 5 below. Stick with long euro/yuan. Trade 5 (New): Underweight Emerging Market Equities Just as we presciently warned of excessive negative groupthink towards bonds in February, we are now seeing similarly excessive positive groupthink towards EM equities hitting its natural technical limit. This is a strong warning that the first half 15% rally risks reversing, or fizzling, in the second half (Chart of the Week). Chart I-8If EM Underperforms DM, Poland ##br##Underperforms Europe If EM Underperforms DM, Poland Underperforms Europe If EM Underperforms DM, Poland Underperforms Europe For the detailed fundamental analysis, I refer you to the latest reports penned by my colleague, BCA's Chief Emerging Markets Strategist, Arthur Budaghyan. But in summary, Arthur says: "China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth... the outlook for EM risk assets is extremely poor... and we continue to recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies."2 For European equity investors, this means underweighting Poland, whose relative performance tracks EM versus DM equities (Chart I-8). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Please see the Emerging Markets Strategy Weekly Report "EM: Contradictions And A Resolution" published on June 14, 2017 and available at ems.bcaresearch.com Fractal Trading Model* As shown on page 1, this week's trade is to go short emerging markets with a corresponding long in developed markets. In this case, the trade duration is up to 6 months with a profit target and stop-loss of 3%. Amongst our other open trades, long FTSE100 / short IBEX35 is approaching its 4% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Long FTSE100 / Short IBEX35 Long FTSE100 / Short IBEX35 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well EM Carry Trade Is Alive And Well EM Carry Trade Is Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR Chart I-7 Chart I-8 The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? ...And AUD Sustainable? ...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Household Consumption Is Declining Household Consumption Is Declining Chart I-13No Confidence, No Investment No Confidence, No Investment No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... Middle Class Has Barely Budged... Middle Class Has Barely Budged... Chart I-16 The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer South African Productivity Has No Peer South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. Chart I-20 Chart I-21 This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. Chart I- BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Structural Unemployment Is Egregious Structural Unemployment Is Egregious Chart I-23 Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Yield Curve Will Steepen Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Geopolitical Calendar

Highlights The EM carry trade - supported by a commodity price rally, falling bond yields, and a weak USD - have propped up South African assets; Investors have largely ignored politics and focused on personalities instead of political fundamentals; South Africa's socio-economic factors - governance, middle class wellbeing, productivity, and unemployment - have all regressed; The "median voter" has therefore turned more radical and left-wing; Stay short ZAR versus USD and MXN, stay underweight stocks, sovereign credit, and domestic bonds, and bet on yield-curve steepening. Feature Why do investors in Europe and the U.S. continue to invest in South Africa? - Every client in South Africa Our recent week-long trip to South Africa was revealing for two reasons. First, it reminded us of the promise and opportunity of this amazing country and its people. Second, it impressed upon us the deep pessimism of its entire financial community. As the quote at the top of this report suggests, every client we met over seven days was deeply puzzled by continued resilience of foreign inflows. Clients were surprised that foreign investors continued to find value in South Africa's fixed income and currency markets amidst a continued growth downtrend, soft commodity prices, and the ongoing political imbroglio (Chart I-1). The answer to the puzzle is simple: the main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart I-2). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart I-1ZAR Rally Amidst Economic##br## And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn ZAR Rally Amidst Economic And Commodity Downturn Chart I-2EM Carry Trade Is ##br##Alive And Well EM Carry Trade Is Alive And Well EM Carry Trade Is Alive And Well How likely is it that the carry trade can continue? BCA's Global Investment Strategy and Emerging Markets Strategy both argue that U.S. growth will soon accelerate.1 The U.S. financial conditions have eased thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart I-3). Historically, an easing in financial conditions has foreshadowed faster growth (Chart I-4). Meanwhile, the relative U.S. growth underperformance versus DM is late and will turn around very soon (Chart I-5). As U.S. economic growth surprises pick up, investors will bid up the 10-year Treasury yield and the greenback, ushering in the end of the carry trade. Chart I-3U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... U.S. Financial Conditions Have Eased... Chart I-4...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound ...U.S. Growth Should Therefore Sharply Rebound Chart I-5U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth U.S. Underperformance Is Long-In-The-Tooth How resilient are South Africa's economic fundamentals and politics? In this report, we argue that they are not resilient at all. The country is facing considerable structural problems on both economic and political fronts. Even its sole silver lining - that it retains cyclical maneuvering room, i.e., it can adopt fiscal stimulus - will only encourage its leaders to double-down on a populist growth model that has already run out of steam. Cyclical Outlook: A Dark Cloud With A Silver Lining The cyclical outlook for South Africa has darkened as of late. All the drivers that pushed the rand to appreciate over the last 12 months are now showing signs of a reversal: The rand's rally in the past six months or so - a period when it decoupled from commodities prices - is often attributed to its higher interest rates. However, Chart I-6 demonstrates that higher local interest rates historically did not prevent the rand's selloff when metal prices fell. In short, we believe the last six months is an aberration rather than a new norm. Remarkably, hedged yields in South Africa are no longer attractive within the EM space. South Africa already offers the worst hedged returns, after Turkey and China, for the U.S. dollar and euro-based investors (Chart I-7 and Chart I-8).2 The situation will only get worse as the U.S. dollar appreciates and Treasury yields rise. Chart I-6High Local Interest Rates ##br##Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR High Local Interest Rates Are No Panacea For ZAR Chart I-7 Chart I-8 The drop in precious metal prices will force the rand to selloff (Chart I-9). The unprecedented resilience in the rand was supported by increasing financial flows. Now that these are decreasing, the historic correlation with precious metals should reemerge. The decoupling between the ZAR and AUD since early this year is unprecedented (Chart I-10). Both economies are leveraged to industrial and precious metals as well as coal prices, making both exchange rates correlated. Needless to say, Australia commands much better governance and politics than South Africa. In fact, higher interest rates in South Africa have never precluded the rand's depreciation when the AUD dropped. Chart I-9Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Is The Divergence With Precious Metals... Chart I-10...And AUD Sustainable? ...And AUD Sustainable? ...And AUD Sustainable? Therefore, we conclude that the rand's strength has not been warranted by any of its historic drivers. It has been due to nothing else than the blind search for yield. Over the medium and long run, the outlook for the rand remains bleak. The ongoing dynamic of high wage growth and negative productivity growth will assure a lingering stagflationary environment (Chart I-11). This is bearish for the rand. Surprisingly, despite a rising currency and falling bond yields over the last 12 months, the South African economy is still showing signs of weakness. The household sector, which represents 61% of the economy, is not showing signs of a recovery yet. Credit growth to households is still falling and private consumption is abysmal. (Chart I-12). On the corporate side, the situation is not reassuring either. Firms are not investing and business confidence has not shown any signs of a significant recovery (Chart I-13). Chart I-11Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Productivity Is Weak But Wages Are Strong Chart I-12Household Consumption Is Declining Household Consumption Is Declining Household Consumption Is Declining Chart I-13No Confidence, No Investment No Confidence, No Investment No Confidence, No Investment The one positive is that the government has fiscal room to maneuver. South African gross government debt is at a comfortable 51% of GDP. However, we suspect that the nature of fiscal spending will likely result in transfers to appease the population - especially ahead of key elections in late 2017 and 2018 - rather than investments that can genuinely improve productivity. In fact, fiscal spending in the form of transfers could very well entice consumers to import more and consequently widen the current account deficit, putting more downward pressure on the rand. Bottom Line: The commodity price rally in 2016 and falling bond yields failed to buoy the economy. While policymakers do retain fiscal room to stimulate, the problem is that such efforts will likely merely rekindle populist policies that have failed South Africa thus far. Structural Outlook: Late Innings Of The Crisis Of Expectations South Africa is not alone in the EM universe in having failed to improve governance over the past decade. Most EM economies have squandered the commodity bull market and Chinese industrialization, allowing their governance to stagnate or even worsen during the good times (Chart I-14).3 However, South Africa does stand alone when it comes to a tepid rise in middle class, as percent of total population (Chart I-15), and continued high income inequality (Chart I-16). Chart I-14Quality Of EM Governance Declined##br## Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Quality Of EM Governance Declined Amidst The Good Times Chart I-15Middle Class Has ##br##Barely Budged... Middle Class Has Barely Budged... Middle Class Has Barely Budged... Chart I-16 The data is clear: South Africa is as unequal overall, and its middle class unchanged relative to overall population, as it was at the end of apartheid in the early 1990s. Governance in the country has continued to deteriorate, and while it remains higher than in Sub-Saharan Africa, the gap has astonishingly begun to narrow from both ends (Chart I-17). Chart I-17Governance Gap With Sub-Saharan ##br##Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! Governance Gap With Sub-Saharan Africa Is Closing! A major reason for the deterioration in governance is the "state capture" thesis that has become a popular one in characterizing President Jacob Zuma's rule.4 This process began early, as the country shifted its developmental program in 1996 away from a top-down, state-led, developmental model to one that encouraged a free-market economy balanced with welfare spending. This was a natural result of the global rise of laissez-faire capitalism, the Washington Consensus, and "Third Way" politics of left-leaning parties. A commitment to laissez-faire capitalism and free markets, combined with a strong welfare state, were seen as hallmarks of a successful economy. The problem with this approach is that it confused the symptoms of developed economies with their catalysts. South Africa needed a much more state-led approach to development, one that would have harnessed the resources of the state for productivity-enhancing investments. As such, the laissez-faire approach unsurprisingly failed to address the inequalities of the apartheid system and the country saw a decline in the middle class as percent of total population under both Presidents Nelson Mandela and Thabo Mbeki. This pivot towards free-market capitalism ended with the 2007 "Polokwane moment," which saw President Mbeki's free-market, reactive, attempt to address inequality between the white and black populations replaced with the proactive policy of Jacob Zuma. Zuma's more radical approach was to complement welfare transfers and high wage growth with an activist use of state owned enterprises (SOEs) as a vehicle for redistribution. This proactive policy meant using the government's tender system to doll out lucrative contracts to well-connected insiders, under the auspices of helping enfranchise black entrepreneurs and businesses. While the media has focused on the role that the Indian-born Gupta family has played in this process, it is highly unlikely that they are the only beneficiaries. Zuma's administration has, in the name of black enfranchisement and the fight against inequality, essentially rigged the entire government tender system for the sake of its own political preservation. The results of this process are unsurprising. First, government wages have outpaced those in both manufacturing and mining sectors (Chart I-18). Meanwhile, productivity has declined precipitously since 2007 and has been negative since 2012. South Africa has a lower productivity rate than both Latin American EM economies and its neighbors in sub-Saharan Africa (Chart I-19). Chart I-18Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Government Wages Have Outpaced All Others Chart I-19South African Productivity Has No Peer South African Productivity Has No Peer South African Productivity Has No Peer Financial media and investment research have continued to focus on the intricacies of the ruling African National Congress (ANC) politics. And we do so as well below. However, investors have to understand that South Africa's ills will not be fixed by the appointment of a pro-market finance minister or even the removal of Jacob Zuma from rule. South Africa has failed to develop inclusive economic institutions that engender creative destruction, which is at the heart of all successful development stories.5 South Africa ranked 74th in the World Bank's annual Doing Business report in 2017, an astonishing fall from grace over the past decade (Chart I-20). Compared to regional averages, South Africa barely beats the Sub-Saharan "distance to frontier" scores in several World Bank categories (Chart I-21). This is not due to the gross failure of the Zuma administration to do the "right thing." Rather, it exhibits a structural failing of South African political institutions. Chart I-20 Chart I-21 This development path is not unique to South Africa. Most sub-Saharan African states experienced a similar regression within 10-20 years of decolonization. Political scientist Robert Bates famously documented how African leaders co-opted colonial-era extractive economic institutions - such as the state marketing boards that purchased all cash crops and exported them on the global market - in order to generate enough revenue to industrialize their economies.6 While their intentions may have originally been noble, if misplaced, they quickly began to use control over marketing boards for political purposes. The rent generated from marketing boards became an immense source of political power for African leaders and they held on to it to the detriment of the economic development of their state. South Africa is far more developed than its sub-Saharan peers were in the 1970s. Nevertheless, its leaders are exhibiting similar rent-seeking behavior, albeit at a much higher level of development. It is also entering a dangerous period in its post-apartheid history: it has now been twenty years since South Africa's effective decolonization and it is facing its first serious economic downturn. Bottom Line: We doubt that anyone in the current leadership elite will be able to fully abandon the rent-seeking behavior of the Zuma administration and improve South Africa's economic institutions. The crisis of expectations among the country's voters is palpable and demands for greater redistribution are rising. This is not a context for pro-market reforms that will encourage creative destruction. Instead, we would expect a doubling-down of populism and greater emphasis on proactive redistribution, which will, at the same time, encourage greater out-migration of talent out of the country and rent seeking behavior from political elites. Can Any One Man Or Woman Fix South Africa? The African National Congress (ANC) will meet in December 2017 to decide the party candidate that will contest the 2019 general election (Diagram I-1). Given the ANC's stranglehold on the country's politics, it is likely that whoever emerges at the upcoming ANC Congress will be the next president of South Africa. Chart I- BCA's Geopolitical Strategy subscribes to the idea that policymakers are price takers in the political marketplace, not price makers. This is particularly the case in democracies, but it is also the case in some authoritarian regimes where public opinion is relevant. As such, the puzzle investors have to resolve is not what policymakers stand for, but rather what the median voter wants. In South Africa, the median voter lives in a rural area, works in the agriculture or service industry, and is a black citizen. The polls indicate that the main concerns of the median voter are a high structural unemployment rate (Chart I-22), endemic corruption (Chart I-23), poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. Chart I-22Crisis Of Expectations Structural Unemployment Is Egregious Structural Unemployment Is Egregious Chart I-23 Is this the profile of a median voter about to elect a pro-market reformer willing to pursue painful structural reforms? We do not think so. The two candidates vying for the ANC presidency are the ex-wife of Jacob Zuma and former Chair of the African Union, Nkosazana Dlamini-Zuma, and former Deputy President, Cyril Ramaphosa. Ramaphosa is the darling of the international investment community. This is because he has abandoned his previous union credentials - he founded the country's largest trade union, the National Union of Mineworkers in addition to founding the Congress of South African Trade Unions (COSATU) - and turned into a successful businessman. As such, the narrative among South Africa bulls (who are exclusively found in Europe and the U.S.) is that he would be able to bridge the divide between the demands for redistribution and pro-market reforms. To the median voter, however, Ramaphosa is alleged to be involved in the Marikana Massacre. Acting as the Deputy President, he ordered increased police presence at the mines and called for the use of force, which resulted in 47 deaths in August-September 2012. Dlamini-Zuma, on the other hand, speaks the language of the median voter while also not being seen as part of Zuma's corrupt entourage. Her credentials are bolstered by a successful tenure as Chair of the African Union and as a woman independent and strong enough to divorce President Zuma. She has not amassed personal wealth and does not hold strong loyalties to a particular faction within the ANC. However, she has begun to parrot Zuma's line that the country requires "radical economic transformation," which is a signal to left-leaning members of the ANC that she will continue much of economic policies begun under Zuma. Both the ANC Youth and Women's Leagues, which are left leaning, support her. The problem that investors face in South Africa is that there is no clear demand for pro-market reforms. Investors cheered the results of the August 2016 municipal election, for example, because the ANC lost in several key cities and saw its total vote share fall by 8%. However, few in the media or investment research community raised the obvious point that the centrist Democratic Alliance only saw its vote total rise by 3% compared to the 2011 election. It was the radically left-wing Economic Freedom Fighters, led by ex-Youth League leader Julius Malema, which saw the largest increase in vote share, by over 8%. In other words, ANC voters that did abandon Zuma most likely fell behind Malema, who is far more redistributionist. As such, we stick to our long-held view that Zuma and the ANC leadership are unlikely to do what investors want them to do given that the South African median voter is swinging further to the left. There is no demand for pro-market reforms and thus policymakers are more likely to double-down on populism. Bottom Line: Dlamini-Zuma is the likely winner of the upcoming ANC Congress, which will effectively decide the next president of South Africa. She has the sufficient left-leaning economic credentials to satisfy the demands for redistribution of the median voter. There is also a chance that she will attempt to clean up the corruption that has become endemic under Zuma, which would undoubtedly be a good thing for the country. However, it is unlikely that the macroeconomic context she will face will be positive, or that she will have the mandate to balance redistributive policies with painful pro-market reforms that would rebuild institutions required for creative destruction. Investment Implications South African assets are ultimately at the mercy of foreign inflows. When the dollar is weakening, U.S. bond yields falling, and Chinese growth stable, even the election of Julius Malema to the presidency would not dent foreign enthusiasm for yield in South African assets. Given the expected improvement in U.S. growth and the transitory nature of the drop in the U.S. inflation rate, we expect the global macro backdrop to worsen substantially for carry trades in general, and for South Africa in particular. China remains the wild card in our analysis, but its credit and fiscal impulse has rolled over, suggesting slower import growth over the next six months (Chart I-24). Even if Chinese policymakers react by re-stimulating the economy, the effects will only be felt in early 2018 given lead times. When the global carry trade reverses, it will not matter who is in charge of South Africa. Investors will realize that the country has failed to address serious socio-economic ills that have plagued South Africa since the end of apartheid. BCA's Emerging Markets Strategy continues to recommend the following investment positions: Chart I-24China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM China Slowdown Is A Risk To EM Chart I-25Yield Curve Will Steepen Yield Curve Will Steepen Yield Curve Will Steepen Continue shorting ZAR versus USD and MXN. Underweight South African stocks, sovereign credit and domestic bonds relative to their respective EM benchmarks. A new trade: bet on yield-curve steepening (Chart I-25). The short end of the curve will be steady but populist politics, larger fiscal deficits/higher public debt, and an inflationary backdrop will push up long-end yields. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Beement Alemayehu, Research Assistant beementa@bcaresearch.com 1 Please see BCA Global Investment Strategy Weekly Report, "Stocks Are From Mars, Bonds Are From Venus?" dated June 23, 2017, available at gis.bcaresearch.com, and BCA Emerging Market Strategy Weekly Report, "EM: Contradictions And A Resolution," dated June 14, 2017, available at ems.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Special Report, "EM Local Bonds: Looking At Hedged Yields," dated May 10, 2017, available at ems.bcaresearch.com. 3 'Governance' is a catchall term that attempts to capture the quality of public service delivery, broadly defined. In essence, investors can consider governance as a factor that underpins the quality of political institutions. We rely on the World Bank's Development Indicators because the World Bank aggregates the work of several credible surveys on governance. These indicators are also useful because the World Bank standardizes the results in a way that allows cross-country/region comparisons. We then aggregate the scores across five different variables and look for trends and changes over time. 4 Please see State Capacity Research Project, "Betrayal Of The Promise: How South Africa Is Being Stolen," dated May 2017, available at pari.org.za. 5 Please see Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 6 Please see Robert H. Bates, Markets and States in Tropical Africa: The Political Basis of Agricultural Policies (Berkeley, University of California Press, 2014 edition). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear client, This week, we are sending you an abbreviated Weekly Report as we co-authored a Special Report on Wednesday with our sister Geopolitical Strategy service. In our Special Report, available on our website, we argue that Italy's flirtation with leaving the euro area is rooted in its positive experience with devaluations in the 1990s. However, we note that this time is different and devaluing the euro through exit will not be a panacea, as financial market linkages would cause a deep domestic recession that could be brought forward by the mere reality of a referendum on the topic. As such, we think that Italy is unlikely to leave the Euro Area, but that it will remain a drag on the Eurozone - one that will force the European Central Bank to stay a bit more dovish than warranted by conditions in the broader Euro Area. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature Chart I-1The Dollar At A Critical Spot The Dollar At A Critical Spot The Dollar At A Critical Spot Since the end of last week, the dollar has staged a small rebound. This rebound was of the utmost importance as it materialized at an important level. Had DXY punched below the 96 level, the dollar could have sold off toward 93 in a matter of weeks. However, if the dollar can remain above 96, the greenback is likely to have formed a trough for the remainder of 2017 as it will rest above an important congestion zone that has been in place since early 2015 (Chart I-1). What are the odds of the greenback moving back to 93? We think that right now the balance of probability is in favor of a continued rebound. A call on DXY is first and foremost a call on the euro, as EUR/USD represents 60% of this index. We'll thus focus on the dynamics in this pair. Currently, nominal short rate differentials remain in the dollar's favor. As Chart I-2 illustrates, interbank rate spreads between the Euro Area and the U.S. are broadly supportive of the USD. Additionally, in both the late 1990s and in 2005-06, this spread had been much more negative than at present. BCA still expects the spread to grow more negative as the Federal Reserve continues on its intended policy path, while we also believe it will take a few more years before the ECB can begin lifting rates.1 Real rate differentials paint a similar picture. The euro's strength in the second quarter has emerged in spite of a move in real rate spreads in favor of the USD. As Chart I-3 shows, this divergence has mostly reflected dynamics at the short end of the yield curve, but over the past month and a half the real interest rate difference at the 10-year maturity has also diverged from the EUR/USD's path. Chart I-2EUR/USD Short Rate Differentials ##br##Can Grow Deeper EUR/USD Short Rate Differentials Can Grow Deeper EUR/USD Short Rate Differentials Can Grow Deeper Chart I-3EUR/USD Has Dissociated##br## From A Key Driver EUR/USD Has Dissociated From A Key Driver EUR/USD Has Dissociated From A Key Driver Technically, the dollar is beginning to look attractive against the euro as well. Our positioning indicator - based on sentiment, net speculative positions, and the euro's advanced/decline line - shows that investors are already positioned the most euro bullish since 2012 (Chart I-4). Our intermediate-term technical indicator is also at highly overbought levels, highlighting the euro's limited upside potential. Most importantly though, these moves have happened as the Euro Area economic surprise index massively beat the U.S. one (Chart I-4, bottom panel). This means that Europe's economic outperformance has been driving the euro's strength, unlike in 2015 when the surge in the European surprise index relative to the U.S. was reflective of the euro's 2014 collapse. This paints a picture where much good European news has been priced into EUR/USD during the recent rally. At current levels, the mean-reverting nature of the relative surprise index suggests that European surprises are unlikely to continue to beat U.S. ones by such a margin going forward. This means that the already overbought euro is likely to lose a key support. Finally, as we highlighted two weeks ago, global analysts have already ratcheted up their year-end estimates for EUR/USD (Chart I-5). Not only are their forecasts at levels that have in recent years been indicative of a peak, but the speed and magnitude of their adjustments has also been exceptional. This corroborates that the positive momentum in the Eurozone vis-à-vis the U.S. has already been internalized by market participants. If anything, this favorable relative economic momentum must only grow going forward for the euro to rally further. However, European LEIs have already rolled over relative to the U.S. as the latter looks set to exit its soft patch in the coming months (Chart I-6). Chart I-4Good News Already ##br##In The Euro Good News Already In The Euro Good News Already In The Euro Chart I-5Investors Have Already##br## Bought The Euro Investors Have Already Bought The Euro Investors Have Already Bought The Euro Chart I-6The Economic Tailwinds For The ##br##Euro Are Beginning To Fade The Economic Tailwinds For The Euro Are Beginning To Fade The Economic Tailwinds For The Euro Are Beginning To Fade Bottom Line: DXY has rebounded at a crucial level. If it can stay above 96, this would suggest that its correction is over. We are willing to make this bet as the euro - the key component of the DXY - has dissociated from rate differentials on strong optimism toward the economic outlook for Europe - at the exact time that investors have become more incredulous of the Fed's intentions. Due to these dynamics, EUR/USD is now massively overbought and at risk of a further pullback. Cutting Loose Short USD/JPY Last week, we closed our short USD/JPY position at a 4.2% gain. We did so because we see an increasingly less-supportive environment for the yen. To begin with, the U.S. Treasury notes' fair-value model used by our U.S. Bond Strategy service highlights that U.S. bond yields are currently quite expensive, and could be set to rise anew (Chart I-7). Because JGBs possess a very low beta relative to U.S. yields, an environment where global rates rise tends to be associated with rate differentials moving in favor of USD/JPY, often prompting a rally in the latter. Also, the Bank of Japan is keenly aware that it will be very difficult to achieve its 2% inflation target. The yen's recent strength has exerted a significant tightening in Japanese financial conditions that will drag down inflation (Chart I-8). Hence, the BoJ will continue to be among the most dovish central banks in the world. Additionally, while Japanese industrial production has been strong, it looks set to soften in the coming months, which will give further reason to the BoJ to talk down the yen: Japanese industrial production is very much a function of financial conditions. We are entering a window where the recent tightening in Japanese financial conditions should begin to bite industrial production. The growth rate of the Japanese shipments-to-inventories ratio has rolled over, historically a precursor of a slowdown in industrial production (Chart I-9). Chart I-7T-Notes Are Expensive T-Notes Are Expensive T-Notes Are Expensive Chart I-8Japanese FCI Points To Lower Inflation Japanese FCI Points To Lower Inflation Japanese FCI Points To Lower Inflation Chart I-9Japanese IP Will Turn Japanese IP Will Turn Japanese IP Will Turn Finally, the annual growth rate of Japan's industrial production is heavily influenced by China's economic dynamics, as EM represents 43% of Japanese exports. Two months ago, the Keqiang index - a barometer of strength for the Chinese economy based on credit growth, railway freight volumes, and electricity production - hit its highest level since June 2010, levels only recorded in early 2007, early 2005, and early 2004. Even though we do not anticipate it to crater, we do expect its recent rollover to deepen further in response to the recent wave of policy tightening in China. This should result in some weakness for Japan's industrial production. In practice there is little additional actions the BoJ can implement to ease policy further. However, because investors are currently so negative on the prospects for further Fed rate increases, with only 40 basis points priced in over the next 24 months, a re-assurance by the BoJ that easy policy is here to stay could put upward pressure on USD/JPY. While we remain worried about EM assets, we think that shorting the AUD or the NZD against the yen represents better portfolio protection than shorting USD/JPY. Bottom Line: USD/JPY has a generous amount of upside from here. Investors are too pessimistic regarding the Fed's ability to increase rates over the next 24 months. Meanwhile, the recent tightening in Japanese financial conditions is a headache for the BoJ, as it points to weaker inflation and a slowdown in industrial production. Hence, we expect the BoJ will try to talk down the yen over the coming months. EUR/NOK At An Interesting Spot Chart I-10If Brent Doesn't Fall Below,##br## EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short The price action in EUR/NOK caught our eye this week. EUR/NOK is at a critical level and has rallied as investor optimism toward the Euro Area economy continues to grow. Meanwhile, oil prices have collapsed to US$45/bbl. Since Norway is an economy heavily geared to oil-price gyrations, this bifurcation created an ideal combination to generate a EUR/NOK rally. However, by discounting these developments, EUR/NOK has now entered massively overbought territory. Additionally, as Chart I-10 illustrates, the cross has only traded at higher levels at the depth of the financial crisis in the first quarter of 2009 and the early days of 2016. In both instances, Brent was trading below US$40/bbl. A selling opportunity could soon emerge. Our Commodity And Energy Strategy service continues to expect a deepening of the adjustment in global oil inventories as the OPEC 2.0 deal remains in vigor and compliance stays in place.2 This means a move below US$40/bbl for Brent is very unlikely, and the upside in EUR/NOK is extremely limited. While in the coming weeks a move in Brent to between US$44/bbl and US$42/bbl could happen, we think this limited downside points to an attractive risk-reward ratio to shorting this cross. We are currently long CAD/NOK and short EUR/CAD, with the latter having greater potential downside than EUR/NOK. However, due to Canada's deep integration with the U.S. economy, the EUR/CAD trade is often affected by dynamics in the U.S. dollar. Shorting EUR/NOK is thus a cleaner play on oil and removes much of the risk associated with the greenback's fluctuations. Finally, yesterday, the Norges Bank policy release displayed less dovish tone than anticipated by the market. This kind of surprise would create an additional support to being short EUR/NOK. Bottom Line: EUR/NOK looks set to weaken. Over the past 10 years, it has only traded above current levels when Brent prices were below US$40/bbl. Based on our commodity team's analysis, such a move is very unlikely. Thus, any short-term weakness in oil prices should be used to sell EUR/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled, "Central Banks Are Sticking To Their Guns", dated June 6, 2017, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report titled "Time For "Whatever It Takes" In Oil?", dated June 2, 2017, available at ces.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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

Highlights Italy cannot rely on currency devaluation to make up for poor competitiveness, as it did before the euro; Italian voters are becoming more Euroskeptic - the elections due by May 2018 pose a serious risk, as do elections thereafter; Necessary structural reforms, not in the cards at present, would be painful and could exacerbate the Euroskeptic trend in Italy; The mere suggestion of a referendum on the euro would cause a banking crisis ... though voters would likely decide to stay in the Euro Area; The ECB will surprise on the dovish side; EUR/USD will weaken slightly below parity by mid-2018; European equities will continue to outperform U.S. equities. Feature European politics have been a boon to investors in 2017 (Chart 1). Instead of destabilizing populism, investors have gotten promises of pro-market reforms. This positive development is as we expected: we dubbed European politics "a trophy red herring" in our 2017 Strategic Outlook1 and predicted the pro-market turn in France.2 Alas, Italy remains a Sword of Damocles hanging over Europe's head. Whereas public sentiment in Europe has turned decisively in favor of integration since 2013, it remains indecisive in Italy (Chart 2). The Italian "median voter" continues to flirt with Euroskepticism, which explains why the country's anti-establishment parties have not softened their Euroskepticism to the same degree as their peers elsewhere in Europe. Chart 1European Stocks Outperform American European Stocks Outperform American European Stocks Outperform American Chart 2Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union Italians Doubting The Euro Monetary Union In this report, we attempt to answer several questions concerning Italy: What is structurally wrong with Italy? Why is Euroskepticism appealing to Italian voters? What would happen if Euroskeptics won the upcoming election and called a referendum on Euro Area membership? What would happen if Italy left the Euro Area? Italy's Purgatory: Aversion To Creative Destruction Italy has a structural productivity problem (Chart 3). Given weak labor force and productivity growth, Italy will be in and out of recessions for much of the next decade as its growth rate oscillates around zero. Particularly concerning is the steep decline in the country's total factor productivity, which suggests that Italians struggle to make use of technological innovation and that the economy is extremely inefficient. Chart 3 There is a vast literature detailing the structural problems of the Italian economy.3 We focus on the three most important impediments: The unproductive South, the Mezzogiorno, remains Europe's backwater; The public sector is riven with inefficiencies; Education and innovation remain sub-par. The first problem with Italy is that it remains an extremely bifurcated economy. Its northern regions, particularly Lombardy, are as wealthy as any in Europe (Map 1). Productivity rates and education standards are on par with core Europe (Chart 4). However, the Mezzogiorno has consistently pulled the aggregate Italian averages down (Chart 5). Chart Chart 4 Chart 5 As the industrialized North was rebuilt after the Second World War, and as productivity and labor force growth rates surged, the backwardness of the Mezzogiorno was conveniently ignored. Since the late 1990s, however, productivity rates have declined in all of the developed world. For Italy, this means that the one-third of the population that lives in the unproductive South is no longer a rounding error. At its root, Italy's problem is that its unification in 1861, the Risorgimento, never went far enough to integrate the south and thus left a bifurcated economy that exemplifies the north-south divide in Europe as a whole.4 Several of the reform efforts undertaken by the Matteo Renzi-led Democratic Party (PD) government have sought to address the disparity between the North and the Mezzogiorno. However, these reforms will take time to bear fruit. Previous efforts have fallen short due to half-hearted implementation. The second structural problem is that Italy's public sector is large, riven with inefficiencies, and largely funded via corporate taxes due to poor overall tax collection. Italy's social security contributions are high, accounting for about 13% of GDP. Of this burden, the employer contribution rate is one of the highest in the world, only surpassed by France and Germany (Chart 6). Chart 6 Chart 7 Despite a developed-world tax burden, Italy has a developing-world system of tax collection. For example, its VAT revenue ratio is well below the OECD average, at the level of an emerging market (Chart 7).5 If the VAT revenue ratio was improved to the OECD average, Italy would see its VAT receipts rise by about €45 billion per year (enough to recapitalize all of its banks, for example, or reduce employers' social security contributions by a third). Not only is tax collection of poor quality, but paying taxes is exorbitantly difficult. The World Bank's "Paying Tax" indicator - which measures the cost and time of paying taxes - nestles Italy between Kenya and São Tomé at 126th out of 190 spots! For comparison sake, its Mediterranean peers Spain and Portugal are 37th and 38th respectively on the same index while even Greece is significantly better at 64th.6 Italy again ranks with EM countries on the World Bank's overall "Doing Business" report (Chart 8). It scores extremely low in the category of "enforcing contracts," where it finds itself sandwiched between the Gambia and Somalia, at the 108th rank! It takes more time - three years - to enforce a contract in Italy than in Pakistan, Egypt, and Mozambique. Chart 8 Public sector inefficiencies are not a result of nostalgia for Roman-era bureaucracy. Instead, Italy's administrative hurdles are a means to stifle domestic creative destruction and protect its numerous small and medium-sized businesses - many family-owned - from competition. Instead of fostering competition through innovation and investment, Italian industrial policy since the Second World War has largely relied on currency depreciation to boost competitiveness. This strategy ceased to be effective with the adoption of the euro, but the country never pushed through painful reforms to adjust to the new reality. While it is difficult to prove a counterfactual, we are not sure that even currency devaluation would have saved Italy from the onslaught of Asian manufacturing in the late 1990s. Euro Area imports from EM Asia have surged from less than 2% of total imports to nearly 10% in the last twenty years. Italy began losing market share to Asia well before the euro was introduced on January 1, 1999, as Chart 9 illustrates. Finally, Italy's educational system is in need of a massive overhaul. Some improvement in educational attainment was apparent by 2015 (Chart 10). However, the quality of Italian education is still woefully inadequate if measured by the results of post-secondary and tertiary education on literacy proficiency (Chart 11). Chart 9Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Italy Lost Market Share Amid Globalization Chart 10 Chart 11 Italian firms are not making up for the poor educational attainments of the labor force with higher investment in knowledge-based capital - software, research, training, or management (Chart 12). There are likely three reasons for this outcome. First, low productivity begets low potential GDP growth, which hurts firms' top line prospects and incentives to invest. Second, decades of reliance on currency devaluation for competitiveness has discouraged Italian corporates from investing in R&D. Third, a plethora of small Italian family-owned businesses lack the resources to leverage their intellectual property with management and technology to become globally competitive. Chart 12 Last time Italy faced a painful recession - 1992-1995 - it did what had worked best since the Second World War: it devalued its way out of trouble (Chart 13A). Yet a comparable devaluation did not work for Italy in recent years, with exports failing to lead the way to recovery despite a 20% drop in EUR/USD since mid-2014 (Chart 13B). Why? Chart 13ACurrency Devaluation Has Not ##br##Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Currency Devaluation Has Not Worked This Time Around (I) Chart 13BCurrency Devaluation Has Not ##br##Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Currency Devaluation Has Not Worked This Time Around (II) Many of Italy's exports go to Euro Area peers. In 1995, the percentage was 48%, today it is 41%. As such, the devaluation in the 1990s was against those peers, allowing Italian exports to the EU Common Market to surge. Nonetheless, the lack of any growth in exports still does not make sense, given the large depreciation in the euro and the fact that 60% of Italy's exports are still destined for non-Euro Area markets. Bottom Line: Italy has failed to keep up in competitiveness over the past twenty years precisely because its reliance on devaluation worked wonders for the economy in the pre-euro era. Instead of committing itself to structural reforms, Italy has preserved its post-Second World War institutions that were expressly designed to limit creative destruction and domestic competition. Unlike France, which has largely an arithmetic problem, Italy has a genuine productivity problem. For Italy to boost economic growth, it will have to do a lot more than adjust a few labor laws or raise the retirement age (both of which it has already done!). It needs deep structural reforms that are impossible without a strong electoral mandate that gives the next government sufficient political capital for reforms. Such a mandate is unlikely to come in the next election, leaving Italy in a purgatory of its own making. Political Risks: An Assessment Current polls show that the ruling, center-left PD is running neck-and-neck with the anti-establishment and Euroskeptic Five Star Movement (M5S) (Chart 14). Also in the mix are the center-right Forza Italia (FI), of former Prime Minister Silvio Berlusconi, which has itself flirted with mild Euroskepticism, and the staunchly anti-EU Lega Nord (LN). The power of Italy's establishment and Euroskeptic parties is perfectly balanced (Chart 15) ahead of the general election, which has to take place before May 20, 2018. The exact date is as yet unclear, with President Sergio Mattarella insisting that it take place after parliament passes a new electoral law that will make the electoral system uniform for both houses of parliament. A recent agreement between the main four parties on an electoral bill broke down, again pushing the date to the second quarter of next year. With the election now likely a year away - and with European populists in retreat across the continent - should investors breathe a sigh of relief? Chart 14Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Euroskeptic Five Star Movement Challenges Ruling Democrats Chart 15Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls Euroskeptics Roughly Equal To Establishment Parties In Polls No. Italy remains the political risk in Europe. There are three broad reasons we remain concerned about Italian politics: The Median Italian Voter Is Flirting With Euroskepticism Policymakers are not price makers in the political marketplace, but price takers. The price maker is the median voter.7 In Europe, the Euroskepticism of the median voter has been massively overstated by the media and markets. Across the Euro Area, support for the common currency has surged since 2013 (Chart 16), likely reflecting an improving economy and the deeply held belief among European voters that continental integration is an intrinsic good. It took some time for anti-establishment politicians to sound off the median voter, but when they did, they adjusted their stances. As such, initially Euroskeptic anti-establishment parties across the continent - from Greece's SYRIZA and Spain's Podemos to Finland's "Finns Party" - have abandoned overt Euroskepticism and moved towards the middle ground on European integration. Politicians who have refused to be price takers - and insisted on campaigning from an inflexible, Euroskeptic position - were punished by the political marketplace (case in point: Marine Le Pen). Italy, however, has not seen a recovery in support for European integration. This is in large part due to the fact that the Italian economy has remained a laggard since 2012 (Chart 17). But it may also reflect the fact that the siren song of currency depreciation remains appealing to a large segment of the Italian electorate. Both M5S and Lega Nord have been vociferously arguing that Italy was far more competitive before joining the Euro Area and that simple currency devaluation would turn Italy from a land of locusts into a land of milk and honey. Chart 16Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Support For The Euro Has Risen Everywhere Else Chart 17Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Lagging Economy Has Hurt Support For The Euro Italy's Relationship With The EU Is Transactional We have long contended that both European patricians and plebeians support further integration.8 Chart 18 shows that a strong majority of Europeans is outright pessimistic about the future of their country outside of the EU. Why? Because, as Chart 19 suggests, the EU stands for geopolitical stability and a stronger say in the world. Chart 18Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Most Europeans Fear Life Outside The EU Chart 19 For a majority of Europeans, the European project is essential for peace and stability in Europe. We would argue that this is not just a product of two world wars in the twentieth century. It is also a product of newfound Russian assertiveness, migration crisis, and a growing ideological distance between Europe and its former security guarantor, the U.S. Italians, on the other hand, appear to be significantly more "transactional" than their European peers. For example, Chart 19 shows that Italians stand apart in being significantly less concerned about "peace" and having a "stronger say in the world." A plurality of Italians has also become confident in the country's future outside of the EU (Chart 20). Italians also appear to have the most negative perception of immigrants, perhaps due to the fact that they are at the frontline of Europe's migration crisis (Chart 21). Chart 20Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Italians Not So Afraid Of Life Outside The EU Chart 21 Why such a discrepancy in views between Italy and the rest of the continent? First, Italians have traditionally had a much more parochial view of the world. Regional differences matter a lot more to Italians than continental ones. Italians are already being asked to subsume one identity (regional) for another (national), so going a step further (supranational) may be too much. Data suggests that about half of all Italians are unwilling to go further (Chart 22). Second, Italy joined the EU as a considerably less developed economy than its core European peers. As such, membership was always sold to Italians from a transactional perspective and thus they do not give supremacy to geopolitical over economic forces. Chart 22Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Italians Less Likely To See Themselves As Europeans Elections Are Unlikely To Be Cathartic Italian Euroskeptics have consistently performed well in the polls for well over a year. Short of a significant surge in support for Matteo Renzi's PD, which we doubt will happen, polls are likely to continue to be tight until the election. The anti-establishment M5S performed extremely poorly in the June 11 municipal elections, failing to make the second-round run-off of the mayoral election in any of the major cities. However, we would fade the significance of this result given the national polls. As such, the best hope for investors is that anti-establishment forces suffer a modest defeat in next year's election. Short of a strong economic recovery that significantly reduces unemployment, an election win for the Italian establishment will not be as cathartic as the just-concluded election in France. And what are the odds of an outright Euroskeptic win? They are low, below 20%. M5S has no incentive to form a weak minority government, support an establishment-led government, or enter a risky coalition with Euroskeptic Lega Nord. It understands that remaining in the opposition would allow it to reap the benefits when the eventual coalition between establishment parties loses steam. The most likely scenario in next year's election is either an establishment Grand Coalition (40%), or a minority center-left government led by the ruling PD and supported on a case-by-case basis by the other parties (40%).9 Neither outcome is likely to survive the entire length of the mandate. Bottom Line: The long-term problem for investors is that the Euroskeptic narrative appears to be quite appealing to a large proportion of the Italian public. As such, even if the market avoids a crisis in 2018, one will likely emerge by 2020. The only way to avoid it would be a strong electoral mandate for deep structural reforms that boost productivity, which is not a likely outcome of the next election. But even if such reforms were initiated, we assume that their short-term consequences would be economic and political pain, which would sour support for establishment parties further and potentially deepen Euroskeptic sentiment in the country. As such, in the rest of the report, we examine what investors should expect in case the anti-establishment parties eventually take power in Italy. While such an outcome is unlikely in 2018, it may happen eventually. Leaving The Euro Is A Panacea... The political analysis above begs a simple question: Why are Italians more likely to be lured by the sirens of leaving the Euro Area than the French or Spanish have been? Fundamentally, the Italian experience is one of relatively successful devaluations. In the early 1990s, Italy was also suffering from a period of un-competitiveness, which prompted the current account to move from a 0.6% of GDP surplus in 1987 to a 2.5% of GDP deficit in 1992 (Chart 23). This deterioration reflected two factors. One was the notorious European Exchange Rate Mechanism (ERM), which forced European currencies to move in lockstep with each other. The second was the fact that Italian unit labor costs had been in a bull market relative to the rest of the European community countries, rising by 380%, 140%, and 370% against German, France, and the Netherlands, respectively, between 1970 and 1991. Thanks to this confluence of events, Italy was in a bind. By early 1992, Italian real wages were contracting. More than a surge in inflation, this contraction reflected intensifying competitive pressures and the implementation of fiscal austerity (Chart 24). Investors ended up punishing Italian assets; Italian yields moved up, with spreads relative to Germany widening from 350 basis points to 750 basis points by September 1992. Chart 23Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Lack Of Competitiveness Caused Current Account Deficits... Chart 24...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages ...And Contributed To Falling Real Wages By that point, Italian authorities chose to let the previously stable lira fall, resulting in a 30% devaluation versus the deutschemark by the end of Q1 1993. Thanks to this easing, by the beginning of 1994 Italian spreads had fallen back below 300 basis points. However, the Italian economy was still under duress, real wages were still contracting, and financial markets revolted again. By February 1995, Italian spreads had gone back up to 480 basis points. In the spring of 1995, the pressures came to a boiling point and the lira was once again devalued versus the deutschemark, suddenly plunging by an additional 20% or so. After this painful adjustment, real wage growth moved back into positive territory, the current account deficit morphed into a surplus, and the economy recovered. Moreover, thanks to the previous wave of fiscal austerity and the rebound of the economy, the government's primary balance, which stood at a deficit of nearly 4% of GDP in 1987, hit a 5% surplus by 1998. Chart 25Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis Domestic Demand Never Recovered From Financial Crisis So why is this experience so important? Today, Italy already runs a large current account surplus of 2.5% of GDP. But unlike in the 1990s, this improvement reflects first and foremost a contraction in imports, itself the symptom of an ill domestic economy. However, like in the early 1990s, the Italian economy remains tired. Real GDP is still 7% below its 2008 peak, while domestic demand continues to linger at a stunning 8.5% below its pre-GFC levels (Chart 25). Real wages are contracting at a 1.4% pace as the unemployment rate remains more than 2.5% above the OECD's estimate of NAIRU. Real estate prices, after having contracted from 2012 to 2016, are only growing in the low single digits. Capex generally is also tepid. This situation suggests that Italy needs even easier monetary policy than what it is getting from the ECB. As the argument goes, if Italy were to devalue its currency today, it would be able to boost its exports, ease domestic monetary conditions, and create the ideal circumstances for generating growth. Moreover, to push the argument to its extreme - something populist politicians are prone to do - Italy should ditch the euro and re-dominate its debt in lira. The Bank of Italy could then monetize this debt to keep interest rates low. Since Italy runs a primary fiscal surplus of 1.4% of GDP, Italy does not need to access the debt market for a few years, and thus it would be irrelevant if it loses access to the market. In other words, outside of the euro, a world of Chianti and creamy cannolis awaits the Italians. ... Well, Maybe Not If this seems too nice to be true, that is because it is. The exit-and-devalue narrative misses the point that financial markets and conditions matter a great deal. The problem with this story is the banking sector. The Italian banking sector is presently saddled with NPLs of €330bn, representing 74% of the banking system's capital and reserves (Chart 26). In and of itself, this is a big problem. However, it is a manageable one, especially with the backstops created by European institutions, notably the support of the ECB. However, without Europe's backstop, this debt load becomes a lot harder to manage. And that's only part of the problem. A deeper issue is the large holdings of treasury bonds (BTPs) of Italian banks. Currently, Italian banks hold 10% of their assets in BTPs, an amount equivalent to 90% of their capital and reserves (Chart 27). In 2011, when the Euro Area crisis was raging, Italian 10-year yields hit 7%, or a spread of more than 500 basis points over German bunds. This was equivalent to an implied probability of breakup - as estimated by Dhaval Joshi who writes our European Investment Strategy sister service - of 20% over the subsequent five years (Chart 28).10 Chart 26Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Italian Banks Carry Loads Of Bad Loans Chart 27Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Italian Banks Also Hold Too Many BTPs Chart 28Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Italian Spreads Signal Euro Break-Up Threat Now, if Italy comes to be governed by Beppe Grillo's M5S, markets will move fast to discount an eventual referendum on Italy's euro membership - even if only a non-binding and consultative referendum, which would still have a powerful political effect.11 In this environment, it is unlikely that the ECB would support Italian assets. The ECB has already played an active role in Italian politics. It was a September 2011 letter by Mario Draghi and Jean-Claude Trichet that prompted the resignation of Berlusconi in November 2011. It was only after Italian policymakers committed to structural reforms that Draghi was willing to utter his famous "whatever it takes" pledge of ECB support. There is practically no chance that the ECB would extend such a guarantee to an M5S-led government looking to play chicken with the Euro Area and default on Italian debt. Chart 29A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession A Drop In Credit Impulse Would Herald Recession This is why the situation could become nasty, and fast. With only 53% of Italians in favor of the euro, pricing in a 50% probability of Italy leaving the Euro Area would result in BTP-bund spreads of around 900 basis points! In the process, Italian bonds could lose 40% to 50% of their value - assuming that German bunds rally on risk aversion flows - which would result in a potential 35% to 45% hit to Italian banks' capital and reserves. Even if markets remained relatively calm, and BTP prices only fell by 25% to 30%, investors would discount bank capital by around 25%. With the large overhang of NPLs, Italian banks would be for all intent and purposes insolvent. We already expect the Italian credit impulse to become a drag on Italian growth in 2018, but if banks are threatened with insolvency as a result of political dynamics, this same credit impulse is likely to fall at rates not experienced since the GFC. This would result in yet another recession in Italy (Chart 29). Like in Greece in 2015, we would expect that this economic pain would prompt Italian voters to rethink their inclination to leave the Euro Area. In other words, the mere thought of exiting the Euro Area would bring forward the cost of such a strategy, giving voters essentially a preview of their future pain. Moreover, with 45% of BTPs held in private hands outside of Italy, and Italy's foreign debt hanging at 126% of GDP, Europeans outside of Italy have a lot of Italian exposure. This suggests that the financial channel of transmission would cause stress in the European banking sector outside of Italy as well. As a result, in all likelihood, this threat would prompt the return of dovish language by the ECB that could weigh on the euro. The fall in the euro would also nullify Italians' need to exit the Eurozone. Even if the scenario above looks remote, the euro could fall as soon as markets begin discounting an M5S victory. For example, in Canada, the Parti Quebecois won the 1994 election promising a referendum on the question of Quebec independence. As a result of that electoral victory, the loonie quickly dipped by 6%. A move back to EUR/USD 1.05 in case of a Beppe Grillo victory thus sounds reasonable as the market would quickly move to discount some probability of an eventual euro referendum in Italy. Bottom Line: The mere suggestion of a referendum on the euro in Italy would have immediate market consequences. The result would be the almost instantaneous insolvency of large portions of the country's banking system, the loss of ECB support, deposit flight, and an almost certain recession. The relationship between politics, markets, and the economy is therefore dynamic, with non-linear outcomes. As markets discount a higher probability of Italian Euro Area exit, voters will discount a higher probability of non-optimal economic outcomes. As such, we highly doubt that Italian voters - who remember, are only flirting with Euroskepticism - would commit to a future outside of the Euro Area. What If Italy Says Arrivederci? What if we have misjudged Italian voters and they vote to exit the Euro Area regardless of the costs? Based on the IMF's External Sector Report's Individual Economy Assessments, the Italian real effective exchange rate is overvalued by around 25% against Germany alone and around 15% against a GDP-weighted average of Germany, France, Spain, Netherlands, and Belgium. However, these amounts grossly underestimate the potential fall in the lira. These estimates are based on competitiveness measures alone, and they do not take into account the negative domestic economic developments associated with falling BTP prices and impairments to banks' balance sheets. Such economic malaise would prompt a massive easing of policy by the newly empowered Bank of Italy, which would also weigh on the lira. Additionally, the Bank of Italy would have little credibility. This would be doubly so in a M5S-led government intent on pursuing unorthodox policy choices. Historically, Italy has been tolerant of elevated inflation, which means that investors would likely bid up inflation protection on Italian assets, a process that would weigh on Italian real interest rates. Additionally, Italian households and businesses would likely ratchet up their own inflation expectations. As a result, this would drive Italian inflation higher and prompt even more downward pressure on real rates. This is the perfect recipe for a downward spiral in the lira against the euro. In this kind of environment, the lira could fall 75% against the euro. Would Italy become a trade champion with this magnitude of currency devaluation? Doubtful. As we have mentioned, Italy's competitiveness problems are not just a function of domestic labor costs relative to those of the rest of the Euro Area. They also reflect the fact that Italy has not moved up the value chain and is competing head-to-head with EM nations that have a much lower cost base. Additionally, the purpose of the euro was to prevent precisely the kind of competitive currency devaluation that plagued Europe in the post-war period. If Italy ditches the euro and devalues its currency by 50% or more, then the other European nations are likely to punish Italy with tariffs, defeating one of the key reasons to re-introduce the lira in the first place. The last thing Europeans would want to establish is a precedent of a major European economy massively devaluing against its Common Market peers for economic gain. This would be the undoing of not just the Euro Area, but European integration itself. In fact, Italy is contractually obligated - as is every EU member state other than Denmark and the U.K. - to obtain EMU membership under the Maastricht Treaty that establishes the European Union. While such a contractual obligation is irrelevant in the face of a sovereign nation's decision to abrogate an international treaty, it does give Italy's EU peers the legal cover to evict Italy from the Common Market should it break its Maastricht pledges. What about the dynamics of the euro itself? After all, without its weakest major member, the Euro Area will be stronger and the euro will become more competitive. However, the early 1990s experience is once again instructive. During the first phase of devaluation of the lira from 1992 to 1994, the deutschemark too came under pressure. This pressure also reflected the fact that the USD was rising between Q3 1992 and the beginning of 1994. However, by early 1995 the deutschmark had recouped all its loss versus the USD (Chart 30). We would expect similar dynamics to be at play, and again, a lot will depend on the dollar's trend. We expect the dollar index (DXY) to peak in 2018 around 108-110, or a bit more than 10% above current levels. This would hurt the euro. Moreover, the likely need for a dovish ECB to ease the blow to the European banking system (from potentially large losses on any Italian assets) would add to the downward pressure on the euro. As a result, an Italian exit should result in a fall to EUR/USD 0.9. However, this would represent a massive buying opportunity. The euro would be extremely cheap, and the economy would ultimately handle the Italian shock (Chart 31). Chart 30Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Lira Devaluation Temporarily Dragged Down The Deutschemark Chart 31An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity An Italian-Inspired Drop In The Euro Would Present A Buying Opportunity Additionally, the pain that Italy would incur as it faced currency collapse, runaway inflation, and loss of market access to the EU Common Market should act as a strong deterrent for future Euro Area exit attempts. As such, while the probability of Italy's Euro Area exit may be higher than zero, the probability of any subsequent exits is essentially zero. We would therefore expect any euro selloff to be violent but brief. Chart 32Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Italian Public Debt: Stuck In Muck Bottom Line: We doubt Italy will ever leave the euro. In all likelihood, the economic pain caused by the mere thought of a referendum would be enough to deter Italians from voting for what would amount to economic suicide. Instead, we would expect Italy to muddle through: its public debt dynamics will worsen, but it will not implode. The IMF expects the government debt-to-GDP ratio to fall toward 125% of GDP by 2022 (Chart 32). We think this is too optimistic. It relies on a big drop in the private sector's investment-saving gap. We think that Italy's entrenched productivity deficit and lack of investment opportunities south of the Alps will ensure that savings remain in excess of investment by a similar degree as today. This would cause the public debt-to-GDP ratio to move toward 140% of GDP by the middle of next decade. This is not a great scenario, but it is not a catastrophe either. In exchange for modest reforms, the ECB would continue to support Italy with dovish monetary policy and unfettered access to emergency liquidity. As a result, we expect European interest rates to remain slightly below what average Eurozone numbers would justify. As such, we continue to anticipate no hike in the ECB's repo rate for the foreseeable future. This, along with greater labor market slack in Europe than the U.S., underpins our view that EUR/USD will ultimately weaken slightly below parity. Investment Conclusions All other things being equal, currency devaluation is a valuable reflationary tool. In Italy's case, however, there are two impediments to using it. First, Italy has lost competitiveness precisely because it relied on the FX lever in the past. Its governance, education, and economic institutions have atrophied as domestic interest groups favored protecting themselves against creative destruction. Second, when it comes to politics, "all other things are rarely equal." It is highly unlikely that the rest of Europe would idly stand back while Italy switched to the lira and devalued it against the euro. This is for three reasons: First, it would set a dangerous precedent for other EU member states if Italy, the Euro Area's third-largest economy and the world's eighth largest, was allowed to reflate via competitive devaluation. Second, it is unlikely that Euro Area peers would accept Italy's devaluation amidst a globally low growth context where export market share is already tough to come by. Third, Italy's government would likely be led by populist, anti-establishment policymakers who would represent a domestic political threat to Italy's European neighbors. As such, it would be in the interest of the rest of Europe to ensure that a M5S-led Italy collapsed after leaving the Euro Area, and then begged to re-enter the core European club. The investment conclusions from the analysis above are very state dependent and represent a playbook for investors going forward. Right now, with the probability of an outright M5S victory low, our base case scenario remains unchanged. The euro will weaken by mid-2018 to slightly below parity as the ECB will maintain a more dovish policy stance than the Fed. European equities are likely to continue to outperform U.S. equities. However, if Beppe Grillo manages to eke out a majority in 2018 or later, investors might be in for a bumpy ride. The euro's fall from grace is likely to be much swifter and European assets could suffer a period of volatility and underperformance relative to the U.S. Ultimately, European stocks will resume their upward relative trajectory as any Italian referendum is likely to result in Italy staying in the euro. Finally, in the highly unlikely case that Italy votes to leave the Euro Area, the euro could plunge to EUR/USD 0.9; European assets, banks especially, could suffer greatly against their U.S. counterparts; and bund yields would likely fall below 0%. The lira would fall by 75% against the euro and Italian bonds would suffer losses north of 50%, in local currency terms. As Italy plunged to its post-Euro Area Inferno, however, we would expect European assets to represent the buying opportunity of a lifetime. Italy's fall from grace would only tighten European integration going forward. 1 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Please see OECD, "Economic Surveys: Italy 2017," available at oecd.org; and Sara Calligaris, et al.,"Italy's Productivity Conundrum," European Commission, dated May 2016, available at ec.europa.eu. 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 5 The VAT revenue ratio (VRR) is defined as the ratio between the actual value-added tax (VAT) revenue collected and the revenue that would theoretically be raised if VAT was applied at the standard rate to all final consumption. This ratio gives an indication of the efficiency and the broadness of the tax base of the VAT regime in a country compared to a standard norm. 6 Please see World Bank Group and PwC, "Paying Taxes 2017," available at www.pwc.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 3, 2011, and Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 9 A minority government would, however, have to obtain a confidence vote in both chambers of the Italian Parliament in order to govern, as per Article 94 of the Italian Constitution. 10 Please see BCA European Investment Strategy Weekly Report, "Threats And Opportunities In The Bond Market," dated April 7, 2016, available at eis.bcaresearch.com. 11 According to Article 75 of the Italian Constitution, referendums are not permitted in the "case of tax, budget, amnesty and pardon laws, in authorization or ratification of international treaties." Nonetheless, a Euroskeptic government could still call for a non-binding referendum on the euro. While its result would not create a legal reality for Italian exit from the Euro Area, it would create a political one. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com We Read (And Liked) ... Why Nations Fail - The Origins Of Power, Prosperity, And Poverty Why Nations Fail is as much about why nations succeed as why they fail.1 World history is replete with examples of the latter, whereas the former is a rarity even today. Economist Daren Acemoglu and political scientist James A. Robinson seek to answer why that is so. Distilling the book to its bottom line is challenging. There is no neat theory of how the world works. Instead, the authors tell their story through case studies replete with "critical junctures," "path dependency," and "small differences." Acemoglu and Robinson do not peddle in false parsimony, but rather try to develop a narrative that explains a complex process. While they never make the point explicitly, the authors define success as a combination of geopolitical relevance (power), escaping the "middle income trap" (prosperity), and some level of equality (escaping poverty). A country that achieves some semblance of all three, and maintains it for a long time, is "successful." At the heart of successful economies is the process of creative destruction. And at the heart of each example of failed states - from the Roman Empire to the Soviet Union - are impediments to such destruction. The recipe to success therefore boils down to "having an idea, starting a firm, and getting a loan." The discipline of economics - and its disciples at the IMF and the World Bank - would appear to be more than capable of taking it from there. But they are not. Why? For Acemoglu and Robinson, the empirical evidence is overwhelmingly stacked against economics and its practitioners. Armies of developmental economists have failed to bring billions of people out of poverty and many of their suggestions have in fact been detrimental. Economics is incapable of resolving the problem of development because it "has gained the title Queen of the Social Sciences by choosing solved political problems as its domain."2 And societal development is a political problem. The first such political problem that Acemoglu and Robinson attempt to explain is the paradox of development. Why don't leaders always choose prosperity? History is replete with examples of how elites actively subvert creative destruction, which is paradoxical given that it would make their societies wealthier and more powerful in the collective sense. From the patricians of Rome, elites of Venice, the szlachta of Poland, the samurai of Japan, to the landed aristocracy of England prior to the Glorious Revolution, those in positions of power consciously limit economic progress. The answer lies in political institutions. When political power is exclusive, unchecked, and limited to a select-group, its value increases. The more power one gains, the greater the political, economic, and societal rewards one can extract from it. The reverse is true when political institutions are inclusive, checked, and open to upwardly mobile entrepreneurs. In that case, the value of political power declines and thus elites are less likely to expend resources to protect their access to it. As such, the key conditions for economic development are inclusive political institutions that allow non-elites to petition the government, keep it in check through an independent judiciary, call it to account with free media, and eventually participate in governing directly. These inclusive political institutions are, in turn, more likely to give rise to inclusive economic institutions, which enshrine the process of creative destruction at the heart of the country's political and economic system. Why is it so difficult to engineer development? Because most trained economists working for international developmental agencies are focused on changing economic institutions. They take the politics of a country as an a priori. However, it is politics that determines economics, not the other way around. A powerful example in the book is the process of de-colonization in Africa. Despite a dramatic change of political leadership, post-colonial governments preserved the extractive economic institutions set up by their former colonial masters. Why? Because they never bothered to truly enfranchise their citizens. In other words, they kept the exclusive political institutions of colonialism largely in place. Once that decision was made, it was inevitable that extractive economic institutions would remain in place as well. In fact, in most examples, economic institutions became more extractive and political institutions more exclusive. Acemoglu and Robinson published their book in 2012, at the height of the "Beijing Consensus" narrative. It is easy to see how most of their examples are applicable to China today, particularly the chapter dealing with the decline of the Soviet Union. The message is that rapid economic growth under exclusive political institutions is possible, but unsustainable. China will therefore either evolve its political institutions or face the fate of the Soviet Union. We generally tend to agree with this analysis, but time horizons are difficult to gauge. For example, Acemoglu and Robinson themselves admit that the Soviet Union grew rapidly for 40 years before it faced limits and 60 years before it collapsed. By those measures, Chinese policymakers may still have decades before crisis forces their hand. A much more interesting question, one that Acemoglu and Robinson spend very little time discussing, is what happens to societies where elites capture political institutions and alter them from inclusive to exclusive? Two examples they detail briefly are the Roman and Venetian republics. In both, relatively inclusive political systems with inclusive economic institutions were captured by rapacious elites who then proceeded to limit access to both with the particular intention of limiting creative destruction. For global investors, this is the process that will have greater implications than the run-of-the-mill collapse of authoritarian and semi-authoritarian regimes. The entire global financial system today depends on the domestic stability of countries like the U.S. and the U.K., perhaps the most successful political systems in the world. And yet, voters in both are itching for radical change as a reaction to elite overproduction and growing income inequality. On one hand, voter discontent could lead to a messy political process, if not an outright revolution, that reestablishes the inclusive institutions that have underpinned their prosperity and power for centuries. On the other, it could lead to the collapse of the inclusive republic and the rise of an exclusive empire. 1 Daron Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Business, 2012). 2 Economist Abba Lerner, quoted at the end of Chapter 2 by the authors. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Inflation Is Rising In CE3 Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Labor Shortages = Higher Wages Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports ECB Policies Have Been A Boon For German Exports ECB Policies Have Been A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted German Wage Inflation Is Muted German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity ...Even After Adjusting For Productivity ...Even After Adjusting For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Bet On Yield Curve Steepening In Hungary Bet On Yield Curve Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Federal Reserve stuck to its guns, which lifted the U.S. dollar despite a disastrous CPI report. We agree with the Fed's assessment and expect U.S. inflation to pick up, clearing the way for higher interest rates and a stronger dollar. With three dissenters voting in favor of higher rates, the Bank of England meeting delivered a hawkish surprise. However, the inflation surge will continue to weigh on consumer spending, limiting the capacity of the BoE to increase rates. Stay short cable, but use any rally in EUR/GBP above 0.88 to short this cross. The Canadian economy is strong, and the CAD should perform well on its crosses. However, USD/CAD downside is limited. Go short EUR/SEK. Feature This week was replete with central bank meetings, most crucially the Federal Reserve and the Bank of England, which provided much-needed color on the near-term future direction of global monetary policy. While the BoE does face a serious rise in inflation, it is still focused on the risks to U.K. growth. In contrast, the Fed mostly ignored the disastrous inflation report released the morning before its policy announcement and kept its focus on the underlying strength in the U.S. economy. We believe both institutions are pursuing the appropriate strategy for their respective economies. The Fed: Straight Ahead Fed Chair Janet Yellen and her gang increased the fed funds rate by 25 basis points to 1-1.25% and pre-announced the parameters around the reduction in the Fed's balance sheet size. On the balance sheet front, the Fed removed any doubt that it will begin reducing its asset holdings this year. Additionally, the Fed provided its new set of forecasts for growth, inflation, unemployment, and interest rates. While it increased its growth forecast for 2017 to 2.2% from 2.1%, it curtailed its core PCE deflator forecast for 2017 by 0.3 percentage points to 1.6%. However, in line with its conviction that the soft patch in inflation is temporary, it kept its 2018 and 2019 core PCE forecasts at 2%. The Fed did also acknowledge that the equilibrium unemployment rate was lower than it believed in March, decreasing its long-term estimate by 0.1% to 4.6%. However, despite recognizing that NAIRU has fallen, the Fed still thinks the labor market is tight. It proceeded to curtail its unemployment rate forecasts by 0.2% in 2017 to 4.3%, and by 0.3% in 2018 and 2019 to 4.2%. Congruent with these forecasts, the Fed did not adjust its intended path for interest rates. It still expects to hike rates once more in 2017, and three more times in both 2018 and 2019. As a result of these policy changes and the intentions associated with the new set of forecasts, the dollar recouped its CPI report-induced decline, and gold suffered. Most interestingly, the market seems to believe that the Fed is entering the realm of policy mistakes as the 2-10-year yield curve flattened considerably, and inflation expectations plunged to their lowest levels since November 4, 2016 (Chart I-1). But is the Fed really making a mistake? We do not think so. Simply put, we agree with the Fed that underlying economic momentum in the U.S. is real, and that both wage growth and inflation will turn the corner this summer. To begin with, our composite capacity utilization gauge, based on both industrial capacity and labor market utilization, is now fully into "no slack" territory. Historically, this has given the Fed the green light to increase interest rates. There is no mystery behind this relationship: when this indicator is above the zero line, inflation pressures emerge and wage growth accelerates (Chart I-2). This time is unlikely to prove different. Chart I-1A Policy ##br##Mistake? A Policy Mistake? A Policy Mistake? Chart I-2Conditions In Place For Higher##br## Inflation And Rates Conditions In Place For Higher Inflation And Rates Conditions In Place For Higher Inflation And Rates Supporting this assessment, many indicators show that the recent slowdown in wage growth will prove a temporary phenomenon. First, the spread between the Conference Board's "jobs plentiful" and "jobs hard to get" series still points to accelerating average hourly earnings (Chart I-3). Second, the labor market is likely to remain healthy. True, the fastest pace of job creation is behind us, a key symptom that labor market slack is vanishing, but some of our favorite employment indicators - such as Janet Yellen's labor market condition index and the NFIB job openings and hiring plans subcomponents - have picked up again (Chart I-4). In an environment of little slack, this might not translate into impressive nonfarm payroll numbers, but most likely faster wage growth. Chart I-3Wages Will Pick Up Wages Will Pick Up Wages Will Pick Up Chart I-4Yes, The Labor Market Is Healthy Yes, The Labor Market Is Healthy Yes, The Labor Market Is Healthy Third, capex intentions are still perky. Historically, capex intentions have tightly correlated with wages, and even the recent softness in wages was forecast by these intentions. This is simply because capex tends to require labor. When corporate investment materializes as worries about the durability of final demand hits cyclical lows, this is generally an environment that requires bidding up the price of labor - i.e. wages. This is precisely the current economic backdrop (Chart I-5). While the slowdown in bank credit to enterprises has caused many commentators to worry about the outlook for capex, we do not share these concerns. For one, although businesses may not have been tapping bank loans in Q1, they have been aggressively borrowing in the bond market (Chart I-6, top panel). Moreover, credit standards are now easing anew, and small firms are reporting little difficulty in accessing credit (Chart I-6, bottom panel). Chart I-5Good Outlook For Growth And Wages Good Outlook For Growth And Wages Good Outlook For Growth And Wages Chart I-6I Need Credit; No Problem! I Need Credit; No Problem! I Need Credit; No Problem! With respect to consumption, weren't retail sales on the soft side as well? Here again, we need to step back. Real retail sales continue to grow at a healthy 4.2% annual pace; meanwhile, the so-called control group - which affects GDP computations - was flat in May, but the April number was revised to 0.6% month-on-month, suggesting real consumption will be robust in Q2. In fact, federal income tax withholdings, a good proxy for household income growth, is also accelerating, further supporting consumption (Chart I-7). Overall, we agree with the Fed that the economy is on its way to escaping from its recent soft patch and that wage growth will accelerate. Ryan Swift, who writes our sister U.S. Bond Strategy service, has also recently argued that the U.S. Philips curve remains alive and well, and that wages and inflation will thus pick up again.1 Our own work does highlight the potential for not just wage growth but core CPI to also perk up. U.S. real business sales have been very strong of late, which historically has been a good leading indicator of core inflation (Chart I-8, top panel). Labor market dynamics tell a similar story. Our unemployment diffusion index is also a good leader of core CPI, and after a soft patch is now pointing to firming underlying inflation (Chart I-8, bottom panel). Chart I-7Real Consumption Will Trudge Along Real Consumption Will Trudge Along Real Consumption Will Trudge Along Chart I-8Inflation Soft Patch Will End Inflation Soft Patch Will End Inflation Soft Patch Will End Therefore, we expect the recent negative inflation surprise in the U.S. to reverse. Moreover, inflation surprises in the U.S. are also likely to beat those of the euro area. To a very large extent, Europe's positive inflation surprise, especially relative to the U.S., reflected the 2014 collapse in the euro. The recent stability in the euro since March 2015 further reinforces that the boost to European relative monetary conditions is dissipating, and that European inflation surprise will not outpace the U.S. going forward (Chart I-9). Chart I-9U.S. Inflation Surprises ##br##Will Pick Up Versus Europe's U.S. Inflation Surprises Will Pick Up Versus Europe's U.S. Inflation Surprises Will Pick Up Versus Europe's Chart I-10Diverging Policy ##br##Expectations Diverging Policy Expectations Diverging Policy Expectations This is very important, as these relative inflation surprise dynamics have been the key factor underpinning divergent expectations behind ECB policy and the Fed's path. While investors have increasingly brought forward the ECB's first hike, they have aggressively curtailed the number of hikes expected in the U.S. over the next two years (Chart I-10). If, as we expect, relative inflation surprises do once again move in favor of the U.S., this gap will disappear, supporting the dollar in the process. Bottom Line: The Fed is right to stay the course. The economy continues to display momentum, and the inflation soft patch should soon dissipate. Moreover, U.S. economic surprises are bottoming. As such, we expect market expectations for inflation and interest rates to move back toward the Fed's forecast, lifting the U.S. dollar in the process. BoE Dissenters Grab The Headlines, But... The poor BoE is in an infinitely more tenuous situation than the Fed. Core inflation continues to pick up, but economic uncertainty is also on the rise. This dichotomy is most pronounced when it comes to wages. At 2.6%, core inflation is now outpacing wage growth, thus real income levels are contracting (Chart I-11). This is problematic because at 65% of GDP, the U.K. is an economy fundamentally driven by consumer spending. As Chart I-12 illustrates, when inflation picks up and puts downward pressure on real wages, consumption sags. Therein lies the BoE's conundrum. Chart I-11U.K.: Inflation Everywhere, But Not In Wages U.K.: Inflation Everywhere, But Not In Wages U.K.: Inflation Everywhere, But Not In Wages Chart I-12The BOE's Dilemma The BOE's Dilemma The BOE's Dilemma Despite the three dissenters who voted in favor of a hike this week, we expect the BoE to continue to favor not lifting rates, leaving its accommodation in place.2 Household inflation expectations remain well moored, but a further relapse in growth could prompt a widening of the output gap and produce entrenched deflationary expectations down the line - something BoE Governor Mark Carney and his colleagues want to avoid at all costs. Chart I-13U.K. FDI At Risk U.K. FDI At Risk U.K. FDI At Risk Some investors have been wondering out loud about the likelihood of a "soft Brexit" coming back on the agenda, arguing that it would support the pound. Remaining in the common market is, after all, an unmitigated positive for the U.K. But to be part of the common market, the U.K. also has to adopt the sacrosanct freedom of movement of people. We remain unconvinced that the British will budge on this point. Brexit was first and foremost a rejection of neo-liberal ideals that have been perceived as detrimental to the British middle class. And no point has been and continues to be more contentious than immigration. With the EU absolutely unwilling to dilute freedom of movement, access to the common market for the U.K. remains a distant dream. Moreover, with the British median voter switching to the left, a topic discussed in last Friday's Geopolitical Strategy Service Special Report on the election, British politics are likely to become less business friendly.3 Compounding this issue, U.K. industrial production is flat on an annual basis, bucking the global improvement seen last year and implying that the falling pound has not boosted competitiveness in the U.K. manufacturing sector. Together these forces suggest that the recent upsurge in FDI inflows into the U.K. could reverse in coming quarters (Chart I-13), a big problem for a country with a current account deficit of more than 4% of GDP and deeply negative real rates. Ultimately, the pound is cheap, trading at a one-sigma discount to its fair value. This means the market is well aware of the negatives that are weighing on sterling. Thus, the risks to GBP are well balanced. As a result, we expect GBP/USD to finish the year toward 1.2 because of our expectation of USD strength. EUR/GBP has limited upside, and rises above 0.88 should be used to build short positions. Bottom Line: The BoE decision was in line with expectations, but the market was nonetheless surprised by the fact that three MPC members dissented and voted for a rate hike. Sure, British inflation is on the rise, but this is hurting household real incomes, and thus consumption. These dynamics limit the upside risk to policy rates. We think that GBP could weaken against the USD; we would use moves above 0.88 to short EUR/GBP. The Bank Of Canada Volte Face Despite a 5% fall in oil prices this week, the CAD has appreciated 1.2% against the USD. Behind this impressive move has been Monday's speech by Senior Deputy Governor Carolyn Wilkins, in which she hinted that the Bank of Canada's next move will be a hike, coming sooner than investors have been anticipating. The BoC assessed that the negative impact of the fall in oil prices in 2014-'15 has passed, and that domestic strength in the Canadian economy has become self-sustaining. With the output gap expected to close in Q2 2018, the logical path for policy is tighter. Do the indicators warrant such a view? Yes: Canadian employment is quite strong, growing at a 1.8% annual pace. Unemployment too has fallen substantially. Capacity utilization is elevated in the manufacturing sector, thanks to a decade of low corporate investment. If our assessment of the U.S. capex cycle is correct, Canadian goods exports should pick up, adding to capacity and inflationary pressures in the country (Chart I-14). Our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits, and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth. Canadian LEIs and PMIs are all strong. Canadian house prices continue to forge ahead, growing at a 14% annual rate, which will additionally support Canadian consumption. This picture highlights that the BoC does have room to adjust its forward guidance, especially if the Fed stays on its desired path. Today, not only are investors the most short CAD since early 2007, but the loonie is cheap relative to real rate differentials (Chart I-15). As a result of these distortions, CAD could respond very positively to continued reaffirmation by the BoC that policy may become tighter. Chart I-14O Canada O Canada O Canada Chart I-15CAD At A Discount To Rates CAD At A Discount To Rates CAD At A Discount To Rates Practically, due to our broad bullish outlook on the USD, we find the most interesting way to play CAD strength is through its various crosses. Thus, we remain short EUR/CAD, short AUD/CAD, and long CAD/NOK. Bottom Line: The Canadian economy has escaped its funk. True, the long-term risks associated with the housing bubble will ultimately come home to roost. However, in the short term, the BoC is finding room to lift its forward guidance. As a result, CAD is likely to move higher on non-USD crosses. EUR/SEK Is A Short EUR/SEK should weaken in the coming quarters. To begin with, EUR/SEK is trading at a 7% premium against its PPP fair value. Additionally, the real trade-weighted SEK stands at a one-sigma discount to its long-term fundamental fair value, which further highlights the SEK's upside potential versus the euro, the main trading counterparty of Sweden (Chart I-16). Valuations are not enough to motivate a position. Economics need to join the ball. Today, the Swedish output gap is positive while that of Europe remains negative. Unsurprisingly, Swedish core inflation has overtaken that of the euro area (Chart I-17). Moreover, while we have argued at length why euro area core inflation is likely to disappoint going forward,4 pressure on Swedish resources is such that Swedish core inflation is likely to display additional upside (Chart I-18). Chart I-16SEK Is Cheap SEK Is Cheap SEK Is Cheap Chart I-17Swedish Core Inflation Is Outpacing Europe's Swedish Core Inflation Is Outpacing Europe's Swedish Core Inflation Is Outpacing Europe's Chart I-18Swedish Core Inflation Will Rise Further Swedish Core Inflation Will Rise Further Swedish Core Inflation Will Rise Further This means there will be attractive relative policy dynamics between the Riksbank and the ECB in the coming months. If the ECB has to tighten policy, the Riksbank has an even better case to be hawkish. If, however, the global economic environment prevents the ECB from tightening and forces it toward an easing bias, these global deflationary pressures should prove more muted in Sweden. Thus, we expect that Swedish policy will tighten relative to the ECB's, despite the economic and inflation environment. Chart I-19CPI Expectations Differential Will Push ##br##Policy Toward A Lower EUR/SEK CPI Expectations Differential Will Push Policy Toward A Lower EUR/SEK CPI Expectations Differential Will Push Policy Toward A Lower EUR/SEK Additionally, inflation expectations are pointing toward a lower EUR/SEK. The recent Swedish Prospera inflation survey showed that economic agents are expecting a pickup in inflation. As a result, market-based inflation expectations in Sweden have outperformed those in Germany, pointing to a lower EUR/SEK (Chart I-19). Essentially, this reflects potential changes in the relative direction of policy between the two currencies. The big risk to this view is that Stefan Ingves, the Riksbank governor, continues to be one of the most dovish policy makers in the world. However, his term ends on January 1, 2018, and unless he is renewed for another six years, his words and desires will increasingly lose their ability to affect markets. Bottom Line: The Swedish economy is increasingly moving closer to an inflationary environment. This cannot yet be said about the euro area. With inflation expectations sharply moving up in Sweden versus the euro zone, investors should begin betting against EUR/SEK. Housekeeping We are closing our short USD/JPY trade this week at a 4.2% profit. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report titled, "Low Inflation And Rising Debt", dated June 3, 2017, available at usbs.bcaresearch.com 2 Moreover, one of the dissenters was Kristin Forbes, who was attending her last meeting as a member of the MPC. 3 Please see Geopolitical Strategy Special Report titled, "U.K. Election: The Median Voter Has Spoken", dated June 9, 2017, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Chairwoman Janet Yellen has halted the dollar selloff for now, with the DXY finally seeing some upside. Following the press conference, the greenback sits 1.2% above the lows seen prior to the Fed policy meeting. We share the view of the Fed and the expect markets to converge over time toward the Fed's forecasts. Additionally, Yellen confirmed that there is still one more hike on the table this year. We believe the market continues to underprice these factors, concentrating too much on what amounts to a temporary soft patch. As we have said in the past, these factors will continue to widen rate differentials between the U.S. and its G10 counterparts. Report Links: Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 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 EUR/USD dropped on the news of a weak trade balance figure of EUR 19.6 bn, below the expected EUR 27.2 bn. Generally, EUR/USD has remained reasonably static as euro weakness was muted by equal dollar weakness, but recent Fed hawkishness has broken this trend. Draghi's hawkishness is tepid at best and the Fed hiking rates this Wednesday, as well as Yellen reiterating that another hike will be seen later this year will continue to help U.S. policy anticipations relative to Europe. As a result, rate differentials are likely to widen, and the euro to soften. The little appreciation in the euro earlier this week, was a result the following positives: German ZEW Survey's Current Situation went up to 88, beating expectations of 85; Euro Area ZEW Survey's Current Situation also went up to 37.7 from 35.1. Report Links: Look Ahead, Not Back - June 9, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 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 negative: Domestic corporate goods prices grew by 2.1% YoY, against expectations of 2.2%. Machinery orders yearly growth came in at 2.7%, underperforming expectations by a wide margin. Industrial production yearly growth stayed flat at 5.7%. Ultimately, economic activity in Japan will largely depend on the currency. With the yen appreciating for most of 2017, it will be difficult for the Japanese economy to improve sustainably. At this point, we are closing our USD/JPY trade, as the correction in the U.S. dollar has run its course. Meanwhile, we remain bearish on NZD/JPY, as the rising dollar and the tightening in Chinese monetary conditions will deliver a formidable one-two punch to risk assets, and thus weigh on this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production contracted by 0.8% on a YoY basis, underperforming expectations. Manufacturing production yearly growth stayed flat, also underperforming. Meanwhile, both core and headline inflation came in above expectations, at 2.6% and 2.9% respectively. Yesterday the BoE came in more hawkish than expected, as Ian McCafferty and Michael Saunders joined Kristin Forbes voting and dissented in favor offor a hike. Meanwhile, in their monetary policy summary the BoE stated that inflation will stay above target for an "extended period". Following the report, EUR/GBP plunged by about 0.8%. We are now not positive on the pound, as core inflation is now outpacing wage growth, a development that should weigh on demand due to the decline in real income. This development could cause GBP/USD and EUR/GBP to reach 1.2 and 0.92 respectively to reach 1.2 by year end, but any move in EUR/GBP above 0.88 should be used to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Data out of Australia was mixed this week: National Australia Bank's Business Confidence declined to 7 from 13; Westpac Consumer Confidence fell to -1.8% from -1.1%; However, the unemployment rate dropped to 5.5%, with full-time employment growing by 52,100, and part-time employment shrinking by 10,100. Most of the movement in the AUD was dominated by the employment data, seeing a broad-based increase versus other G10 currencies. While oil prices kept the CAD and NOK at bay, Chinese industrial production and retail sales increased at a 6.5% and 10.7% annual rate, respectively. Iron ore and copper, commodities important to Australia, however, saw little action, but coal saw a slight upside. The above dynamics resulted in the AUD outperforming other currencies versus the USD, and EUR/AUD weakened massively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales grew by 5.2% year-on-year, increasing from 4.2% the month before. However, the current account deficit came in at 3.1% of GDP against expectations of 2.7%. Meanwhile, yearly GDP growth came in at 2.5%, underperforming expectations. The kiwi rallied this week as expectations of a dovish fed weighed on the dollar, although most of these gains vanished following the FOMC press conference. We continue to be positive on the NZD relative to the AUD, given that the kiwi economy is in much better footing than the Australian one. However, upside for NZD/USD is limited, as this cross has reached highly overbought levels. Furthermore, the tightening in Chinese monetary conditions will become a headwind for a sustainable rally in the NZD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The downside in oil continues as EIA crude oil stocks decreased by 1.661 million barrels, less than the expected 2.739 million. AUD/CAD and NZD/CAD rallied on the news, while CAD/NOK levelled off. In the commodity space, we remain most positive on the Canadian economy. While oil prices are a hurdle, business and consumer confidence, as well as PMIs remain robust, and the BoC expects the output gap to close in Q2 2018. Our Commodity and Energy Strategy team continues to believe that OPEC cuts and increased oil demand will eventually curtail inventories. We therefore expect our short AUD/CAD trade to prove profitable as markets begin to digest these developments. While the CAD looks good on its crosses, the resumption of the dollar bull market will limit the USD/CAD's downside. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Yesterday, in their monetary policy statement, the SNB reasserted its dovish bias, pledging to keep its extremely accommodative monetary policy in the years to come. Their inflation outlook changed little, upgrading the near term slightly while downgrading the longer term outlook. It is important to consider that when the SNB states that they expect that inflation will reach only 1.5% by the first quarter of 2020, they do so assuming the LIBOR rate stays at -0.75%. Meanwhile, they also signaled that they will stay active intervening in the currency market, with SNB president Thomas Jordan reiterating that the Franc “remains significantly overvalued”. We had previously stated that the implied floor put under EUR/CHF by the SNB could be removed by the end of this year. However, this scenario now seems unlikely, given the strong commitment by the SNB to remain accommodative. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Following a sell-off for most of the beginning of the week, USD/NOK has rebounded sharply, following the FOMC interest rate decision. Furthermore, the disappointing draw in oil inventories also contributed to the surge in USD/NOK. We continue to be bearish on the NOK, given that inflation is still receding in Norway. Recent data supports this, with core inflation and producer prices falling from anewApril. Furthermore, any surge in the U.S. dollar will provide a tailwind to USD/NOK given that this cross is highly sensitive to the dollar. Another cross where we are positioned towe use to take advantage of gain from Norway's economic weakness difficulties is CAD/NOK. The Canadian economy is on ain much stronger footing than the Norwegian one, and the rally in the dollar has historically been a tailwind for this cross. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden's economy is developing as expected, with headline inflation reading at the expected level of 1.7%, with a 0.1% monthly increase. Although inflation decreased from the previous 1.9% reading, the Riksbank's Resource Utilization Indicator - historically, a reliable indicator for core inflation - continues to point up, indicating that core inflation will accelerate further. We are putting on a short EUR/SEK trade on the basis of long-term valuations being in the favor of the krona. With a closed output gap, Sweden's economy is more advanced in its business cycle than the euro area', which points to a further bifurcation in inflation rates between the two. These factors will also warrant a quicker removal of policy support from the Riksbank than the ECB. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades