Economic Growth

Highlights Global growth has peaked, but will remain firmly above trend for the remainder of the year. The composition of global growth is shifting back towards the U.S. As often happens in the late stages of business-cycle expansions, asset markets have entered a more volatile phase. A global recession is likely in 2020. Equities: The correction is nearing an end, which will set the stage for a blow-off rally into year-end. For the time being, favor DM over EM stocks, Europe over the U.S., and value over growth. The "real" bear market will start next year. Government bonds: Global bond yields will trend higher over the next 12 months, but will begin moving lower by the middle of next year as recession risks mount. Over the long haul, yields are going higher - much higher. Credit: Spread product will eke out small gains relative to government bonds over the next 12 months. Spreads will blow out as the recession approaches. Investors will be shocked to learn that a lot of what they thought is investment-grade debt is really junk (or worse). Currencies: The U.S. dollar will bounce before resuming its bear market next year. The yen could weaken slightly against the dollar in 2018, but will hold its own against most other currencies. Energy-sensitive currencies such as the CAD will outperform other commodity currencies. Feature Booyah Writing frantically on October 8, 1998, CNBC commentator and former hedge fund manager Jim Cramer entitled his TheStreet.com piece with the indelible words "Get Out Now". Long-Term Capital Management had just imploded. Emerging Markets were crashing. Coming off the heels of a stratospheric ascent, the S&P 500 was down 22% from its highs. The tech-heavy NASDAQ had swooned 33%. The equity bull market had finally ended. Or so he thought. As fate would have it, the S&P 500 bottomed literally the very same minute that Cramer's piece came out.1 It went on to rise 68% before ultimately peaking in March 2000. Cramer would go on to avenge his 1998 call, wisely counseling his readers on October 6, 2008 to "take your money out of the stock market right now, this week." But on that fateful day in 1998, he was wrong. There are many differences in the economic environment between now and then, but on the crucial question of which way global equities are heading, history is likely to rhyme. As was the case in the late 1990s, the shakeout this year may be a prelude to a blow-off rally that takes stocks to new highs. Historically, equity bear markets and recessions almost always overlap (Chart 1). In fact, the most useful lesson I have learned over the past 25 years studying macro and markets is that unless you think a recession is around the corner, you should overweight stocks. It's as simple as that. Chart 1Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Fortunately, another recession is not around the corner. Interest rates are rising but are not yet in restrictive territory. Fiscal policy is being loosened, particularly in the U.S. Easy fiscal policy and still-accommodative monetary policy rarely produce recessions. As we discuss below, a global recession will eventually arrive - probably in 2020 - but that is still two years away. Stocks normally sniff out recessions before they start. However, the lead time is usually about six months. As Table 1 illustrates, equities typically do well in the second-to-last year of business-cycle expansions. We are probably in that window now. Table 1Too Soon To Get Out Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 A Whiff Of Stagflation So why the newfound angst? Partly, it is because markets were technically overbought and due for a correction. We warned clients as much in a report entitled "Take Out Some Insurance", published on February 2nd, one day before the VIX spike began.2 Fears of stagflation are also escalating. Inflation appears to be rising at the same time as global growth is slowing. Real potential GDP has increased at a snail's pace in the G7 economies over the past decade, the result of disappointing productivity gains and sluggish labor force growth (Chart 2). If the world is running out of spare capacity - and GDP growth is forced to climb down towards what many fear is an anemic trendline - then revenue and earnings growth are apt to decelerate. Chart 2Lackluster Productivity Gains And Anemic Labor##br## Force Growth Have Weighed On Potential GDP Lackluster Productivity Gains And Anemic Labor Force Growth Have Weighed On Potential GDP Lackluster Productivity Gains And Anemic Labor Force Growth Have Weighed On Potential GDP Escalating protectionism has further exacerbated anxieties about stagflation. President Trump has threatened to hike tariffs on steel and aluminum, go after China for allegedly stealing U.S. intellectual property, and pull out of NAFTA if a new deal is not negotiated in America's favor. An all-out global trade war would raise consumer prices and reduce output by impairing the efficient allocation of resources across countries. Investors have taken notice. None of these stagflationary concerns can be summarily dismissed, but they are less worrisome than they might appear. Let's start with trade wars. A Trade Spat, Not A Trade War We have long thought that we are in a secular bull market in populism. This is why we argued that investors were greatly understating the risks of Brexit in the weeks leading up to the referendum. It is also why we ignored the derision of others and predicted that Trumpism would prevail back in 2015 and that Trump himself would win the presidency by securing a larger-than-expected share of disgruntled white blue-collar workers in the Midwest.3 Trade protectionism, of course, is a major part of most populist agendas. However, the attractiveness of protectionism tends to ebb and flow depending on the state of the business cycle. There is a reason why the Smoot-Hawley tariff act was introduced during the Great Depression and not the Roaring Twenties. Both economically and politically, beggar-thy-neighbor policies are more appealing when unemployment is high and one more job abroad means one less job at home. That is not the case today, at least not in the U.S. Moreover, while the U.S. legal system gives the president free rein to impose tariffs and other trade barriers, Donald Trump is still constrained by the reaction of the business community and financial markets. After all, this is a president who likes to measure his self-worth by the value of the S&P 500. Needless to say, investors do not like protectionism. It is not surprising, therefore, that Trump has watered down his tariff rhetoric every time the stock market has sold off. It also not surprising that Trump has increasingly focused his wrath on China, a country with which the U.S. business community has had a love-hate relationship. A blue-ribbon commission recently estimated that intellectual property theft - most of it originating from China - costs the U.S. $225 billion-to-$600 billion per year.4 That is a lot of money that American companies could be making but aren't. China will undoubtedly complain that it is being unfairly singled out. It will also threaten retaliatory measures if the Trump administration imposes trade barriers on Chinese imports. In the end, those threats are likely to ring hollow. A war is only worth fighting if you think you can win. China has a very asymmetric trading relationship with the U.S., and one that gives it very little leverage. U.S. exports to China amount to less than one percent of U.S. GDP. That's peanuts - in some cases literally: Nearly half of U.S. goods exports to China consist of soybeans, wheat, cotton, nuts, and other agricultural products and raw materials. It would be difficult to tax them without hurting Chinese consumers. Of course, China could try to punish the U.S. by dumping Treasurys. But why would it? This would only drive down the value of the dollar, giving U.S. exporters a greater advantage. Trump wants that! Saying that you will retaliate against Trump's tariffs by no longer manipulating your currency is not exactly a credible threat.5 In the end, far from retaliating, China will try to placate Trump by easing restrictions on trade and foreign investment and making some politically-calculated purchases of U.S.-made goods. Boeing's stock sold off in the wake of escalating trade tensions. It probably should have risen. Peak Growth? In contrast to last year, global growth is no longer accelerating. Our Global Leading Economic Indicator is still rising, but the diffusion index, which measures the proportion of countries with rising LEIs, is down from its October 2017 high (Chart 3). Changes in the diffusion index have often foreshadowed changes in the composite LEI. An even more worrisome picture is painted by the OECD's LEI, which has actually dipped slightly over the past two months. The OECD's LEI diffusion index has also fallen below 50%. The Chinese economy appears to be slowing on the back of tighter monetary conditions (Chart 4). The Keqiang index, which combines data on electricity production, freight traffic, and bank lending, has come off its highs and our leading indicator for the index is pointing to further weakness. Property price inflation in tier 1 cities has fallen to zero. A number of clients noted during my visit to China last week that a wave of supply has hit the market over the past month following President Xi's warning that homes are for living and for not investing. A weaker Chinese property market could drag down construction spending, with adverse knock-on effects to commodity prices. Slower Chinese growth is rippling across the global economy (Chart 5). Korean exports - a bellwether for global trade - have decelerated. Japanese machinery orders have rolled over. The Baltic dry index has plunged by 40% from its December highs. The expectations component of the German IFO index has fallen to its lowest level since January 2017. Chart 3Global Growth Will Remain Above Trend,##br## But Has Probably Peaked For This Cycle Global Growth Will Remain Above-Trend But Ease From Blistering Pace Global Growth Will Remain Above Trend, But Has Probably Peaked For This Cycle Global Growth Will Remain Above-Trend But Ease From Blistering Pace Global Growth Will Remain Above Trend, But Has Probably Peaked For This Cycle Chart 4China's Industrial Sector Is Set ##br##To Slow Further China Is Slowing China's Industrial Sector Is Set To Slow Further China Is Slowing China's Industrial Sector Is Set To Slow Further China Is Slowing Chart 5Signs Of Slowing##br## Global Growth Signs Of Slowing Global Growth Signs Of Slowing Global Growth So far, the slowdown in global growth has been fairly modest. Goldman's global Current Activity Indicator (CAI), which combines both soft and hard data to gauge underlying economic momentum, was still up 4.9% in March, only slightly below recent cycle highs (Chart 6). The deterioration in a number of leading economic indicators suggests that the slowdown may have further to run. However, we would be surprised if it proves to be especially deep or long-lasting. Global financial conditions are still quite accommodative (Chart 7). Bank balance sheets are in good shape and rising capex intentions should support credit demand over the coming months, even in the face of somewhat higher borrowing costs. Improving labor markets should also bolster consumer confidence. Chart 6But Global Slowdown Has Been Fairly Modest But Global Slowdown Has Been Fairly Modest But Global Slowdown Has Been Fairly Modest Chart 7Global Financial Conditions Are Still Fairly Easy Global Financial Conditions Are Still Fairly Easy Global Financial Conditions Are Still Fairly Easy Back To The USA If global growth were decelerating because capacity constraints were starting to bite, this would be more worrying because it would mean any effort to stimulate demand would simply lead to more inflation rather than stronger economic growth. Reassuringly, that does not appear to be the case. The U.S. has slowed less than other large economies, even though it is closer to full employment. Notably, the manufacturing PMI has continued to rise in the U.S., but has dipped most everywhere else. Both Citigroup's and Goldman's economic surprise indices are still positive for the U.S., but have fallen into negative territory in Europe and Japan (Chart 8). Granted, Bloomberg consensus estimates suggest that U.S. growth will edge down to 2.5% in the first quarter. However, this may reflect ongoing seasonal adjustment problems. First quarter growth has averaged 1.7 percentage points less over the past decade than in the rest of the year. We are particularly skeptical of recent data showing that consumer spending has slowed, which is completely at odds with strong employment growth, rising home prices, and near record-high levels of consumer confidence. Looking out, U.S. demand growth should benefit from all the fiscal stimulus coming down the pike. We expect the fiscal impulse to rise from 0.3% of GDP in 2017 to 0.8% of GDP in 2018, and 1.3% of GDP in 2019 (Chart 9). The actual numbers could be even higher as our estimates do not include any additional expenditures on infrastructure, the possible restoration of earmarks (which could inflate pork-barrel spending), or the high likelihood that recent changes to the tax code will spawn all sorts of unforeseen loopholes, leading to lower-than-expected tax receipts. Chart 8U.S. Is The Standout U.S. Is The Standout U.S. Is The Standout Chart 9Fiscal Stimulus Bode Well For Growth Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Unfortunately, all this fiscal stimulus is coming at a time when the economy does not need it (Chart 10). The U.S. unemployment rate currently stands at 4.1%, 0.4 percentage points below the Fed's estimate of NAIRU. Given the prospect of continued above-trend growth, the unemployment rate is likely to be close to 3.5% by early next year, which would be below the 2000 low of 3.8%. Chart 10Now Is Not The Time For Fiscal Profligacy Now Is Not The Time For Fiscal Profligacy Now Is Not The Time For Fiscal Profligacy Rebalancing Global Demand: The Role Of The Dollar What happens when fiscal stimulus pushes aggregate demand beyond an economy's productive capacity? One possibility is that imports go up, thereby allowing the additional demand to be satiated with increased production from the rest of the world. For this to happen, however, the prices of foreign-made goods sold in the U.S. need to decline relative to the prices of domestically-produced goods. U.S. imports account for only 15% of GDP. Thus, if the prices of U.S.-made goods do not change relative to the prices of foreign-made goods, only 15 cents or so of every additional dollar of income will fall on imports. After all, consumers do not care about the intricacies of balance of payments statistics when they are deciding whether to buy a foreign or domestic automobile. They care about relative prices. This means that either the nominal trade-weighted dollar must appreciate or the U.S. price level must rise relative to foreign prices. Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the volume of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.6 In theory, one can envision a scenario where the nominal dollar exchange rate depreciates while the real exchange rate appreciates over the long haul because inflation rises significantly in the U.S. relative to its trading partners. Much of the market commentary has implicitly focused on just such an outcome. Massive fiscal stimulus, as the story goes, will lift U.S. inflation by so much that the dollar will fall over time. The problem with this narrative is that it is difficult to square with the facts. Long-term inflation expectations have actually risen more in the euro area and Japan since Trump got elected (Chart 11). The true puzzle is that rising U.S. real yields have not translated into a stronger dollar (Chart 12). Chart 11Long-Term Inflation Expectations Have ##br##Risen More In Japan And The Euro Area##br## Than The U.S. Since Trump Took Over Long-Term Inflation Expectations Have Risen More In Japan And The Euro Area Than The U.S. Since Trump Took Over Long-Term Inflation Expectations Have Risen More In Japan And The Euro Area Than The U.S. Since Trump Took Over Chart 12The Dollar Has ##br##Decoupled From Interest##br## Rate Differentials The Dollar Has Decoupled From Interest Rate Differentials The Dollar Has Decoupled From Interest Rate Differentials A Trump Risk Premium? What happened, as Hillary Clinton might ask? One answer is that Trump happened. Larry Summers has argued that political uncertainty around Trump's antics (protectionism, the Mueller probe, the porn stars, etc.) has made holding U.S. assets more risky.7 This risk has been exacerbated by the prospect of large current account and fiscal deficits - the so-called "twin deficits" - stretching for as far as the eye can see. If this theory is correct, the increase in U.S. real bond yields may be less the result of better growth expectations and more the consequence of a rising risk premium on long-term government debt. It's an intriguing hypothesis, but it cannot explain why business confidence is near all-time highs or why the S&P 500, despite this year's selloff, has risen by 23% since the U.S. presidential election. It also cannot explain why the yield curve has flattened recently, which is not what you would expect if investors were shunning long-term bonds. Perhaps it is best not to overthink things. The dollar is a high-momentum currency (Chart 13). At the start of 2017, the greenback was overbought (Chart 14). Then global growth began to accelerate, which has historically has been bad news for the dollar (Chart 15). The lion's share of that growth also came from outside the U.S. None of this is true today, but the downward trend in the dollar has remained intact, and that is proving hard to break. Chart 13USD Is A Momentum Winner Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Chart 14USD Was Overbought At The Start Of 2017 USD Was Overbought At The Start Of 2017 USD Was Overbought At The Start Of 2017 Hard but not impossible. The dollar could get a bit of a reprieve. USD Libor has broken out recently (See Box 1 for details). As Chart 16 illustrates, there has been an extremely close relationship between the dollar index and the 3-month lagged value of the Libor-OIS spread. The cost of shorting the dollar is about to spike as borrowing rates linked to Libor reset over the next few weeks. The Libor spread will eventually come down, but perhaps not before the negative momentum against the dollar has turned into positive momentum. Chart 15Slowing Global Growth Tends##br## To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Slowing Global Growth Tends To Be Bullish For The Dollar Chart 16Shorting The Dollar Is About##br##To Get A Lot More Expensive Shorting The Dollar Is About To Get A Lot More Expensive Shorting The Dollar Is About To Get A Lot More Expensive Fixed-Income: Hedged Or Unhedged? Chart 17Bond Yields, Currency-Hedged Bond Yields, Currency-Hedged Bond Yields, Currency-Hedged When European investors buy U.S. bonds, they take on exposure to both the value of the bond and what happens to the euro-dollar exchange rate. If they do not want to assume the currency risk, they can sell the dollar forward, effectively locking in the number of euros they will receive for every dollar sold. The purchase of the bond increases the demand for dollars, while the commitment to sell the dollar increases the supply of dollars. For the value of the dollar, it is largely a wash.8 Likewise, if U.S. investors do not want to bear currency risk when purchasing German bunds, they can sell the euro forward. This also entails two offsetting transactions: One that boosts the demand for euros and one that raises the supply of euros. The spike in USD Libor has increased the currency-hedged return of non-U.S. bonds relative to U.S. bonds. Chart 17 shows that the yield on 10-year Treasurys, hedged into euros, has fallen to 0.06%, which is below the 0.5% yield offered by German bunds. In contrast, the 10-year bund yield, hedged into dollars, has risen to 3.16% - which is above the 2.78% yield offered by Treasurys. All things equal, it becomes less attractive for foreign investors who wish to buy U.S. bonds to hedge currency risk as USD Libor rises. In contrast, it becomes more attractive for U.S. investors to currency-hedge their overseas bond purchases when USD Libor goes up. Unhedged bond purchases bid up the currency of the issuer, but hedged purchases do not. If a smaller share of foreign investors decide to hedge currency risk when buying Treasurys, while a larger share of U.S. investors decide to hedge currency risk when purchasing foreign bonds, the net demand for dollars will rise. This could help the dollar over the coming months. Go Long Treasurys/Short German Bunds, Currency-Unhedged The correlation between the German-U.S. 30-year bond spread and EUR/USD was extremely tight in 2017 but has completely broken down this year (Chart 18). At this juncture, betting on a normalization of this correlation - effectively, a bet that U.S. Treasurys will outperform bunds in currency-unhedged terms - has become too good to resist. In fact, it is almost a "can't lose" wager. Consider the fact that 30-year Treasurys are yielding 182 basis points above comparable-maturity bunds. The euro would have to rise to 1.23*(1.0182)^30=2.11 against the dollar over the next 30 years for investors to lose money on this investment. Chart 18Unsustainable Divergence? Unsustainable Divergence? Unsustainable Divergence? Granted, inflation is likely to be lower in the euro area. CPI swaps are forecasting that euro area inflation will be roughly 40 bps lower compared to the U.S. over the next three decades. However, this would only lift the Purchasing Power Parity (PPP) value of EUR/USD from its current level of 1.32 to 1.49. In other words, long-term investors betting on the euro are effectively betting on a major euro overshoot. The discussion above raises a more fundamental point. Investors often equate their view about the direction in which a currency is heading with whether to be bullish or bearish on it. We completely agree that the trade-weighted dollar will weaken over the long haul because most valuation metrics suggest that the greenback is still expensive. However, given the carry advantage the U.S. enjoys, long-term investors would still be better off overweighting U.S. fixed-income assets. Regional Equity Allocation U.S. equities have outperformed their global peers since the start of 2017 in local-currency terms but have underperformed in common-currency terms (Chart 19). If the dollar rebounds over the next few months, as we expect, this should boost the local-currency value of European stocks since many large multinational European companies generate sales in dollars. Sector skews should also work in Europe's favor. Financials are the largest overweight in euro area bourses, while technology is the biggest overweight in the U.S. (Table 2). Chart 19U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency U.S. Equities Have Outperformed In Local-Currency Terms, But Not In Common-Currency Table 2Global Sector Skews: Tech Resides In The U.S. And Growth Indexes,##br## Financials Live In The Eurozone And Value Indexes Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 While global growth has peaked, it will remain firmly above trend. This will ensure that spare capacity continues to shrink, taking global bond yields higher. Since the ECB will not raise rates for at least another year, the yield curve in the euro area will steepen, boosting the profitability of European banks (Chart 20). Tech companies are particularly sensitive to changes in discount rates since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening (more than 50% of U.S. tech sales are derived from abroad). Recent concerns over the way Facebook and other tech companies have handled privacy issues could further sour sentiment towards the sector. The outlook for Japanese stocks is a tough call. Japan, like Europe, is trading at a discount relative to the U.S. based on our in-house valuation metrics (Chart 21). However, we do not see much downside for the yen, even after its recent appreciation. The currency remains very cheap by historic standards, Japan's current account surplus has widened to 4% of GDP, and unlike the euro, speculative positioning is short. While Japanese corporate earnings have been able to expand rapidly over the past 16 months without the support of a weaker currency, now that profit margins are near record highs (Chart 22), further gains in profits and equity prices are likely to be limited. Chart 20Euro Area Yield Curve ##br##Steepening Will Boost Banks Euro Area Yield Curve Steepening Will Boost Banks Euro Area Yield Curve Steepening Will Boost Banks Chart 21Japanese And Euro Area##br##Stocks Are Relatively Cheap Japanese And Euro Area Stocks Are Relatively Cheap Japanese And Euro Area Stocks Are Relatively Cheap The combination of higher U.S. rates, a stronger dollar, and weaker Chinese growth will weigh on EM equities over the coming months. There is $17 trillion in U.S. dollar-denominated debt held outside the U.S., most of it in emerging markets. Ironically, weaker Chinese growth will hurt other EMs more than it hurts China. China accounts for more than 50% of base metal demand compared to only 13.5% for oil (Chart 23). This means that the outlook for metal producers such as Brazil, South Africa, Chile, and Australia is more challenging than for energy producers such as Canada and Norway. Chart 22Global Profit ##br##Margin Picture Global Profit Margin Picture Global Profit Margin Picture Chart 23Base Metals Are More Sensitive##br## To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Base Metals Are More Sensitive To Slower Chinese Growth Favor Value Over Growth We expect global value stocks to start outperforming growth stocks after more than a decade of deep underperformance (Chart 24). The valuation measures constructed by Anastasios Avgeriou and his global equity sector strategy team suggest that value stocks are trading more than two standard deviations cheap relative to growth stocks. Earnings revisions are also starting to move in favor of value names9. Similar to the U.S./euro area equity split, financials are overrepresented in value indices, while technology is overrepresented in growth indices. The weights of the energy and consumer discretionary sectors in the U.S. index are roughly the same as the weights of those two sectors in the euro area index. However, energy is overrepresented in global value indices while consumer discretionary is overrepresented in growth indices. Despite our outlook for a somewhat stronger dollar, our commodity strategists see upside for oil prices this year thanks to continued discipline by OPEC 2.0. This should help energy stocks. On the flipside, consumer discretionary stocks often struggle in a rising rate environment, so this should tilt the playing field in favor of value (Chart 25). Chart 24Value Versus Growth: ##br##Compelling Entry Point Value Versus Growth: Compelling Entry Point Value Versus Growth: Compelling Entry Point Chart 25Consumer Discretionary Stocks Do##br## Poorly In A Rising Rate Environment Consumer Discretionary Stocks Do Poorly In A Rising Rate Environment Consumer Discretionary Stocks Do Poorly In A Rising Rate Environment With all this in mind, we are initiating a trade recommendation to go long the All-Country World Value Index relative to the corresponding Growth Index starting today. Investment Conclusions Volatility typically rises in the late stages of business-cycle expansions, as inflation picks up and monetary policy becomes progressively less accommodative (Chart 26). We have entered such a phase. This does not mean that equities cannot go higher. Chart 27 shows that the VIX rose in the late 1990s, even as stocks zoomed to new highs. We are probably at the tail end of an equity correction now. A blow-off rally into year-end is likely. Chart 26A More Hawkish Fed Usually Means A Higher VIX A More Hawkish Fed Usually Means A Higher VIX A More Hawkish Fed Usually Means A Higher VIX Chart 27Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise We expect the fed funds rate to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, the U.S. fiscal impulse will have dropped back to zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to increasingly binding supply-side constraints, the economy could easily stall out in 2020. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller PE ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 3% over the next decade (Chart 28). A composite valuation measure incorporating both the trailing and forward PE ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault investors for taking some money off the table now. A somewhat more defensive posture would certainly be warranted. Recall that the NASDAQ bubble burst in March 2000, but the S&P 500, excluding the technology sector, did not peak until May 2001. During the intervening period, S&P tech stocks underperformed the rest of the market by 70% (Chart 29). As was the case back then, a shift away from tech leadership may be afoot. This would support our value over growth, and euro area over the U.S., recommendations. Chart 28Demanding U.S. Valuations Point##br## To Low Long-Term Returns Demanding U.S. Valuations Point To Low Long-Term Returns Demanding U.S. Valuations Point To Low Long-Term Returns Chart 29The Force Of Tech At ##br##The Turn Of The Century The Force Of Tech At The Turn Of The Century The Force Of Tech At The Turn Of The Century Spread product should be able to eke out small gains relative to government bonds over the next 12 months. Ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart 30). Spreads will blow out as the recession approaches. In this month's issue of The Bank Credit Analyst, my colleague Mark McClellan simulated the effect on investment grade credit from: 1) A 100 basis-point increase in interest rates across the curve; and (2) A more severe scenario where interest rates rise by 100 basis points and corporate profits fall by 25% peak- to-trough. Mark's calculations suggest that the next recession will see the interest coverage ratio drop more than in previous downturns (Chart 31).10 Investors may be shocked to discover that a lot of what they thought is investment-grade debt is really junk (or worse). Chart 30Ratings Migration Is Supportive For Credit But... Ratings Migration Is Supportive For Credit But... Ratings Migration Is Supportive For Credit But... Chart 31...Corporate Leverage Will Take Its Toll ...Corporate Leverage Will Take Its Toll ...Corporate Leverage Will Take Its Toll We suggested going long the dollar in August 2014. This view worked well for a while but struggled mightily last year. However, the broad trade-weighted dollar index has been fairly stable since September, and is actually up 2.3% since its January lows (Chart 32). The greenback is due for another rally, one that no doubt would catch many traders by surprise. After a heated internal debate, BCA shifted its house view on bonds towards a more bearish stance in July 2016. As fate would have it, our note entitled "The End Of The 35-Year Bond Bull Market" came out on the same day that the U.S. 10-year yield reached an all-time closing low of 1.37%.11 We observed in February that bond positioning had become extremely short and, thus, tactically, yields could come down a bit. This has indeed happened. Over a 12-month horizon, however, we continue to see yields rising more than what is currently priced in. Both the TIPS 10-year and 5-year/5-year forward breakeven rates are 20-40 basis point below the 2.3%-to-2.5% range that prevailed in the pre-recession period (Chart 33). Somewhat higher oil prices should also boost inflation expectations. Chart 32Up Then##br## Down Up Then Down Up Then Down Chart 33Breakevens Still Below Levels Consistent##br## With 2% Inflation Mandate Breakevens Still Below Levels Consistent With 2% Inflation Mandate Breakevens Still Below Levels Consistent With 2% Inflation Mandate In addition, the real yield component could rise as the market revises up its expectation of the terminal rate. Revealingly, the mean and median terminal dots in the Fed's Summary of Economic Projections increased by 8.3 and 12.5 bps, respectively, in March, but are still more than 100 bps below where they were five years ago. Bond yields will increase in the euro area, as the ECB continues to taper asset purchases. We see less scope for yields to rise in the U.K., as the Brexit hangover continues to weigh on growth. Yields in Japan will remain repressed due to the continuation of the Bank of Japan's Yield Curve Control regime. As the next recession approaches, global bond yields will fall, but are unlikely to take out their 2016 lows. As we discussed in a series of recent reports, both yields and inflation will make a series of "higher highs" and "higher lows" in the U.S. and most other countries over the next decade and beyond.12 Appendix B shows stylistic diagrams of how we expect returns across the major asset classes to evolve over the next decade. The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Box 1 What's Up With Libor? The spike in the U.S. Libor-OIS spread appears to be driven by the confluence of a couple of factors. First, Congress raised the debt ceiling on February 9th. This has allowed the U.S. Treasury to rebuild its cash reserves by issuing more T-bills. The sale of these T-bills has drained cash from the overnight market. Second, U.S. corporations have started to repatriate dollars held overseas following the passage of the tax bill. This has further exacerbated the dollar shortage abroad. Libor represents unsecured lending, and hence embeds a credit risk premium. Banks and other financial institutions have been reluctant to put up capital to arbitrage the difference between the rate on Libor and OIS (the latter being a good risk-free proxy for the market's expectation of where short-term policy rates will be). This reluctance reflects regulatory changes, rather than systemic financial risk of the sort experienced during the Global Financial Crisis and the European Sovereign Debt Crisis. The 3-month TED spread - the difference between Libor and Treasury yields - has moved up only modestly due to the fact that short-term Treasury yields have also risen relative to short-term interest rate expectations. Bank CDS spreads have barely increased at all. The Libor-OIS spread will probably fall over the remainder of this year. However, the cost of shorting the dollar will still rise as the Fed continues to raise policy rates. 1 In his book, Confessions Of A Street Addict, which I highly recommend, Cramer wrote: On October 8, a dreary, chilly rainy Thursday in New York ... the stock market bottomed. At eighteen minutes after 12:00 P.M. I ought to know. I caused it. At 12:18 P.M. I capitulated. I couldn't take it anymore. I gave up both literally, at my fund, and virtually, on my website, TheStreet.com, where I penned a piece entitled "Get Out Now". And the prop wash from that article marked the low point in the most vicious bear market of the last century. 2 Please see BCA Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com. 3 Please see BCA Global Investment Strategy reports, "Trumponomics: What Investors Need To Know," dated September 4, 2015; "Worry About Brexit, Not Payrolls", dated June 10, 2016; "Three (New) Controversial Calls", dated September 30, 2016, available at gis.bcaresearch.com. Also see BCA New York Investment Conference presentations: "Five Controversial Calls - Call #5: The Trumpists Will Win" (September 2015), and "Three Controversial Calls - Call #1: Trump Wins And The Dollar Rallies" (September 2016). 4 Please see "Update To The IP Commission Report - The Theft Of American intellectual Property: Reassessments Of The Challenge And United States Policy," The Commission on the Theft of American Intellectual Property (The National Bureau of Asian Research), (2017). 5 The fact that China's foreign exchange reserves have been trending sideways since early last year does not mean that past interventions should be disregarded. Just as both theory and evidence suggest that quantitative easing affects bond yields primarily through the "stock channel" (how many bonds central banks own) rather than the "flow channel" (the purchase or sales of bonds in any given period), the yuan's value is also more affected by the stock of foreign assets the PBOC controls rather than its recent interventions. This makes intuitive sense. If a central bank drives down its currency by buying a lot of foreign assets, and then suspends further purchases, one might expect the currency to stop falling, but one would not expect it strengthen to where it was before the intervention began. 6 Expressed mathematically, the real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 7 Larry Summers, "Currency Markets Send A Warning On The US Economy," March 5, 2018. 8 We say "largely" a wash because while selling the dollar forward is not exactly the same as short-selling it in the spot market due to the presence of the so-called currency basis swap spread, it is economically similar. When European investors short-sell the dollar, they are effectively borrowing dollars at Libor, selling them for euros, and parking the proceeds in a short-term account that pays Euribor. Three-month U.S. Libor is 230 bps these days, while three-month Euribor is -33 bps. Thus, European investors lose 263 bps by currency-hedging their U.S. bond purchases. Conversely, when U.S. investors go short the euro, they are effectively borrowing euros, selling them for dollars, and then parking the proceeds in a short-term account paying Libor. Thus, they gain the equivalent amount from the decision to currency-hedge purchases of euro area bonds. 9 Please see BCA Global Alpha Sector Strategy Weekly Report, "Global Size And Style Update," dated March 9, 2018, available at gss.bcaresearch.com. 10 Please see BCA The Bank Credit Analyst, "U.S. Twin Deficits: Is The Dollar Doomed?" dated March 29, 2018, available at bca.bcaresearch.com. 11 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016; and Strategy Outlook, "Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 9, 2016. 12 Please see BCA Global Investment Strategy Weekly Report, "What Central Bankers Don't Know: A Rumsfeldian Taxonomy," dated March 16, 2018; Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. Appendix A APPENDIX A CHART 1Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 2Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 3Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX A CHART 4Long-Term Return Prospects Are Slightly Better Outside The U.S. Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Appendix B APPENDIX B CHART 1Market Outlook: Bonds Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 2Market Outlook: Equities Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 3Market Outlook: Currencies Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 APPENDIX B CHART 4Market Outlook: Commodities Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Q2 2018 Strategy Outlook: It's More Like 1998 Than 2000 Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Yesterday, my colleagues Marko Papic, Matt Gertken, and I had a webcast to discuss the rising threats of trade wars between the U.S. and China. If you have not listened to it yet, I encourage you to listen to it here. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A trade war between China and the U.S. is an increasing source of long-term risk for the global economy. While the tensions between China and the U.S. are likely to decline in the short run, their materialization as the global economy is set to hit a soft patch and as the Federal Reserve's policy is becoming tight further validates our view that financial market volatility is rising cyclically. The dollar and the yen should prove to be the main beneficiaries of this phenomenon. The U.K. economy remains soft and investors should not become complacent about British political risk. Moreover, British inflation is set to slow in response to tighter monetary conditions. Sell GBP/USD on a tactical basis. Feature Two weeks ago, we argued that volatility was making a comeback in global financial markets.1 The interim events have only confirmed this thesis. Geopolitical risk is rearing its unwanted head as macroeconomic vulnerabilities are already rising because U.S. policy will soon exit accommodative territory and global growth is experiencing a speed bump. The dollar and the yen should benefit from these circumstances. Trade Wars Are Back Trade wars are once again on the radar screen of investors. The U.S. is the bellicose country, but as we argued three weeks ago, this acrimony is not really generalized to the entire world: it is first and foremost pointed at China.2 The events of the past weeks are confirming this thesis, with U.S. President Donald Trump having announced the levy of a potential 25% tariff on US$60 billion of Chinese shipments to the U.S. Beijing also announced its own tariffs - a retaliation to the U.S.'s steel and aluminum tariffs - of at least 15% on US$3 billion U.S. exports to China. The response from China is a measured one, and BCA's Geopolitical Strategy service argues that President Xi Jinping will likely push Beijing to offer small concessions to the U.S., especially as President Trump is currently trying to rally the EU to his cause.3 However, while China is willing to pacify Trump for now, this recent episode highlights that the relationship between the two global superpowers is becoming increasingly fraught with tensions - a consequence of China's ascent and the U.S.'s relative decline (Chart I-1). Chart I-1The Incumbent Versus The Upstart Do Not Get Flat-Footed By Politics Do Not Get Flat-Footed By Politics While fears of a trade war are likely to recede in the short term, the longer-term outlook remains worrisome. China is likely to become more confrontational toward the U.S. as time passes, and vice-versa. This supports one of BCA's important theses: The apex of globalization is behind us. As a result, global trade is unlikely to expand anymore on a secular basis. China and the U.S. are also likely to become increasingly insular, which could hurt their future growth. Table I-1 highlights the G-10 economies most at risk from this phenomenon, at least measured by their combined exports to the two superpowers. Canada and Switzerland stand out as the two countries most exposed to a rise in future trade conflicts, with exports to China and the U.S. representing 20.6% and 9.6% of their respective GDP. Australia, Germany and New Zealand stand as the second group most at risk, with around 6% of their GDP dependent on these economies. Interestingly, Sweden, an economy that has historically fluctuated with EM growth indicators, seems modestly impacted by China and the U.S., with exports to those countries only representing 3.2% of GDP. However, this picture is misleading. While Swedish exports to the euro area represent 12% of GDP, 60% of Swedish overall exports are intermediate and capital goods. As a result, euro area demand for Swedish goods is deeply affected by fluctuations in Chinese and EM final demand. This means that Sweden is in fact on par with Australia regarding its exposure to a trade war between the U.S. and China. Ranked Exposure To The Warring Kingdoms Do Not Get Flat-Footed By Politics Do Not Get Flat-Footed By Politics The rising risks of a trade conflict between the U.S. and China has been very impactful on financial market volatility. This is because the world economy is being affected by two other negatives right now: global growth is set to decelerate and the Fed's real fed funds rate is moving close to equilibrium, which normally supports financial market volatility. Regarding the outlook for a growth slowdown this year, we have already highlighted that EM carry trades funded in yen have rolled over, which has historically led to a weakening in global industrial activity (Chart I-2). Not only are EM carry trades very sensitive to the outlook for global growth, they are also a key component of EM liquidity conditions: when carry trades are increasingly profitable, they attract capital which generate funds inflow in EM economies; when they become less profitable, the capital abandons these strategies, generating fund outflows out of the EM space. These dynamics end up affecting global economic conditions. The OECD's global leading economic indicator has also begun corroborating this message. Its diffusion index has collapsed below the 50% line, which normally leads to a deceleration in the LEI itself (Chart I-3, top panel). Meanwhile, Korean exports have clearly rolled over, providing another negative signal for global growth (Chart I-3, bottom panel). None of these charts suggest that growth will fall below trend anytime soon, but they clearly highlight that the sunniest days for global growth are behind us. Chart I-2Global Growth Is Slowing Global Growth Is Slowing Global Growth Is Slowing Chart I-3More Indicators Of A Slowdown More Indicators Of A Slowdown More Indicators Of A Slowdown Despite this backdrop, the U.S. Fed is being forced to tighten policy as the U.S. economy is at full employment and the federal government is expanding stimulus. Interestingly, the next two hikes or so are likely to bring the real fed funds rate above the neutral rate, or R-star. As Chart I-4 highlights, when this happens, volatility increases. The upside to volatility is only made more salient by the current upgrade to long-term geopolitical risks and the imminent soft patch in global growth. In this environment, the clearest winner could remain the yen. The yen enjoys rising volatility. This is first and foremost because when volatility picks up, carry trades are reversed, prompting investors to buy back funding currencies like the yen. AUD/JPY seems especially vulnerable in this context. Not only is this cross directly hurt by rising volatility (Chart I-5), but Australia also stands to lose from tensions between the U.S. and China. The U.S. dollar could also benefit for now if the current environment does lead to higher financial market volatility. Historically, the USD has benefited from periods of rising risk aversion,4 but the recent widening in the LIBOR-OIS spread could also exacerbate these pressures (Chart I-6). The widening in this spread may have been aggravated by technical considerations: as financial intermediaries begin to move away from LIBOR as the key interest rate benchmark for USD loans, liquidity in this market may decline. This in of itself would not represent a systematic decline in USD-liquidity. However, this year's U.S. corporate tax cuts are prompting important repatriations of profits held abroad, to the tune of US$300-400 billion. Because U.S. firms keep their earnings abroad in the form of high-quality U.S. securities, this repatriation is likely to mean there will be less collateral available to secure transactions in the offshore USD market. This increases the cost of dollar funding. Thus, some of the rise in the LIBOR-OIS spread does in fact reflect a real tightening in global liquidity conditions. This is why the widening in this spread could help the USD, albeit temporarily. Chart I-4Policy Is Getting Tighter, ##br##Higher Vol Will Ensue Policy Is Getting Tighter, Higher Vol Will Ensue Policy Is Getting Tighter, Higher Vol Will Ensue Chart I-5Short AUD/JPY As##br## A Volatility Hedge Short AUD/JPY As A Volatility Hedge Short AUD/JPY As A Volatility Hedge Chart I-6Money Market Tensions Will Help ##br##The Dollar In Coming Months Money Market Tensions Will Help The Dollar In Coming Months Money Market Tensions Will Help The Dollar In Coming Months Bottom Line: Even if the recent spike peters off in the short term, geopolitical tensions between China and the U.S. are on a structural uptrend, reflecting growing competition between the incumbent power and the rising upstart. Trade conflicts between these two nations will only grow as time passes, hurting global trade and global growth in the process. Small open economies like Canada, Australia and Sweden could be the main collateral damage of this process. Today, the pricing of this risk is likely to exacerbate pressure on financial volatility created by a soft patch in growth and a tightening Fed. The yen and the USD should benefit from these dynamics over the coming months. Sterling: Risks Brewing Ahead Early last year, in a report titled "GBP: Dismal Expectations,"5 we argued that investors were too pessimistic on the British economic outlook, and that the cheap pound could surprise to the upside. Since then, GBP/USD has rallied by nearly 20%, back to pre-Brexit levels. Apart from generalized dollar weakness, three main factors have been behind the surge in cable: Fears of a hard Brexit have dissipated. Brexit did not plunge the U.K. economy into immediate recession. The Bank of England and market participants were surprised by higher-than-expected inflation, prompting a rethink of policy. Hard Brexit Chart I-7Monetary Conditions Are No ##br##Longer Accommodative Monetary Conditions Are No Longer Accommodative Monetary Conditions Are No Longer Accommodative BCA's Geopolitical Strategy team has written extensively against underestimating the probability of a hard Brexit, given that polls have not turned definitively to bremorse.6 Thus, if Labour becomes the ruling party, U.K. politicians will continue to pursue Brexit so long as the polls show support for it. Thus, investors should be careful in quickly removing the Brexit risk premium from the pound, especially as EU-U.K. negotiations remain fraught with risks. The Economy The dire economic forecasts made in the direct wake of the 2016 referendum did not come to fruition because the collapse in the pound and the fall in Gilts yields massively eased British financial conditions (Chart I-7), providing an unexpected boon to the economy. This is no longer the case: both the pound and U.K. yields have come back to pre-Brexit levels. The impact of this tightening in monetary conditions is now being felt. Household real consumption growth has fallen to seven-year lows, creating a drag for businesses, as consumer spending represents 66% of the British economy (Chart I-8). Moreover, various measures of the British credit impulse have collapsed, pointing to a continued slowdown in economic activity (Chart I-9). Chart I-8Weak Demand Is Hurting Businesses Weak Demand Is Hurting Businesses Weak Demand Is Hurting Businesses Chart I-9Credit Impulse Points To Downside Credit Impulse Points To Downside Credit Impulse Points To Downside How exactly is Brexit affecting the economy today? Simply put, money is leaving the U.K. Before the referendum, both the basic balance and net FDI stood at 2% of GDP. Today these measures stand at -4% and -3%, respectively. Uncertainty about the exact terms of the Brexit deal and the loss of passporting rights for financial institutions have scared away international capital. The housing market has been especially hit, experiencing its slowest growth rate since 2013, in spite of extremely low mortgage rates (Chart I-10). Foreign capital is a major driver of the U.K.'s real estate market, with academic research suggesting that a 1% increase in foreign residential transactions translates to a 2.1% increase in house prices.7 Hence, as foreign capital continues to flee, the housing market will suffer further. Moreover, the housing market has historically been a key leading indicator of U.K. growth, suggesting that British domestic demand will remain weak (Chart I-11). Chart I-10Low Mortgage Rates Are##br## Not Helping Real Estate Low Mortgage Rates Are Not Helping Real Estate Low Mortgage Rates Are Not Helping Real Estate Chart I-11The Housing Market Points##br## To A Contraction In Demand The Housing Market Points To A Contraction In Demand The Housing Market Points To A Contraction In Demand Inflation Can inflation dynamics trump the lack of growth and force the BoE to tighten policy anyway, supporting the pound in the process? Two opposing forces could determine the path of inflation: the tight labor market and the appreciating pound. A hot labor market like the U.K.'s (Chart I-12) should put upward pressure on wages, pushing up inflation and consequently, rate expectations. However, this ignores the behavior of British inflation over the past 25 years. U.K. core inflation has mostly been driven by previous movements in the currency (Chart I-13). Meanwhile, the labor market has had very little impact on prices, with core inflation staying below 2% from 1996 to 2008, despite an unemployment rate consistently below NAIRU and a global economy firing on all cylinders. Chart I-12U.K. Has A Tight Labor Market... U.K. Has A Tight Labor Market... U.K. Has A Tight Labor Market... Chart I-13...But Inflation Is Determined By The Currency ...But Inflation Is Determined By The Currency ...But Inflation Is Determined By The Currency This kind of tight relationship between inflation and exchange rate fluctuations tends to be associated with EM countries and small open economies, not large service-based economies like the U.K. In fact, the U.K. has to import a larger percentage of its goods and services than other developed countries. Therefore, despite its large service-oriented economy, British import penetration is much more similar to New Zealand and Norway than to the U.S. or Japan (Chart I-14).8 Consequently, core inflation is relatively insensitive to labor market dynamics. Instead, prices of import-sensitive goods and services are the main contributors to variations in core inflation (Chart I-15). Chart I-14Imports Are A Big Share Of U.K. Demand Imports Are A Big Share Of U.K. Demand Imports Are A Big Share Of U.K. Demand Chart I-15Import Prices Determine U.K. Core Inflation Import Prices Determine U.K. Core Inflation Import Prices Determine U.K. Core Inflation Because of this interplay, we do not expect that the labor market tightness will be enough to compensate the depressing impact on inflation from the pound's recent large appreciation. The above dynamics will likely limit how high the BoE will be able to lift interest rates. As a result, we do not expect the pound to buck any rally in the USD this year. Moreover, rising volatility will likely increase the cost of financing the already large current account deficit, which further argues for a weaker pound. We are therefore selling GBP/USD this week. Bottom Line: The combined impact of a likely rollover in inflation, continued soft growth and still-elevated political uncertainty will limit the capacity of the BoE to hike rates. Since the pound's discount to fair value has now melted, the outlook for GBP/USD is now more bearish, particularly as U.S. inflation is set to outperform expectations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Are Tariffs Good Or Bad For The Dollar?", dated March 9, 2018, available at fes.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, titled "We Are All Geopolitical Strategists Now", dated March 28, 2018, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, titled "In Search Of A Timing Model", dated July 22, 2016, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Special Report, "GBP: Dismal Expectations", dated January 13, 2017, available at fes.bcaresearch.com 6 Please see Geopolitical Strategy Weekly Report, "Bear Hunting And A Brexit Update", dated February 14, 2018, available at gps.bcaresearch.com 7 Sa, Filipa. "The Effect of Foreign Investors on Local Housing Markets: Evidence from the UK". King's College London, 2016. 8 It is worth noting that although imports constitute an even higher share of consumption in euro area economies, a lot of this imports are from other EMU countries, therefore the impact of currency fluctuations on prices is more muted on the continent. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was mixed: Q4 GDP growth was revised up to 2.9%, more than the expectations of 2.7%; Headline PCE came out higher than expected at 1.8%; Core PCE improved to 1.6% from 1.5% but was in line with expectations; Initial jobless claims came in at 215,000, lower than the expected 230,000; The DXY's downward momentum has subsided, and trading has been constrained to a range of around 88.5 to 90.5 for the past two months. Importantly, the DXY is approaching a key downward-sloping trendline which the greenback has not been able to punch above since Q1 2017. As signs are accumulating that global growth may experience a soft patch, the USD may finally be able to punch above this powerful resistance over the coming months. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has generally been weak: German import prices contracted by 0.6%; Euro area private loans grew by 2.9%, less than the expected 3%; Euro area M3 money supply increased by 4.2%, underperforming expectations of 4.6%; Euro area Business Climate survey fell to 1.34 from 1.48, below the anticipated 1.39; German headline consumer prices came in below expectations of 1.6% annually; German harmonized consumer prices also failed to meet expectations, coming in at 1.5%. Mirroring the DXY, EUR/USD is has lost some of its powerful upward momentum. Net speculative positions are still at all-time highs, but long positions seem to be rolling over. Markets may begin to be concerned about the implications for euro area growth and inflation of a global growth prospects. Investors should be positioned for a short-term correction. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been negative: Both import and export yearly growth underperformed expectations, coming in at 16.5% and 1.8% respectively. Moreover, both the coincident and the leading economic indicators surprised negatively, coming in at 114.9 and 105.6. The Nikkei manufacturing PMI also underperformed expectations, coming in at 53.2 Finally, the National consumer price index also surprised to the downside, coming in at 1.5% Economic data in Japan show that the strength in the currency has started to bite into the Japanese economic outlook. Overall we continue to be bullish on the yen, as this currency doesn't need a strong Japanese economy to rise, instead, it tends to benefit from rising financial market volatility, a rising risk in the current environment. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Both core and headline inflation underperformed expectations, coming in at 2.4% and 2.7% respectively. Moreover, mortgage approvals also underperformed expectations, coming in at 64 thousand. However, average hourly earnings yearly growth surprised to the upside, coming in at 2.8%. GBP/USD has fallen by roughly 2.3% this week. Right now there are two opposing forces that could affect inflation. The first is a very tight labor market, which right is pushing up wages. The second is the pass through from an appreciating pound, which is lowering import prices. Out of these two, the effect of the pound will likely win out, given that imports satisfy a large percentage of demand in the U.K., making inflation less sensitive to labor market dynamics. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Last week's lackluster employment report for Australia continues to weigh down on the Aussie as investors are rightfully reticent to bet on any policy tightening by the RBA. Further hampering the prospects of hikes are the recent developments in the Australian interbank market: Funding costs for Australian banks have increased substantially since the end of last year, with the 3-month Australian bank bill rates gaining 26 bps, and the yield on AUD 3-month implied yield gaining about 50 bps. This is consistent with the increase in the LIBOR-OIS spread. Additionally, this has occurred alongside a flat AUD Swap OIS curve, meaning that no additional rate hikes are being priced in by the market. It will be extremely difficult for the RBA to hike rates alongside these widening spreads, especially when equipped with a slacking economy. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Last Thursday the RBNZ kept its policy rate unchanged at 1.75%. The statement was rather dovish, as governor Graham Spencer stated that "monetary policy will remain accommodative for a considerable period". Moreover Governor Spencer also highlighted that the RBNZ expected CPI to weaken further in the near term due to soft tradable inflation. Overall, we expect that the NZD will outperform the AUD, given that the kiwi economy is less sensitive to a global growth slowdown than the Australian economy. However the kiwi will suffer against the USD or the JPY, given that its positive link with commodity prices and inverse relationship with volatility. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was disappointing: Raw material prices contracted by 0.3% in February; Industrial product prices grew by less than expected, at 0.1% in monthly terms; Monthly GDP was also lackluster, contracting by 0.1%. However, inflation in February was at 2.2%, which is in line with the Bank's target. The fiscal impulse flow-through from the U.S. to Canada is likely to at the very least uphold this inflation figure. This will allow the BoC to stay in line with hike expectations. However, risks such as low wage growth, high debt levels, and NAFTA negotiations were mentioned in the Bank's 2017 Annual Report and need to be monitored carefully when proceeding with hikes. But on the bright side, recent reports that the U.S. is willing to drop its auto-content proposal from NAFTA talks point toward a positive outcome for NAFTA negotiations. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance for February outperform expectations, coming in at 3.138 billion. However, the KOF leading indicator underperformed expectations. EUR/CHF has rallied by roughly 1% this past week. Overall, we expect that this cross will continue to appreciate given that inflation in Switzerland is still very weak. Therefore the SNB will intervene in the currency markets to keep the franc from appreciating. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: The credit indicator underperformed expectations, coming in at 6.1%. Moreover, registered unemployment also surprised negatively, coming in at 2.5%. However it stay flat from last month's reading. USD/NOK has rallied by nearly 2.5% in the past couple days, as the dollar has regained vigor and oil prices have been toppy. Overall, we expect that the Norwegian krone will be one of the best performing commodity currency, as OPEC cuts will help oil outperform other commodities. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Lackluster data continued to come out of Sweden: Consumer confidence dropped to 101.5, underperforming the expected 105; Producer prices contracted 0.5% on a monthly basis, but grew 2.8% on an annual basis; The monthly trade deficit contracted by SEK 3.4 bn; Retail sales disappointed, coming in at 1.5%, less than the expected 1.7%. EUR/SEK has continued to climb on this news flow. It is likely that the SEK received a hit due to Riksbank Deputy Governor Cecilia Skingsley's comments that if the krona appreciates too much, it would jeopardize their inflation outlook. However, she also brought up Sweden's higher inflation relative to the euro area, which means it is "natural" that the Riksbank eventually can start raising rates "a little bit before" the ECB. This will prove to be bullish for the krona this year. Another factor weighing on the SEK today is the rising acrimony in global trade, a risk to which Sweden is very exposed. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. EM stocks have seen their tops. Even though current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. We are reinstating our long MXN / short BRL and ZAR trade. We are also upgrading Mexican sovereign credit and local bonds to overweight within their respective EM benchmarks. This week we review our recommended country allocation for the EM sovereign credit space. Feature The combination of budding signs of deceleration in both China and global trade, the trade confrontation between the U.S. and China as well as elevated equity valuations, leaves EM stocks extremely vulnerable. Odds are that EM share prices have made a major top. A few financial indicators point to a top in EM risk assets and commodities, while several leading economic indicators herald a global trade slowdown. Taken together we are reiterating our bearish stance on EM risk assets. Market- And Liquidity- Based Indicators Financial market indicators are signalling a major top in EM risk assets and commodities prices: The relative total return (carry included) of four equally weighted EM (ZAR, RUB, BRL and CLP) and three DM (AUD, NZD and CAD) commodities currencies versus an equally weighted average of two safe-haven currencies - the Japanese yen and Swiss franc - has rolled over at its previous highs, and is about to break below its 200-day moving average (Chart I-1). This technical profile points to rising odds of a major down-leg in this carry adjusted ratio of seven 'risk-on' versus two 'safe-haven' currencies, herein referred to as the risk-on / safe-haven currency ratio. Importantly, Chart I-2 demonstrates that this risk-on / safe-haven currency ratio has historically been coincident with EM share prices. A breakdown in this ratio would herald a major downtrend in EM equities. This is consistent with our qualitative assessment that EM equities have seen the peak in this rally. Chart I-1A Major Top In Risk-On Versus ##br##Safe-Haven Currency Ratio bca.ems_wr_2018_03_29_s1_c1 bca.ems_wr_2018_03_29_s1_c1 Chart I-2Risk-On Versus Safe-Haven Currency Ratio##br## And EM Share Prices: Twins? bca.ems_wr_2018_03_29_s1_c2 bca.ems_wr_2018_03_29_s1_c2 The annual rate of change in the risk-on / safe-haven currencies ratio leads global export volumes by several months. It currently indicates that global trade has already peaked, and a meaningful slowdown is in the cards (Chart I-3). As we documented in March 15 report,1 global cyclical sectors - mining, machinery and chemicals - have been underperforming since January. Industrial metals prices, including copper, are gapping down, as are steel and iron ore prices in China (Chart I-4). Chart I-3Global Trade Is Set To Slow bca.ems_wr_2018_03_29_s1_c3 bca.ems_wr_2018_03_29_s1_c3 Chart I-4A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making A Breakdown In Metals Prices Is In The Making Our aggregate credit and fiscal spending impulse for China projects considerable downside risks for industrial metals prices (Chart I-5). In this context, a question arises: Why is oil doing well so far? Chart I-6 illustrates that industrial metals prices typically lead oil at peaks. Oil prices have historically been a lagging variable of global business cycles. Chart I-5China's Slowdown Is Far From Over China's Slowdown Is Far From Over China's Slowdown Is Far From Over Chart I-6Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Industrial Metals Lead Oil Prices At Tops Furthermore, our two measures of U.S. dollar liquidity have rolled over. These two measures have a high correlation with EM share prices and are inversely correlated with the trade-weighted U.S. dollar (Chart I-7A and Chart I-7B). The dollar is shown inverted on Chart I-7B. The rollover in these measures of U.S. dollar liquidity is due to shrinking U.S. banks' excess reserves at the Federal Reserve. The Fed's ongoing balance sheet reduction and the Treasury's replenishment of its account at the Fed will continue to shrink banks' excess reserves, and thereby weigh on these measures of U.S. dollar liquidity. In short, downside risks to EM stocks and upside risks to the U.S. dollar have increased. Last but not least, China's yield curve has recently ticked down again and is about to invert, signaling weaker growth ahead (Chart I-8). Chart I-7AU.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... U.S. Dollar Liquidity And EM Stocks... Chart I-7B...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) ...And Trade-Weighted Dollar (Inverted) Chart I-8China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert China's Yield Curve Is About To Invert Hard Data In addition, certain economic data have also decisively rolled over, in particular: Taiwanese shipments to China lead global trade volumes by several months, and they now portend a meaningful slowdown in global export volumes (Chart I-9). The basis for this relationship is that Taiwan sends a lot of intermediate products to mainland China. These inputs are in turn assembled by China and then shipped worldwide. Therefore, diminishing trade flow from Taiwan to China is a sign of a slowdown in world trade. The three-month moving average of Korea's 20-day exports growth rate, which includes the March data point, reveals that considerable softness in global trade is underway (Chart I-10). Chart I-9Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Another Sign Of Peak In Global Trade Chart I-10Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak Korean Export Growth Is Already Weak China's shipping freight index - the freight rates for containers out of China - is softening, and its annual rate of change points to weaker Asian exports (Chart I-11). The annual growth rate of vehicle sales in China has dropped to zero, with both passenger cars and commercial vehicles registering no growth in the past three months from a year ago (Chart I-12). Chart I-11Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Container Freight Rates In Asia Are Softening Chart I-12China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover China's Auto Sales: Post-Stimulus Hangover Finally, measures of industrial activity in China such as total freight volumes and electricity output growth continue to downshift (Chart I-13). Next week we are planning to publish a Special Report on China's property market. Our initial research shows that structural imbalances remain acute in the nation's real estate market, and a downturn commensurable if not worse than those that occurred in 2011 and 2014-'15 is very likely. Will the Fed and the People's Bank of China (PBoC) reverse their stance quickly to stabilize growth or preclude a downdraft in global risk assets? In the U.S., the primary trend in core inflation is up. Chart I-14 demonstrates that measures of core inflation have recently risen. This, along with the tight labor market, potential upside surprises in U.S. wages and a still-large fiscal stimulus entails that the bar for the Fed to turn dovish will be somewhat higher this year. It may take a large drawdown in the S&P 500 and a meaningful appreciation in the dollar for the Fed to come to the rescue of risk assets. Chart I-13Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chinese Industrial Sector Is Decelerating Chart I-14U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed U.S. Core Inflation Has Bottomed The Chinese authorities on the other hand, had already been facing enormous challenges in balancing the needs for structural reforms and achieving robust growth before the eruption of the trade confrontation with the U.S. As such, the balancing task is becoming overwhelming. Even if the Chinese authorities stop tightening liquidity now, the cumulated impact of earlier liquidity and regulatory tightening will continue to work its way into the economy, thereby slowing growth. Bottom Line: There is growing evidence that China's industrial sector is slowing, as are Asian trade flows. This is bearish for commodities and EM risk assets. Geopolitics: Icing On The Cake The recent U.S. trade spat with China has arrived at a time when global trade and China's industrial cycle have already begun to downshift, as discussed above. At the same time, investor sentiment on global risk assets remains very complacent, and equity and credit markets are pricey. As such, the U.S.-China trade confrontation has become the icing on the cake. U.S. equity valuations are elevated - the median stock's P/E ratio is at an all-time high (Chart I-15). While EM share prices are not at record expensive levels, valuations are on the pricey side. The top panel of Chart I-16 shows the equal-weighted average of trailing and forward P/E, price-to-book, price-to-cash earnings and price-to-dividend ratios for the median EM sub-sector. This valuation indicator is about one standard deviation above its historical mean. Chart I-15U.S. Equities: Median P/E ##br##Is At Record High U.S. Equities: Median P/E Is At Record High U.S. Equities: Median P/E Is At Record High Chart I-16EM Stocks Are Expensive##br## In Absolute Term bca.ems_wr_2018_03_29_s1_c16 bca.ems_wr_2018_03_29_s1_c16 The bottom panel of Chart I-16 illustrates the same valuation ratio relative to DM. Contrary to prevailing consensus, EM equities are not cheap relative their DM peers. Using median multiples of sub-sectors helps remove outliers. We discussed EM stock valuations in greater detail in our January 24 and March 1 special reports; the links to these reports are available on page 17. As to the duration and depth of the U.S.-China trade confrontation, we have the following remarks: If the U.S.'s plan to impose import tariffs on Chinese goods is primarily about domestic politics ahead of the mid-term elections later this year, as well as to obtain some trade concessions from China, then the current standoff will be resolved in a matter of months. If the true intention of the U.S. is to contain China's geopolitical rise to preserve its global hegemony, this episode of import tariffs will likely mark the beginning of a much longer and drawn-out geopolitical confrontation. In such a case, the U.S.-China relationship will likely witness a roller-coaster pattern with periods of ameliorations followed by periods of escalation and confrontation. Critically, mutual distrust will set in - if not already the case - which will hamper cooperation on various issues. As trade tensions ebb and flow in the months ahead, the reality is that America is worried about losing its geopolitical hegemony to the Middle Kingdom. Our colleagues at BCA's Geopolitical Strategy service have been noting for several years that a U.S.-China confrontation is unavoidable.2 Bottom Line: Even though the current trade tensions between the U.S. and China could well dissipate, we are at the beginning of a long-term geopolitical standoff between these two superpowers. Re-Instating Long MXN / Short BRL and ZAR Trade Chart I-17MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR MXN's Carry Is Above Those Of BRL And ZAR Odds are that the Mexican peso will begin outperforming the Brazilian real and the South African rand. The main reason why we closed these trades in October was due to NAFTA renegotiation risks. Presently, with the U.S.-Sino trade confrontation escalating, the odds of NAFTA abrogation are declining. In fact, the U.S. may attempt to strike a deal with its allies, including its NAFTA partners, to focus more directly on China. Consequently, a menace hanging over the peso from the Sword of Damocles, i.e., NAFTA retraction, will continue to diminish. Consistently, the risk premium priced into Mexican risk assets will wane, helping Mexican markets outperform their EM peers. Interestingly, for the first time in many years, the Mexican peso's carry is above those of the Brazilian real and the South African rand (Chart I-17). Therefore, going long MXN versus ZAR and BRL are carry positive trades. Importantly, the Mexican peso is cheap. Chart I-18A illustrates the peso is cheap in absolute terms, according to the real effective exchange rate (REER) based on unit labor costs. Chart I-18B shows the peso's relative REER against those of the rand and real. These measures are constructed using consumer and producer prices-based REERs. The peso is cheaper than the South African and Brazilian currencies. Not only is Mexico's currency cheap versus other EM currencies, but Mexican domestic bonds and sovereign spreads also offer great value relative to their EM benchmarks (Chart I-19).Finally, the Mexican equity market has massively underperformed the EM benchmark and is beginning to look attractive on a relative basis. Chart I-18AMXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... MXN Is Cheap In Trade-Weighted Terms... Chart I-18B...And Relative BRL And ZAR ...And Relative BRL And ZAR ...And Relative BRL And ZAR Chart I-19Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value Mexican Local Currency And Dollar Bonds Offer Value If and as dedicated EM portfolios rotate into Mexican domestic bonds and equities, this will bid up the peso. Brazil and South Africa are leveraged to China and metals, while Mexico is exposed to the U.S. and oil. Our main theme remains that U.S. growth will do much better than that of China. While a potential drop in oil prices is a risk to the peso, Mexican goods shipments to the U.S. will remain strong, benefiting the nation's balance of payments. Macro policy in Mexico has been super-orthodox: the central bank has hiked interest rates significantly, and the government has tightened fiscal policy (Chart I-20, top panel). This has hurt growth but is positive for the trade balance and the currency (Chart I-20). Mexico will elect a new president in July, and odds of victory by leftist candidate Lopez Obrador are considerable. However, we do not expect a massive U-turn in macro policies after the elections. Importantly, the starting point of Mexico's macro settings is very healthy. In Brazil, government debt dynamics remain unsustainable, yet its financial markets have been extremely complacent. Brazil needs much higher nominal GDP growth and much lower interest rates to stabilize its public debt dynamics. As we have repeatedly argued, a major currency depreciation is needed to boost nominal GDP and government revenues. Besides, Brazil is set to hold general elections in October, and there is no visibility yet on the type of government that will enter office. In South Africa, financial markets have cheered the election of President Cyril Ramaphosa, but the outlook for structural reforms is still very uncertain. The recent decision to consider a constitutional change in Parliament that would allow the confiscation of land from white landlords may be an indication that investors have become overly optimistic on the outlook for structural reforms. In short, the median voter in both Brazil and South Africa favors leftist and populist policies. This entails that the odds of supply side reforms without meaningful riots in financial markets are not great. Finally, the relative performance of the MXN against the BRL and ZAR, including carry, seems to be attempting to make a bottom (Chart I-21). Chart I-20Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Mexico: Improved Macro Fundamentals Chart I-21A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? A Major Bottom In MXN's Cross? Bottom Line: Go long MXN versus an equally weighted basket of BRL and ZAR. Consistently, we also recommend overweighting Mexican local currency bonds and sovereign credit relative to their respective EM benchmarks. We will review the outlook for Mexican stocks in the coming weeks. EM Sovereign Credit Space: Country Allocation Asset allocators should compare EM sovereign and corporate credit with U.S. and European corporate bonds rather than EM local bonds or equities. The basis is that EM sovereign U.S. dollar bonds are a credit market, and vastly differ from local bonds and equities in terms of volatility, risk-reward trade-off and many other parameters. In short, EM credit markets should be compared to DM credit markets and EM equities to DM equities. EM local currency bonds are a separate, unique asset class.3 We continue to recommend underweighting EM sovereign and corporate credit versus U.S. and European corporate bonds. Within the EM sovereign space, our overweights are: Mexico, Argentina, Russia, Hungary, Poland, the Philippines, Chile and Peru. Neutral: Colombia, Indonesia, Egypt and Nigeria. Our underweights are: Brazil, Venezuela, Malaysia, Turkey and South Africa. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report "EM: Disguised Risks", dated March 15, 2018; the link is available on page 17. 2 Please see Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategies Now", dated March 28, 2018, available at gps.bcaresearch.com. 3 You may request May 7, 2013 Emerging Markets Strategy Weekly Report discussing our perspectives on how asset allocation for EM financial markets should be done. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The 2018 outlook for both economic growth and corporate profits remains constructive for risk assets, although evidence is gathering that global growth is peaking. Some measures of global activity related to capital spending have softened in recent months. Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, suggesting that it is too soon to call an end in the mini capital spending boom. Our global leading indicators are not heralding any major economic slowdown. The dip in early 2018 in the Global ZEW index likely reflected uncertainty over protectionist trade action. Economic growth in the major countries outside of the U.S. may have peaked, but will remain robust at least through this year. The potential for a trade war is a key risk facing investors. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy. That said, there are hopeful signs that the latest trade skirmish will not degenerate into a full-blown trade war and thereby cause lasting damage to risk assets. Stay overweight equities and corporate bonds. President Trump will announce on May 19 whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Stay long oil and related investments. The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated. EPS growth is peaking in Europe and Japan, but has a bit more upside in the U.S. later this year. Cross-country equity allocation is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. Rising U.S. corporate leverage is not an issue now, but could intensify the next downturn as ratings are slashed, defaults rise and banks tighten lending standards. The bond bear market remains intact, although the consolidation phase has further to run. By Q1 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below NAIRU. Policymakers will then try to nudge up the unemployment rate, but the odds of avoiding a recession are very low. Feature Investors are right to be concerned following the March 23 U.S. announcement of tariffs on about $50 billion of Chinese imports. The President is low in the polls and needs a victory of some sort heading into midterm elections. Getting tough on trade plays well with voters, and the President faces few constraints from Congress on this issue. Trump wants a raft of items from China, including opening up to foreign investment and a crackdown on intellectual theft. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy.1 That said, we do not expect the latest trade skirmish to degenerate into a full-blown trade war. First, China has already signaled it wants to avoid significant escalation. Beijing has offered several concessions, and its threat of retaliatory trade action has been measured so far. On the U.S. side, the fact that the Administration has decided to bring its case against China to the World Trade Organization (WTO) shows that the Americans are willing to proceed through the normal trade-dispute channels. The bottom line is that, while we cannot rule out escalating trade action that causes meaningful damage to the equity market, it is more likely that the current round of tensions will be limited to brief flare-ups. Investors should monitor the extent of European involvement. If Europe joins the U.S. effort to force China to change its trade practices via the WTO, then China will have little choice but to give in without a major fight. In terms of other geopolitical risks, North Korea should move to the back burner for a while now that the regime has agreed to negotiations. Of greater near-term significance is May 19, when Trump will announce whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Oil prices would benefit if the May deadline for issuing waivers on Iran sanctions passes. Trade penalties against Iran would reduce its oil production and exports. The U.S. is also considering sanctions on Venezuela's oil industry. Moreover, Russia and Saudi Arabia are reportedly considering a deal to greatly extend their alliance to curb oil supply. While there are downside risks as well, our base case outlook sees the price of Brent reaching US$74 before year end. Global Growth: Some Mixed Signs Also facing investors this year is the risk that the recent softening in the economic data morphs into a serious growth scare. The 2018 outlook for both the economy and corporate profits remains constructive in our view, but evidence is gathering that global growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart I-1). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports, a leading indicator for the global business cycle, have also softened. The Chinese economy is decelerating and we believe the growth risks are underappreciated. President Xi has cemented his power base and there has been a shift toward accelerated reform. Chinese leaders recognize that leverage in the system is a problem, and the regime is tightening policy on a multi-pronged basis. Structural reforms are positive for long-term growth, but are negative in the short term. The tightening in financial conditions is already evident in the Chinese PMI and the sharp deceleration in the Li Keqiang index (although the latest reading shows an uptick; not shown). A hard landing is not our base case, but the risks are to the downside because the authorities will err on the side of tight policy and low growth. It is also disconcerting that some of our measures of global activity related to capital spending have softened in recent months, including capital goods imports and industrial production of capital goods (Chart I-2). Nonetheless, the fact that the G3 aggregate for capital goods orders remains in an uptrend suggests that it is too soon to call an end in the mini capital spending boom. Consumer and business confidence continues to firm in the major economies. Chart I-1Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Chart I-2A Soft Spot For Capital Spending A Soft Spot For Capital Spending A Soft Spot For Capital Spending Our global leading indicators are not heralding any major economic slowdown (Chart I-3). BCA's Global LEI remains in an uptrend and its diffusion index is above the 50 line. In contrast, the global measure of the ZEW investor sentiment index plunged in March. We attribute the decline to the announcement of steel and aluminum tariffs and the subsequent market swoon, suggesting that the ZEW pullback will prove to be temporary. Turning to the U.S., retail sales disappointed in January and February, especially considering that taxpayers just received a sizable tax cut. Nonetheless, this probably reflects lagged effects and weather distortions. Our U.S. consumer spending indicator continues to strengthen as all of the components remain constructive outside of auto sales. Household balance sheets are the best that they have been since 2007; net worth is soaring and the aggregate debt-to-income ratio is close to the lowest level since the turn of the century (Chart I-4). Given robust employment growth and the tightest labor market in decades, there is little to hold U.S. consumer spending back. We expect that the tax cut effect on retail sales will be revealed in the coming months, helping to sustain the healthy backdrop for corporate profits. Chart I-3Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Chart I-4U.S. Consumers In Good Shape U.S. Consumers In Good Shape U.S. Consumers In Good Shape Global Margins Still Rising The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated (Chart I-5). Earnings-per-share surged in the early months of the year in both the U.S. and Japan, although they languished in the Eurozone according to IBES data (local currencies; not shown). Relative equity returns in local currency tend to follow relative shifts in 12-month forward EPS expectations over long periods, and bottom-up analysts have lifted their U.S. earnings figures in light of the fiscal stimulus (Chart I-6). Chart I-5Global Margins Still Rising Global Margins Still Rising Global Margins Still Rising Chart I-6EPS And Relative Equity Returns EPS And Relative Equity Returns EPS And Relative Equity Returns The key question is: can the U.S. market outperform again in 2018 now that the tax cuts have largely been priced in? One can make a compelling case either way. Growth: Global growth will remain robust for at least the next year, and the Eurozone and Japanese markets are more geared to global growth than is the U.S. However, the impressive fiscal stimulus in the pipeline means that economic growth momentum is likely to swing back toward the U.S. this year. GDP growth in Europe and Japan will remain above-trend, but it has probably peaked for the cycle in both economies. Valuation: Our composite measure of valuation suggests that Europe and Japan are on the cheap side relative to the U.S. based on our aggregate valuation indicator, which takes into consideration a wide variety of yardsticks (Chart I-7). That said, one of the reasons why European stocks are on the cheap side at the moment is that export-oriented German exporters are quite exposed to rising international tariffs. Earnings: Previous currency shifts will add to EPS growth in the U.S. in the first half of the year, but will be a drag in Europe and Japan (Chart I-8). However, these effects will wane through the year unless the dollar keeps falling. Indeed, we expect the dollar to firm modestly over the next year, favoring the European equity market at the margin. In contrast, we expect the yen to strengthen in the near term, which will trim Japanese EPS growth. Chart I-7Valuation Ranking Of Nonfinancial ##br##Equity Markets Relative To The U.S. April 2018 April 2018 Chart I-8Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Chart I-9 updates the forecast from our top-down earnings models. The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up. Narrowing margins are less of a risk in Europe. U.S. EPS growth should be above that of Europe in 2018, but will then fall to about the same pace in 2019. We expect Japanese profit growth to remain very strong this year and next, given Japan's highly pro-cyclical earnings sensitivity. However, this does not incorporate the risk of further yen strength. Earnings expectations will also matter. Twelve-month bottom-up expectations are higher than our U.S. forecast ('x' in Chart I-9 denotes 12-month forward EPS expectations). In contrast, expectations are roughly in line with our forecast for the European market. It will therefore be more difficult at the margin for U.S. earnings to surprise to the upside. Monetary Policy: The relative shift in monetary policies should favor the European and Japanese markets to the U.S. The FOMC will continue tightening, with risks still to the upside on rates in absolute terms and relative to the other two economies. Sector Performance: Sector skews should work in Europe's favor. Financials are the largest overweight in Euro area bourses, while technology is the largest overweight in the U.S. We are constructive on the financial sector in both markets, but out-performance of the sector will favor the Eurozone broad market. Meanwhile, tech companies are particularly sensitive to changes in discount rates, since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening. The Japanese market has a relatively high weighting in industrials and consumer discretionary. The market will benefit if the global mini capex boom continues, but this could be counteracted by softness in global auto sales and further yen strength. It is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. We continue to avoid the Japanese market for the near term because of the potential for additional yen gains. As for the equity sector call, investors should remain oriented toward cyclicals versus defensives. Our key themes of a synchronized global capex mini boom, rising bond yields and firm oil prices favor the industrials, energy and financial sectors. Chart I-10 highlights four indicators that support the cyclicals over defensives theme, the dollar and the business sales-to-inventories ratio. Telecom, consumer discretionary and homebuilders are underweight. Chart I-9Profit Forecast Profit Forecast Profit Forecast Chart I-10These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks We will be watching the indicators in Chart I-10 to time the shift to a more defensive equity sector allocation. Leverage And The Next Recession As the economic expansion enters the late stages, investors are focused on where leverage pressure points may lurk. Last month's Special Report on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. For our sample of 770 companies, we estimated how much interest coverage for the average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits fall by 25% peak to trough. Given all the client inquiries, we decided to delve deeper into the results. We were concerned that our sample of high-yield companies distorted the overall results because it includes many small firms and outliers. We are more comfortable with the results using only the investment-grade firms, shown in Chart I-11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart I-12 shows that the interest coverage ratio has declined even as profit margins have remained elevated. Normally the two move together through the cycle. Chart I-11Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Chart I-12The Consequences Of Rising Leverage The Consequences Of Rising Leverage The Consequences Of Rising Leverage The implication is that the next recession will see interest coverage fare worse than in previous recessions. Of course, there are many other financial ratios and statistics that the rating agencies employ, but our results suggest that downgrades will proliferate when the agencies realize that the economy is turning south. Moreover, banks may tighten C&I lending standards earlier and more aggressively because they will also be finely attuned to the first hint of economic trouble given the leverage of the companies in their portfolio. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressure in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a greater overall tightening in financial conditions. Corporate leverage could therefore intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macro-economic imbalances, such as areas of overspending, that could turn a mild recession into a nasty one. As long as growth remains solid, the market and rating agencies will ignore the leverage issue. Indeed, ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart I-13). We remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios for now. The European corporate sector is further behind in the leverage cycle (Chart I-14). Europe does not appear to be nearly as vulnerable to rising interest rates. Nonetheless, our European Corporate Health Monitor (CHM) has deteriorated over the past couple of years due to some erosion in profit margins, debt coverage and the return on capital. Meanwhile, the U.S. CHM has improved in recent quarters because the favorable earnings backdrop has temporarily overwhelmed rising leverage (top panel of Chart I-14). For the short-term, at least, corporate health is moving in favor of the U.S. at the margin. Chart I-13Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Chart I-14Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. The implication is that, while we see trouble ahead for the U.S. corporate sector in the next economic downturn, in the short term we now favor the U.S. over Europe in the credit space. We are watching our Equity Scorecard, bank lending standards, the yield curve and our profit margin proxy in order to time our exit from both corporate bonds and equities (see last month's Overview section). We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. Powell Doesn't Rock The Boat The Fed took a measured approach when reacting to the fiscal stimulus that is in the pipeline. The FOMC lifted rates in March and marginally raised the 'dot plot' for 2019 and 2020. Policymakers shaved the projection for unemployment to 3.6% by the end of 2019. This still appears too pessimistic, unless one assumes that the labor force participation rate will rise sharply. Table I-1 provides estimates for when the unemployment rate will reach 3½% based on different average monthly payrolls and participation rates. Our base case scenario, with 200k payrolls per month and a flat participation rate, sees the unemployment rate reaching 3½% by March 2019. Table I-1Dates When 3.5% Unemployment Rate Threshold Is Reached April 2018 April 2018 The soft-ish February reports for consumer prices and average hourly earnings took some of the heat off the FOMC. Core CPI, for example, rose 'only' 0.2% from the month before. Still, when viewed on a 3-month rate-of-change basis, underlying inflation remains perky; the core CPI inflation rate increased from 2.8% in January to 3% in February (Chart I-15). Inflation in core services excluding medical care and shelter, as well as in core goods, have also surged on a 3-month basis. We expect the latter to continue to pressure overall inflation higher, following the upward trend in import prices. The recent downtrend in shelter inflation should also stabilize due to the falling rental vacancy rate. Chart I-15U.S. Inflation Is Perky U.S. Inflation Is Perky U.S. Inflation Is Perky Moreover, the NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. The ISM manufacturing survey shows that companies are paying more for their inputs and experiencing delays with suppliers. This describes a late-cycle environment marked with rising inflationary pressures. We expect that core inflation will grind up to the 2% target by early next year. By the first quarter of 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below its estimate of the non-inflationary limit. Policymakers will then attempt a 'soft landing' in which they tighten policy enough to nudge up the unemployment rate. Unfortunately, the Fed has never been able to generate a soft landing. Once unemployment starts to rise, the next recession soon follows. Our base case is that the next recession begins in 2020. Bond Bear In Hibernation For Now The bond market showed that it can still intimidate in February, but things have since calmed down as the U.S. mini inflation scare ebbed, some economic data disappointed and trade friction created additional macro uncertainty. Bearish sentiment and oversold technical conditions suggest that the consolidation period has longer to run. Nonetheless, unless inflation begins to trend lower, the fact that even the doves on the FOMC believe that the headwinds to growth have moderated places a floor under bond yields. Fair value for the 10-year Treasury is 2.90% based on our short-term model, but we expect it to reach the 3.3-3.5% range before the cycle is over. Both real yields and long-term inflation expectations have room to move higher. Private investors will also have to absorb US$680 billion worth of bonds this year from governments in the U.S., Eurozone, Japan and U.K., the first positive net flow since 2014 (see last month's Overview). Yields may have to fatten a little in order for the private sector to make room in their portfolios for that extra government supply. In the Eurozone, the net supply of government bonds available to the private sector will still be negative this year, even if the ECB tapers to zero in September as we expect. Some investors are concerned about a replay in the European bond markets of the Fed's 'taper tantrum' of 2013, when then-Chair Bernanke surprised markets with a tapering announcement. The ECB has learned from that mistake and has given several speeches recently highlighting that policymakers will be making full use of forward guidance to avoid "...premature expectations of a first rate rise."2 We think they will be successful in avoiding a similar tantrum, but the flow effect of waning bond purchases will still place some upward pressure on the term premium in Eurozone bonds (Chart I-16).3 Chart I-16ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium The bottom line is that monetary policy will undermine global bond prices in both the U.S. and Eurozone, but we expect U.S. yields to lead the way higher this year. Japanese bond prices will be constrained by the 10-year yield target. Investors with a horizon of 6-12 months should remain overweight JGBs, at benchmark in Eurozone government bonds and underweight Treasurys within hedged global bond portfolios. We recommend hedging the currency risk because we continue to expect the dollar to rebound this year. This month's Special Report, beginning on page 18, discusses the cyclical factors that will support the dollar: interest rate differentials, a rebound in U.S. productivity growth and a shift in international growth momentum back in favor of the U.S. In terms of the longer-term view, the Special Report makes the case that the U.S. dollar's multi-decade downtrend will persist. This does not mean, however, that long-term investors will make any money by underweighting the greenback. The 30-year U.S./bund yield spread of 190 basis points means that the €/USD would have to rise to more than 2.2 to offset the yield disadvantage of being overweight the euro versus the dollar over the next 30-years. Indeed, once it appears that the U.S. yield curve has discounted the full extent of the Fed tightening cycle (perhaps 12 months from now), it will make sense for long-term investors to go long U.S. Treasurys versus bunds on an unhedged basis. Conclusion Recent data releases suggest that global growth is peaking, especially in the manufacturing sector. Nonetheless, we do not believe that this heralds a slowdown in growth meaningful enough to negatively impact the profit outlook in the major countries. Indeed, the major fiscal tailwind in the U.S. will lift growth and extend the runway for earnings to expand at least through 2019. That said, fiscal stimulus at this stage of the U.S. business cycle will serve to accentuate a boom/bust cycle, where stronger growth in 2018/19 gives way to higher inflation a hard landing in 2020. The Fed is willing to sit back and watch the impact of fiscal stimulus unfold in the near term. But by early 2019, the Fed will find itself behind the curve with rising inflation and an overheating economy. The monetary policy risk for financial markets will then surge, setting up for a classic end to this expansion. The consequences of years of corporate releveraging will come home to roost. This year, trade skirmishes will be a headwind for risk assets and will no doubt generate further bouts of volatility. Nonetheless, recent signals from both the U.S. and China suggest that the situation will not degenerate into a trade war. The bottom line is that, while the economic expansion and equity bull market are both in late innings, investors should stay overweight risk assets and short duration for now. Stay overweight cyclical stocks versus defensives, overweight corporate bonds versus governments, overweight oil-related plays, and modestly long the U.S. dollar against most currencies except the yen. Our checklist of items to time the exit from risk is not yet flashing red. We would change our mind if our checklist goes south, our forward-looking indicators turn sharply lower or U.S. inflation suddenly picks up. We are also watching closely the situation in Iran, the U.S./China trade spat and NAFTA negotiations. Mark McClellan Senior Vice President The Bank Credit Analyst March 29, 2018 Next Report: April 26, 2018 1 For more information on why we believe that Sino-American conflict will be a defining feature of the 21st century, please see BCA Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com 2 ECB President Mario Draghi. Speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html 3 For more information, please see BCA's Global Fixed Income Strategy Weekly Report "Bond Markets Are Suffering Withdrawal Symptoms," dated March 20, 2018, available at gfis.bcaresearch.com II. U.S. Twin Deficits: Is The Dollar Doomed? In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart II-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. Chart II-1At Full Employment, Import Tariffs Raise Rates April 2018 April 2018 The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up, as we discuss in the Overview section. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart II-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart II-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart II-2A Replay Of The Nixon Years? A Replay Of The Nixon Years? A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart II-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart II-3Twin Deficits And The Dollar Twin Deficits And The Dollar Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart II-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. Chart II-4Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart II-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next (see the Overview section). (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart II-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart II-5Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart II-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart II-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart II-6U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns Chart II-7Composition Of Net International ##br##Investment Position April 2018 April 2018 A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart II-6, top panel). In Chart II-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart II-8Primary Investment Balance Simulations Primary Investment Balance Simulations Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart II-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart II-9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart II-9 reveals. Chart II-9U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart II-1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. III. Indicators And Reference Charts The earnings backdrop remains constructive for the equity market. In the U.S., bottom-up forward earnings estimates and the net earnings revisions ratio have spiked on the back of the tax cuts. Unfortunately, many of the other equity-related indicators in this section have moved in the wrong direction. The monetary indicator is shifting progressively into negative territory as the Fed gradually tightens the monetary screws. Valuation in the U.S. market improved a little over the past month, but our composite Valuation Indicator is still very close to one sigma overvalued. Technically, our Speculation Indicator is still in frothy territory, but our Composite Sentiment Indicator has pulled back significantly toward the neutral line. Our Technical Indicator broke below the 9-month moving average in March (i.e. a 'sell' signal). These are worrying signs. Nonetheless, at this point we believe they are a reflection of the more volatile late-cycle period that the market has entered. An equity correction could occur at any time, but a bear market would require a significant and sustained economic downturn that depresses earnings estimates. Our checklist does not warn of such a scenario over the next 12 months. It is also a good sign that our Willingness-to-Pay indicator is still rising, at least for the U.S. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. While this suggests that investor flows remain positive for the U.S. equity market, the WTP appears to have rolled over in both Europe and Japan. This goes against our overweight in European stocks versus the U.S. in currency hedged terms (see the Overview section). Our Revealed Preference Indicator (RPI) remained on its bullish equity signal in March. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. So far, the indicator has not flashed 'red'. Treasurys are hovering on the 'inexpensive' side of fair value, but are not cheap based on our model. Extended technicals suggest that the period of consolidation will persist for a while longer. Value is not a headwind to a continuation in the cyclical bear phase. Little has changed on the U.S. dollar front. It is expensive by some measures, but is on the oversold side technically. We still expect a final upleg this year, before the long-term downtrend resumes. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Fixed Income Asset Allocation: Global growth indicators remain solid, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Gilts: Bank of England hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr in a 2yr/5yr/10yr butterfly trade. Feature Chart of the WeekStill A Bond-Bearish Backdrop Still A Bond-Bearish Backdrop Still A Bond-Bearish Backdrop Higher financial market volatility remains the most important investment theme for 2018, as investors continue to be fed a steady diet of worrisome headlines. Threats of a U.S. - China trade war, widening LIBOR-OIS spreads in the U.S., the ascent of trade and foreign policy hawks in the White House, troubles at Facebook hitting the market-leading technology stocks - all are just the latest reasons for investors to become more cautious on taking risk. Yet the ability of markets to shrug off, or succumb to, growing uncertainty will be related to two things - the momentum of global economic growth and the future direction of global monetary policy. On the former, the latest data releases have shown some moderation in the strong coordinated global growth upturn witnessed over the past year. Our aggregate measures such as the global PMI and global ZEW indices have dipped lower in the first few months of 2018. These indicators remain at levels suggesting growth is still in decent shape, even with some worsening in expectations (Chart of the Week). On the latter, the BCA Central Bank Monitors are still showing a growing need to tighten monetary policy further in the major developed economies. This continues to put upward pressure on government bond yields through rising inflation expectations and a higher expected path of short-term interest rates. Until there is evidence of a more meaningful downturn in global growth, bond yields will keep on drifting higher. We continue to recommend a below-benchmark overall portfolio duration stance for fixed income investors, favoring spread product over government bonds, while running below-average portfolio risk (i.e. tracking error) given more elevated levels of market volatility. The "TINA Trade" Is Now The "TISNA Trade" - There Is STILL No Alternative Central bankers remain on a path to normalize the extraordinary monetary accommodation of the past several years, led by their steadfast belief in the Phillips Curve at a time of low unemployment in most countries. Against this backdrop, government bond yields cannot fall enough to limit the damage from rapid equity market selloffs without much softer growth or inflation data that would alter the expected trajectory of policy rates. This implies a higher structural level of market volatility now relative to previous years, as we discussed in a recent Global Fixed Income Strategy Weekly Report.1 Yet despite the signs of greater nervousness among investors, there is still a strong level of positive sentiment towards equities and bearish sentiment towards bonds according to the Market Vane indices (Chart 2). The latest edition of the widely-followed Bank of America Merrill Lynch Investor Survey also revealed a disconnect between the opinions of investors (worries over protectionism, trade wars, higher inflation and softer global growth) and actual positions (large equity overweight's favoring cyclical growth stocks).2 Investors seem to be "nervously complacent", staying long risk assets (equities, credit) and underweight safe havens (government bonds) but with a growing list of concerns. For now, this appears to be the most appropriate allocation, for the following reasons: Global growth is still generally strong. Our global manufacturing PMI remains close to the cyclical highs, although there was some pullback seen in the "flash estimates" for March in the euro area, Japan and the U.K. (Chart 3). The breadth of the current cyclical global upturn remains strong, with all eighteen countries in the composite index having a PMI in the "growth zone" above 50 (top panel). Chart 2Pro-Risk Sentiment,##BR##Despite More Volatile Markets Pro-Risk Sentiment, Despite More Volatile Markets Pro-Risk Sentiment, Despite More Volatile Markets Chart 3Global Growth##BR##Still Looks Good Global Growth Still Looks Good Global Growth Still Looks Good The OECD global leading economic indicator continues to accelerate, while the Citigroup global inflation surprise index is also picking up (Chart 4). These are pointing to continued upward pressure on global bond yields through higher real yields and faster inflation expectations, respectively. The global cyclical backdrop is boosting inflation. 75% of OECD countries are operating beyond full employment while capacity utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 5, top panel). Global oil prices should continue to grind higher, with BCA's commodity strategists now expecting the benchmark Brent oil price hitting $80/bbl in one year's time (middle panel). Also, global export price inflation is showing no signs of slowing, suggesting that global headline inflation should continue moving higher (bottom panel). Chart 4Upward Pressure On##BR##Real Yields AND Inflation Upward Pressure On Real Yields AND Inflation Upward Pressure On Real Yields AND Inflation Chart 5A More Inflationary##BR##Global Backdrop A More Inflationary Global Backdrop A More Inflationary Global Backdrop Central bankers are still biased towards becoming less accommodative. This was seen last week with the U.S. Federal Reserve hiking the fed funds rate and raising its growth and interest rate projections (Chart 6), while the Bank of England (BoE) gave a strong indication that an interest rate increase was coming in May. This comes as the European Central Bank continues to signal a tapering of its asset purchase program later this year. The latter point is critical for markets, as tighter global monetary policy has diminished the ability for investors to ignore sources of potential uncertainty. Take the current concern over trade tensions between the U.S. and China, for example. A Google Trends search of the phrase "China Trade War" shows, unsurprisingly, a huge recent spike in interest in that topic (Chart 7, top panel). There was also a big increase in such online searches around the time of Donald Trump's election victory in November 2016 and his inauguration in January 2017. At that time, however, global monetary policy was still accommodative, with the real fed funds rate well below the neutral "r-star" estimate (middle panel) and central bank balance sheets in the major developed economies expanding at a 20% annual rate (bottom panel). Chart 6The Fed Will Keep On Hiking The Fed Will Keep On Hiking The Fed Will Keep On Hiking Chart 7Expect More Vol Spikes While CBs Tighten Expect More Vol Spikes While CBs Tighten Expect More Vol Spikes While CBs Tighten The easy monetary settings helped keep market volatility low despite the shock of Trump's election win and what it meant for the implementation of his more aggressive campaign promises, like raising tariffs on U.S. imports from China. Fast forward to today and the real fed funds rate is now at neutral and central banks are buying bonds at a much slower pace. This means that markets will have a tougher time ignoring greater uncertainty, as was witnessed in last week's equity market selloff following President Trump's announcement of $60 billion in Chinese import tariffs. Going forward, without the soothing balm of very low interest rates and plentiful central bank liquidity expansion, volatility spikes like the ones seen in early February and last week will become more frequent. The implication is that volatility-adjusted returns on risk assets will be lower, even if the global growth backdrop remains reasonably supportive. A pro-risk investment bias, but playing with fewer chips on the table, is still appropriate over at least the next six months. Bottom Line: Global growth indicators remain at elevated levels, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Update: Sticking With Our Overweight Call On Gilts Chart 8Mixed Messages On U.K. Growth Mixed Messages On U.K. Growth Mixed Messages On U.K. Growth The BoE kept interest rates unchanged at last week's policy meeting, but sent clear signals that a rate hike would be very likely in May. Two members of the Monetary Policy Committee (MPC), Michael Saunders and Ian McCafferty, actually voted a rate hike last week, which was a surprise. The BoE's increasing hawkishness continues a process that began in autumn of 2017, when policymakers began shifting their language in advance of a November rate hike - the first BoE rate increase since May 2007. The central bank had been worried more about the risks to the U.K. growth outlook since the July 2016 Brexit vote, while ignoring the currency-driven overshoot of its inflation target. Now, the BoE seems a bit more comfortable with the U.K. growth outlook, even amid the ongoing Brexit uncertainty, as was noted in the official policy statement from last week's MPC meeting: Developments regarding the United Kingdom's withdrawal from the European Union - and in particular the reaction of households, businesses and asset prices to them - remain the most significant influence on, and source of uncertainty about, the economic outlook. In such exceptional circumstances, the MPC's remit specifies that the Committee must balance any significant trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity. The steady absorption of slack has reduced the degree to which it is appropriate for the MPC to accommodate an extended period of inflation above the target. We find it a bit of a surprise that the BoE would seek to switch to inflation-fighting mode now, for two reasons: U.K. growth momentum may be slowing. The flash estimate for the March manufacturing PMI fell to an 8-month low, while the leading economic indicators (LEIs) from both the OECD and Conference Board have clearly rolled over (Chart 8). The BoE did highlight the recent pickup in wage inflation, with year-over-year growth in average weekly earnings now up to 2.8% in nominal terms. This has pushed real wage growth back into positive territory (3rd panel), which appears to be feeding through into a slight pickup in consumer confidence (bottom panel). Although the modest increase in February retail sales suggests that a consumer spending revival may be slower to arrive than the BoE is hoping for. U.K. inflation momentum is slowing. The surge in U.K. inflation following the decline in the British Pound after the 2016 Brexit vote is in the process of unwinding. The trade-weighted currency is up 9% from the 2016 low, which has sliced imported goods price inflation from 10% to 2% over the same period (Chart 9). Headline CPI inflation, which rose from near 0% to 3.1% in November 2017, now sits at 2.7%. The upturn in core CPI inflation has also stabilized. While both CPI inflation measures remain above the 2% BoE target, the momentum has clearly peaked and pipeline price pressures continue to decelerate. Investors have listened to the signals sent by the BoE, pricing in 45bps of hikes over the next year and pushing the 2-year Gilt yield to 0.9% - the highest level since May 2011 (Chart 10). At the same time, market-based inflation expectations have dipped a bit and the U.K. data surprise index has fallen back to the zero line (bottom panel). Chart 9U.K. Inflation Has Peaked U.K. Inflation Has Peaked U.K. Inflation Has Peaked Chart 10A Rapid BoE Repricing At The Wrong Time? A Rapid BoE Repricing At The Wrong Time? A Rapid BoE Repricing At The Wrong Time? Conflicting signals can also be seen in the slope of the Gilt curve. The nominal 2-year/10-year Gilt curve now sits at 55bps, just above the 2016 post-Brexit lows. The real Gilt curve (the nominal curve minus the 2-year/10-year U.K. CPI swap curve) is sitting at the flattest levels last seen since 2015/16 (Chart 11, top panel) when the BoE base rate was above zero in real terms (2nd and 3rd panels). Now, the real base is deeply negative around -2%, suggesting that the Gilt curve may already be discounting higher real BoE policy rates. At the same time, the U.K. inflation expectations curve is steepening, with 2-year CPI swaps falling faster than 10-year CPI swaps, as was the case during that 2015/16 episode (bottom panel). U.K. money markets are now pricing in an increase in the base rate to 1% over the next year. Given the slowing trends in the U.K. LEIs, the manufacturing PMI and realized inflation rates, we remain doubtful that the BoE will be able to deliver more hikes than are currently discounted. We continue to view U.K. Gilts as a "defensive" overweight within dedicated global government bond portfolios, especially given our recommendation to also stay defensive on overall duration exposure. The primary trend in the performance of U.K. Gilts relative to the Barclays Global Treasury Index, on a currency-hedged basis, is broadly correlated (inversely) to the ratio of the U.K. OECD LEI to the overall OECD LEI (Chart 12, top panel). Thus, we feel comfortable sticking with our call to expect U.K. Gilt outperformance in the next 6-12 months as long as the U.K. LEI continues to underperform - especially with the yield betas of Gilts to U.S. Treasuries and euro area government bonds now well below 1 (middle panel). Chart 11The Gilt Curve##BR##Looks Too Flat The Gilt Curve Looks Too Flat The Gilt Curve Looks Too Flat Chart 12Stay O/W Gilts & Add Go Long##BR##The Belly On A 2/5/10 Butterfly Stay O/W Gilts & Add Go Long The Belly On A 2/5/10 Butterfly Stay O/W Gilts & Add Go Long The Belly On A 2/5/10 Butterfly Given the recent flattening of the Gilt curve, which appears a bit extreme, we are adding a new trade to our Tactical Overlay this week: going long the belly (5-year) of a 2-year/5-year/10-year (2/5/10) Gilt butterfly. The current level of that 2/5/10 butterfly is 9bps, and we are targeting a move down to the -10bp to -15bp range. This trade is mildly negative carry, with -0.75bps of flattening per month already discounted in the forwards over the next year (bottom panel), but we anticipate the 2/5/10 butterfly to compress at a faster rate than the forwards in the coming months. Bottom Line: BoE hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr point in a 2yr/5yr/10yr butterfly trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6th 2018, available at gfis.bcaresearch.com. 2 https://www.bloomberg.com/news/articles/2018-03-20/cracks-in-bull-case-emerge-yet-stubborn-investors-not-moving Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Nervous Complacency Nervous Complacency Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economy: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Fed: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loans: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Feature Yet another down week for risk assets, and all of a sudden 2018 is shaping up to be a pretty miserable year for spread product (Chart 1). High-Yield corporate bonds have underperformed duration-equivalent Treasuries by 29 basis points year-to-date, and investment grade corporates have underperformed by 90 bps. Meanwhile, the sell-off in Treasuries has also paused and the 10-year yield is now 12 bps below its 2018 peak. Chart 1Annual Excess Returns To Credit Annual Excess Returns To Credit Annual Excess Returns To Credit What exactly is going on? We identify two catalysts for the recent market moves and consider each in turn. Questioning The Synchronized Global Recovery Market moves during the past few weeks have, to some extent, been driven by investors starting to question the sustainability of the so-called "synchronized global recovery". The strong pace of global growth has been a key driver of higher bond yields and risk asset outperformance, and most indicators suggest this trend remains intact. The Global Manufacturing PMI is high compared to recent years, and our PMI diffusion index shows that only 1 out of 36 countries has a PMI below the 50 boom/bust line (Chart 2). Our Global Leading Economic Indicator is similarly elevated, and has a diffusion index that has mostly been in positive territory since mid-2016 (Chart 2, panel 2). But last week we received some evidence that this rapid pace of growth may not persist. Flash PMIs predict that the Eurozone Manufacturing PMI will fall to 56.6 in March, down from a recent peak of 60.6 (Chart 2, panel 3). Similarly, the Japanese PMI is predicted to fall to 53.2 in March, down from a recent peak of 54.8 (Chart 2, bottom panel). There is no Flash PMI data for China, the country with the largest weighting in the Global PMI index, but leading indicators suggest that Chinese PMI will also moderate in the months ahead. This is a risk we have flagged in several recent reports.1 Granted, these are all strong PMI readings that are still well above the 50 boom/bust line, but the pace of improvement has clearly moderated and this sort of marginal change often causes investors to extrapolate weaker growth into the future. This appears to be exactly what is happening. The Global ZEW index, a survey of investors' economic sentiment, fell in March (Chart 3). The BCA Carry Canary Indicator, a composite measure of emerging market currency trades geared to global growth, has also weakened (Chart 3, panel 2). Meanwhile, cyclical equity sectors (excluding technology) have not managed to outperform defensives even as Treasury yields have risen, a break from the prior correlation (Chart 3, panel 3). Of the four market-based indicators that most closely track the 10-year Treasury yield, only our Boom/Bust Indicator is not currently pointing to lower yields in the near-term (Chart 3, bottom panel). As usual, we turn to our 2-Factor Treasury Model to assess the impact of moderating global growth on the 10-year Treasury yield. At present, the model - which is based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar - pegs fair value for the 10-year Treasury yield at 2.96% (Chart 4). However, if we assume that Flash PMI readings for the U.S., Eurozone and Japan are accurate, and also that PMIs in the rest of the world and dollar sentiment stay flat at current levels, then the fair value reading from our model will drop to 2.85% when the final March PMI data are released next week. This is not far from the current yield level, and could even be an optimistic forecast if the Chinese PMI starts to roll over, as we expect. Chart 2Global Recovery Still Intact Global Recovery Still Intact Global Recovery Still Intact Chart 3Global Growth Warning Signs Global Growth Warning Signs Global Growth Warning Signs Chart 42-Factor Treasury Model 2-Factor Treasury Model 2-Factor Treasury Model Of course the global economy also has to contend with the possibility of an escalating trade war between the U.S. and China. Markets reacted last week as the U.S. government ramped up the pressure by announcing a 25% tariff on $50-$60 billion worth of trade with China. While the immediate economic impact of these measures is highly uncertain, our Geopolitical strategists view an escalating trade war as a real possibility during the next 1-2 years.2 Bottom Line: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Stay tuned. A Less Supportive Fed Chart 5Fed Versus Market Fed Versus Market Fed Versus Market The second catalyst driving bond markets at the current juncture is that the Fed is providing markets with a less accommodative monetary back-drop. Faced with a firmer outlook for U.S. growth and inflation, the Fed is now somewhat less responsive to tighter financial conditions than it has been during the past few years. This hawkishness will put a floor under Treasury yields going forward, and is also the most immediate risk to credit spreads, as we have explained in several recent reports.3 Chart 6The Fed's Phillips Curve Model The Fed's Phillips Curve Model The Fed's Phillips Curve Model Case in point, the Fed went ahead with a rate hike at last week's FOMC meeting despite the recent turbulence in financial markets. Not only that, but FOMC participants generally revised up their projections for both economic growth and the fed funds rate. The same number of participants (6) now expect four rate hikes this year as expect three. Last December only four participants expected four or more rate hikes in 2018. Further, the committee's median projection for the fed funds rate at the end of 2019 rose from 2.7% to 2.9%, the median for the end of 2020 rose from 3.1% to 3.4%, and even the median federal funds rate expected to prevail in the longer run rose from 2.8% to 2.9%. The market has moved a long way towards the Fed's dots in recent months, but is still somewhat more pessimistic. The overnight index swap curve is priced for slightly more than three rate hikes in 2018 (including last week's), but is below the Fed's median projection for 2019, 2020 and the longer run (Chart 5). As mentioned above, the Fed also revised up its projections for economic growth and the pace of labor market tightening. The Fed is now looking for an unemployment rate of 3.6% by the end of next year, well below its estimated 4.5% natural rate. At the same time, however, the Fed left its projections for core inflation largely unchanged leaving some to question whether the Fed is re-assessing its commitment to the Phillips curve. In fact, the following question was asked to Chairman Powell at last week's post-meeting press conference:4 Question: Interesting changes in the forecast. A higher growth forecast [...]. Lower unemployment, [...]. And yet, very little change in inflation. What does that say about what you and the Committee believe about the inflation dynamic? Answer: [...] that suggests that the relationship between changes in slack and inflation is not so tight. [...] It has diminished, but it's still there. In other words, the Chairman refused to dismiss the Phillips curve framework altogether but acknowledged that the slope is very flat. The implication is that the labor market will have to run hot for the next couple of years for the Fed to achieve its inflation target. By our assessment, the Fed's projections for the unemployment rate and inflation seem fairly reasonable. Chart 6 shows an expectations-augmented Phillips curve model of core inflation that we re-created from a 2015 Janet Yellen speech.5 Using the Fed's median projections for the unemployment rate, and also holding relative import prices and inflation expectations flat, the model projects that core inflation will rise during the next two years, but will remain slightly below the Fed's target. In other words, the Fed's inflation forecasts seem to agree with the empirical data. In Search Of A More Robust Phillips Curve One of the reasons that the Phillips curve is so flat is that while core PCE inflation includes some prices that respond briskly to labor market slack, it also includes many prices that are less driven by labor slack and more by idiosyncratic factors. The price of imported goods being a prime example. Recent research from the San Francisco Fed splits out those prices that are more sensitive to labor slack - procyclical inflation - from those that are less sensitive to labor slack - acyclical inflation.6 Interestingly, it is the acyclical components that have caused core inflation to run below the Fed's target in recent years, while procyclical inflation has been well above 2% (Chart 7). This framework is helpful because it allows us to estimate a more robust Phillips curve on just the components of inflation that are most sensitive to tightness in the labor market. For example, when we estimate a Phillips curve relationship on just procyclical inflation (excluding housing), the model shows that this component of inflation will rise by 0.18% for every percentage point decline in the unemployment rate. When we estimate the Phillips curve model on overall core PCE we find that a 1 percentage point decline in the unemployment rate only raises core PCE inflation by 0.09%. The top panel of Chart 8 shows that if the unemployment rate follows the path predicted by the Fed, then procyclical inflation (ex. housing) will rise during the next two years, and should stay above the Fed's 2% target. Our own model of housing inflation also shows that its deceleration should reverse in the coming months (Chart 8, panel 2). Chart 7Acyclical Components A Drag On Inflation Acyclical Components A Drag On Inflation Acyclical Components A Drag On Inflation Chart 8TCore Inflation Will Move Higher TCore Inflation Will Move Higher TCore Inflation Will Move Higher As for the acyclical components of inflation, in a prior report we discussed why health care inflation should rise during the next two years, and this has so far been confirmed by strong producer price data (Chart 8, panel 3).7 For the remaining acyclical components, of which 41% are goods and 59% are services, we would expect that at least the goods component will rise in response to the recent acceleration in non-oil import prices (Chart 8, bottom panel). In conclusion, there is reason to expect some upside in each component of core inflation. We anticipate that core inflation will move higher in the coming months and that the Fed will respond with continued gradual rate hikes. Bottom Line: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loan Update Chart 9Loan Coupons Will Rise Loan Coupons Will Rise Loan Coupons Will Rise We continue to recommend that investors favor floating rate leveraged loans over fixed rate high-yield bonds in their credit portfolios. The two main reasons for this recommendation are that (i) loans will benefit from higher coupons as the Fed lifts rates and LIBOR resets higher and (ii) loans will benefit from higher recoveries than bonds when the next default cycle occurs. However, somewhat puzzlingly, as 3-month LIBOR has increased during the past few years the coupon return on the S&P Leveraged Loan index has not kept pace. In fact, leveraged loans only started to outperform fixed rate junk a couple of months ago (Chart 9). There are two reasons for this. First, many leveraged loans have LIBOR floors at around 1%, so initial increases in LIBOR in 2016 had no impact on leveraged loan coupons. But 3-month LIBOR is now well above 1%, and yet leveraged loan coupons are still not rising. This is because issuers have been aggressively refinancing loans at lower spreads as LIBOR has increased. This spread compression has kept coupon payments low, but history tells us that this dynamic cannot persist. Eventually, as credit spreads stop tightening near the end of the credit cycle, issuers will not be able to reduce their interest costs through refinancing and will be forced to accept higher coupon payments as interest rates rise. Notice that even though the average price on the S&P Leveraged Loan index was higher between 2004 and 2006 than it is today, that did not prevent loan coupons from rising alongside LIBOR, after some initial lag (Chart 9, bottom panel). Bottom Line: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 https://gps.bcaresearch.com/blog/view_blog/460 3 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 4 A full transcript of the post-meeting press conference: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180321.pdf 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 https://www.frbsf.org/economic-research/files/el2017-35.pdf 7 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Financial market volatility in general and FX market volatility in particular is set to increase because of the following three factors: Rising U.S. inflation will make the Federal Reserve increasingly hawkish, and the European Central Bank is moving away from maximum accommodation; The Chinese economy is not accelerating; And geopolitical tensions are growing. While EM and commodity currencies will suffer, safe havens like the yen and Swiss franc will benefit. The euro may correct at first, but it remains on an upward trajectory. Feature Chart I-1Low And High Growth Sentiment##br## Are Linked Low And High Growth Sentiment Are Linked Low And High Growth Sentiment Are Linked A defining feature of global financial markets over the past two years has been the outright collapse of volatility. However, in late January the VIX rebounded, recording readings not seen since 2015. Currency volatility also hit three-year lows before the same wake-up call, causing a sharp but temporary increase in FX volatility. It is important to understand whether this recent rebound in volatility was just a blip or a symptom of something more profound - a sign that volatility is back on an uptrend and will continue to rise as it did from 1996 to 2002, or again from 2007 to 2009. This matters because volatility is an important determinant of FX returns. High-yielding carry currencies perform well when volatility is low. While low-yielding funding currencies like the Swiss franc or the yen suffer in periods of calm, their returns improve once volatility rises. Moreover, low-volatility environments are often associated with buoyant expectations about global growth among international investors (Chart I-1). Thus, a return of volatility could fray the edges of global growth sentiment, which is currently ebullient. This would hurt EM and commodity currencies. Our view is that volatility is making a comeback as global monetary policy is becoming less accommodative, China's path is becoming rockier and global geopolitical risks are rising. These dynamics will hurt EM and commodity currencies, while at the margin, help safe-haven currencies like the yen and Swiss franc. Monetary Policy In DM Economies Monetary policy in the advanced economies is not yet tight, but is moving away from the large accommodation implemented in the wake of the Great Financial Crisis. Historically, a removal of accommodative policy tends to be associated with rising volatility, especially in the FX space. The link is not that clear-cut though. Policy tightening tends to lead to higher volatility. However, it only does so once we enter the latter innings of the business cycle. Only when inflation begins to gain enough momentum to force the Fed to increase rates fast enough to raise the specter that policy will soon begin to hurt growth, does volatility start rising durably. We are getting closer to this moment in the U.S. The U.S. is increasingly showing signs of late-stage business expansion. For one, the yield curve has flattened to 53 basis points. This level of slope has historically been associated with full employment and rising wage pressures. Surveys corroborate this picture. The NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. This normally marks rising wage pressures, the hallmark of full employment (Chart I-2). Moreover, the ISM manufacturing survey shows that companies are paying more for the price of their inputs and experiencing delays with suppliers. Normally, this also describes a late-cycle environment marked with rising inflationary pressures (Chart I-3). Chart I-2Late Cycle Dynamics##br## In The U.S. Late Cycle Dynamics In The U.S. Late Cycle Dynamics In The U.S. Chart I-3Firms Are Facing Budding##br## Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Firms Are Facing Budding Inflationary Pressures Other variables are generally pointing toward an acceleration of U.S. inflation. Because aggregate U.S. capacity utilization - which incorporates both labor market conditions and the Fed's own capacity utilization measure - highlights a notable absence of slack, and because the change in the velocity of money in the U.S. is accelerating, our models forecast a sustained uptick in U.S. core inflation to 2% and above (Chart I-4). U.S. CPI excluding food and energy data for February is also pointing toward budding inflationary pressures. While the annual core inflation rate was flat compared to January, the annualized three-month rate of change has surged to 3%. The muted year-on-year comparison is being depressed by some base effect. In 2017, inflation started to weaken significantly in March. Therefore, beginning in March 2018, consumer price inflation in the U.S. will likely accelerate more noticeably than it has until now. Shelter inflation too is moving from a headwind to a tailwind. Shelter inflation represents 42% of the core CPI basket, and it has been on a decelerating trend for 14 months. However, the model developed by our U.S. Bond Strategy colleagues shows that U.S. shelter inflation is now set to start bottoming (Chart I-5, top panel). Chart I-4Core Inflation Will Rise Core Inflation Will Rise Core Inflation Will Rise Chart I-5Other Inflationary Pressures Other Inflationary Pressures Other Inflationary Pressures Core goods prices are also regaining some vigor. This is not much of a surprise. The strength of the global economy along with the weakness of the U.S. dollar have filtered through to higher import prices. Historically, import prices tend to lead core goods prices in the U.S. (Chart I-5, bottom panel). We could see rising inflationary pressures on the services front as well. The employment cost index - the cost component used to compute unit labor costs - is still displaying a tight positive correlation with the employment-to-population ratio for prime-age workers (Chart I-6). BCA estimates that employment gains above 123,000 new jobs a month will push this ratio up, and consequently labor costs. But as Chart I-7 illustrates, the strength in the Conference Board Leading Credit Index highlights that employment growth in the U.S. is likely to remain robust. This suggests the key driver of service inflation - wages - will continue to improve. Chart I-6Wages Will Keep Rising... The Return Of Macro Volatility The Return Of Macro Volatility Chart I-7...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong ...As Employment Growth Will Stay Strong Thus, it seems the stars are already aligning to foment a rise in U.S. core CPI. The Trump administration throwing in some large-scale fiscal stimulus into the mix is only akin to throwing fuel on a fire. Accordingly, we expect the Fed to upgrade its interest rate forecasts for 2019. Markets are not yet ready for this scenario, anticipating only five rate hikes between now and the end of 2019. Thus, the most important central bank for setting the global cost of capital will likely surprise in a hawkish fashion over the coming 21 months. But what about the other big DM central bank, the ECB? The ECB too has begun to remove monetary accommodation, as it has started to taper its purchases of securities. It aims to be done this in September. Moreover, the narrowing gap between the unemployment rate and NAIRU in the euro area points to budding inflationary pressures (Chart I-8). This would argue that the ECB will begin lifting interest rates toward the summer of 2019. In fact, the shadow policy rate for the euro area has already begun to turn higher (Chart I-9), suggesting European policy is already starting to move away from its accommodative extremes. This combination is very important for volatility. As Chart I-10 illustrates, the average shadow policy rate for the U.S., the euro area, the U.K., and Japan leads financial markets and FX volatility. While Japanese rates may remain at low levels, the path for Europe and the U.S. is clearly up, suggesting volatility will rise. Chart I-8Growing Wage Pressures In Europe Growing Wage Pressures In Europe Growing Wage Pressures In Europe Chart I-9ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod ECB Policy Is Already Less Accommod Chart I-10Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Tighter Global Policy Leads To Higher Volatility Bottom Line: The U.S. is increasingly displaying symptoms that its business cycle expansion is at an advanced stage. With inflationary pressures growing more intense, the Fed will need to ratchet up its tightening path. The ECB too has begun removing accommodation. This means that two of the three most important price setters for the cost of money are either fully tightening policy or beginning to remove accommodation. This has historically marked the point when global financial market volatility begins to rise. China Uncertainty China is another factor pointing toward a rise in global financial volatility. China has exerted a benign influence on global growth from the second half of 2016 and through most of 2017. In response to a large easing in monetary conditions and a hefty dose of fiscal stimulus, Chinese growth had until recently regained vigor, with the Li Keqiang index - our preferred measure of Chinese industrial activity - swinging from -2.6 sigma to 0.5 sigma in 15 months. A key gauge of Chinese activity - the average of the new orders and backlog of order subcomponents of the PMIs surveys - captured these dynamics very well. This indicator also explains the gyrations in various measures of asset markets volatility well (Chart I-11). Currently, it points to a rise in global financial market volatility. Going forward, the key question for investors is whether or not Chinese orders continue to deteriorate, flagging a further rise in volatility. We are inclined to say yes. Chinese monetary conditions have continued to deteriorate, and administrative measures to slow down the growth of total social financing are starting to bite. Chart I-12 shows that the issuance of bonds by small financial intermediaries has slowed significantly. Based on this message, the early slowdown in total debt growth should continue over the coming months. Optimists about China often highlight that this should have a limited impact on economic activity. After all, 62% of fixed asset investments in China are financed by internally generated funds. However, the biggest problem for China is the misallocation of capital. As Chart I-13 shows, construction as a percentage of total capex has been linked to population growth. However, after 2008, these two series decoupled: population growth has been stagnating while construction activity has been skyrocketing, despite a slowdown in the rate of migration from rural to urban areas. This suggests that post-2008, China has been building too many structures. Chart I-11China To Affect ##br##Volatility China To Affect Volatility China To Affect Volatility Chart I-12Administrative Tightening Will ##br##Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Administrative Tightening Will Weigh On Chinese Credit Chart I-13After The GFC, Chinese ##br##Construction Took Off After The GFC, Chinese Construction Took Off After The GFC, Chinese Construction Took Off When capital is misallocated, even if the share of debt financing is low, tight monetary conditions and administrative measures to limit excesses in the economy can bite sharply. This raises the risk that Chinese growth will not pick up much going forward, and that in fact, capex and industrial activity will struggle. Jonathan LaBerge, who writes BCA's Chinese Investment Strategy, has built a list of some of the key indicators he follows to track the evolution of the Chinese economy. Table I-1 shows that all but the Caixin/Markit manufacturing PMI index are in a downtrend, and that 11 out of the 14 variables have been deteriorating in recent months.1 Moreover, as Chart I-14 illustrates, the strength in the Caixin PMI is likely to be an aberration. When the spread between the Caixin and the official measure is as wide as it currently is, the following quarters tend to be followed by a fall in the average of the two series. Table I-1No Convincing Signs Of An Impending##br## Upturn In China's Economy The Return Of Macro Volatility The Return Of Macro Volatility Chart I-14The Caixin PMI Is Probably##br## The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal We would therefore expect Chinese economic momentum to slow further. Since Chinese policymakers still want to engineer some deleveraging, the Chinese industrial sector will decelerate. This will contribute to the rise in financial market volatility for the remainder of the business cycle, especially as global monetary policy in the G-10 is becoming less accommodative. Bottom Line: The Chinese economy contributed to low levels of volatility in financial markets from 2016 to late 2017. However, China still suffers from a large misallocation of capital, which is making its economy vulnerable to both monetary and administrative tightening. With most key gauges of Chinese economic activity still pointing south, industrial activity could deteriorate further. This will contribute to a rise in global financial market volatility, especially as DM central banks are removing monetary accommodation. Rising Geopolitical Tensions The last factor pointing toward rising financial market volatility are growing global geopolitical tensions. As Marko Papic has highlighted in BCA's Geopolitical Strategy service, the world's unipolar moment under the umbrella of U.S. dominance is over. The world is increasingly becoming a multi-polar environment, where multiple powers vie for local dominance. As the early 20th century and the 1930s showed, when the world becomes multi-polar, geopolitical risks rise (Chart I-15). Chart I-15Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Geopolitical Risk Is The Outcome Of Global Multipolarity Today's increasingly multi-polar world may not be headed for an imminent global war, but tensions are likely to increase. This means policies could become more erratic. Additionally, domestic politics are under stain as well. Rising inequality and social stagnation in the U.S. are fomenting public discontent (Chart I-16). Moreover, U.S. citizens are not champions of free trade; in fact, they view unfettered trade with a rather suspicious eye, as do the citizens of Italy, Japan or France (Chart I-17). Chart I-16The U.S. Is Unequal And Ossified The Return Of Macro Volatility The Return Of Macro Volatility Chart I-17America Belongs To The Anti-Globalization Bloc The Return Of Macro Volatility The Return Of Macro Volatility Practically, this means tensions such as those experienced two weeks ago around the imposition of tariffs on steel and aluminum imports into the U.S. are likely to continue. The White House is already discussing the possibility of imposing a 15% tariff on Chinese imports to the U.S. totaling US$60 billion. As we highlighted last week, alleged intellectual property theft by China will likely remain a hot-button topic that could result in painful sanctions, prompting swift retaliation by Beijing. Additionally, NAFTA negotiations are not over, pointing to continued headline risk in the space. Moreover, relations with Russia are tense, and the Iran deal looks increasingly fraught with uncertainty. These two spots could easily morph into yet another source of risk. Bottom Line: The global geopolitical environment has become a multi-polar system - an environment historically prone to serious tensions. The rise of populism in the U.S. only makes this risk more salient, especially with respect to global trade. As a result, the threat of a trade war, especially between the U.S. and China, is increasing. This means shocks to global trade and global growth could become more frequent. This will likely create another source of financial market volatility, compounding the impact of economic fundamentals like global monetary policy and China's economic risks. Investment Implications Carry trades should fare especially poorly in this environment, as they abhor rising volatility.2 Hence, the performance of EM high-yielders like the BRL, TRY, and ZAR could progressively deteriorate. Moreover, because rising volatility often hurts economic sentiment, this increase in volatility could weigh on growth-sensitive currencies like the KRW in the EM space or the AUD and the NZD in the DM space. The SEK would normally suffer when global growth sentiment deteriorates. Yet this time may play out differently. Swedish short rates are -0.5%, making the SEK a funding currency. If carry trades do suffer, the need to buy back funding currencies could put a bid under the SEK. In this context, the JPY and the CHF could be the great winners. Both currencies have been used as funding vehicles. Moreover, both Switzerland and Japan sport outsized net international investment positions equal to 126% and 65% of their respective GDPs. If volatility does rise, some Swiss and Japanese investors will likely repatriate funds from abroad, generating purchases of yen and Swiss francs in the process. Moreover, from an empirical perspective, both these currencies continue to react well when global volatility spikes. Chart I-18The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol The Euro Is Vulnerable To Higher Vol However, both Japan and Switzerland are still experiencing weak inflation. The BoJ and the SNB will therefore try to lean against currency strength caused by exogenous volatility shocks. The JPY and the CHF could be caught between these forces. The currency depreciation these central banks try to engineer will be occasionally interrupted by sharp rallies when financial market volatility spikes. This means that monetary policy in these two countries will have to stay extremely accommodative. For now, it is still too early to bet against the yen's current strength. Finally, the impact of rising volatility on the euro's outlook is more nebulous. The euro is neither a carry currency nor a funding currency, but it generally appreciates when global growth sentiment improves. Thus, since long positioning in the euro is very stretched, a renewed spike in volatility would likely hurt the euro, especially as European economic surprises are plummeting relative to the U.S. (Chart I-18). Nonetheless, this pain will be a temporary phenomenon. The euro is still cheap, and one of the factors driving global volatility higher is the ECB abandoning its accommodative monetary policy stance. Moreover, as terminal interest rate expectations in Europe are still well below their historical average relative to the U.S., there is still ample room for investors to upgrade their assessment of where the European policy rate will end up vis-à-vis the U.S. at the end of the cycle. Bottom Line: Any negative impact of rising global financial markets volatility will be felt most acutely by carry and growth-sensitive currencies like the BRL, TRY, ZAR, AUD, and KRW. Contrastingly, funding currencies underpinned with large positive net international investment positions such as the JPY and the CHF will be beneficiaries. The impact on the euro may be negative at first, as speculators are massively long the euro despite a collapse in euro area economic surprises. However, the long-term impact should prove to be more muted as the euro's fundamentals are still improving. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation", dated March 7,2018, available at cis.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was generally positive for the dollar: Headline and core CPI came in line with expectations, growing at 2.2% and 1.8% annually, respectively; NFIB Business Optimism Index was hit 107.6, beating expectations of 107.1; Continuing jobless claims came in at 1.879 million, beating the expected 1.9 million; Initial jobless claims came in line with expectations at 226,000; However, retail sales came in weaker than expected, contracting by 0.1% monthly. Despite this generally positive tone to the data, the dollar was still soft this week. However, downward momentum has slowed, paving the way for a short-term counter trend rally. This is consistent with a global growth slowdown. Report Links: Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 Who Hikes Again? - February 9, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was disappointing: Industrial production contracted in monthly terms by 1% and also grew at only 2.7% yearly, less than the expected 4.7% pace; German CPI grew at a 1.4% yearly pace, with the harmonized index growing by 1.2%, both in line with expectations. In a speech on Wednesday, President Draghi clarified that "monetary policy will remain patient, persistent and prudent" as there is still a need for "further evidence that inflation dynamics are moving in the right direction". As global growth is downshifting, the euro could experience a significant correction before resuming its bull market. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Machinery orders yearly growth came in at 2.9%, outperforming expectations. However, domestic corporate goods inflation surprised to the downside, coming in at 2.5%. Moreover, the tertiary industry Index month-on-month growth also underperformed expectations, coming in at -0.6%. Finally, labor cash earnings yearly growth came in line with expectations at 0.7%. Last Friday, the BoJ decided to leave its interest rate benchmark unchanged at 0.1%. In its minutes, the board members shared the view that CPI will reach their 2% in fiscal 2019. Overall, we expect that rising global interest rates will cause a rise in currency volatility. This will result in a positive environment for the yen for now, but one that could prevent Japanese inflation from hitting that 2% objective in 2019. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound 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 yearly growth underperformed expectations, coming in at 1.6%. Manufacturing production also underperformed expectations, coming in at 2.7%. However, the trade balance outperformed expectations, coming in at -3.074 billion pounds. The pound has been relatively flat this week against the U.S. dollar. Overall, we believe that the upside to the British pound against the dollar is limited, as there are already 40 basis points of interest rate hikes priced for the BoE this year. Given that inflation is set to ease following last year's rally in the pound, it is unlikely that the pound will raise rates more than what is currently priced. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was mixed: Home loans fell by 1.1%; Investment lending for homes increased by 1.1%; The NAB Confidence survey declined to 9 from 11 but was in line with expectations; The NAB Conditions survey increased to 21, outperforming expectations; The Westpac Consumer Confidence increased from -2.3% to 0.2%. Elevated Household debt and the absence of wage growth are still at the forefront of Australian policymaker's minds. The RBA is reluctant to raise rates in order to avoid a deflationary spiral which would set the economy back severely. The AUD will most likely suffer this year because of this. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been negative: The current account surprised to the downside, coming in at -2.7% of GDP. Moreover, GDP yearly growth also underperformed expectations, coming in at 2.9%. However, it did improve from last quarter growth of 2.7%. Finally, Food Price Index monthly growth decline from last month, coming in at -0.5%. The New Zealand dollar has been flat this week against the U.S. dollar. We believe that NZD/USD and NZD/JPY are likely to suffer moving forward, as financial markets volatility is set to rise in the coming months due to the rise in global interest rates and the possibility of a slowdown in China. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian employment figures remain strong, with the ADP employment change coming in at 39,700, above the 10,700 experienced last month. Canada's export growth should improve further as the White House is adding large amounts of fiscal stimulus in the U.S. economy, Canada's largest trading partner. This will help the BoC stick to its hiking path. However, risks are high. While Canada has so far been able to avoid the U.S. steel and aluminum tariffs, NAFTA negotiations still remain a danger for the Canadian economy. Furthermore, the housing market still remains overheated and the debt load is at risk of spiraling when mortgages begin to be refinanced at higher rates. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 The SNB left its reference rate unchanged at -0.75%. The Swiss central bank reiterated that the negative rates as well as foreign exchange intervention "remain essential". Moreover, the SNB decreased its inflation forecast for this year form 0.7% to 0.6%. The SNB also changed its forecast for 2019 from 1.1% to 0.9%. Overall, the SNB is likely to maintain a very dovish stance, given the headwinds to Swiss inflation. This will continue to put upward pressure on EUR/CHF. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Headline inflation surprised to the upside, coming in at 2.2%. It also increased from 1.6% the previous month. Meanwhile, core inflation also outperformed expectations, coming in at 1.4%. It also increased from 1.1% the previous month. USD/NOK has depreciated by roughly 1.4% this week. On Thursday, the Norges Bank left its policy rate unchanged at 0.5%. In its monetary policy report the central bank highlighted that the outlook for the Norwegian economy suggests that "it will soon be appropriate to raise rates". Overall, we believe that the krone is likely to outperform other commodity currencies, given that there are only 18 basis points priced for the next 12 months, which is less than is warranted given the strength of the economy and BCA's outlook for oil prices in 2018. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 While Swedish inflation came in line with expectations, with consumer prices growing at a 0.7% monthly pace and a 1.6% yearly pace, Sweden's unemployment came in at a much lower level than anticipated. The krona is finally strengthening after EUR/SEK traded above the critical 10.00 level. This trend should continue as the euro weakens from overbought levels. Furthermore, the eventual resurgence of inflation in Sweden will propel the SEK to stronger levels as markets reprice the Riksbank's likely policy path. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights There are many things that central bankers know they don't know. "Known unknowns" include the outlook for growth (both actual and potential), NAIRU, the neutral rate of interest, and the true shape of the Phillips curve. "Unknown unknowns" are, by definition, unknowable, but are often at the heart of economic downturns. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around, most likely in 2020. Keep a close eye on credit spreads. Stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Feature Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones. - Donald Rumsfeld, former Secretary of Defense under George W. Bush Uncertainty Galore Central bankers know many things. They know that growth is currently strong across most of the world, unemployment is falling and inflation, while still low, has been slowly trending higher. Unfortunately, there are also many things they don't know. These include things they know they don't know, as well as things that are not even on their radar screens - the "unknown unknowns" that Donald Rumsfeld famously warned about. Known Unknowns Let's start with five "known unknowns." 1. Will Growth Stay Strong? Global growth has likely peaked, but should remain comfortably above-trend over the remainder of this year (Chart 1). The OECD's Global Leading Economic Indicator (LEI) has leveled off, while the diffusion index, which tabulates the share of countries with rising LEIs, has dropped below 50 percent. A fall in the diffusion index has often foreshadowed outright declines in the composite LEI. Consistent with this prognosis, the Citi global Economic Surprise Index has swooned, the Chinese Keqiang index has decelerated, and Korean export growth - a leading indicator for global trade - has slowed. Global manufacturing PMIs have also edged off their highs (Chart 2). The one exception is the U.S., where the ISM index continues to power higher. Despite the occasional blip such as this week's retail sales report - which was probably depressed by tax refund delays - recent U.S. economic data have been reasonably upbeat. Goldman Sachs' Current Activity Indicator remains near cycle highs, implying strong momentum going into the second quarter. Chart 1Global Growth Has Peaked ##br##But Will Remain Above Trend Global Growth Has Peaked But Will Remain Above Trend Global Growth Has Peaked But Will Remain Above Trend Chart 2Global Manufacturing PMIs ##br##Are Off Their Highs Global Manufacturing PMIs Are Off Their Highs Global Manufacturing PMIs Are Off Their Highs Changes in financial conditions tend to lead growth by about six-to-nine months. U.S. financial conditions have eased a lot more since the start of 2017 than elsewhere (Chart 3). In addition, U.S. fiscal policy is likely to be much more expansionary over the next two years than in the rest of the world (Chart 4). All this suggests that the composition of global growth will shift in favor of the U.S. over the coming months. Chart 3Composition Of Global ##br##Growth Will Shift To The U.S. ... Composition Of Global Growth Will Shift To The U.S. ... Composition Of Global Growth Will Shift To The U.S. ... Chart 4U.S. Fiscal Policy Will Become More ##br##Expansionary Than In R.O.W. What Central Bankers Don't Know: A Rumsfeldian Taxonomy What Central Bankers Don't Know: A Rumsfeldian Taxonomy 2. Will Potential Growth Accelerate? The U.S. unemployment rate has declined from a high of 10% in 2009 to 4.1% in February 2018, even though real GDP growth has averaged a meager 2.2% over this period. Extremely weak productivity growth explains why the output gap has managed to contract in the face of subdued GDP growth. Sluggish capital spending has exacerbated the productivity downturn, but probably did not cause it. Chart 5 shows that productivity growth began to decelerate well before the financial crisis erupted. The slowdown has been pervasive across countries and sectors. Economists have a poor track record of predicting productivity trends. Not only did they fail to predict the productivity revival in the late 1990s, but because of data lags and subsequent revisions, they did not even know it had happened until the early 2000s. It is too early to say whether robotics and AI will yield the same sort of productivity windfall that the Internet did. My colleagues, Mark McClellan and Brian Piccioni, have cast a skeptical eye on some of the alleged revolutionary breakthroughs in both fields.1 If it turns out that the late 1990s was the exception rather than the rule, and that we are going back to the lackluster productivity performance of the 1970s, this will make life more challenging for central bankers. 3. What Is The True Level Of NAIRU? Spare capacity has diminished in most countries, but questions linger over how much slack remains. No one truly knows where NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - really stands. The Fed and the Congressional Budget Office believe that NAIRU has fallen from over 6% in the late 1970s to around 4.5%-to-4.7% today (Chart 6). Chart 5Productivity Growth Slowdown ##br##Has Been Pervasive Productivity Growth Slowdown Has Been Pervasive Productivity Growth Slowdown Has Been Pervasive Chart 6NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards An aging workforce has reduced frictional unemployment because older workers are less likely to switch jobs than younger ones. The internet has also made it easier for employers to find suitably qualified workers. On the flipside, globalization, automation, and the opioid crisis have likely made it difficult for a growing list of workers to hold down a job for long. Our best guess is that the U.S. economy is operating at close to full employment. This is confirmed by various employer surveys, which show that companies are struggling to find qualified workers (Chart 7). The fact that the share of people outside the labor force who want a job has fallen to pre-recession levels also suggests that labor slack is running thin (Chart 8). Chart 7U.S. Economy: Operating At ##br##Close To Full Employment U.S. Economy: Operating At Close To Full Employment U.S. Economy: Operating At Close To Full Employment Chart 8Few People Left Who Are Eager ##br##To Rejoin The Labor Force Few People Left Who Are Eager To Rejoin The Labor Force Few People Left Who Are Eager To Rejoin The Labor Force There is more slack outside the United States. Labor underutilization is still 2.5 percentage points higher in the euro area than it was in 2008. Taking Germany out of the picture, labor underutilization is nearly six points higher (Chart 9). A number of major emerging markets, most notably Brazil and Russia, also have a lot of excess cyclical unemployment. The Japanese labor market has tightened significantly in recent years, but there is probably a fair amount of hidden underemployment left, particularly in the service sector (factoid of the week: there are more police officers in Tokyo than in New York City).2 4. Where Is The Neutral Rate Of Interest? One of the most vexing questions facing central banks is how high interest rates can go before they move into restrictive territory. There are a variety of reasons for thinking that the neutral real rate of interest - the rate consistent with full employment and stable inflation - is lower today than it was in the past. Trend real GDP growth has fallen. This has reduced the need for firms to expand capacity. The shift to a capital-lite economy - where value-added increasingly takes the form of bits and bytes rather than factory output - has further reduced the need for fresh investment. Meanwhile, a reluctance to take on new debt has restrained spending. Rising inequality has shifted more wealth into the hands of people who tend to save a lot. Globally, savings must equal investment. If desired savings go up and desired investment goes down, interest rates must fall to push down the former and push up the latter (Chart 10). Chart 9Euro Area: There Is Still Labor ##br##Market Slack Outside Of Germany Euro Area: There Is Still Labor Market Slack Outside Of Germany Euro Area: There Is Still Labor Market Slack Outside Of Germany Chart 10Interest Rates Must Fall If Desired Savings ##br##Increase And Desired Investment Declines What Central Bankers Don't Know: A Rumsfeldian Taxonomy What Central Bankers Don't Know: A Rumsfeldian Taxonomy None of these forces are immutable, however. Investment demand appears to be picking up, as judged by capex intention surveys (Chart 11). Consumer credit is rising anew. The U.S. personal saving rate is back near an all-time low (Chart 12). A tighter labor market is likely to cause labor's share of income to rise, just like it did in the late 1990s (Chart 13). This should boost aggregate demand. An unprecedented increase in the U.S. budget deficit should help absorb much of the savings from cash-rich corporations (Chart 14). Meanwhile, savings are likely to decline over the long haul as well-paid baby boomers retire en masse. All this is causing the neutral rate to move higher. Chart 11Upswing In Global Capex Is Underway Upswing In Global Capex Is Underway Upswing In Global Capex Is Underway Chart 12U.S. Consumer Credit Revival U.S. Consumer Credit Revival U.S. Consumer Credit Revival Chart 13Tight Labor Market And Rising Labor ##br##Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Chart 14Now Is The Time For Fiscal Consolidation, Not Profligacy Now Is The Time For Fiscal Consolidation, Not Profligacy Now Is The Time For Fiscal Consolidation, Not Profligacy 5. What Is The Shape Of The Phillips Curve? Central bankers assume that dwindling spare capacity will lead to higher inflation, a relationship immortalized by the so-called Phillips curve. The fact that inflation has barely risen over the past few years is an obvious challenge to this theory. It may simply be that the Phillips curve is "kinked" at very low levels - it only steepens when the economy has gone beyond full employment. The fact that it has taken this long to reach the kink could explain why inflation has not taken off sooner. The success that central banks have enjoyed in anchoring long-term inflation expectations is another reason why the Phillips curve has become flatter. Chart 15An Overheated Economy Led To ##br##Rising Inflation In The 1960s An Overheated Economy Led To Rising Inflation In The 1960s An Overheated Economy Led To Rising Inflation In The 1960s The problem is that there is no God-given reason why inflation expectations should stay well anchored. Core inflation was remarkably low and stable in the first half of the 1960s. However, the combination of low real interest rates and increased fiscal spending associated with Lyndon Johnson's Great Society programs and the Vietnam War led to a surge in inflation starting in 1966 (Chart 15). Inflation kept climbing thereafter, rising to 6% in 1970. This was three years before the first oil shock occurred, suggesting that an overheated economy, rather than OPEC, was the main inflationary culprit. Unknown Unknowns Then there are the things central bankers are not even thinking about, or even worse, the things they think are true but aren't.3 In the lead-up to the Great Recession, U.S. policymakers blithely assumed that house prices could not fall at the nationwide level. This caused them to turn a blind eye to soaring home prices and the deterioration of underwriting standards in the mortgage market. Warren Buffet once said, "Only when the tide goes out do you discover who's been swimming naked." Our guess is that rising rates will expose a lot of things one would rather not see in the corporate debt market. In the latest issue of the Bank Credit Analyst, my colleague Mark McClellan estimated that the interest coverage ratio for U.S. companies would drop from 4 to 2.5 if rates increased by 100 basis points across the corporate curve. Such a move would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 16A and Chart 16B).4 Consumer staples, tech, and health care would be the most adversely affected. Chart 16AU.S. Interest Coverage Ratio ##br##Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) Chart 16BU.S. Interest Coverage Ratio ##br##Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) Political shocks are also very difficult for policymakers to foresee. President Trump's decision to impose steel and aluminum tariffs spooked the markets. NAFTA negotiations remain stalled and the odds are high that the U.S. will pursue trade sanctions against China for alleged intellectual property theft. That said, as we noted last week, an all-out trade war would cause equities to crater.5 Trump remains focused on the value of the stock market as a gauge of the success of his presidency. This will curb his hawkishness. Unemployment is also very low these days, which limits the attractiveness of protectionist policies. The specter of trade wars will escalate if a recession causes stocks to tumble and unemployment to rise in key midwestern swing states. Other "unknown unknowns" include another flare-up in sovereign debt markets in Europe, a hard landing in China, and a supply-induced spike in oil prices. Investment Conclusions It may be tempting to think that central banks can calibrate monetary policy as events unfold in order to keep economies on an even keel. If only it were so easy. Monetary policy affects the economy with a lag of 12-to-24 months. By the time it is clear that either more or less monetary stimulus is needed, it is often too late to act. Central bankers have to work with incomplete or inaccurate data. One of the reasons that inflation spiraled out of control in the 1970s was because the Federal Reserve systematically overstated the size of the output gap (Chart 17). This led the Fed to falsely conclude that slower growth was the result of inadequate demand rather than a deceleration in the economy's supply-side potential. It is impossible to know what mistakes central banks will make in the future, but it is almost certain that something will go awry. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around. As we discussed several weeks ago, the next recession is most likely to arrive in 2020.6 Investors should stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Similar to the 1970s, investors should expect inflation and bond yields to make a series of "higher highs" and "higher lows" with every boom/bust episode (Chart 18). Chart 17The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Chart 18A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "The Coming Robotics Revolution," dated May 16, 2017; The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and The Bank Credit Analyst, "The Impact Of Robots On Inflation," dated January 25, 2018. 2 "As crime dries up, Japan's police hunt for things to do," The Economist, May 18, 2017. 3 Mark Twain is often credited for saying that "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." It's a great quote, but there's only one problem: There is no evidence that he ever said it. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 5 Please see Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018. 6 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way U.S. Growth Leading The Way U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Sticking With The Plan Sticking With The Plan 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations Tracking Our Recommendations Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Sticking With The Plan Sticking With The Plan Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor The Japan Corporate Health Monitor The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. 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Highlights Duration: Fed Governor Lael Brainard stated last week that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. Labor Market: The economy continues to add jobs at a rapid pace, but there is some debate about whether the unemployment rate accurately reflects the amount of slack in the labor market. We find that even using the broadest measures of labor market slack, we should expect to see wages accelerate in the coming months. Credit Cycle: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Feature Chart 1Fed's Current Projections Are Priced In Fed's Current Projections Are Priced In Fed's Current Projections Are Priced In The cyclical bond bear market is at a critical juncture. The yield curve has now largely priced-in the Fed's median fed funds rate projections (Chart 1), and this raises the possibility that the bear market could stall unless the Fed starts to signal a more aggressive path for hikes. With that in mind, last week's speech by Fed Governor Lael Brainard caught our attention.1 As the most dovish member of the Board of Governors, Governor Brainard's speeches are important bellwethers of inflection points in monetary policy. This is particularly true when the speeches convey a more hawkish tone, as was the case last week. Governor Brainard's shift in tone signals that the Fed is poised to adopt a somewhat more aggressive tightening bias. This will likely lead to upward revisions to its interest rate projections and give the green light for the cyclical bond bear market to continue. Brainard On Growth Comparatively weak economic growth outside of the U.S. has been a perennial concern for Governor Brainard, and indeed a key theme in this publication.2 But last week she acknowledged that this dynamic has shifted: Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand. [...] The upward revisions to the foreign economic outlook are also pulling forward expectations of monetary policy tightening abroad and contributing to an appreciation of foreign currencies and increases in U.S. import prices. By contrast, foreign currencies weakened in the earlier period, pushing the dollar higher and U.S. import prices lower. Chart 2 shows the dramatic shift that has occurred since mid-2016. The Global Manufacturing PMI has soared, and all but one of the 36 countries with available data now have PMIs above the 50 boom/bust line. As a consequence, the U.S. dollar has depreciated and import prices have surged. A more broadly-based global recovery is bearish for U.S. bonds. With less drag from a stronger U.S. dollar, interest rates must rise further to achieve the same amount of monetary tightening. Although we would still characterize the global economic recovery as highly synchronized, we recently flagged some preliminary signals that suggest the breadth of global growth might be deteriorating.3 Specifically, we observe that leading indicators of Chinese economic activity have rolled over, and the outperformance of emerging market currency carry trades has moderated (Chart 2, bottom panel). We will closely monitor both of these indicators during the next few months to see if the weakness persists, or if it starts to bleed into broader global growth aggregates. While the more optimistic assessment of global growth was the starkest change between last week's speech and Governor Brainard's earlier missives, she also noted reasons for optimism on the domestic front. Nonresidential investment is hooking up, and leading indicators point to further gains (Chart 3, panel 1). Financial conditions remain accommodative despite persistent Fed tightening. This differs from the mid-2014 to mid-2016 period when financial conditions tightened even though monetary policy was more accommodative (Chart 3, panel 2). Most importantly, the economy is poised to receive a huge dose of fiscal stimulus during the next two years in the form of a $1.5 trillion tax cut and a $300 billion increase in federal spending (Chart 3, bottom panel). Even our simple tracking estimate for U.S. GDP suggests that growth is shifting into a higher gear. Aggregate hours worked are growing at an annual pace of 2.2%. When coupled with a conservative estimate of 0.8% for productivity growth - the average since 2012 - that translates into real GDP growth of 3%, well above the average pace of 2.2% we've seen since 2010 (Chart 4). With growth that strong we will almost certainly see further tightening of the labor market in 2018. Chart 2Synchronized Growth Is Bond Bearish Synchronized Growth Is Bond Bearish Synchronized Growth Is Bond Bearish Chart 3Domestic Tailwinds Domestic Tailwinds Domestic Tailwinds Chart 4U.S. GDP Tracking At 3% U.S. GDP Tracking At 3% U.S. GDP Tracking At 3% Brainard On The Labor Market A key question for policymakers is how much slack remains in the labor market. If the Fed views the labor market as at full employment, then it necessarily expects inflation to accelerate and should be prepared to tighten policy. Conversely, an economy with significant labor market slack is not expected to generate inflation. Officially, the Fed's most recent Monetary Policy Report to Congress describes the labor market as "near or a little beyond full employment",4 and in last week's speech Governor Brainard gave an excellent summary of the risks surrounding that assessment. First, she noted that "if the unemployment rate were to continue to fall in the coming year at the same pace as in the past couple of years, it would reach levels not seen since the late 1960s" (Chart 5). With growth set to accelerate, we view this as a very likely outcome. In fact, we calculate that, assuming a flat labor force participation rate, the U.S. economy needs to add only 123k jobs each month to keep the unemployment rate under downward pressure. The economy has added an average of 190k jobs per month during the past year, and added a shocking 313k in February (Chart 6). We anticipate it will be some time before job growth falls below the 123k threshold. Chart 5How Much Slack? How Much Slack? How Much Slack? Chart 6Employment Growth Employment Growth Employment Growth However, it is possible that the unemployment rate is masking some hidden slack in the labor market. Governor Brainard noted that "the employment-to-population ratio for prime-age workers remains more than 1 percentage point below its pre-crisis level" (Chart 5, panel 2). "If substantially more workers could be drawn into the labor force, it would be possible for the labor market to firm notably further without generating imbalances." Chart 7Wage Growth Set To Accelerate Brainard Gives The Green Light Brainard Gives The Green Light In other words, if the labor force participation rate increases, then the unemployment rate could level-off even if job growth remains robust. This would keep a lid on inflation for longer than would be the case otherwise. In our view it will be very difficult for the participation rate to rise meaningfully on a cyclical horizon. As Governor Brainard noted in her speech: "declining labor force participation among prime-age workers predates the crisis" (Chart 5, bottom panel). Added to that, now nine years into the economic recovery, it is questionable whether workers that have been out of the labor force for so long are even able to be drawn back in. Our sense is that the unemployment rate will decline further in the coming months, and it will not be long before that translates into upward pressure on wages. It is important to note that whether we use the unemployment rate or the prime-age employment-to-population ratio as our preferred measure of labor market slack, we are very close to levels that have coincided with exponential wage gains in past cycles (Chart 7). Brainard On Inflation As discussed in our report from two weeks ago, our view is that the headwinds that had been working against inflation are set to fade this year.5 While Governor Brainard agrees that "transitory factors no doubt played a role in last year's step-down in core PCE inflation," she remains concerned that inflation's underlying trend may have softened. Brainard's concern relates to various measures of inflation expectations that are still below levels that prevailed prior to the financial crisis (Chart 8). Without expectations adjusting higher it is doubtful whether inflation can sustainably return to the Fed's 2% target. We share this concern, but note that the cost of inflation protection priced into bond yields has surged in recent months. Survey measures take longer to adjust than market prices, but we anticipate that these measures will also rise as inflation recovers in 2018. The further that measures of inflation expectations (both market-based and survey-based) recover, the more Brainard's concerns about a decline in inflation's underlying trend will fade into the background. Bottom Line: Governor Brainard correctly observed that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. How Sustainable Is Corporate Profit Growth? We've been growing more cautious on the outlook for credit spreads during the past few months, principally because the shift toward a less accommodative monetary policy removes an important support for the corporate bond trade. We view the Fed as getting even more hawkish once inflation expectations are re-anchored around pre-crisis levels, and as such we stand ready to reduce exposure to corporate bonds once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5% (Chart 8, panels 1 & 2). At the time of publication the 10-year TIPS breakeven inflation rate was 2.12% and the 5-year/5-year forward rate was 2.14%. But this is only one piece of the puzzle. For a true bear market in corporate bonds to set in we also need to see rising leverage and mounting defaults. At least for now that is not happening. Our measure of gross leverage for the nonfinancial corporate sector - calculated as total debt divided by EBITD - has flattened off during the past year, and the 12-month trailing default rate is in a steady decline (Chart 9). Chart 8The Re-Anchoring Of Inflation Expectations The Re-Anchoring Of Inflation Expectations The Re-Anchoring Of Inflation Expectations Chart 9Wider Spreads Need Rising Leverage Wider Spreads Need Rising Leverage Wider Spreads Need Rising Leverage Chart 9 shows that periods of sustained corporate spread widening almost always coincide with rising gross leverage. Or put differently, for corporate spreads to widen we need to see corporate debt growth consistently exceed profit growth (Chart 9, panel 2). At first blush it is not obvious that profit growth will weaken any time soon. Leading indicators such as total business sales less inventories and the ISM manufacturing index point to a favorable profit outlook (Chart 10). Profit growth should also continue to benefit from dollar weakness for at least the next few months (Chart 10, bottom panel). But there is one leading profit indicator that is starting to flash red. A simple profit margin proxy created by taking the difference between the nonfarm business sector's implicit price deflator and its unit labor costs turned negative in Q4. Chart 11 shows that, although this indicator can be volatile, sustained negative readings almost always foreshadow periods of falling profit growth and corporate bond underperformance. Chart 10Rising Leverage Needs Weaker Profit Growth Rising Leverage Needs Weaker Profit Growth Rising Leverage Needs Weaker Profit Growth Chart 11Watch Unit Labor Costs In 2018 Watch Unit Labor Costs In 2018 Watch Unit Labor Costs In 2018 The Q4 weakness was driven by a big jump in unit labor costs, and with labor markets as tight as they are this is certainly a trend we see continuing. Unless corporate selling prices can keep pace we will see profit growth sustainably fall below debt growth this year, and this will lead to corporate bond underperformance. Bottom Line: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20180306a.htm 2 Please see Theme 3 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017" dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification