Economic Growth

Highlights Idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Idea 2: Long EUR/USD Idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Feature Question 1: Where Is The Worrying Imbalance? Last week, in the Quantum Theory Of Finance,1 we pointed out that when bond yields reach ultra-low levels, the payoff profile from bonds becomes highly asymmetric. When yields approach a lower bound, they cannot fall much further but they can rise a lot. Meaning that bond prices have very limited potential for gains, but have great potential for sudden and deep losses. Chart of the WeekThe Norway Versus Euro Area Bond Yield Spread Is Too Wide The Norway Versus Euro Area Bond Yield Spread Is Too Wide The Norway Versus Euro Area Bond Yield Spread Is Too Wide The unattractive asymmetric payoff profile - known as negative skew - applies to both nominal and real returns. This is because negative skew is concerned about deep nominal losses over a relatively short period. In which case, a deep nominal loss will be a deep real loss too.2 As equity returns always possess negative skew we can say that at ultra-low bond yields, bond risk becomes equity-like. Given this risk equalization, equities no longer justify a risk premium over bonds. And the lower prospective return required from equities means that today's equity valuations and prices become a lot richer. But the new delicate balance of valuations is conditional on bond yields remaining ultra-low. This is because the unattractive negative skew on a 10-year bond's returns disappears when its yield moves up into the 'high 2s' (Chart I-2). At this point, risk is no longer equalized and the equity risk premium must fully re-emerge - requiring today's equity market valuation and price to drop, perhaps substantially. However, the ensuing fight to havens would then once again pull bond yields back down from the 'high 2s'. It follows that the rise in expected interest rates is self-limiting. Any policy interest rate expectation already in the 'high 2s' - such as the Eurodollar December 2022 contract - cannot sustainably rise much further, whereas those that are still some way below - such as the Euribor December 2022 contract - can (Chart I-3). Which leads to our first investment idea. Chart I-2Bonds Become Much More ##br##Risky At Ultra-Low Yields Five Pressing Questions (And Investment Ideas) Five Pressing Questions (And Investment Ideas) Chart I-3The Euro Area/U.S. Interest Rate Expectation ##br##Spread Is Too Wide The Euro Area/U.S. Interest Rate Expectation Spread Is Too Wide The Euro Area/U.S. Interest Rate Expectation Spread Is Too Wide Investment idea 1: Long Eurodollar, short Euribor - December 2022 interest rate futures contracts. Alternatively just go outright long the Eurodollar contract. Question 2: Which Is The Safest Currency To Hold? Chart I-4Euro/Dollar Just Tracks ##br##The Bond Yield Spread Euro/Dollar Just Tracks The Bond Yield Spread Euro/Dollar Just Tracks The Bond Yield Spread To reiterate, at ultra-low bond yields, bond returns offer a highly unattractive payoff profile. Put simply, you can quickly lose a lot more money - in both nominal and real terms - than you can make! Now observe that the payoff profile for a foreign exchange rate just tracks the bond yield spread (Chart I-4). This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive payoff profile called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, the direction of policy rate expectations cannot go significantly lower. Conversely, policy rate expectations for the Federal Reserve (for 2022) are not far from our upper bound of the 'high 2s'. So these expectations cannot go significantly higher without threatening a risk-asset selloff. On this basis, EUR/USD has more scope to gap up than to gap down. Investment idea 2: Long EUR/USD But be aware that investment ideas 1 and 2 are highly correlated with each other! Question 3: Where Are We In The Global Growth Mini-Cycle? Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May we can infer that it is likely to end in early 2018. So one surprise in 2018 could be that global growth slows in the first half rather than in the second half - contrary to what the consensus is expecting. That said, half-cycle lengths do have some degree of variation: the current upswing might be a few months longer or shorter than the average. So how can we avoid positioning too early or too late for the next turn? The answer is to focus on investments that have already fully priced the current upswing, so that timing becomes less of an issue. On this basis, we propose that the rally in industrial metals and Basic Materials equities is already extended. Our technical indicator which captures herding and groupthink correctly identified the trough at the end of 2015, the mini-peak at the end of 2016, and is now signalling that the latest rally is likely to fade (Chart I-5 and Chart I-6). Chart I-5Metals Have Fully Priced ##br##The Mini-Upswing... Metals Have Fully Priced The Mini-Upswing... Metals Have Fully Priced The Mini-Upswing... Chart I-6...And The Metal Rally Is Reaching##br## Its Technical Limit ...And The Metal Rally Is Reaching Its Technical Limit ...And The Metal Rally Is Reaching Its Technical Limit Investment idea 3: Underweight Basic Materials equities versus market. Alternative expressions are to go short the LMEX index, or underweight Norway (OMX) versus Ireland (ISE). Question 4: Will Inflation Lift Off? The ECB's continued indulgence with ultra-loose monetary policy would make you think that the euro area is on the edge of a deflationary abyss. In fact, inflation has been running comfortably within a 0-2% band for almost two years. Will inflation edge closer to the ECB's 2% point target? Given our view on the growth mini-cycle, not immediately. In the first half of 2018, inflation may even edge lower within the 0-2% band, but this global dynamic will affect inflation in all jurisdictions, not just in the euro area. There is nothing wrong with inflation running comfortably within a 0-2% band. Now that we know that nominal interest rates can go slightly negative, a 0-2% inflation band even permits negative real interest rates. The big mistake is to aim for an arbitrary point target, like 2%. This is because inflation is a non-linear phenomenon, and a defining characteristic of a non-linear phenomenon is that it cannot hit an arbitrary point target.3 It is our high conviction expectation that the major central banks will eventually change their point targets for inflation into target bands such as 0-2% or 1-3%. But afraid to lose credibility, they will not change tack abruptly. In the meantime, we notice that the Norges Bank is undershooting its 2.5% inflation target by considerably more than the ECB is undershooting its 2% target (Chart I-7). Yet the yield spread between Norwegian and euro area bonds has not caught up with this reality (Chart of the Week). Chart I-7The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB The Norges Bank Is Undershooting Its Inflation Target By More Than The ECB Investment idea 4: Long Norwegian 10-year bonds, short German 10-year bunds. Question 5: Will Political Risk Re-emerge? Political events have had a hand in three of the sharpest recent moves in financial markets. The vote for Brexit catalysed a 15% decline in the pound; the vote for Trump triggered an 80 bps spike in the 10-year T-bond yield, and the vote for Macron unleashed a 10% rally in the euro. Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism (perhaps unrealistically); and the election of Macron exorcised the potential chaos of a Le Pen presidency. Chart I-8The U.K. Versus Ireland Bond ##br##Yield Spread Is Too Wide The U.K. Versus Ireland Bond Yield Spread Is Too Wide The U.K. Versus Ireland Bond Yield Spread Is Too Wide In contrast, the recent (disputed) vote for independence in Catalonia, and the breakdown of coalition discussions in Germany barely moved the markets - because neither event changed expectations of long-term economic outcomes. As investors, this is the test we should apply to all political events. In 2018, the evolution of Brexit has the potential to move markets. This is because hard Brexiters and the EU27 are on a collision course. Specifically, the issue of the Irish border is insoluble. It is Brexit's Gordian knot. Theresa May has promised the hard Brexiters that the U.K. will leave the EU customs union and single market. She has also promised the Northern Ireland Unionists - who are propping up May's minority government - that there will be no hard border between Northern Ireland and the Republic of Ireland or the rest of the U.K. But these promises are irreconcilable. The Republic of Ireland will veto a border that threatens the Good Friday peace agreement; the Northern Ireland Unionists will not tolerate the border moving to the Irish Sea, which would effectively take Northern Ireland into the EU customs union and single market; and the EU27 will block a Hong Kong type 'free port' status for Northern Ireland - as this would remove the integrity of harmonized standards across the EU. Eventually, the impenetrable Irish border problem is likely to be the roadblock to a hard Brexit. But first there needs to be a collision. And the collision could move markets. With the yield spread between U.K. 10-year gilts and Irish 10-year bonds near a 2-year wide (Chart I-8), this leads us to our fifth investment idea. Investment idea 5: Long U.K. 10-year gilts, short Irish 10-year bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Quantum Theory Of Finance' November 23 2017 available at eis.bcaresearch.com. 2 For example if the nominal return over 3 months was a very painful -10%, and inflation was running at -10% per annum, the real return over 3 months would be a still very painful -7.5%. 3 Please see the European Investment Strategy Weekly Report 'Three Mantras For Investors' August 17 2017 available at eis.bcaresearch.com. Fractal Trading Model* Ahead of the OPEC meeting on November 30, the WTI crude oil price is vulnerable to any disappointment - because its rally is technically very extended. This week's trade recommendation is to expect a retracement of 7.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Chart I-9 Short WTI Oil Short WTI Oil The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Higher Treasury Yields: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. TIPS Over Nominal Treasuries: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Curve Steepeners, Then Flatteners: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens widen, transitioning to flattening once breakevens level-off around mid-year. The Cyclical Sweet Spot Comes To An End: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. A Year Of Low Returns: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Feature BCA's Outlook for 2018 was published last week.1 That report laid out the macroeconomic themes that will impact markets during the next year. In this week's report we expand on those themes and discuss what they mean for U.S. fixed income markets specifically. We identify five key implications. Implication 1: Higher Yields One important theme for 2018 will be the resumption of the cyclical uptrend in inflation. As was stated in the Outlook: The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil import prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. Rising inflation mustn't necessarily translate into higher yields, but the Treasury market is not currently priced for the possibility that core inflation will ever re-gain the Fed's 2% target. Chart 1 shows the nominal 10-year Treasury yield split into its two main components: Chart 110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components The compensation for future inflation - proxied by the 10-year TIPS breakeven inflation rate. The real 10-year Treasury yield - proxied by the 10-year TIPS yield. As has been stated repeatedly in this publication, in an environment where realized inflation is well-anchored around the Fed's 2% target the 10-year TIPS breakeven inflation rate has historically traded in a range between 2.4% and 2.5% (Chart 1, top panel). The 10-year TIPS breakeven inflation rate currently sits at 1.84%. This means that by the time core inflation returns to the Fed's 2% target, a feat we think will be achieved in 2018, the 10-year TIPS breakeven inflation rate will impart 56 to 66 basis points of upside to the nominal 10-year Treasury yield. It is possible that any increase in the compensation for inflation protection could be offset by falling real yields. However, it is highly unlikely that the 10-year real yield would decline while the Fed is hiking rates, unless there is a sharp downward adjustment in our 12-month Fed Funds Discounter2 (Chart 1, panel 2). On that front, the market is currently priced for between two and three rate hikes during the next 12 months. This expectation could be revised even higher in the near-term as inflation recovers, but that faster pace of rate hikes is unlikely to be sustained for any significant period of time. All in all, the discounter appears not that far from its fair value, meaning that the 10-year real yield should impart some modest additional upside to the 10-year nominal yield on a 6-12 month horizon. To summarize, if core inflation returns to the Fed's target in 2018, then the nominal 10-year Treasury yield will move into a range between 2.90% and 3.00% (Chart 1, bottom panel), conservatively assuming no additional upside or downside from real yields. This is substantially above the 1-year forward rate of 2.49%, and we therefore advocate a below-benchmark portfolio duration stance. The Importance Of Synchronized Growth It was also observed in the Outlook that, according to the IMF, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018. If these forecasts pan out, then 2018 will also be the first year since the recession that more than 50% of those 20 economies have output gaps in positive territory. Meanwhile, the IMF estimates that the U.S. output gap has been essentially closed since 2015 (Chart 2). In other words, the U.S. has been leading the global economic recovery for the past few years but this is now starting to change. The rest of world is quickly catching up and the global economic recovery is now much more synchronized. This is critically important for U.S. bond yields because it lessens the impact of foreign inflows. For example, when U.S. growth was far outpacing growth in the rest of the world in 2014 and 2015, any increase in U.S. Treasury yields also widened the spread between U.S. yields and yields in the rest of the world. The wider gap encouraged foreign inflows to the U.S. bond market and limited how high U.S. yields could rise. Now, with the global economic recovery more synchronized, U.S. yields will have to increase by much more to have the same impact on the spread between U.S. yields and yields in the rest of the world. In our view this is an extremely bond-bearish development that often goes under-appreciated. Our 2-factor Treasury model attempts to quantify the impact of synchronized global growth on the U.S. 10-year Treasury yield (Chart 3). The model uses Global Manufacturing PMI as its proxy for global growth, and bullish sentiment toward the U.S. dollar as a proxy for the synchronization of the global recovery - a less synchronized recovery should lead to increased bullishness toward the dollar and vice-versa. The model's current reading pegs fair value for the 10-year Treasury yield at 2.69%. Chart 2Rest of World Playing Catch-Up Rest of World Playing Catch-Up Rest of World Playing Catch-Up Chart 32-Factor Treasury Model 2-Factor Treasury Model 2-Factor Treasury Model Bottom Line: As core inflation returns to the Fed's target in 2018 the 10-year TIPS breakeven inflation rate will rise by at least 50 basis points and the nominal 10-year Treasury yield will move above 2.80%. This is substantially higher than the 1-year forward rate of 2.49%. Maintain a below-benchmark portfolio duration stance. Implication 2: TIPS Over Nominal Treasuries It should be obvious that if the forecasts in the prior section pan out then TIPS will substantially outperform nominal Treasury securities as breakeven inflation rates widen in 2018. In our opinion the low level of long-maturity TIPS breakeven inflation rates represents the greatest source of medium-term value in U.S. bond markets. Chart 4Breakevens Biased Wider Breakevens Biased Wider Breakevens Biased Wider In addition, a wide range of indicators, such as our own Pipeline Inflation Indicator and the New York Fed's Underlying Inflation Gauge, already suggest that breakevens are biased wider (Chart 4). With the Fed engaged in a rate hike cycle, evidence of price pressures in the realized inflation data will be required before breakevens see significant upside. Our base case forecast is that the 10-year TIPS breakeven rate will reach our target range of 2.4% to 2.5% around the same time that core PCE inflation reaches 2%, probably in the middle of next year. However, there is one political risk that could speed up that adjustment. Namely, if Congress manages to pass tax cuts in the first half of 2018. From the Outlook: The U.S. tax system is desperately in need of reform [...]. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. [...] There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. Fiscal stimulus from tax cuts at this late stage of the cycle would be very inflationary, and judging by the sharp increase in TIPS breakevens that followed President Trump's election last November, the market has already figured this out. The passage of a tax bill early next year would no doubt speed up the return of long-maturity TIPS breakevens to our target range. Bottom Line: TIPS will outperform nominal Treasury securities in 2018 as long-maturity TIPS breakeven inflation rates widen alongside rising core inflation. The passage of tax cuts in the first half of next year would speed up the adjustment in breakevens. Implication 3: Curve Steepeners, Then Flatteners Another recommendation that follows from rising inflation is that the yield curve will steepen as long-maturity TIPS breakeven inflation rates rise. We have previously observed that changes in the slope of the 2/10 Treasury curve are positively correlated with changes in the 5-year/5-year forward TIPS breakeven inflation rate. Crucially, this positive correlation remains intact even when the Fed is hiking rates.3 In the current rate hike cycle (which started in December 2015) we observe that monthly changes in the 2/10 nominal Treasury slope have been positively correlated with monthly changes in the 5-year/5-year forward TIPS breakeven rate in 22 out of 24 months (Chart 5). It stands to reason that we should expect the yield curve to steepen as TIPS breakevens rise. Chart 52/10 Nominal Treasury Slope Vs. TIPS Breakeven Inflation Rate 5-Year/5-Year Forward ##br##(December 2015 - Present) Implications For U.S. Fixed Income Implications For U.S. Fixed Income However, we caution that curve steepening is probably only a story for the first half of 2018. Steepening will transition to flattening once long-dated TIPS breakevens reach our 2.4% to 2.5% target range, and in the meantime, there is a limit to how steep the yield curve can get. Let's assume that the Fed's median projection of a 3% terminal fed funds rate is reasonably accurate. It follows that the 10-year Treasury yield is unlikely to rise much above 3% before the end of the recovery. We can also calculate what the 2-year Treasury yield will be under different scenarios for the fed funds rate and the 2-year/fed funds slope. The latter can be thought of as simply the number of rate hikes the market expects during the subsequent two years. With these assumptions we can craft scenarios for where the 2/10 Treasury slope will be under different conditions, and these scenarios are presented in Table 1. The shaded cells in Table 1 are the scenarios that cause the 2/10 Treasury slope to steepen from its current level of 59 bps. Table 1Scenarios For The Number Of Fed Rate Hikes By ##br##The Time That Inflation Returns To Target Implications For U.S. Fixed Income Implications For U.S. Fixed Income For example, by the time that inflation recovers to the Fed's 2% target, the nominal 10-year Treasury yield will most likely be in a range between 2.8% and 3.25%. If the Fed only delivers two rate hikes between now and then it is very likely that the yield curve will steepen. This is shown in the section of Table 1 labelled "2 Rate Hikes". However, if the Fed lifts rates four times between now and the time that inflation returns to target, then it is much more likely that the 2/10 curve will flatten. These scenarios are shown in the top three rows of Table 1. The message is that the order of events matters. In our base case scenario, inflation starts to recover early next year and long-dated TIPS breakeven inflation rates reach our 2.4% to 2.5% target by mid-2018. At that point it is quite likely that the Fed will have only hiked rates a couple of times and the curve will have steepened. More rapid rate hikes, however, would severely limit the amount of potential steepening. We continue to advocate positioning for 2/10 steepening via a long position in the 5-year bullet versus a short position in the duration-matched 2/10 barbell. At present, the 2/5/10 butterfly spread is priced for 4 bps of 2/10 curve flattening during the next six months, so even mild curve steepening will lead to outperformance during that timeframe.4 We will shift from curve steepeners to flatteners once TIPS breakevens return to our target range. Bottom Line: The slope of the yield curve is positively correlated with TIPS breakeven inflation rates. Look for mild curve steepening in the first half of 2018 as breakevens recover, transitioning to flattening once breakevens re-normalize around mid-year. Implication 4: The Cyclical Sweet Spot Comes To An End From the Outlook: The perfect environment for markets has been moderate economic growth, low inflation and easy money. [...] We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. Chart 6The "Fed Put" Is Still In Place The "Fed Put" Is Still In Place The "Fed Put" Is Still In Place This publication has named that goldilocks environment the "cyclical sweet spot" for risk assets. Essentially, as long as inflation is below the Fed's target, the Fed must respond to any economic weakness (or tightening of financial conditions) by adopting a more accommodative policy stance. The market knows that this "Fed put" is in place and that makes it very difficult to get a meaningful sell-off. In fact, the last major sell-off in corporate credit (in 2014/15) only occurred because the market assumed that the Fed would not deviate from its projected rate hike path even though commodity prices were plunging, causing defaults in certain exposed industry groups. Notice in Chart 6 that our 24-month Fed Funds Discounter stayed flat as spreads widened. Spreads only tightened in early 2016 after the Fed capitulated. So under what conditions will the "Fed put" disappear? Logically, if inflation were much higher the Fed would be less inclined to support markets at any sign of trouble. This is the reason that, while we remain overweight spread product versus Treasuries for now, we expect the cyclical sweet spot for spreads will come to an end next year. Long-maturity TIPS breakeven inflation rates approaching our target range of 2.4% to 2.5% will be the first signal that it is time to pare exposure. The importance of supportive monetary policy for spread product performance is also evident when looking at our three favorite credit cycle indicators (Chart 7). Historically, three conditions must be met before a sustained period of spread widening can occur. Chart 7Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators Our Corporate Health Monitor must be in "deteriorating health" territory (Chart 7, panel 2). Fed policy must be restrictive. This can be proxied by an inverted yield curve, or a real fed funds rate above its estimated equilibrium level (Chart 7, panels 3 & 4). Bank Commerical & Industrial lending standards must be in "net tightening" territory (Chart 7, bottom panel). For the time being only corporate health is sending a negative signal, but once inflation recovers we will be at increasing risk of monetary conditions turning restrictive. Tighter lending standards tend to follow restrictive monetary policy with a short lag. Bottom Line: The cyclical sweet spot of solid growth and low inflation that has been driving the outperformance of spread product will come to an end in 2018. The catalyst will be higher inflation. We will start paring exposure to spread product once long-maturity TIPS breakeven inflation rates approach our target range of 2.4% to 2.5%, probably in the middle of next year. Implication 5: A Year Of Low Returns From the Outlook: Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation. That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. Heading into 2018 almost all U.S. spread product sectors are indeed faced with a more adverse starting point for valuations. Chart 8 compares today's option-adjusted spread (OAS) with the OAS at the end of 2016 for seven major spread products. With the exception of MBS, all sectors currently have lower spreads than at they did at the beginning of 2017. Chart 8Less Value In Spread Product Implications For U.S. Fixed Income Implications For U.S. Fixed Income Starting valuation is only one component of excess returns. Capital gains/losses from the change in spreads is the other. However, the deeper we move into the credit cycle the less room there is for further spread compression. In fact, we have previously calculated that the average spread for the investment grade Corporate bond index can only tighten another 35 bps before it reaches all-time expensive levels. This represents only 3 months of historical average spread tightening. The same calculation for the High-Yield index shows that the spread can only tighten another 145 bps, representing 4 months of average tightening.5 In other words, there is not much potential for spread compression at this late stage of the credit cycle and excess returns will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Chart 9 shows annualized 2017 year-to-date excess returns for each sector alongside projected excess returns for 2018 under two scenarios. The "flat spread" scenario assumes that spreads stay flat at current levels, while the "optimistic" scenario assumes that spreads tighten to all-time expensive valuation levels. Chart 92018 Excess Return Projections Implications For U.S. Fixed Income Implications For U.S. Fixed Income For investment grade corporate bonds even this extremely optimistic scenario would only provide excess returns of 363 bps, just 121 bps above this year's likely returns. For High-Yield, the optimistic scenario would provide excess returns of 637 bps, a mere 148 bps above this year's likely returns. For consumer ABS and domestic Agency bonds, the projections from our optimistic scenario do not even surpass this year's likely excess returns. Bottom Line: Spreads are not that far from all-time expensive levels, meaning there is limited room for spread compression at this late stage of the credit cycle. Excess returns from spread product will be very similar to carry in 2018 - at least until inflation rises and it is time to prepare for a sustained period of spread widening. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Outlook 2018, "Policy And The Markets: On A Collision Course", dated November 20, 2017, available at bca.bcaresearch.com 2 Our 12-month Fed Funds Discounter measures the number of rate hikes priced into the overnight index swap curve for the next 12 months. 3 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 4 For further details on our yield curve models and how we calculate the amount of steepening/flattening priced into the butterfly spread please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 These numbers refer to the spread tightening necessary to reach all-time lows on the 12-month breakeven spread for each index. We calculate the 12-month breakeven spread as OAS divided by duration. Fixed Income Sector Performance

Highlights Overstated geopolitical risks in 2017 are giving way to understated risks in 2018; The reshuffle of China's government raises policy headwinds for global growth and EM assets; U.S. politics will be roiled by a leftward turn and Trump's protectionism and foreign policy; Italian politics, more than German, is the chief threat to European risk assets; Volatility and the USD will rise; shift to neutral on European risk assets; close tactical long on Chinese Big Banks. Feature BCA's Geopolitical Strategy has operated this year on a high conviction view that geopolitical risks would be overstated, thus generating considerable upside for risk assets. Our analysis focused on three particular "red herrings": European populism, U.S. politics, and Brexit.1 Meanwhile we identified North Korea as a genuine geopolitical risk, though not one that would cause us to change our "risk on" outlook. We therefore take issue - and perhaps offense - with the contemporary narrative that "geopolitics did not matter" in a year when the S&P 500 rose by 15% and VIX plumbed historic lows (Chart 1). Stocks rose and the VIX stayed muted precisely because geopolitical risks were overstated earlier in the year. Investors who correctly assessed the balance of geopolitical risks and opportunities would have known to "buy in May and enjoy your day."2 At the same time that we encouraged investors to load up on risk this year, we cautioned that 2018 would be a challenging year.3 Three themes are now coming into focus as 2017 draws to a close: Politics has become a headwind to growth in China as Beijing intensifies deleveraging and structural reforms; U.S. fiscal and monetary policy favor the USD, which will reignite trade protectionism from Washington D.C.; Italian elections may reignite Euro Area breakup risk. In this report, we update our view on these three risks. Data out of China are particularly concerning: broad money (M3) growth has decelerated sharply with negative implications for the economy (Chart 2).4 M3 is at last ticking up but the consequences of its steep drop have not yet translated to the economy. Our message to clients since 2016 has been that the nineteenth Party Congress would mark a turning point in President Xi Jinping's tenure, that he would see his political capital replenished, and that Beijing's pain threshold would therefore rise appreciably in 2018. Hence we do not expect any new stimulus to be quick in coming or very large. Chart 1Buy In May And Enjoy Your Day Buy In May And Enjoy Your Day Buy In May And Enjoy Your Day Chart 2China's Money Impulse Spells Slowdown China's Money Impulse Spells Slowdown China's Money Impulse Spells Slowdown What happens in China will not stay in China. Signs of cracks are emerging in the buoyant global growth narrative (Chart 3), with potentially serious consequences for emerging markets (EM) (Chart 4).5 Chart 3Signs Of Cracks Forming Signs Of Cracks Forming Signs Of Cracks Forming Chart 4EM Manufacturing: Rolling Over EM Manufacturing: Rolling Over EM Manufacturing: Rolling Over China: Ramping Up For The New Year Crackdown The aftermath of the Communist Party's nineteenth National Party Congress is unfolding largely as we expected: with a reboot of President Xi Jinping's reform agenda. Chinese economic data are starting to reflect the consequences of tighter policy since late last year (Chart 5), and BCA's China Investment Strategy has shown consumer-oriented sectors outperforming industrials and materials since the party congress, as the reform drive would have one expect.6 China's policymakers have already allowed the monetary impulse - the rate of growth in the supply of money - to slow to the lowest levels in recent memory. This bodes ill for Chinese imports and base metal prices (Chart 6), as BCA's Emerging Market Strategy has emphasized.7 Chart 5Expect More Disappointments From China Expect More Disappointments From China Expect More Disappointments From China Chart 6Chinese Imports And Base Metals At Risk Chinese Imports And Base Metals At Risk Chinese Imports And Base Metals At Risk It is true that policymakers will re-stimulate the economy when they reach their pain threshold, but with Xi Jinping's political capital replenished and the party and state unified under him, we expect that threshold to have moved higher than financial markets expect. Yes, the government will try to prevent its policies from being highly disruptive and destabilizing - as with the People's Bank of China injecting liquidity to ease rapidly rising bond yields (Chart 7) - but the bottom line is that it is pressing forward with tightening. How can we be so sure that this policy trajectory is set? The initiatives in the early stages of implementation after the congress confirm our view that the central government is hardening the line on several key economic-political fronts: Financial regulatory overhaul: People's Bank Governor Zhou Xiaochuan has made a series of dire comments about China's financial risks and the danger that it is reaching a "Minsky Moment," or accumulation of risks that will end in a catastrophe.8 Zhou's likeliest replacements are both financial reformers, and one of them, Guo Shuqing, is the hawkish regulator who has led the crackdown on shadow lending this year (Chart 8). Moreover, whoever heads the central bank will have the benefit of new financial oversight capabilities. The Financial Stability and Development Commission (FSDC), a new entity charged with coordinating the country's various financial regulatory agencies, has just held its first meeting. Its inaugural chairman, Vice-Premier Ma Kai, is likely to retire soon, but rumors are swirling that his replacement will be Liu He, President Xi's top economic thinker and a reformist, who wrote an ominous article about excessive leverage in the People's Daily in May 2016 and has now made it onto the Politburo. If Liu He takes charge, given his very close relationship with Xi, the FSDC will be irresistible. If not, the FSDC will still be effective, judging by the fact that Ma Kai's replacement will likely be someone, like Ma, who sits on both the Politburo and State Council. Chart 7China's Bond Yields Rising Sharply China's Bond Yields Rising Sharply China's Bond Yields Rising Sharply Chart 8Shadow Banking Has Peaked Shadow Banking Has Peaked Shadow Banking Has Peaked Local government crackdown: Local government officials in two cities in Inner Mongolia have canceled urban metro projects due to excessive debt, reportedly under orders from the central government. Other cities in other provinces have suggested that approvals for such projects are being delayed.9 In other words, the central government is no longer endlessly accommodating debt-financed local government projects, even projects that support priority goals like urbanization and interior development. This news, so soon after the party congress, is likely to be the tip of the iceberg, which suggests that local government spending cannot be assumed to shake off its weakening trend anytime soon (Chart 9). Top officials pointed out local government leverage as a systemic risk, along with shadow banking, at the National Financial Work Conference in July, and both the outgoing finance minister and the outgoing central bank chief have called for reining in local governments. The latter's comments were formally endorsed by being included in the Communist Party's official "party congress study guide," suggesting that they are more than just the parting advice of a soon-to-be retiree. Property tightening: China's real estate sector, which provides 22% of investment in the country, is feeling the squeeze from financial tightening and targeted measures to drive out speculation since October 2016 (Chart 10). More, not less, of a squeeze is expected in both the short and long term. In the short term, inspections of commercial housing for corruption and speculative excesses could exert an additional dampening effect. In the medium and long term, the Xi administration plans to roll out a nationwide property tax, according to Huang Qifan, an economic policymaker tied to the legislature, "in the near future, not ... 10-20 years. It could happen in the next several years."10 The tax was delayed in 2016 amid economic turmoil. A national property tax would be an important fiscal reform that would tamp down on the asset bubble, rebalance the growth model, and enable the government to redistribute wealth from multiple homeowners to lower income groups. Chart 9Local Government Spending Is Weak Local Government Spending Is Weak Local Government Spending Is Weak Chart 10Property Tightening Continues Property Tightening Continues Property Tightening Continues Industrial restructuring: Environmental curbs on outdated and excess industrial capacity are continuing. Although China aggressively cut overcapacity in coal, steel and other sub-sectors over the past twelve months, it continues to face larger overcapacity than other economies (Chart 11), particularly in glass, cement, chemical fertilizers, electricity generation and home construction. It is also possible that SOE restructuring will become more aggressive. Currently, SOEs listed on the Shanghai exchange are rallying relative to the A-share market, as they have tended to do when the Communist Party reaffirms its backing of the state sector (Chart 12). However, announcements of SOE reforms in this administration have also triggered phases of under-performance. SOEs targeted for reforms face greater scrutiny of their finances and operations.11 Moreover, any SOE is vulnerable to the new wave of the anti-corruption campaign.12 National Supervision Commission: The new anti-corruption czar, Zhao Leji, will be a very influential figure if he is even to hold a candle to his predecessor, Wang Qishan. Zhao is to oversee the creation of a nationwide anti-corruption system that targets not only the Communist Party, as before, but every public official. The new commission will have branches at each level of administration (city, province, central government) and will combine the various existing anti-corruption agencies under one head. The purpose is not merely to root out political enemies (as administration critics, with some justice, would argue) but also to improve the effectiveness of policy implementation and address public grievances that threaten to undermine the regime. The latest environmental curbs have shown that employing anti-corruption teams to help enforce broader economic policy can be highly effective. Xi and Zhao Leji look set to extend this practice to state ministries, including financial regulators.13 It is not clear whether they will succeed in rebuilding the regime's legitimacy in public eyes, but in the short term an initiative like this should send a chilling effect throughout the state bureaucracy, similar to that which occurred among local government party chiefs in 2014 after the initial anti-corruption campaign was launched.14 Chart 11Overcapacity Still A Problem For China Overcapacity Still A Problem For China Overcapacity Still A Problem For China Chart 12SOEs Preserved, But Face Reforms SOEs Preserved, But Face Reforms SOEs Preserved, But Face Reforms In short, preparations are under way for Xi's second five-year term in office. (Perhaps not his last term, as the party congress also made clear.)15 New agencies and personnel suggest that the administration is embarking on an intensification of policy tightening. Tougher policy is viewed as necessary, not optional: top leadership has repeatedly stated that a lack of action on systemic threats will lead to regime-threatening crises down the road.16 Chart 13China's Impact On Global Growth Geopolitics - From Overstated To Understated Risks Geopolitics - From Overstated To Understated Risks How will this agenda impact the rest of the world? Our colleagues at China Investment Strategy hold that China may step up reforms but will not do so in a way that will negatively impact China's imports or key assets like base metal prices.17 However, from a political perspective, we view the combination of Xi's political capital with the new financial and anti-corruption commissions as likely to increase policy effectiveness to an extent that causes banks to lend less eagerly and local governments and SOEs to err on the side of less borrowing and spending. This will reduce demand for imports and commodities and will also raise the tail-risk of excessive tightening. China's contribution to global growth had fallen over the years, but has recently rebounded on the back of stimulus in 2015-16 (Chart 13). As such, it will not take much of a drag on import growth in 2018 to have a global impact. The most exposed commodity exporters to China (outside of oil) are Brazil, Chile and Peru (with Indonesia and South Africa also at risk), while the most exposed exporters of capital goods are Taiwan and South Korea, followed by Southeast Asia (the Philippines, Malaysia, Vietnam and Thailand). Looking at the China-exposed countries whose stocks rallied the most while China stimulated in 2016, the prime candidates for a negative impact in 2018 will be Brazil and Peru, and less so Hungary and Thailand. Bottom Line: The Xi administration is rebooting its reform agenda and has a higher tolerance for pain than the market yet realizes. Centralization, deleveraging and industrial restructuring have been deemed necessary to secure the long-term stability of the regime. China's policy risks are understated and the next wave of stimulus will not be as rapidly forthcoming as financial markets expect. U.S.: Trouble In (GOP) Paradise Markets have rallied throughout the year despite a lack of policy initiatives from the U.S. Congress. Judging by the performance of highly taxed S&P 500 equities, the rally this year has not been about the prospects of tax reform (Chart 14).18 Rather, markets have responded to strong earnings data and a lack of policy initiatives. Wait, what? Yes, markets have rallied because nothing has been accomplished. Investors just want President Trump and the Republican-held Congress to maintain a pro-business regulatory stance (Chart 15) and not do anything anti-corporate. Doing nothing is just fine. Chart 14Market Has Doubted Tax Reform Market Has Doubted Tax Reform Market Has Doubted Tax Reform Chart 15Market Has Cheered De-Regulation Market Has Cheered De-Regulation Market Has Cheered De-Regulation Here Come The Socialists Dems The Democratic Party leads the 2018 generic Congressional vote polling by 10.8%, up from 5.9% in May (Chart 16). The generic ballot polling is notoriously unreliable as most U.S. electoral districts are politically designed to be safe seats - "gerrymandered" - and as such are unlikely to respond to nation-wide polling (Chart 17). However, Republican support has fallen and Democratic candidates have performed extremely well this year. Chart 16U.S. Public Leans Democratic U.S. Public Leans Democratic U.S. Public Leans Democratic Chart 17Electoral System Reduces Competition Electoral System Reduces Competition Electoral System Reduces Competition First, candidates for governor in Virginia and New Jersey have outperformed their polling in November elections. Second, in the four special elections this summer, Democrats narrowed Republican leads by 18%. If the electoral results from Table 1 are replicated in 2018, Republicans could face a massacre in the House of Representatives. In addition, Republicans are suddenly vulnerable in Alabama, where the anti-establishment Senate candidate, and Breitbart-endorsee, Roy Moore is struggling with accusations of pedophilia (Chart 18). Table 12017 Special Elections Are Ominous For The GOP Geopolitics - From Overstated To Understated Risks Geopolitics - From Overstated To Understated Risks Chart 18Republican Senate Majority May Lose A Seat Geopolitics - From Overstated To Understated Risks Geopolitics - From Overstated To Understated Risks Why should investors fear a Democratic takeover of the House of Representatives? Yes, the odds of impeachment proceedings against President Trump would rise, but we are on record saying that investors should fade any impeachment risk to assets.19 The greater risk is that the Democratic Party has turned firmly to the left with its new manifesto, "A Better Deal." A strong performance by unusually left-of-center Democratic candidates could spook financial markets that have been lulled into complacency by the lack of genuine populism from the (thus far) pluto-populist president. Protectionism While most investors are focused on the ongoing NAFTA negotiations - which we addressed in last week's Special Report20 - we would draw attention again to the shift towards protectionism by the Republicans in the Senate. Normally a bastion of pro-business free-traders, the Senate has turned to the left on free trade. Senator John Cornyn (R, Texas) has introduced a bill to make significant reforms to the process by which the United States reviews foreign investments for national security, led by the Committee on Foreign Investment in the United States (CFIUS). Two further bills, one in the House and another in the Senate, would also significantly tighten access to the U.S. by foreign investors. China is foremost in their sights. In early 2018, investors will also be greeted by two significant decisions. First, on tariffs: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. The International Trade Commission has already determined that imports of these goods can cause material injury to U.S. industries, so Trump merely has to decide whether to impose tariffs (likely from 35% to 50%), import quotas (which have never received limits from courts), or bilaterally negotiated export limitations from trade partners.21 The consequences would go beyond the current, country-specific tariffs on these items, setting a precedent that would expose a wide range of similar imports to punitive action, and more broadly would signal to the world that the U.S.'s protectionist turn under Trump is real.22 Second, the White House has allegedly completed a comprehensive review of China policy under way since June.23 The review is said to focus on economic rather than strategic matters and to call for the use of punitive measures to insist that China alter tactics long complained about by the United States, including intellectual property theft, export subsidies, and forced tech transfer from joint ventures in China. Already the U.S. is investigating China for intellectual property theft under Section 301 of the 1974 Trade Act, with results that could prompt tariffs no later than August 2018.24 As if on cue, Wang Yang, a new inductee on China's Politburo Standing Committee and a prominent reformer, wrote an editorial in the People's Daily declaring that China should protect intellectual property, not require tech transfers, and give foreign firms equal treatment under the "Made in China 2025" plan.25 China has made similar promises and the U.S. has made similar threats many times before, so decisions in the coming months will be telling. Ultimately we fear that President Trump may feel compelled to ratchet up protectionism in 2018 for two reasons. First, Americans within his populist base will grow restless as they do the math on the tax legislation and realize that their champion is not quite the populist they voted for. Trump will need to re-convince them of his protectionist credentials and independence from Washington elites and the policy status quo. Second, if our view on Chinese slowdown and American fiscal thrust is correct, the USD bull market should restart in 2018. This would hurt U.S. export competitiveness, expand the trade deficit, and motivate U.S. companies to invest abroad, a paradox of President Trump's tax and fiscal policy. The White House may, therefore, be compelled to reach for mercantilist solutions to an FX problem. Foreign Policy The final reason to worry is a "Lame Duck" presidency. Far more predictable presidents sought relevancy abroad late in their mandate. For example, President George H. W. Bush committed troops to Somalia on his way out of the White House. President Bill Clinton bombed Yugoslavia. Given Trump's dismal approval polling and a potentially historic "wave" election for the Democrats in November, President Trump could similarly shift focus to geopolitics. If that shift includes confronting regional powers like China (and/or North Korea), or Iran, risk premiums may rise. In the meantime, we expect tax cuts to pass. The going is getting tougher in the Senate. The decision to include the repeal of the Obamacare individual mandate - designed to cut another $300 billion in government spending over the next ten years - will make it more difficult to secure 51 Senate votes. We maintain our view that the final legislation may need until Q1 to pass. Between now and then, legislators may need a failure or two in order to realize that the clock is ticking toward the midterms. Bottom Line: Markets have cheered lack of action from the Congress. However, the going will get tougher in 2018 as investors fret about protectionism, President Trump's itch to remain relevant, and a potential takeover of the House by the most left-of-center Democratic Party in a generation. Europe: Germany Is A Passing Risk, Focus On Italy The collapse of coalition talks in Germany is not a structural concern for Europe. The breakdown in the negotiations occurred because of the immigration debate, in which the right-of-center Christian Social Union (CSU) and the Free Democratic Party (FDP) struck out a different position from the ruling Christian Democratic Union (CDU) and the liberal Green Party. Of course, the disagreement is not about immigration today, given that inflows of asylum seekers this year has been well below past flows (Chart 19A). Rather, the fundamental disagreement is over how the CDU and its leader Angela Merkel handled the 2015 migration crisis and how it will be handled in the future. Chart 19ANo Immigration Crisis Today No Immigration Crisis Today No Immigration Crisis Today Chart 19BGermans Love Europe Germans Love Europe Germans Love Europe For investors, what matters is that there is no substantive disagreement over the EU, European integration, or Germany's role in it. The mildly euroskeptic FDP did not draw any red lines. The reason is obvious: the German euroskeptic constituency is small, shrinking, and largely already captured by the Alternative for Germany (AfD) anti-establishment party (Chart 19B). Germans are objectively the most europhile people in Europe. Going forward, a new election would cause further political uncertainty. On the margin, it could cause business confidence to stall. However, Germany runs a 14 billion euro budget surplus and is not expected to launch any structural reforms or fundamental economic changes. As such, if the formation of a government is delayed by three-to-six months, the economic implications will be fleeting. In fact, the result of a new election could be a Grand Coalition between the CDU and Socialists, which would be positive for European integration. However, as we have argued before, hopes for a significant restart of integration have probably run ahead of reality.26 For us, Italy is the immediate concern. Italy passed a new electoral law in late October, setting the stage for the election due by May 2018. The consensus in the news media is that the president will call elections in January, with the vote taking place sometime in March.27 The consensus is that the new law will make it more difficult for the populist Five Star Movement (M5S) to win a majority of seats in the Italian Parliament. In addition, it will give a lift to the parties with strong regional ties - such as the governing Democratic Party (PD) and Lega Nord. Chart 20Italy Set For A Hung Parliament Italy Set For A Hung Parliament Italy Set For A Hung Parliament The nuances of the new law are largely irrelevant, however, given the close polling of the three electoral blocs. The most likely outcome will be a hung parliament (Chart 20). Nonetheless, we can still learn something from the law: the Italian establishment parties are cooperating to subvert the electoral chances of M5S. The ruling PD and the center-right Forza Italia of former Prime Minister Silvio Berlusconi are working together to design an electoral system that favors the pre-election norm of coalition-building and parties with strong regional representation. Neither of these factors fits M5S's profile. This suggests that the two centrist blocs will be able to put together an establishment coalition following the election. On one hand, this will give stability to the Euro Area for at least the duration of that government. On the other hand, the underlying data continues to point to structural euroskepticism in Italy. Unlike their European peers, Italians seem to be flirting with overt euroskepticism. When it comes to support for the common currency, Italians are clear outliers, with support levels around 55% (Chart 21). Similarly, over 40% of Italians appears to be confident in the country's future outside the EU (Chart 22). These are ominous signs for the future. Still, both M5S and the mildly euroskeptic Lega Nord have tempered their demands for an exit from the common currency union. The official stance of the M5S is that the exit from the Euro Area is only "option B," that is, an option if the bloc is not reformed. Meanwhile, Lega Nord is on record opposing a referendum on membership in the currency union because it is illegal.28 Chart 21Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Italians Stand Out For Distrust Of Euro Chart 22Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU Italians Not Enthusiastic About EU The stance of Italy's euroskeptics will change as soon as it is convenient. The country's establishment is likely making a mistake by contemplating a grand coalition alliance. Unless such a government develops a serious plan for painful structural reforms - it will not - it will likely waste its mandate and fall at the first sign of recession or crisis. At that point, the only alternative will be the M5S, which will stand alone in opposition to such an ineffective government. Investors can therefore breathe a sigh of relief in the medium term. Italy will likely not be a source of risk-off in 2018 or even 2019, although it is still the main risk in Europe for next year and bears monitoring. However, in the long term, we maintain that Italy will be a catalyst for a serious global risk-off episode within the next five years. We remain optimistic that such a crisis will ultimately strengthen Italy's commitment to the Euro Area, as we outlined in a recent Special Report.29 But that is a low conviction view that will require constant monitoring. Could there be another scenario? Several clients have asked us if an Emmanuel Macron could emerge in Italy? Our answer is that there already was an Emmanuel Macron: Matteo Renzi, the former prime minister and current PD leader, was Macron before Macron. And yet he failed to enact significant structural and constitutional reforms. Yet two potential candidates may be ready to swoop in from the "radical center" position that Renzi and Macron characterize. The first is ECB President Mario Draghi. He is widely respected in Italy and is seen as someone who not only allayed the Euro Area sovereign debt crisis, but also stood up to German monetarist demands in doing so. The second is Fiat-Chrysler CEO Sergio Marchionne, one of the world's most recognizable business leaders and a media star inside and outside Italy. If the centrist coalition begins to fray by the end of 2019, both of these individuals may be available to launch a star-studded campaign to "save Italy." Bottom Line: We remain cautiously optimistic about the upcoming Italian elections. While our baseline case is that Italian elections will produce a weak and ineffective government, though crucially not a euroskeptic one, nevertheless risks abound and require monitoring. Investment Implications There are a lot of unknowns heading into 2018. What will become of U.S. tax cuts? How deep will the policy-induced slowdown become in China? What will President Trump do if he becomes the earliest "Lame Duck" president in recent U.S. history? Will he embark on military or protectionist adventures abroad? Asset implications are unclear, but we offer several broad takeaways. First, the VIX will not stay low in 2018. Second, the USD should rally. Both should happen because investors are far too complacent about the Fed's pace of hikes and because of potential global growth disappointments as Beijing tinkers with the financial and industrial sectors. Chart 23AEuro Area Versus U.S. Growth: Don't Ignore China (I) Euro Area Versus U.S. Growth: Don't Ignore China (I) Euro Area Versus U.S. Growth: Don't Ignore China (I) Chart 23BEuro Area Versus U.S. Growth: Don't Ignore China (II) Euro Area Versus U.S. Growth: Don't Ignore China (II) Euro Area Versus U.S. Growth: Don't Ignore China (II) Third, it is time to close our recommendation to be overweight European risk assets. European equities have a higher beta to global growth due to the continent's link to Chinese demand. As our colleague Mathieu Savary has pointed out, when Chinese investment slows, Europe feels it more acutely than the U.S. (Chart 23). Chart 24U.S. Dollar Rebound = EM Pullback U.S. Dollar Rebound = EM Pullback U.S. Dollar Rebound = EM Pullback We are also closing our tactical long position on China's big banks versus its small-to-medium-sized banks. This position has been stopped out at a loss of 5%, despite the riskier profile of the latter banks and the fact that their non-performing loans are rising. Faced with these challenges, Beijing decided to open the door to foreign investment and too ease regulations on these banks so that they can lend to small cap companies as part of the reform drive. These actions inspired a rally relative to the Big Banks that worked against our trade. As financial tightening will continue, however, we expect this rally to be short-lived, and for big banks to benefit from state backing. Our highest conviction view is that it is time to short emerging markets. Our two core views - that politics will become a tailwind to growth in the U.S. and a headwind to growth in China - should create a policy mix that will act as a headwind to EM (Chart 24). The year 2017 may therefore turn out to have been an anomaly. Emerging markets outperformed as China aggressively stimulated in 2016 and as both the U.S. dollar and bond yields declined. This mix of global fiscal and liquidity conditions proved to be a boon for EM, giving it a liquidity-driven year to remember. That year is now coming to an end. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 4 China's official broad money (M2) measure has also sharply decelerated, as have all measures of China's money. We prefer BCA's Emerging Market Strategy's broader M3 measure. The official M2 has underestimated the amount of new money in China because banks and shadow banks have done extensive off balance sheet lending. The M3 measure includes bank liabilities excluded from M2, it is calculated by taking the total of non-financial institution and household deposits, plus other financial corporation deposits, and other liabilities. Please see BCA Emerging Market Strategy, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Temporary Short-Term Risks," dated November 10, 2017, available at fes.bcaresearch.com and BCA Emerging Markets Strategy Weekly Report, "EM: Cracks Are Appearing," dated November 15, 2017, available at ems.bcaresearch.com. 6 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 8 Zhou's comments should not be interpreted merely as a farewell speech of a retiring central bank governor, since they echo the general policy shift in the administration since December 2016's Central Economic Work Conference, and April 2016's Politburo meeting, toward tackling financial risk. For Zhou's comments, please see "China's central bank chief lays out plans to avert future financial crisis," South China Morning Post, November 4, 2017, available at www.scmp.com. 9 Xianyang in Shaanxi, and Wuhan in Hubei. Please see Wu Hongyuran and Han Wei, "Another City Halts Subway Projects Amid Financing Concerns," Caixin, November 13, 2017, available at www.caixinglobal.com. 10 Please see Kevin Yao, "China central bank adviser expects less forceful deleveraging in 2018," Reuters, November 15, 2017, available at www.reuters.com. 11 The latest official announcement claims that an additional 31 SOEs will be listed for restructuring. Please see "More SOEs to be included in reform plan," People's Daily, November 16, 2017, available at en.people.cn. 12 We fully expect SOEs to be subjected to rigorous treatment from the National Supervision Commission. Note that the crackdown on overseas investment earlier this year merely touches the tip of the iceberg in terms of the SOE corruption that could be revealed by probes. See, for example, the following report on the National Audit Office's public notice on SOE fraud and irregularities, "20 Central Enterprises Overseas Investment Audit Revealed A Lot Of Problems," Pengpai News (Shanghai), June 26, 2017, available at news.163.com. 13 Please see BCA Geopolitical Strategy Special Report, "How To Read Xi Jinping's Party Congress Speech," dated October 18, 2017, available at gps.bcaresearch.com. 14 Please see BCA China Investment Strategy Weekly Report, "Policy Mistakes And Silver Linings," dated October 7, 2015, and "Legacies Of 2014," dated December 17, 2014, available at cis.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 16 Xi Jinping has called financial security an important part of national security and declared that "safeguarding financial security is a strategic and fundamental task in the economic and social development of our country." Please see Wang Yanfei, "Leaders aim to fend off financial risks," China Daily, April 26, 2017, available at www.chinadailyasia.com. For Zhao Leji's post-congress comments on this topic in the People's Daily, please see "China faces historic corruption battle, new graft buster says," The Guardian, November 11, 2017, available at www.theguardian.com. 17 See footnote 6. 18 More anecdotally, a clear majority of our clients disagrees with our bullish prospects of tax cuts. 19 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 21 Please see Chad P. Bown, "Donald Trump Now Has The Excuse He Needs To Open The Floodgates Of Protectionism," Peterson Institute of International Economics, October 9, 2017, available at piie.com. 22 Other measures could follow thereafter. For instance, the Commerce Department will issue its final report on steel and aluminum in January and Trump could decide to take punitive actions on these goods under Section 232 of the 1962 Trade Expansion Act. Please see Ana Swanson, "Democrats Pressure Trump to Fulfill Promise to Impose Steel Tariffs," New York Times, October 26, 2017, available at www.nytimes.com. 23 The review itself began in June, around the time when Trump's and Xi's initial "100-day plan" to improve trade relations expired. The report that the review is completed is from Lingling Wei et al, "Beyond Trump-Xi Bond, White House Looks to Toughen China Policy," Fox Business News, November 19, 2017, available at www.foxbusiness.com. See also Adam Behsudi et al, "White House conducting wide-ranging review of China policy," Politico, September 28, 2017, available at www.politico.com. 24 The U.S. Trade Representative Robert Lighthizer is supposed to finish his investigation into intellectual property under Section 301 of the 1974 Trade Act within a year of August 18, 2017. Please see Gary M. Hnath and Jing Zhang, "Trump Administration Initiates Section 301 Investigation of China's Acts, Policies and Practices Related to Technology Transfer, Intellectual Property and Innovation," dated August 25, 2017, available at www.lexology.com. 25 Please see "Chinese vice premier pledges fair treatment of foreign firms as China opens up," Reuters, November 10, 2017, available at www.reuters.com. 26 Please see BCA Geopolitical Strategy Weekly Report, "Stick To The Macro(n) Picture," dated May 10, 2017, available at gps.bcaresearch.com. 27 Just in time to get a new government in place ahead of the World Cup! Oh wait... Too soon? 28 Which is an odd position to take given their supposed anti-establishment orientation. For example, the U.K. referendum on EU membership was non-binding, and yet it took place and had relatively binding political consequences. 29 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com.

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to sit down with you to discuss the economic and investment outlook. And I am thrilled to bring my daughter to the meeting. She and I do not always agree on the market outlook and appropriate investment strategy, but even in her first year working with me she has added tremendous value to our decisions and performance. As you know, I have a very conservative bias in my approach and this means I sometimes miss out on opportunities. My daughter is more willing than me to take risks, so we make a good team. I am happy that our investment portfolio has performed well over the past year, but am puzzled by the high level of investor complacency. I can't understand why investors do not share my concerns about by sky-high valuations, a volatile geopolitical environment and the considerable potential for financial instability. Over the years, you have made me appreciate the power of easy money to create financial bubbles and also that market overshoots can last for a surprisingly long time. Thus, I am fully aware that we could easily have another year of strong gains, but were that to happen, I would worry about the potential for a sudden 1987-style crash. I remember that event well and it was an unpleasant experience. My inclination is to move right now to an underweight equity position. Ms. X: Let me add that I am delighted to finally attend the annual BCA meeting with my father. Over the years, he has talked to me at length about your discussions, making me very jealous that I was not there. He and I do frequently disagree about the outlook so it will be good to have BCA's independent and objective perspective. As my father noted, I do not always share his cautious bias. When I joined the family firm in early 2017, I persuaded him to raise our equity exposure and that was the right decision. I have been in the business long enough to know that it is dangerous to get more bullish as the market rises and I agree there probably is too much complacency. However, I do not see an early end to the conditions that are driving the bull market and I am inclined to stay overweight equities for a while longer. Thus, the big debate between us is whether or not we should now book profits from the past year's strong performance and move to an underweight stance in risk assets. Hopefully, this meeting will help us make the right decision. Chart 1An Impressive Bull Market An Impressive Bull Market An Impressive Bull Market BCA: First of all, we are delighted to see you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating whether to cut exposure to risk assets because that question is on the mind of many of our clients. We share your surprise about complacency - investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices continue to rise, it would make sense to reduce exposure to risk assets to a neutral position over the next few months. A blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk strategy. We are not yet recommending underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction in the second half of 2018. Ms. X: It seems that you are siding with my father in terms of wanting to scale back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, I would be interested in reviewing your forecasts from last year. BCA: Of course. A year ago, our key conclusions were that: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time lags in implementing policy mean that the fiscal plans of President-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. The key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given President-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. The most important prediction that we got right was our view that conditions were ripe for an overshoot in equity prices. The MSCI all-country index has delivered an impressive total return of around 20% in dollar terms since the end of 2016, one of the best calendar year performances of the current cycle (Table 1). So it was good that your daughter persuaded you to keep a healthy equity exposure. It is all the more impressive that the market powered ahead in the face of all the concerns that you noted earlier. Our preference for European markets over the U.S. worked out well in common currency terms, but only because the dollar declined. Emerging markets did much better than we expected, with significant outperformance relative to their developed counterparts. Table 1Market Performance 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course With regard to the overall economic environment, we were correct in forecasting a modest improvement in 2017 global economic activity and that growth would not fall short of the IMF's predictions for the first time in the current expansion. However, one big surprise, not only for us, but also for policymakers, was that inflation drifted lower in the major economies. Latest data show the core inflation rate for the G7 economies is running at only 1.4%, down from 1.6% at the end of 2016. We will return to this critical issue later as the trend in inflation outlook will be a key determinant of the market outlook for the coming year and beyond. Regionally, the Euro area and Japanese economies registered the biggest upside surprises relative to our forecast and those of the IMF (Table 2). That goes a long way to explaining why the U.S. dollar was weaker than we expected. In addition, the dollar was not helped by a market downgrading of the scale and timing of U.S. fiscal stimulus. Nonetheless, it is worth noting that the dollar has merely unwound the 2016 Trump rally and recently has shown some renewed strength. Table 2IMF Economic Forecasts 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course A year ago, there were major concerns about potential political turmoil from important elections in Europe, the risk of U.S.-led trade wars and a credit bust-up in China. We downplayed these issues as near-term threats to the markets and that turned out to be appropriate. Nevertheless, there are many lingering risks to the outlook and market complacency is a much bigger concern now than it was a year ago. Mr. X: As you just noted, a key theme of your Outlook last year was "Shifting Regimes" such as the end of disinflation and fiscal conservatism, a retreat from globalization, and the start of a rebalancing in income shares away from profits toward labor. And of course, you talked about the End of the Debt Supercycle a few years ago. Do you still have confidence that these regime shifts are underway? BCA: Absolutely! These are all trends that we expect to play out over a number of years and thus can't be judged by short-term developments. There have been particularly important shifts in the policy environment. The 2007-09 economic and financial meltdown led central banks to fight deflation rather than inflation and we would not bet against them in this battle. Inflation has been lower than expected, but there has been a clear turning point. On fiscal policy, governments have largely given up on austerity against a background of a disappointingly slow economic recovery in recent years and rising populist pressures (Chart 2). The U.S. budget deficit could rise particularly sharply over the next few years. In the U.S., the relative income shares going to profits and labor have started to shift direction, but there is a long way to go. Finally, the same forces driving government to loosen fiscal purse strings have also undermined support for globalization with the U.S. even threatening to abandon NAFTA. The ratio of global trade to output has trended sideways for several years and is unlikely to turn higher any time soon. All these trends are part of our Regime Shift thesis. Chart 2Regime Shifts Regime Shifts Regime Shifts The remarkable macro backdrop of low inflation, easy money and healthy profits has been incredibly positive for financial markets in recent years. You would have to be an extreme optimist to believe that such an environment will persist. Our big concern for the coming year is that we are setting up for a collision between the markets and looming changes in economic policy. The Coming Collision Between Policy And The Markets BCA: As you mentioned earlier, we attach enormous importance to the role of easy money in supporting asset prices and it is hard to imagine that we could have had a more stimulative monetary environment than has existed in recent years. Central banks have been in panic mode since the 2007-09 downturn with an unprecedented period of negative real interest rates in the advanced economies, coupled with an extraordinary expansion of central bank balance sheets (Chart 3). Initially, the fear was for another Great Depression and as that threat receded, the focus switched to getting inflation back to the 2% target favored by most developed countries. In a post-Debt Supercycle world, negative real rates have failed to trigger the typical rebound in credit demand that was so characteristic of the pre-downturn era. Central banks have expanded base money in the form of bank reserves, but this has not translated into markedly faster growth in broad money or nominal GDP. This is highlighted by the collapse in money multipliers (the ratio of broad to base money) and in velocity (the ratio of GDP to broad money). This has been a double whammy: there is less broad money generated for each dollar of base money and less GDP for every dollar of broad money (Chart 4). Chart 3An Extraordinary Period Of Easy Money An Extraordinary Period of Easy Money An Extraordinary Period of Easy Money Chart 4Monetary Policy: Pushing On A String Monetary Policy: Pushing On A String Monetary Policy: Pushing On A String Historically, monetary policy acted primarily through the credit channel with lower rates making households and companies more willing to borrow, and lenders more willing to supply funds. In the post-Debt Supercycle world, the credit channel has become partly blocked, forcing policymakers to rely more on the other channels of monetary transmission, the main one being boosting asset prices. However, there is a limit to how far this can go because the end result is massively overvalued assets and building financial excesses. The Fed and many other central banks now realize that this strategy cannot be pushed much further. The economic recovery in the U.S. and other developed economies has been the weakest of the post-WWII period. But potential growth rates also have slowed which means that spare capacity has gradually been absorbed. According to the IMF, the U.S. output gap closed in 2015 having been as high as 2% of potential GDP in 2013. The IMF estimates that the economy was operating slightly above potential in 2017 with a further rise forecast in 2018 (Chart 5). According to IMF estimates, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018 (i.e. they will be operating above potential). This makes it hard to justify the maintenance of hyper-stimulative monetary policies. Chart 5No More Output Gaps No More Output Gaps No More Output Gaps The low U.S. inflation rate is giving the Fed the luxury of moving cautiously and that is keeping the markets buoyant. Indeed, the markets don't even believe the Fed will be able to raise rates as much they expect. The most recent FOMC projections show a median federal funds rate of 2.1% by the end of 2018 but the markets are discounting a move to only 1.8%. The markets probably have this wrong because inflation is likely to wake up from its slumber in the second half of the year. Ms. X: This is another area where my father and I disagree. I view the world as essentially deflationary. We all know that technological innovations have opened up competition in a lot of markets, driving down prices. Two obvious examples are Uber and Airbnb, but these are just the tip of the iceberg. Amazon's purchase of Whole Foods is another example of how increased competitive pressures will continue to sweep through previously relatively stable industries. And such changes have an important impact on employee psychology and thus bargaining power. These days, people are glad to just keep their jobs and this means companies hold the upper hand when it comes to wage negotiations. So I don't see a pickup in inflation being a threat to the markets any time soon. Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the things I buy have risen a lot in price over the past couple of years. Secondly, given the extremely stimulative stance of monetary policy in recent years, a pickup in inflation would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation forecasts proved so wrong and what underpins your view that it will increase in the coming year? BCA: There is an interesting disconnect between the official data and the inflation views of many consumers and economic/statistics experts. According to the Conference Board, U.S. consumers' one-year ahead inflation expectations have persistently exceeded the published data and the latest reading is close to 5% (Chart 6). That ties in with your perception. Consumer surveys by the New York Fed and University of Michigan have year-ahead inflation expectations at a more reasonable 2.5%. At the same time, many "experts" believe the official data is overstated because it fails to take enough account of technological changes and new lower-priced goods and services. The markets also have a moderately optimistic view with the five-year CPI swap rate at 2%. This is optimistic because it is consistent with inflation below the Fed's 2% target, if one allows for an inflation risk premium built in to the swap price. We are prepared to take the inflation data broadly at face value. Low inflation is consistent with an ongoing tough competitive environment in most sectors, boosted by the disruptive impact of technological changes that Ms. X described. The inflation rate for core goods (ex-food and energy) has been in negative territory for several years while that for services ex-shelter is at the low end of its historical range (Chart 7). Chart 6Differing Perspectives Of Inflation Differing Perspectives of Inflation Differing Perspectives of Inflation Chart 7Not Much Inflation Here Not Much Inflation Here Not Much Inflation Here There is no simple explanation of why inflation has fallen short of forecasts. Economic theory assumes that price pressures build as an economy moves closer to full employment and the U.S. is at that point. This raises several possibilities: There is more slack in the economy than suggested by the low unemployment rate. The lags are unusually long in the current cycle. Technological disruption is having a greater impact than expected. The link between economic slack and inflationary pressures is typically captured by the Phillips Curve which shows the relationship between the unemployment rate and inflation. In the U.S., the current unemployment rate of 4.1% is believed to be very close to a full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained softer than expected (Chart 8). Chart 8Inflationary Pressures Are Turning Inflationary Pressures Are Turning Inflationary Pressures Are Turning We agree with Ms. X that employee bargaining power has been undermined over the years by globalization and technological change and by the impact of the 2007-09 economic downturn. That would certainly explain a weakened relationship between the unemployment rate and wage growth, but does not completely negate the theory. The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. As far as the impact of technology is concerned, there is no doubt that innovations like Uber and Airbnb are deflationary. However, our analysis suggests that the growth in online spending has not had a major impact on the inflation numbers. E-commerce still represents a small fraction of total U.S. consumer spending, depressing overall consumer inflation by only 0.1 to 0.2 percentage points. The deceleration of inflation since the global financial crisis has been in areas largely unaffected by online sales, such as energy and rent. Moreover, today's creative destruction in the retail sector is no more deflationary than the earlier shift to 'big box' stores. We are not looking for a dramatic acceleration in either wage growth or inflation - just enough to convince the Fed that it needs to carry on with its plan to raise interest rates. And the pressure to do this will increase if the Administration is able to deliver on its planned tax cuts. Ms. X: You make it sound as if cutting taxes would be a bad thing. Surely the U.S. would benefit from the Administration's tax plan? A reduction in the corporate tax rate would be very bullish for equities. BCA: The U.S. tax system is desperately in need of reform via eliminating loopholes and distortions and using the savings to lower marginal rates. That would make it more efficient and hopefully boost the supply side of the economy without undermining revenues. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. Importantly, there is not a strong case for personal tax cuts given that a married worker on the average wage and with two children paid an average income tax rate of only 14% in 2016, according to OECD calculations. There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. The combination of easier fiscal policy and Fed rate hikes will be bullish for the dollar and this will contribute to tighter overall financial conditions. That is why we see a coming collision between economic policy and the markets. The narrative for the so-called Trump rally in markets was based on the assumption that the Administration's platform of increased spending, tax cuts and reduced regulations would be bullish for the economy and thus risk assets. That was always a misplaced notion. The perfect environment for markets has been moderate economic growth, low inflation and easy money. The Trump agenda would be appropriate for an economy that had a lot of spare capacity and needed a big boost in demand. It is less suited for an economy with little spare capacity. Reduced regulations and lower corporate tax rates are good for the supply side of the economy and could boost the potential growth rate. However, if a key move is large personal tax cuts then the boost to demand will dominate. Mr. X: It seems that you are making the case for a serious policy error in the U.S. in the coming year - both on fiscal and monetary policy. I can't argue against that because everything that has happened over the past few years tells me that policymakers don't have a good grip on either the economy or the implications of their actions. I never believed that printing money and creating financial bubbles was a sensible approach to an over-indebted economy. I always expected it to end badly. BCA: Major tightening cycles frequently end in recession because monetary policy is a very blunt tool. Central banks would like to raise rates by just enough to cool things down but that is hard to achieve. The problem with fiscal policy is that implementation lags mean that it often is pro-cyclical. In other words, there is pressure for fiscal stimulus in a downturn, but by the time legislation is passed, the economy typically has already recovered and does not really need a big fiscal boost. And that certainly applies to the current environment. The other area of potential policy error is on trade. Having already pulled the U.S. out of the Trans-Pacific Partnership, the Trump Administration is taking a hardline attitude toward a renegotiation of NAFTA. This could even end up with the deal being scrapped and that would add another element of risk to the North American economies. Ms. X: Your scenario assumes that the Fed will be quite hawkish. However, everything I have read about Jerome Powell, the new Fed chair, suggests that he will err on the side of caution when it comes to raising rates. So monetary policy may not collide with markets at all over the coming year. BCA: It is certainly true that Powell does not have any particular bias when it comes to the conduct of monetary policy. That would not have been the case if either John Taylor or Kevin Warsh had been given the job - they both have a hawkish bias. Powell is not an economist so will likely follow a middle path and be heavily influenced by the Fed's staff forecasts and by the opinions of other FOMC members. There are still several vacancies on the Fed's Board so much will depend on who is appointed to those positions. The latest FOMC forecasts are for growth and inflation of only 2% in 2018 and these numbers seem too low. Meanwhile, the prediction that unemployment will still be at 4.1% at end-2018 is too high. We expect projections of growth and inflation to be revised up and unemployment to be revised down. That will embolden the Fed to keep raising rates. So, even with Powell at the helm, monetary policy is set to get tighter than the market currently expects. Ms. X: So far, we have talked mainly about the U.S. What about other central banks? I can't believe that inflation will be much of a problem in the euro area or in Japan any time soon. Does that not mean that the overall global monetary environment will stay favorable for risk assets? BCA: The Fed is at the leading edge of the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised rates and the ECB has announced that it will cut its asset purchases in half beginning January 2018, as a first step in normalizing policy. Even the Bank of England has raised rates despite Brexit-related downside risks for the economy. The BoJ will keep an accommodative stance for the foreseeable future. You are correct that financial conditions will be tightening more in the U.S. than in other developed economies. Moreover, equity valuations are more stretched in the U.S. than elsewhere leaving that market especially vulnerable. Yet, market correlations are such that any sell-off in U.S. risk assets is likely to become a global affair. Another key issue relates to the potential for financial shocks. Long periods of extreme monetary ease always fuel excesses and sometimes these remain hidden until they blow up. We know that companies have taken on a lot of debt, largely to fund financial transactions such as share buybacks and merger and acquisitions activity. That is unlikely to be the direct cause of a financial accident but might well become a problem in the next downturn. It typically is increased leverage within the financial sector itself that poses the greatest risk and that is very opaque. The banking system is much better capitalized than before the 2007-09 downturn so the risks lie elsewhere. As would be expected, margin debt has climbed higher with the equity market, and is at a historically high level relative to market capitalization (Chart 9). We don't have good data on the degree of leverage among non-bank financial institutions such as hedge funds but that is where leverage surprises are likely to occur. And the level of interest rates that causes financial stress is almost certainly to be a lot lower than in the past. Chart 9Financial Leverage Has Risen Financial Leverage Has Risen Financial Leverage Has Risen Mr. X: That is the perfect lead-in to my perennial concern - the high level of debt in the major economies. I realize high debt levels are not a problem when interest rates are close to zero, but that will change if your view on the Fed is correct. Ms. X: I would just add that this is one area where I share my father's concerns, but with an important caveat. I wholeheartedly agree that high debt levels pose a threat to economic and financial stability, but I see this as a long-term issue. Even with rising interest rates, debt servicing costs will stay low for at least the next year. It seems to me that rates will have to rise a lot before debt levels in the major economies pose a serious threat to the system. Even if the Fed tightens policy in line with its plans, real short rates will still stay low by historical standards. This will not only keep debt financing manageable but will also sustain the search for yield and support equity prices. BCA: We would be disappointed if you both had not raised the issue of debt. Debt levels do indeed remain very elevated among advanced and emerging economies (Chart 10). The growth in private debt remains far below pre-crisis levels in the advanced countries, but this has been offset by the continued high level of government borrowing. As a result, the total debt-to-GDP ratio has stayed close to a peak. And both private and public debt ratios have climbed to new highs in the emerging economies, with China leading the charge. Chart 10ADebt Levels Remain Elevated Debt Levels Remain Elevated Debt Levels Remain Elevated Chart 10BDebt Levels Remain Elevated 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course As we have discussed in the past, there is not an inconsistency between our End of Debt Supercycle thesis and the continued high levels of debt in most countries. As noted earlier, record-low interest rates have not triggered the kind of private credit resurgence that occurred in the pre-crisis period. For example, household borrowing has remained far below historical levels as a percent of income in the U.S., despite low borrowing costs (Chart 11). At the same time, it is not a surprise that debt-to-income ratios are high given the modest growth in nominal incomes in most countries. Chart 11Low Rates Have Not Triggered ##br##A Borrowing Surge In U.S. Low Rates Have Not Triggered A Borrowing Surge In U.S. Low Rates Have Not Triggered A Borrowing Surge In U.S. Debt growth is not benign everywhere. In the developed world, Canada's debt growth is worryingly high, both in the household and corporate sectors. As is also the case with Australia, Canada's overheated housing market has fueled rapid growth in mortgage debt. These are accidents waiting to happen when borrowing costs increase. In the emerging word, China has yet to see the end of its Debt Supercycle. Fortunately, with most banks under state control, the authorities should be able to contain any systemic risks, at least in the near run. With regard to timing, we agree that debt levels are not likely to pose an economic or financial problem in next year. It is right to point out that debt-servicing costs are very low by historical standards and it will take time for rising rates to have an impact given that a lot of debt is locked in at low rates. For example, in the U.S., the ratio of household debt-servicing to income and the non-financial business sector's ratio of interest payments to EBITD are at relatively benign levels (Chart 12). However, changes occur at the margin and the example of the Bernanke taper tantrum highlighted investor sensitivity to even modest changes in the monetary environment. You may well be right Ms. X that risk assets will continue to climb higher in the face of a tighter financial conditions. But given elevated valuations, we lean toward a cautious rather than aggressive approach to strategy. We would rather leave some money on the table than risk being caught in a sudden downdraft. Other investors, including yourself, might prefer to wait for clearer signals that a turning point is imminent. Returning to the issue of indebtedness, the end-game for high debt levels continues to be a topic of intense interest. There really are only three options: to grow out of it, to write it off, or to try and inflate it away. The first option obviously would be best - to have fast enough growth in real incomes that allowed debtors to start paying down their debt. Unfortunately, that is the least likely prospect given adverse demographic trends throughout the developed world and disappointing productivity growth (Chart 13). Chart 12Borrowing Costs Are Benign Borrowing Costs Are Benign Borrowing Costs Are Benign Chart 13It's Hard To Grow Out Of Debt ##br##With These Structural Headwinds It's Hard To Grow Out Of Debt With These Structural Headwinds It's Hard To Grow Out Of Debt With These Structural Headwinds Writing the debt off - i.e. defaulting - is a desperate measure that would be the very last resort after all other approaches had failed. In this case, we are talking mainly about government debt, because private debt always has to be written off when borrowers become bankrupt. Japan is the one developed country where government debt probably will be written off eventually. Given that the Bank of Japan owns around 45% of outstanding government debt, those holdings can be neutralized by converting them to perpetuals - securities that are never redeemed. If the first two options are not viable, then inflation becomes the preferred solution to over-indebtedness. To make a big impact, inflation would need to rise far above the 2% level currently favored by central banks, and it would have to stay elevated for quite some time. Central banks are not yet ready to allow such an environment, but that could change after the next economic downturn. Central banks have made it clear that they are prepared to pursue radical policies in order to prevent deflation. This sets the scene for increasingly aggressive actions after the next recession and the end result could be a period of significantly higher inflation. Mr. X: I don't disagree with that view which is why I always like to hold some physical gold in my portfolio. It is interesting that you are worried about a looming setback for risk assets because you are positive on the near-run economic outlook. That is contrary to the typical view that sees a decent economy as supporting higher equity prices. Let's spend a bit more time on your view of the economic outlook. Ms. X: Before we do that, I would just emphasize that it is far too early to worry about debt end games and the potential for sharply rising inflation. I don't disagree that monetary policy could be forced to embrace massive reflation during the next downturn and perhaps that will make me change my view of the inflation outlook. But the sequencing is important because we would first have to deal with a recession that could be a very deflationary episode. And before the next recession we could have period of continued decent growth, which would be positive for risk assets. So I agree that the near-term view of the economic outlook is important. The Economic Outlook BCA: This recovery cycle has been characterized by a series of shocks and headwinds that constrained growth in various regions. In no particular order, these included fiscal austerity, the euro crisis, a brief U.S. government shutdown, the Japanese earthquake, and a spike in oil prices above $100. As we discussed a year ago, in the absence of any new shocks, we expected global growth to improve and that is what occurred in 2017. A broad range of indicators shows that activity has picked up steam in most areas. Purchasing managers' indexes are in an uptrend, business and consumer confidence are at cyclical highs and leading indicators have turned up (Chart 14). This is hardly a surprise given easy monetary conditions and a more relaxed fiscal stance almost everywhere. Chart 14Global Activity On An Uptrend Global Activity On An Uptrend Global Activity On An Uptrend The outlook for 2018 is positive and the IMF's projections for growth is probably too low (see Table 2). So, for the second year in a row, the next set of updates due in the spring are likely to be revised up. Ms. X: Let's talk about the U.S. economy. You are concerned that tax cuts could contribute to overheating, tighter monetary policy and an eventual collision with the markets. But there are two alternative scenarios, both quite optimistic for risk assets. On the one hand, a cut in the corporate tax rate could trigger a further improvement in business confidence and thus acceleration in capital spending. This would boost the supply side of the economy and mean that faster growth need not lead to higher inflation. It would be the perfect world of a low inflation boom. At the other extreme, if political gridlock prevents any meaningful tax cuts, we will be left with the status quo of moderate growth and low inflation that has been very positive for markets during the past several years. Mr. X: You can always rely on my daughter to emphasize the potential for optimistic outcomes. I would suggest another entirely different scenario. The cycle is very mature and I fear it would not take much to tip the economy into recession, even if we get some tax relief. So I am more concerned with near-term downside risks to the U.S. economy. A recession in the coming year would be catastrophic for the stock market in my view. BCA: Before we get to the outlook, let's agree on where we are right now. As we already noted, the U.S. economy currently is operating very close to its potential level. The Congressional Budget Office estimates potential growth to be only 1.6% a year at present, which explains why the unemployment rate has dropped even though growth has averaged a modest 2% pace in recent years. The consumer sector has generally been a source of stability with real spending growing at a 2¾% pace over the past several years (Chart 15). And, encouragingly, business investment has recently picked up from its earlier disappointing level. On the negative side, the recovery in housing has lost steam and government spending has been a source of drag. Looking ahead, the pattern of growth may change a bit. With regard to consumer spending, the pace of employment growth is more likely to slow than accelerate given the tight market and growing lack of available skilled employees. According to the National Federation of Independent Business survey, 88% of small companies hiring or trying to hire reported "few or no qualified applicants for the positions they were trying to fill". Companies in manufacturing and construction say that the difficulty in finding qualified workers is their single biggest problem, beating taxes and regulations. In addition, we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 16). On the other hand, wage growth should continue to firm and there is the prospect of tax cuts. Overall, this suggests that consumer spending should continue to grow by at least a 2% pace in 2018. Chart 15Trends In U.S. Growth Trends In U.S. Growth Trends In U.S. Growth Chart 16Personal Saving At A Recovery Low Personal Saving At A Recovery Low Personal Saving At A Recovery Low Survey data suggests that business investment spending should remain strong in the coming year, even without any additional boost from corporate tax cuts. Meanwhile, rebuilding and renovations in the wake of Hurricanes Harvey and Irma should provide a short-term boost to housing investment and a more lasting improvement will occur if the millennial generation finally moves out of their parents' basements. On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 17). And although housing affordability is down from its peak, it remains at an attractive level from a historical perspective. Chart 17A Weak Housing Recovery A Weak Housing Recovery A Weak Housing Recovery Last, but not least, government spending will face countervailing forces. The Administration plans to increase spending on defense and infrastructure but there could be some offsetting cutbacks in other areas. Overall, government spending should make a positive contribution to 2018 after being a drag in 2017. Putting all this together, the U.S. economy should manage to sustain a growth rate of around 2.5% in 2018, putting GDP further above its potential level. And it could rise above that if tax cuts are at the higher end of the range. You suggested three alternative scenarios to our base case: a supply-side boom, continued moderate growth and a near-term recession. A supply-side revival that leads to strong growth and continued low inflation would be extremely bullish, but we are skeptical about that possibility. The revival in capital spending is good news, but this will take time to feed into faster productivity growth. Overall, any tax cuts will have a greater impact on demand than supply, putting even greater pressure on an already tight labor market. The second scenario of a continuation of the recent status quo is more possible, especially if we end up with a very watered-down tax package. However, growth would actually have to drop below 2% in order to prevent GDP from rising above potential. We will closely monitor leading indicators for signs that growth is about to lose momentum. The bearish scenario of a near-term recession cannot be completely discounted, but there currently is no compelling evidence of such a development. Recessions can arrive with little warning if there is an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve has provided a warning sign ahead of most recessions and the curve currently is still positively sloped (Chart 18). Another leading indicator is when cyclical spending1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical spending is still at a historically low level relative to GDP and we expect this to rise rather than fall over the coming quarters. While a near-term recession does not seem likely, the odds will change during the course of 2018. By late year, there is a good chance that the yield curve will be flat or inverted, giving a warning signal for a recession in 2019. Our base case view is for a U.S. recession to start in the second half of 2019, making the current expansion the longest on record. At this stage, it is too early to predict whether it would be a mild recession along the lines of 1990-91 and 2000-01 or a deeper downturn. Chart 18No Recession Signals For The U.S. ...Yet No Recession Signals For The U.S. ...Yet No Recession Signals For The U.S. ...Yet Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not entirely convinced but will keep an open mind, and my daughter will no doubt keep me fully informed of any positive trends. Ms. X: You can be sure of that. Although I lean toward the optimistic side on the U.S. economy, I have been rather surprised at how well the euro area economy has done in the past year. Latest data show that the euro area's real GDP increased by 2.5% in the year to 2017 Q3 compared to 2.3% for the U.S. Can that be sustained? BCA: The relative performance of the euro area economy has been even better if you allow for the fact that the region's population growth is 0.5% a year below that of the U.S. So the economic growth gap is even greater on a per capita basis. The euro area economy performed poorly during their sovereign debt crisis years of 2011-13, but the subsequent improvement has meant that the region's real per capita GDP has matched that of the U.S. over the past four years. And even Japan's GDP has not lagged much behind on a per capita basis (Chart 19). Chart 19No Clear Winner On Growth No Clear Winner On Growth No Clear Winner On Growth The recovery in the euro area has been broadly based but the big change was the end of a fiscal squeeze in the periphery countries. Between 2010 and 2013, fiscal drag (the change in the structural primary deficit) was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There was little fiscal tightening in the subsequent three years, allowing those economies to recover lost ground. Meanwhile, Germany's economy has continued to power ahead, benefiting from much easier financial conditions than the economy has warranted. That has been the inevitable consequence of a one size fits all monetary policy that has had to accommodate the weakest members of the region. The French and Italian economies have disappointed, but there are hopes that the new French government will pursue pro-growth policies. And Italy should also pick up given signs that it is finally starting to deal with its fragile banking system. Both Spain and Italy faced a sharp rise in non-performing bank loans during the great recession, but Italy lagged Spain in dealing with the problem (Chart 20). That goes a long way to explaining why the Italian economic recovery has been so poor relative to Spain. With Italian banks raising capital and writing off non-performing loans more aggressively, the Italian economy should start to improve, finally catching up with the rest of the region. Overall, the euro area economy should manage to sustain growth above the 2.1% forecast by the IMF for 2018. Overall financial conditions are likely to stay favorable for at least another year and we do not anticipate any major changes in fiscal policy. If, as we fear, the U.S. moves into recession in 2019, there will be negative fallout for Europe, largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S. during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a turn for the worse. How do you see things playing out with this issue? BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed since then. The negotiations with the EU are not going particularly well and the odds of a "hard" exit have risen. This means withdrawing from the EU without any agreement on a new regime for trade, labor movements or financial transactions. A growing number of firms are taking the precaution of shifting some operations from the U.K. to other EU countries. As you noted, there are signs that Brexit is starting to undermine the U.K. economy. For example, London house prices have turned down and the leading economic index has softened (Chart 21). The poor performance of U.K. consumer service and real estate equities relative to those of Germany suggest investors are becoming more wary of the U.K. outlook. Of course, a lot will depend on the nature of any deal between the U.K. and the EU and that remains a source of great uncertainty. Chart 20A Turning Point For Italian Banks? A Turning Point For Italian Banks? A Turning Point For Italian Banks? Chart 21U.K. Consumer Services Equities Are ##br##Underperforming Brexit Effects Show Up U.K. Consumer Services Equities Are Underperforming Brexit Effects Show Up U.K. Consumer Services Equities Are Underperforming Brexit Effects Show Up At the moment, there are no real grounds for optimism. The U.K. holds few cards in the bargaining process and the country's strong antipathy toward the free movement of people within the EU will be a big obstacle to an amicable separation agreement. Ms. X: I think the U.K. made the right decision to leave the EU and am more optimistic than you about the outlook. There may be some short-term disruption but the long-term outlook for the U.K. will be good once the country is freed from the stifling bureaucratic constraints of EU membership. The U.K. has a more dynamic economy than most EU members and it will be able to attract plenty of overseas capital if the government pursues appropriate policies toward taxes and regulations. It will take a few years to find out who is correct about this. In the meantime, given the uncertainties, I am inclined to have limited exposure to sterling and the U.K. equity market. Let's now talk about China, another country facing complex challenges. This is a topic where my father and I again have a lot of debates. As you might guess, I have been on the more optimistic side while he has sided with those who have feared a hard landing. And I know that similar debates have occurred in BCA. BCA: It is not a surprise that there are lots of debates about the China outlook. The country's impressive economic growth has been accompanied by an unprecedented build-up of debt and supply excesses in several sectors. The large imbalances would have led to a collapse by now in any other economy. However, China has benefited from the heavy state involvement in the economy and, in particular, the banking sector. The big question is whether the government has enough control over economic developments to avoid an economic and financial crisis. The good news is that China's government debt is relatively low, giving them the fiscal flexibility to write-off bad debts from zombie state-owned enterprises (SOEs). The problems of excessive leverage and over-capacity are particularly acute in SOEs that still comprise a large share of economic activity. The government is well aware of the need to reform SOEs and various measures have been announced, but progress has been relatively limited thus far. The IMF projects that the ratio of total non-financial debt to GDP will remain in an uptrend over the next several years, rising from 236% in 2016 to 298% by 2022 (Chart 22). Yet, growth is expected to slow only modestly over the period. Of course, one would not expect the IMF to build a crisis into their forecast. Some investors have been concerned that a peak in China's mini-cycle of the past two years may herald a return to the economic conditions that prevailed in 2015, when the industrial sector grew at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary conditions and weak global growth. While China's export growth may slow over the coming year, monetary policy remains accommodative. Monetary conditions appear to have peaked early this year but are still considerably easier than in mid-2015. Shifts in the monetary conditions index have done a good job of leading economic activity and they paint a reasonably positive picture (Chart 23). The industrial sector has finally moved out of deflation, with producer prices rising 6.9% in the year ended October. This has been accompanied by a solid revival in profits. Chart 22China: Debt-Fueled Growth To Continue China: Debt-Fueled Growth To Continue China: Debt-Fueled Growth To Continue Chart 23China Leaves Deflation Behind China Leaves Deflation Behind China Leaves Deflation Behind On balance, we assume that the Chinese economy will be able to muddle through for the foreseeable future. President Xi Jinping has strengthened his grip on power and he will go to great lengths to ensure that his reign is not sullied with an economic crisis. The longer-term outlook will depend on how far the government goes with reforms and deleveraging and we are keeping an open mind at this point. In sum, for the moment, we are siding with Ms. X on this issue. Mr. X: I have been too bearish on China for the past several years, but I still worry about the downside risks given the massive imbalances and excesses. I can't think of any example of a country achieving a soft landing after such a massive rise in debt. I will give you and my daughter the benefit of the doubt, but am not totally convinced that you will be right. BCA has been cautious on emerging economies in general: has that changed? BCA: The emerging world went through a tough time in 2015-16 with median growth of only 2.6% for the 23 constituent countries of the MSCI EM index (Chart 24). This recovered to 3% in 2017 according to IMF estimates, but that is still far below the average 5% pace of the period 2000-07. Chart 24Emerging Economy Growth: ##br##The Boom Years Are Over Emerging Economy Growth: The Boom Years Are Over Emerging Economy Growth: The Boom Years Are Over It is always dangerous to generalize about the emerging world because the group comprises economies with very different characteristics and growth drivers. Two of the largest countries - Brazil and Russia - went through particularly bad downturns in the past couple of years and those economies are now in a modest recovery. In contrast, India has continued to grow at a healthy albeit slowing pace, while Korea and the ASEAN region have not suffered much of a slowdown. If, as seems likely, Chinese growth holds above a 6% pace over the next year, then those countries with strong links to China should do fine. And it also points to reasonably steady commodity prices, supporting resource-dependent economies. Longer-run, there are reasons to be cautious about many emerging economies, particularly if the U.S. goes into recession 2019, as we fear. That would be associated with renewed weakness in commodity prices, and capital flight from those economies with high external debt such as Turkey and South Africa. As we stated a year ago, the heady days of emerging economy growth are in the past. Mr. X: It seems that both my daughter and I can find some areas of agreement with your views about the economic outlook. You share her expectation that the global growth outlook will stay healthy over the coming year, but you worry about a U.S.-led recession in 2019, something that I certainly sympathize with. But we differ on timing: I fear the downturn could occur even sooner and I know my daughter believes in a longer-lasting upturn. Let's now move onto what this all means for financial markets, starting with bonds. Bond Market Prospects Ms. X: I expect this to be a short discussion as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no prospect of capital gains in the year ahead and even the running yield offers little advantage over the equity dividend yield. BCA: As you know, we have believed for some time that the secular bull market in bonds has ended. We expect yields to be under upward pressure in most major markets during 2018 and thus share your view that equities offer better return prospects. By late 2018, it might well be appropriate to switch back into bonds against a backdrop of higher yields and a likely bear market in equities. For the moment, we recommend underweight bond exposure. It is hard to like government bonds when the yield on 10-year U.S. Treasuries is less than 50 basis points above the dividend yield of the S&P 500 while the euro area bond yield is 260 basis points below divided yields (Chart 25). Real yields, using the 10-year CPI swap rate as a measure of inflation expectations, are less than 20 basis points in the U.S. and a negative 113 basis points in the euro area. Even if we did not expect inflation to rise, it would be difficult to recommend an overweight position in any developed country government bonds. One measure of valuation is to compare the level of real yields to their historical average, adjusted by the standard deviation of the gap. On this basis, the most overvalued markets are the core euro area countries, where real yields are 1.5 to 2 standard deviations below their historical average (Chart 26). There are only two developed bond markets where real 10-year government yields currently are above their historical average: Greece and Portugal. This is warranted in Greece where there needs to be a risk premium in case the country is forced to leave the single currency at some point. This is less of a risk for Portugal, making it a more interesting market. Real yields in New Zealand are broadly in line with their historical average, also making it one of the more attractive markets. Chart 25Bonds Yields Offer Little Appeal Bonds Yields Offer Little Appeal Bonds Yields Offer Little Appeal Chart 26Valuation Ranking Of Developed Bond Markets 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course Mr. X: Given your expectation of higher inflation, would you recommend inflation-protected Treasuries? BCA: Yes, in the sense that they should outperform conventional Treasuries. The 10-year TIPS are discounting average inflation of 1.85% and we would expect this to be revised up during the coming year. However, the caveat is that absolute returns will still be mediocre. Ms. X: You showed earlier that corporate bonds had a reasonable year in 2017, albeit falling far short of the returns from equities. A year ago, you recommended only neutral weighting in investment-grade bonds and an underweight in high yield. But you became more optimistic toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the tight level of spreads? BCA: Yes, we were cautious on U.S. corporates a year ago because valuation was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved enough early in 2017 to warrant an upgrade to overweight given our constructive macro and default rate outlook. The cyclical sweet spot for carry trades should continue to support spread product for a while longer. Moreover, value is better than it appears at first glance. The dotted line in Chart 27 shows the expected 12-month option-adjusted spread for U.S. junk bonds after adjusting for our base case forecast for net default losses. At 260 basis points, this excess spread is in line with the historical average. In the absence of any further spread narrowing, speculative-grade bonds would return 230 basis points more than Treasurys in 2018. If high-yield spreads were to tighten by another 150 basis points, then valuations would be at a historical extreme, and that seems unwarranted. An optimistic scenario would have another 100 basis point spread tightening, delivering excess returns of 5%. Of course, if spreads widen, then corporates will underperform. If financial conditions tighten in 2018 as we expect then it will be appropriate to lower exposure to corporates. In the meantime, you should favor U.S. and U.K. corporate bonds to issues in the Eurozone because ECB tapering is likely to spark some spread widening in that market. Mr. X: What about EM hard-currency bonds? BCA: The global economic background is indeed positive for EM assets. However, EM debt is expensive relative to DM investment-grade bonds which, historically, has heralded a period of underperformance (Chart 28). We expect that relative growth dynamics will be more supportive of U.S. corporates because EM growth will lag. Any commodity price weakness and/or a stronger U.S. dollar would also weigh on EM bonds and currencies. Chart 27Not Much Value In U.S. Corporates Not Much Value In U.S. Corporates Not Much Value In U.S. Corporates Chart 28Emerging Market Bonds Are Expensive Emerging Market Bonds Are Expensive Emerging Market Bonds Are Expensive Mr. X: We have not been excited about the bond market outlook for some time and nothing you have said changes my mind. I am inclined to keep our bond exposure to the bare minimum. Ms. X: I agree. So let's talk about the stock market which is much more interesting. As I mentioned before, I am inclined to remain fully invested in equities for a while longer, while my father wants to start cutting exposure. Equity Market Outlook BCA: This is one of those times when it is important to draw a distinction between one's forecast of where markets are likely to go and the appropriate investment strategy. We fully agree that the conditions that have driven this impressive equity bull market are likely to stay in place for much of the next year. Interest rates in the U.S. and some other countries are headed higher, but they will remain at historically low levels for some time. Meanwhile, in the absence of recession, corporate earnings still have upside, albeit not as much as analysts project. However, we have a conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. For long-term investors, our recommended strategy is to gradually lower equity exposure to neutral. However, those who are trying to maximize short-term returns should stay overweight and wait for clearer signs that tighter financial conditions are starting to bite on economic activity. Chart 29Reasons For Caution On U.S. Stocks Reasons For Caution On U.S. Stocks Reasons For Caution On U.S. Stocks Getting down to specifics, here are the trends that give us cause for concern and they are all highlighted in Chart 29. Valuation: Relative to both earnings and book value, the U.S. equity market is more expensive than at any time since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 500 is around 30% above its 60-year average on the basis of both trailing operating earnings and a 10-year average of earnings. The market is not expensive on a relative yield basis because interest rates are so low, but that will change as rates inevitably move higher. Other developed markets are not as overvalued as the U.S., but neither are they cheap. Earnings expectations: The performance of corporate earnings throughout this cycle - particularly in the U.S. - has been extremely impressive give the weaker-than-normal pace of economic growth. However, current expectations are ridiculously high. According to IBES data, analysts expect long-run earnings growth of around 14% a year in both the U.S. and Europe. Even allowing for analysts' normal optimistic bias, the sharp upward revision to growth expectations over the past year makes no sense and is bound to be disappointed. Investor complacency: We all know that the VIX index is at a historical low, indicating that investors see little need to protect themselves against market turmoil. Our composite sentiment indicator for the U.S. is at a high extreme, further evidence of investor complacency. These are classic contrarian signs of a vulnerable market. Most bear markets are associated with recessions, with the stock market typically leading the economy by 6 to 12 months (Chart 30). The lead in 2007 was an unusually short three months. As discussed earlier, we do not anticipate a U.S. recession before 2019. If a recession were to start in mid-2019, it would imply the U.S. market would be at risk from the middle of 2018, but the rally could persist all year. Of course, the timing of a recession and market is uncertain. So it boils down to potential upside gains over the next year versus the downside risks, plus your confidence in being able to time the top. Chart 30Bear Markets And Recessions Usually Overlap Bear Markets And Recessions Usually Overlap Bear Markets And Recessions Usually Overlap We are not yet ready to recommend that you shift to an underweight position in equities. A prudent course of action would be to move to a broadly neutral position over the next few months, but we realize that Ms. X has a higher risk tolerance than Mr. X so we will leave you to fight over that decision. The timing of when we move to an underweight will depend on our various economic, monetary and market indicators and our assessment of the risks. It could well happen in the second half of the year. Mr. X: My daughter was more right than me regarding our equity strategy during the past year, so maybe I should give her the benefit of the doubt and wait for clearer signs of a market top. Thus far, you have focused on the U.S. market. Last year you preferred developed markets outside the U.S. on the grounds of relative valuations and relative monetary conditions. Is that still your stance? BCA: Yes it is. The economic cycle and thus the monetary cycle is far less advanced in Europe and Japan than in the U.S. This will provide extra support to these markets. At the same time, profit margins are less vulnerable outside the U.S. and, as you noted, valuations are less of a problem. In Chart 31, we show a valuation ranking of developed equity markets, based on the deviation of cyclically-adjusted PERs from their historical averages. The chart is not meant to measure the extent to which Portugal is cheap relative to the U.S., but it indicates that Portugal is trading at a PER far below its historical average while that of the U.S. is above. You can see that the "cheaper" markets tend to be outside the U.S. Japan's reading is flattered by the fact that its historical valuation was extremely high during the bubble years of the 1980s, but it still is a relatively attractive market. Chart 31Valuation Ranking Of Developed Equity Markets 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course From a cyclical standpoint, we are still recommending overweight positions in European and Japanese stocks relative to the U.S., on a currency-hedged basis. Nevertheless, market correlations are such that a sell-off in the U.S. will be transmitted around the world (Chart 32). Chart 32When the U.S. Market Sneezes, The World Catches A Cold When the U.S. Market Sneezes, The World Catches A Cold When the U.S. Market Sneezes, The World Catches A Cold Ms. X: I would like to turn the focus to emerging equity markets. You have been cautious on these for several years and that worked out extremely well until 2017. I note from your regular EM reports that you have not changed your stance. Why are you staying bearish given that you see an improvement in global growth and further potential upside in developed equity prices? BCA: The emerging world did extremely well over many years when global trade was expanding rapidly, China was booming, commodity prices were in a powerful bull market and capital inflows were strong. Those trends fostered a rapid expansion in credit-fueled growth across the EM universe and meant that there was little pressure to pursue structural reforms. However, the 2007-09 economic and financial crisis marked a major turning point in the supports to EM outperformance. As we noted earlier, the era of rapid globalization has ended, marking an important regime shift. Meanwhile, China's growth rate has moderated and the secular bull market in commodities ended several years ago. We do not view the past year's rebound in commodities as the start of a major new uptrend. Many emerging equity markets remain highly leveraged to the Chinese economy and to commodity prices (Chart 33). Although we expect the Chinese economy to hold up, growth is becoming less commodity intensive. Finally, the rise in U.S. interest rates is a problem for those countries that have taken on a marked increase in foreign currency debt. This will be made even worse if the dollar appreciates. Obviously, the very term "emerging" implies that this group of countries has a lot of upside potential. However, the key to success is pursuing market-friendly reforms, rooting out corruption and investing in productive assets. Many countries pay only lip service to these issues. India is a case in point where there is growing skepticism about the Modi government's ability to deliver on major reforms. The overall EM index does not appear expensive, with the PER trading broadly in line with its historical average (Chart 34). However, as we have noted in the past, the picture is less compelling when the PER is calculated using equally-weighted sectors. The financials and materials components are trading at historically low multiples, dragging down the overall index PER. Emerging market equities will continue to rise as long as the bull market in developed markets persists, but we expect them to underperform on a relative basis. Chart 33Drivers Of EM Performance Drivers of EM Performance Drivers of EM Performance Chart 34Emerging Markets Fundamentals Emerging Markets Fundamentals Emerging Markets Fundamentals Mr. X: One last question on equities from me: do you have any high conviction calls on sectors? BCA: A key theme of our sector view is that cyclical stocks should outperform defensives given the mature stage of the economic cycle. We are seeing the typical late-cycle improvement in capital spending and that will benefit industrials, and we recommend an overweight stance in that sector. Technology also is a beneficiary of higher capex but of course those stocks have already risen a lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights are financials and energy. The former should benefit from rising rates and a steeper yield curve while the latter will benefit from firm oil prices. If, as we fear, a recession takes hold in 2019, then obviously that would warrant a major shift back into defensive stocks. For the moment, the positive growth outlook will dominate sector performance. Ms. X: I agree that the bull market in equities, particularly in the U.S., is very mature and there are worrying signs of complacency. However, the final stages of a market cycle can sometimes be very rewarding and I would hate to miss out on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my inclination is to stay heavily invested in equities for a while longer and I have confidence that BCA will give me enough of a warning when risks become unacceptably high. Of course, I will have to persuade my father and that may not be easy. Mr. X: You can say that again, but we won't bother our BCA friends with that conversation now. It's time to shift the focus to commodities and currencies and I would start by commending you on your oil call. You were far out of consensus a year ago when you said the risks to crude prices were in the upside and you stuck to your guns even as the market weakened in the first half. We made a lot of money following your energy recommendations. What is your latest thinking? Commodities And Currencies BCA: We had a lot of conviction in our analysis that the oil market would tighten during 2017 against a backdrop of rising demand and OPEC production cuts, and that view turned out to be correct. As we entered the year, the big reason to be bearish on oil prices was the bloated level of inventories. We forecast that inventories would drop to their five-year average by late 2017, and although that turned out to be a bit too optimistic, the market tightened by enough to push prices higher (Chart 35). Chart 35Oil Market Trends Oil Market Trends Oil Market Trends The forces that have pushed prices up will remain in force over the next year. Specifically, our economic view implies that demand will continue to expand, and we expect OPEC 2.0 - the producer coalition of OPEC and non-OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d production cuts to at least end-June. On that basis, OECD inventories should fall below their five-year average by the end of 2018. We recently raised our 2018 oil price target to an average of $65 in 2018. Of course, the spot market is already close to that level, but the futures curve is backwardated and that is likely to change. We continue to see upside risks to prices, not least because of potential production shortfalls from Venezuela, Nigeria, Iraq and Libya. Mr. X: The big disruptor in the oil market in recent years was the dramatic expansion in U.S. shale production. Given the rise in prices, could we not see a rapid rebound in shale output that, once again, undermines prices? BCA: Our modeling indicates that U.S. shale output will increase from 5.1 mb/d to 6.0 mb/d over the next year, in response to higher prices. This is significant, but will not be enough to materially change the global oil demand/supply balance. Longer run, the expansion of U.S. shale output will certainly be enough to prevent any sustained price rise, assuming no large-scale production losses elsewhere. A recent report by the International Energy Agency projected that the U.S. is destined to become the global leader in oil and gas production for decades to come, accounting for 80% of the rise in global oil and gas supply between 2010 and 2025. Ms. X: You have suggested that China's economic growth is becoming less commodity intensive. Also, you have shown in the past that real commodity prices tend to fall over time, largely because of technological innovations. What does all this imply for base metals prices over the coming year? BCA: The base metals story will continue to be highly dependent on developments in China. While the government is attempting to engineer a shift toward less commodity-intensive growth, it also wants to reduce excess capacity in commodity-producing sectors such as coal and steel. Base metals are likely to move sideways until we get a clearer reading on the nature and speed of economic reforms. We model base metals as a function of China's PMIs and this supports our broadly neutral stance on these commodities (Chart 36). Chart 36China Drives Metals Prices 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course Mr. X: As usual, I must end our commodity discussion by asking about gold. Last year, you agreed that an uncertain geopolitical environment coupled with continued low interest rates should support bullion prices, and that was the case with a respectable 12% gain since the end of 2016. You also suggested that I should not have more than 5% of my portfolio in gold which is less than I am inclined to own. It still looks like a gold-friendly environment to me. Ms. X: Let me just add that this is one area where my father and I agree. I do not consider myself to be a gold bug, but I think bullion does provide a good hedge against shocks in a very uncertain economic and political world. I would also be inclined to hold more than 5% of our portfolio in gold. BCA: There will be opposing forces on gold during the coming year. On the positive side, it is safe to assume that geopolitical uncertainties will persist and may even intensify, and there also is the potential for an increase in inflation expectations that would support bullion. On the negative side, rising interest rates are not normally good for gold and there likely will be an added headwind from a firmer U.S. dollar. Gold appears to be at an important point from a technical perspective (Chart 37). It currently is perched just above its 200-day average and a key trend line. A decisive drop below these levels would be bearish. At the same time, there is overhead resistance at around 1350-1360 and prices would have to break above that level to indicate a bullish breakout. Traders' sentiment is at a broadly neutral level, consistent with no clear conviction about which way prices will break. There is no science behind our recommendation of keeping gold exposure below 5%. That just seems appropriate for an asset that delivers no income and where the risk/reward balance is fairly balanced. Ms. X: You referred to the likelihood of a firmer dollar as a depressant on the gold price. You also were bullish on the dollar a year ago, but that did not work out too well. How confident are you that your forecast will fare better in 2018? BCA: We did anticipate that the dollar would experience a correction at the beginning of 2017, but we underestimated how profound this move would be. A combination of factors explains this miscalculation. Chart 37Gold At A Key Level Gold At A Key Level Gold At A Key Level It first began with positioning. We should have paid more attention to that fact that investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. And disappointment did come with U.S. inflation weakening and accelerating in the euro area. Additionally, there were positive political surprises in Europe, especially the presidential victory of Emmanuel Macron in France. In the U.S., the government's failure to repeal Obamacare forced investors to lower expectations about fiscal stimulus. As a result, while investors were able to price in an earlier first hike by the ECB, they cut down the number of rate hikes they anticipated out of the Fed over the next 24 months. In terms of the current environment, positioning could not be more different because investors are aggressively shorting the dollar (Chart 38). The hurdle for the dollar to deliver positive surprises is thus much lower than a year ago. Also, we remain confident that tax cuts will be passed in the U.S. by early 2018. As we discussed earlier, U.S. GDP will remain above potential, causing inflation pressures to build. This will give the Fed the leeway to implement its planned rate hikes, and thus beat what is currently priced in the market. This development should support the dollar in 2018. Ms. X: A bullish view on the U.S. dollar necessarily implies a negative view on the euro. However, the European economy seems to have a lot of momentum, and inflation has picked up, while U.S. prices have been decelerating. To me, this suggests that the ECB also could surprise by being more hawkish than anticipated, arguing against any major weakness in the euro. BCA: The European economy has indeed done better than generally expected in the past year. Also, geopolitical risks were overstated by market participants at the beginning of 2017, leaving less reason to hide in the dollar. However, the good news in Europe is now well known and largely discounted in the market. Investors are very long the euro, by both buying EUR/USD and shorting the dollar index (Chart 39). In that sense, the euro today is where the dollar stood at the end of 2016. Chart 38Too Much Pessimism On The Dollar Too Much Pessimism On The Dollar Too Much Pessimism On The Dollar Chart 39Positioning Risk In EUR/USD Positioning Risk In EUR/USD Positioning Risk In EUR/USD Valuations show a similar picture. The euro might appear cheap on a long-term basis, but not so much so that its purchasing power parity estimate - which only works at extremes and over long-time periods - screams a buy. Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency is at risk if the economy disappoints. Overall, we expect EUR/USD to trade around 1.10 in 2018. Long-run, the picture is different because a U.S. recession in 2019 would trigger renewed broad-based weakness in the dollar. Mr. X: I have been perplexed by the yen's firmness in the past year, with the currency still above its end-2016 level versus the dollar. I expected a lot more weakness with the central bank capping bond yields at zero and more or less monetizing the government deficit. A year ago you also predicted a weak yen. Will it finally drop in 2018? BCA: We were not completely wrong on the yen as it has weakened over the past year on a trade-weighted basis and currently is about 2% below its end-2016 level. But it has risen slightly against the U.S. dollar. In the past couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did not move against the yen as much as we expected because U.S. yields drifted lower and there was no major change in relative inflation expectations. Chart 40Bond Yield Differentials Drive The Yen Bond Yield Differentials Drive The Yen Bond Yield Differentials Drive The Yen The real yield gap is likely to move in the dollar's favor over the next year, putting some downward pressure on the yen. Meanwhile, the Bank of Japan will continue to pursue a hyper-easy monetary stance, in contrast to the Fed's normalization policy. However, it is not all negative: the yen is cheap on a long-term basis, and Japan is an international net creditor to the tune of more than 60% of GDP. Investors are also quite short the yen as it remains a key funding currency for carry trades. Thus, it will continue to benefit each time global markets are gripped with bouts of volatility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth noting? BCA: The outlook for sterling obviously will be tied to the Brexit negotiations. Having fallen sharply after the Brexit vote, sterling looks cheap relative to its history. This has allowed it to hold in a broad trading range over the past 18 months, even though the negotiations with the EU have not been going well. At this stage, it is hard to know what kind of deal, if any, will emerge regarding Brexit so we would hedge exposure to sterling. Our optimism toward the oil price is consistent with a firm Canadian dollar, but developments in the NAFTA negotiations represent a significant risk. At the moment, we are overweight the Canadian dollar, but that could change if the NAFTA talks end badly. We still can't get enthusiastic about emerging market currencies even though some now offer reasonable value after falling sharply over the past few years. Mr. X: We can't leave currencies without talking about Bitcoin and cryptocurrencies in general. I like the idea of a currency that cannot be printed at will by governments. There are too many examples of currency debasement under a fiat money system and the actions of central banks in recent years have only served to increase my mistrust of the current monetary system. But I can't profess to fully understand how these cryptocurrencies work and that makes me nervous about investing in them. What are your thoughts? BCA: You are right to be nervous. There have been numerous cases of hackers stealing Bitcoins and other cryptocurrencies. Also, while there is a limit to the number of Bitcoins that can be issued, there is no constraint on the number of possible cryptocurrencies that can be created. Thus, currency debasement is still possible if developers continue creating currencies that are only cosmetically different from the ones already in existence. Moreover, we doubt that governments will sit idly by and allow these upstart digital currencies to become increasingly prevalent. The U.S. Treasury derives $70 billion a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At some point, governments could simply criminalize the use of cryptocurrencies. This does not mean that Bitcoin prices cannot rise further, but the price trend is following the path of other manias making it a highly speculative play (Chart 41). If you want more detail about our thoughts on this complex topic then you can read the report we published last September.2 Chart 41Bitcoin Looks Like Other Bubbles Bitcoin Looks Like Other Bubbles Bitcoin Looks Like Other Bubbles Ms. X: I don't fear bubbles and manias as much as my father and have made a lot of money during such episodes in the past. But I am inclined to agree that Bitcoin is best avoided. The topic of manic events presents a nice segue into the geopolitical environment which seems as volatile as ever. Geopolitics Ms. X: Which geopolitical events do you think will have the biggest impact on the markets over the coming year? BCA: Domestic politics in the U.S. and China will be very much in focus in 2018. In the U.S., as we discussed, the Republicans will pass tax cuts but it is unclear whether this will help the GOP in the November midterm elections. At this point, all of our data and modeling suggests that Democrats have a good chance of picking up the House of Representatives, setting a stage for epic battles with President Trump about everything under the sun. In China, we are watching carefully for any sign that Beijing is willing to stomach economic pain in the pursuit of economic reforms. The two reforms that would matter the most are increased financial regulation and more aggressive purging of excess capacity in the industrial sector. The 19th Party Congress marked a serious reduction in political constraints impeding President Xi's domestic agenda. This means he could launch ambitious reforms, akin to what President Jiang Zemin did in the late 1990s. While this is a low-conviction view, and requires constant monitoring of the news and data flow out of China, it would be a considerable risk to global growth. Reforms would be good for China's long-term outlook, but could put a significant damper on short-term growth. The jury is out, but the next several months will be crucial. Three other issues that could become market-relevant are the ongoing North Korean nuclear crisis, trade protectionism, and tensions between the Trump administration and Iran. The first two are connected because a calming of tensions with North Korea would give the U.S. greater maneuvering room against China. The ongoing economic détente between the U.S. and China is merely a function of President Trump needing President Xi's cooperation on pressuring North Korea. But if President Trump no longer needs China's help with Kim Jong-Un, he may be encouraged to go after China on trade. As for Iran, it is not yet clear if the administration is serious about ratcheting up tensions or whether it is playing domestic politics. We suspect it is the latter implying that the market impact of any brinkmanship will be minor. But our conviction view is low. Mr. X: We seem to be getting mixed messages regarding populist pressures in Europe. The far right did not do as well as expected in the Netherlands or France, but did well in Austria. Also, Merkel is under some pressure in Germany. BCA: We don't see much in the way of mixed messages, at least when it comes to support for European integration. In Austria, the populists learned a valuable lesson from the defeats of their peers in the Netherlands and France: stay clear of the euro. Thus the Freedom Party committed itself to calling a referendum on Austria's EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing in Austria signaled to the wider public that it was not anti-establishment on the issue of European integration. In Germany, the Alternative for Germany only gained 12.6%, but it too focused on an anti-immigration platform. The bottom line for investors is that the European anti-establishment right is falling over itself to de-emphasize its Euroskepticism and focus instead on anti-immigration policies. For investors, the former is far more relevant than the latter, meaning that the market relevance of European politics has declined. One potential risk in 2018 is the Italian election, likely to be held by the end of the first quarter. However, as with Austria, the anti-establishment parties have all moved away from overt Euroskepticism. At some point over the next five years, Italy will be a source of market risk, but in this electoral cycle and not with economic growth improving. Ms. X: The tensions between the U.S. and North Korea, fueled by two unpredictable leaders, have me very concerned. I worry that name-calling may slide into something more serious. How serious is the threat? BCA: The U.S.-Iran nuclear negotiations are a good analog for the North Korean crisis. The U.S. had to establish a "credible threat" of war in order to move Iran towards negotiations. As such, the Obama administration ramped up the war rhetoric - using Israel as a proxy - in 2011-2012. The negotiations with Iran did not end until mid-2015, almost four years later. We likely have seen the peak in "credible threat" display this summer between the U.S. and North Korea. The next two-to-three months could revisit those highs as North Korea responds to President Trump's visit to the region, as well as to the deployment of the three U.S. aircraft carriers off the coast of the Korean Peninsula. However, we believe that we have entered the period of "negotiations." It is too early to tell how the North Korean crisis will end. We do not see a full out war between either of the main actors. We also do not see North Korea ever giving up its nuclear arsenal, although limiting its ballistic technology and toning down its "fire and brimstone' rhetoric is a must. The bottom line is that this issue will remain a source of concern and uncertainty for a while longer. Conclusions Mr. X: This seems a good place to end our discussion. We have covered a lot of ground and your views have reinforced my belief that it would make good sense to start lowering the risk in our portfolio. I know that such a policy could leave money on the table as there is a reasonable chance that equity prices may rise further. But that is a risk I am prepared to take. Ms. X: I foresee some interesting discussions with my father when we get back to our office. At the risk of sounding reckless, I remain inclined to stay overweight equities for a while longer. I am sympathetic to the view that the era of hyper-easy money is ending and at some point that may cause a problem for risk assets. However, timing is important because, in my experience, the final stages of a bull market can deliver strong gains. BCA: Good luck with those discussions! We have similar debates within BCA between those who want to maximize short-run returns and those who take a longer-term view. Historically, BCA has had a conservative bias toward investment strategy and the bulk of evidence suggests that this is one of these times when long-run investors should focus on preservation of capital rather than stretching for gains. Our thinking also is influenced by our view that long-run returns will be very poor from current market levels. Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation (Table 3). That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. There is a negligible equity risk premium on offer, implying that stock prices have to fall at some point to establish higher prospective returns. Table 310-Year Asset Return Projections 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course The return calculations for equities assume profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or PERs stay at historically high levels. In that case, equities obviously would do better than our estimates. In terms of the outlook for the coming year, a lot will depend on the pace of economic growth. We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. That is possible, but we would not make it our base case scenario. Ms. X: You have left us with much to think about and I am so glad to have finally attended one of these meetings. My father has always looked forward to these discussions every year and I am very happy to be joining him. Many thanks for taking the time to talk to us. Before we go, it would be helpful to have a recap of your key views. BCA: That will be our pleasure. The key points are as follows: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 20, 2017 1 This comprises consumer spending on durables, housing and business investment in equipment and software. 2 Please see 'Bitcoin's Macro Impact', BCA Global Investment Strategy Special Report, September 15, 2017.

Mr. X is a long-time BCA client who visits our offices toward the end of each year to discuss the economic and financial market outlook. This year, Mr. X introduced us to his daughter, who we shall identify as Ms. X. She has many years of experience as a portfolio manager, initially in a wealth management firm, and subsequently in two major hedge funds. In 2017, she joined her father to help him run the family office portfolio. She took an active role in our recent discussion and this report is an edited transcript of our conversation. Mr. X: As always, it is a great pleasure to sit down with you to discuss the economic and investment outlook. And I am thrilled to bring my daughter to the meeting. She and I do not always agree on the market outlook and appropriate investment strategy, but even in her first year working with me she has added tremendous value to our decisions and performance. As you know, I have a very conservative bias in my approach and this means I sometimes miss out on opportunities. My daughter is more willing than me to take risks, so we make a good team. I am happy that our investment portfolio has performed well over the past year, but am puzzled by the high level of investor complacency. I can't understand why investors do not share my concerns about by sky-high valuations, a volatile geopolitical environment and the considerable potential for financial instability. Over the years, you have made me appreciate the power of easy money to create financial bubbles and also that market overshoots can last for a surprisingly long time. Thus, I am fully aware that we could easily have another year of strong gains, but were that to happen, I would worry about the potential for a sudden 1987-style crash. I remember that event well and it was an unpleasant experience. My inclination is to move right now to an underweight equity position. Ms. X: Let me add that I am delighted to finally attend the annual BCA meeting with my father. Over the years, he has talked to me at length about your discussions, making me very jealous that I was not there. He and I do frequently disagree about the outlook so it will be good to have BCA's independent and objective perspective. As my father noted, I do not always share his cautious bias. When I joined the family firm in early 2017, I persuaded him to raise our equity exposure and that was the right decision. I have been in the business long enough to know that it is dangerous to get more bullish as the market rises and I agree there probably is too much complacency. However, I do not see an early end to the conditions that are driving the bull market and I am inclined to stay overweight equities for a while longer. Thus, the big debate between us is whether or not we should now book profits from the past year's strong performance and move to an underweight stance in risk assets. Hopefully, this meeting will help us make the right decision. Chart 1An Impressive Bull Market An Impressive Bull Market An Impressive Bull Market BCA: First of all, we are delighted to see you both and look forward to getting to know Ms. X in the years to come. It is not a surprise that you are debating whether to cut exposure to risk assets because that question is on the mind of many of our clients. We share your surprise about complacency - investors have been seduced by the relentless upward drift of prices since early 2016. The global equity index has not suffered any setback above 2% during the past year, and that has to be close to a record (Chart 1). The conditions that have underpinned this remarkable performance are indeed still in place but we expect that to change during the coming year. Thus, if equity prices continue to rise, it would make sense to reduce exposure to risk assets to a neutral position over the next few months. A blow-off phase with a final spike in prices cannot be ruled out, but trying to catch those moves is a very high-risk strategy. We are not yet recommending underweight positions in risk assets, but if our economic and policy views pan out, we likely will shift in that direction in the second half of 2018. Ms. X: It seems that you are siding with my father in terms of wanting to scale back exposure to risk assets. That would be premature in my view and I look forward to discussing this in more detail. But first, I would be interested in reviewing your forecasts from last year. BCA: Of course. A year ago, our key conclusions were that: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time lags in implementing policy mean that the fiscal plans of President-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. The key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given President-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. The most important prediction that we got right was our view that conditions were ripe for an overshoot in equity prices. The MSCI all-country index has delivered an impressive total return of around 20% in dollar terms since the end of 2016, one of the best calendar year performances of the current cycle (Table 1). So it was good that your daughter persuaded you to keep a healthy equity exposure. It is all the more impressive that the market powered ahead in the face of all the concerns that you noted earlier. Our preference for European markets over the U.S. worked out well in common currency terms, but only because the dollar declined. Emerging markets did much better than we expected, with significant outperformance relative to their developed counterparts. Table 1Market Performance 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course With regard to the overall economic environment, we were correct in forecasting a modest improvement in 2017 global economic activity and that growth would not fall short of the IMF's predictions for the first time in the current expansion. However, one big surprise, not only for us, but also for policymakers, was that inflation drifted lower in the major economies. Latest data show the core inflation rate for the G7 economies is running at only 1.4%, down from 1.6% at the end of 2016. We will return to this critical issue later as the trend in inflation outlook will be a key determinant of the market outlook for the coming year and beyond. Regionally, the Euro area and Japanese economies registered the biggest upside surprises relative to our forecast and those of the IMF (Table 2). That goes a long way to explaining why the U.S. dollar was weaker than we expected. In addition, the dollar was not helped by a market downgrading of the scale and timing of U.S. fiscal stimulus. Nonetheless, it is worth noting that the dollar has merely unwound the 2016 Trump rally and recently has shown some renewed strength. Table 2IMF Economic Forecasts 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course A year ago, there were major concerns about potential political turmoil from important elections in Europe, the risk of U.S.-led trade wars and a credit bust-up in China. We downplayed these issues as near-term threats to the markets and that turned out to be appropriate. Nevertheless, there are many lingering risks to the outlook and market complacency is a much bigger concern now than it was a year ago. Mr. X: As you just noted, a key theme of your Outlook last year was "Shifting Regimes" such as the end of disinflation and fiscal conservatism, a retreat from globalization, and the start of a rebalancing in income shares away from profits toward labor. And of course, you talked about the End of the Debt Supercycle a few years ago. Do you still have confidence that these regime shifts are underway? BCA: Absolutely! These are all trends that we expect to play out over a number of years and thus can't be judged by short-term developments. There have been particularly important shifts in the policy environment. The 2007-09 economic and financial meltdown led central banks to fight deflation rather than inflation and we would not bet against them in this battle. Inflation has been lower than expected, but there has been a clear turning point. On fiscal policy, governments have largely given up on austerity against a background of a disappointingly slow economic recovery in recent years and rising populist pressures (Chart 2). The U.S. budget deficit could rise particularly sharply over the next few years. In the U.S., the relative income shares going to profits and labor have started to shift direction, but there is a long way to go. Finally, the same forces driving government to loosen fiscal purse strings have also undermined support for globalization with the U.S. even threatening to abandon NAFTA. The ratio of global trade to output has trended sideways for several years and is unlikely to turn higher any time soon. All these trends are part of our Regime Shift thesis. Chart 2Regime Shifts Regime Shifts Regime Shifts The remarkable macro backdrop of low inflation, easy money and healthy profits has been incredibly positive for financial markets in recent years. You would have to be an extreme optimist to believe that such an environment will persist. Our big concern for the coming year is that we are setting up for a collision between the markets and looming changes in economic policy. The Coming Collision Between Policy And The Markets BCA: As you mentioned earlier, we attach enormous importance to the role of easy money in supporting asset prices and it is hard to imagine that we could have had a more stimulative monetary environment than has existed in recent years. Central banks have been in panic mode since the 2007-09 downturn with an unprecedented period of negative real interest rates in the advanced economies, coupled with an extraordinary expansion of central bank balance sheets (Chart 3). Initially, the fear was for another Great Depression and as that threat receded, the focus switched to getting inflation back to the 2% target favored by most developed countries. In a post-Debt Supercycle world, negative real rates have failed to trigger the typical rebound in credit demand that was so characteristic of the pre-downturn era. Central banks have expanded base money in the form of bank reserves, but this has not translated into markedly faster growth in broad money or nominal GDP. This is highlighted by the collapse in money multipliers (the ratio of broad to base money) and in velocity (the ratio of GDP to broad money). This has been a double whammy: there is less broad money generated for each dollar of base money and less GDP for every dollar of broad money (Chart 4). Chart 3An Extraordinary Period Of Easy Money An Extraordinary Period of Easy Money An Extraordinary Period of Easy Money Chart 4Monetary Policy: Pushing On A String Monetary Policy: Pushing On A String Monetary Policy: Pushing On A String Historically, monetary policy acted primarily through the credit channel with lower rates making households and companies more willing to borrow, and lenders more willing to supply funds. In the post-Debt Supercycle world, the credit channel has become partly blocked, forcing policymakers to rely more on the other channels of monetary transmission, the main one being boosting asset prices. However, there is a limit to how far this can go because the end result is massively overvalued assets and building financial excesses. The Fed and many other central banks now realize that this strategy cannot be pushed much further. The economic recovery in the U.S. and other developed economies has been the weakest of the post-WWII period. But potential growth rates also have slowed which means that spare capacity has gradually been absorbed. According to the IMF, the U.S. output gap closed in 2015 having been as high as 2% of potential GDP in 2013. The IMF estimates that the economy was operating slightly above potential in 2017 with a further rise forecast in 2018 (Chart 5). According to IMF estimates, the median output gap for 20 advanced economies will shift from -0.1% in 2017 to +0.3% in 2018 (i.e. they will be operating above potential). This makes it hard to justify the maintenance of hyper-stimulative monetary policies. Chart 5No More Output Gaps No More Output Gaps No More Output Gaps The low U.S. inflation rate is giving the Fed the luxury of moving cautiously and that is keeping the markets buoyant. Indeed, the markets don't even believe the Fed will be able to raise rates as much they expect. The most recent FOMC projections show a median federal funds rate of 2.1% by the end of 2018 but the markets are discounting a move to only 1.8%. The markets probably have this wrong because inflation is likely to wake up from its slumber in the second half of the year. Ms. X: This is another area where my father and I disagree. I view the world as essentially deflationary. We all know that technological innovations have opened up competition in a lot of markets, driving down prices. Two obvious examples are Uber and Airbnb, but these are just the tip of the iceberg. Amazon's purchase of Whole Foods is another example of how increased competitive pressures will continue to sweep through previously relatively stable industries. And such changes have an important impact on employee psychology and thus bargaining power. These days, people are glad to just keep their jobs and this means companies hold the upper hand when it comes to wage negotiations. So I don't see a pickup in inflation being a threat to the markets any time soon. Mr. X: I have a different perspective. First of all, I do not even believe the official inflation data because most of the things I buy have risen a lot in price over the past couple of years. Secondly, given the extremely stimulative stance of monetary policy in recent years, a pickup in inflation would not surprise me at all. So I am sympathetic to the BCA view. But, even if the data is correct, why have inflation forecasts proved so wrong and what underpins your view that it will increase in the coming year? BCA: There is an interesting disconnect between the official data and the inflation views of many consumers and economic/statistics experts. According to the Conference Board, U.S. consumers' one-year ahead inflation expectations have persistently exceeded the published data and the latest reading is close to 5% (Chart 6). That ties in with your perception. Consumer surveys by the New York Fed and University of Michigan have year-ahead inflation expectations at a more reasonable 2.5%. At the same time, many "experts" believe the official data is overstated because it fails to take enough account of technological changes and new lower-priced goods and services. The markets also have a moderately optimistic view with the five-year CPI swap rate at 2%. This is optimistic because it is consistent with inflation below the Fed's 2% target, if one allows for an inflation risk premium built in to the swap price. We are prepared to take the inflation data broadly at face value. Low inflation is consistent with an ongoing tough competitive environment in most sectors, boosted by the disruptive impact of technological changes that Ms. X described. The inflation rate for core goods (ex-food and energy) has been in negative territory for several years while that for services ex-shelter is at the low end of its historical range (Chart 7). Chart 6Differing Perspectives Of Inflation Differing Perspectives of Inflation Differing Perspectives of Inflation Chart 7Not Much Inflation Here Not Much Inflation Here Not Much Inflation Here There is no simple explanation of why inflation has fallen short of forecasts. Economic theory assumes that price pressures build as an economy moves closer to full employment and the U.S. is at that point. This raises several possibilities: There is more slack in the economy than suggested by the low unemployment rate. The lags are unusually long in the current cycle. Technological disruption is having a greater impact than expected. The link between economic slack and inflationary pressures is typically captured by the Phillips Curve which shows the relationship between the unemployment rate and inflation. In the U.S., the current unemployment rate of 4.1% is believed to be very close to a full-employment level. Yet, inflation recently has trended lower and while wage growth is in an uptrend, it has remained softer than expected (Chart 8). Chart 8Inflationary Pressures Are Turning Inflationary Pressures Are Turning Inflationary Pressures Are Turning We agree with Ms. X that employee bargaining power has been undermined over the years by globalization and technological change and by the impact of the 2007-09 economic downturn. That would certainly explain a weakened relationship between the unemployment rate and wage growth, but does not completely negate the theory. The historical evidence still suggests that once the labor market becomes tight, inflation eventually does accelerate. A broad range of data indicates that the U.S. labor market is indeed tight and the Atlanta Fed's wage tracker is in an uptrend, albeit modestly. Two other factors consistent with an end to disinflation are the lagged effects of dollar weakness and a firming in oil prices. Non-oil prices have now moved decisively out of deflationary territory while oil prices in 2017 have averaged more than 20% above year-ago levels. As far as the impact of technology is concerned, there is no doubt that innovations like Uber and Airbnb are deflationary. However, our analysis suggests that the growth in online spending has not had a major impact on the inflation numbers. E-commerce still represents a small fraction of total U.S. consumer spending, depressing overall consumer inflation by only 0.1 to 0.2 percentage points. The deceleration of inflation since the global financial crisis has been in areas largely unaffected by online sales, such as energy and rent. Moreover, today's creative destruction in the retail sector is no more deflationary than the earlier shift to 'big box' stores. We are not looking for a dramatic acceleration in either wage growth or inflation - just enough to convince the Fed that it needs to carry on with its plan to raise interest rates. And the pressure to do this will increase if the Administration is able to deliver on its planned tax cuts. Ms. X: You make it sound as if cutting taxes would be a bad thing. Surely the U.S. would benefit from the Administration's tax plan? A reduction in the corporate tax rate would be very bullish for equities. BCA: The U.S. tax system is desperately in need of reform via eliminating loopholes and distortions and using the savings to lower marginal rates. That would make it more efficient and hopefully boost the supply side of the economy without undermining revenues. However, the economy does not need stimulus from net tax giveaways given that it is operating close to potential. That would simply boost demand relative to supply, create overheating, and give the Fed more reason to get aggressive. The Republican's initial tax plan has some good elements of reform such as cutting back the personal mortgage interest deduction, eliminating some other deductions and making it less attractive for companies to shift operations overseas. However, many of these proposals are unlikely to survive the lobbying efforts of special interest groups. The net result probably will be tax giveaways without much actual reform. Importantly, there is not a strong case for personal tax cuts given that a married worker on the average wage and with two children paid an average income tax rate of only 14% in 2016, according to OECD calculations. There inevitably will be contentious negotiations in Congress but we assume that the Republicans will eventually come together to pass some tax cuts by early next year. The combination of easier fiscal policy and Fed rate hikes will be bullish for the dollar and this will contribute to tighter overall financial conditions. That is why we see a coming collision between economic policy and the markets. The narrative for the so-called Trump rally in markets was based on the assumption that the Administration's platform of increased spending, tax cuts and reduced regulations would be bullish for the economy and thus risk assets. That was always a misplaced notion. The perfect environment for markets has been moderate economic growth, low inflation and easy money. The Trump agenda would be appropriate for an economy that had a lot of spare capacity and needed a big boost in demand. It is less suited for an economy with little spare capacity. Reduced regulations and lower corporate tax rates are good for the supply side of the economy and could boost the potential growth rate. However, if a key move is large personal tax cuts then the boost to demand will dominate. Mr. X: It seems that you are making the case for a serious policy error in the U.S. in the coming year - both on fiscal and monetary policy. I can't argue against that because everything that has happened over the past few years tells me that policymakers don't have a good grip on either the economy or the implications of their actions. I never believed that printing money and creating financial bubbles was a sensible approach to an over-indebted economy. I always expected it to end badly. BCA: Major tightening cycles frequently end in recession because monetary policy is a very blunt tool. Central banks would like to raise rates by just enough to cool things down but that is hard to achieve. The problem with fiscal policy is that implementation lags mean that it often is pro-cyclical. In other words, there is pressure for fiscal stimulus in a downturn, but by the time legislation is passed, the economy typically has already recovered and does not really need a big fiscal boost. And that certainly applies to the current environment. The other area of potential policy error is on trade. Having already pulled the U.S. out of the Trans-Pacific Partnership, the Trump Administration is taking a hardline attitude toward a renegotiation of NAFTA. This could even end up with the deal being scrapped and that would add another element of risk to the North American economies. Ms. X: Your scenario assumes that the Fed will be quite hawkish. However, everything I have read about Jerome Powell, the new Fed chair, suggests that he will err on the side of caution when it comes to raising rates. So monetary policy may not collide with markets at all over the coming year. BCA: It is certainly true that Powell does not have any particular bias when it comes to the conduct of monetary policy. That would not have been the case if either John Taylor or Kevin Warsh had been given the job - they both have a hawkish bias. Powell is not an economist so will likely follow a middle path and be heavily influenced by the Fed's staff forecasts and by the opinions of other FOMC members. There are still several vacancies on the Fed's Board so much will depend on who is appointed to those positions. The latest FOMC forecasts are for growth and inflation of only 2% in 2018 and these numbers seem too low. Meanwhile, the prediction that unemployment will still be at 4.1% at end-2018 is too high. We expect projections of growth and inflation to be revised up and unemployment to be revised down. That will embolden the Fed to keep raising rates. So, even with Powell at the helm, monetary policy is set to get tighter than the market currently expects. Ms. X: So far, we have talked mainly about the U.S. What about other central banks? I can't believe that inflation will be much of a problem in the euro area or in Japan any time soon. Does that not mean that the overall global monetary environment will stay favorable for risk assets? BCA: The Fed is at the leading edge of the shift away from extreme monetary ease by hiking interest rates and starting the process of balance sheet reduction. But the Bank of Canada also has raised rates and the ECB has announced that it will cut its asset purchases in half beginning January 2018, as a first step in normalizing policy. Even the Bank of England has raised rates despite Brexit-related downside risks for the economy. The BoJ will keep an accommodative stance for the foreseeable future. You are correct that financial conditions will be tightening more in the U.S. than in other developed economies. Moreover, equity valuations are more stretched in the U.S. than elsewhere leaving that market especially vulnerable. Yet, market correlations are such that any sell-off in U.S. risk assets is likely to become a global affair. Another key issue relates to the potential for financial shocks. Long periods of extreme monetary ease always fuel excesses and sometimes these remain hidden until they blow up. We know that companies have taken on a lot of debt, largely to fund financial transactions such as share buybacks and merger and acquisitions activity. That is unlikely to be the direct cause of a financial accident but might well become a problem in the next downturn. It typically is increased leverage within the financial sector itself that poses the greatest risk and that is very opaque. The banking system is much better capitalized than before the 2007-09 downturn so the risks lie elsewhere. As would be expected, margin debt has climbed higher with the equity market, and is at a historically high level relative to market capitalization (Chart 9). We don't have good data on the degree of leverage among non-bank financial institutions such as hedge funds but that is where leverage surprises are likely to occur. And the level of interest rates that causes financial stress is almost certainly to be a lot lower than in the past. Chart 9Financial Leverage Has Risen Financial Leverage Has Risen Financial Leverage Has Risen Mr. X: That is the perfect lead-in to my perennial concern - the high level of debt in the major economies. I realize high debt levels are not a problem when interest rates are close to zero, but that will change if your view on the Fed is correct. Ms. X: I would just add that this is one area where I share my father's concerns, but with an important caveat. I wholeheartedly agree that high debt levels pose a threat to economic and financial stability, but I see this as a long-term issue. Even with rising interest rates, debt servicing costs will stay low for at least the next year. It seems to me that rates will have to rise a lot before debt levels in the major economies pose a serious threat to the system. Even if the Fed tightens policy in line with its plans, real short rates will still stay low by historical standards. This will not only keep debt financing manageable but will also sustain the search for yield and support equity prices. BCA: We would be disappointed if you both had not raised the issue of debt. Debt levels do indeed remain very elevated among advanced and emerging economies (Chart 10). The growth in private debt remains far below pre-crisis levels in the advanced countries, but this has been offset by the continued high level of government borrowing. As a result, the total debt-to-GDP ratio has stayed close to a peak. And both private and public debt ratios have climbed to new highs in the emerging economies, with China leading the charge. Chart 10ADebt Levels Remain Elevated Debt Levels Remain Elevated Debt Levels Remain Elevated Chart 10BDebt Levels Remain Elevated 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course As we have discussed in the past, there is not an inconsistency between our End of Debt Supercycle thesis and the continued high levels of debt in most countries. As noted earlier, record-low interest rates have not triggered the kind of private credit resurgence that occurred in the pre-crisis period. For example, household borrowing has remained far below historical levels as a percent of income in the U.S., despite low borrowing costs (Chart 11). At the same time, it is not a surprise that debt-to-income ratios are high given the modest growth in nominal incomes in most countries. Chart 11Low Rates Have Not Triggered ##br##A Borrowing Surge In U.S. Low Rates Have Not Triggered A Borrowing Surge In U.S. Low Rates Have Not Triggered A Borrowing Surge In U.S. Debt growth is not benign everywhere. In the developed world, Canada's debt growth is worryingly high, both in the household and corporate sectors. As is also the case with Australia, Canada's overheated housing market has fueled rapid growth in mortgage debt. These are accidents waiting to happen when borrowing costs increase. In the emerging word, China has yet to see the end of its Debt Supercycle. Fortunately, with most banks under state control, the authorities should be able to contain any systemic risks, at least in the near run. With regard to timing, we agree that debt levels are not likely to pose an economic or financial problem in next year. It is right to point out that debt-servicing costs are very low by historical standards and it will take time for rising rates to have an impact given that a lot of debt is locked in at low rates. For example, in the U.S., the ratio of household debt-servicing to income and the non-financial business sector's ratio of interest payments to EBITD are at relatively benign levels (Chart 12). However, changes occur at the margin and the example of the Bernanke taper tantrum highlighted investor sensitivity to even modest changes in the monetary environment. You may well be right Ms. X that risk assets will continue to climb higher in the face of a tighter financial conditions. But given elevated valuations, we lean toward a cautious rather than aggressive approach to strategy. We would rather leave some money on the table than risk being caught in a sudden downdraft. Other investors, including yourself, might prefer to wait for clearer signals that a turning point is imminent. Returning to the issue of indebtedness, the end-game for high debt levels continues to be a topic of intense interest. There really are only three options: to grow out of it, to write it off, or to try and inflate it away. The first option obviously would be best - to have fast enough growth in real incomes that allowed debtors to start paying down their debt. Unfortunately, that is the least likely prospect given adverse demographic trends throughout the developed world and disappointing productivity growth (Chart 13). Chart 12Borrowing Costs Are Benign Borrowing Costs Are Benign Borrowing Costs Are Benign Chart 13It's Hard To Grow Out Of Debt ##br##With These Structural Headwinds It's Hard To Grow Out Of Debt With These Structural Headwinds It's Hard To Grow Out Of Debt With These Structural Headwinds Writing the debt off - i.e. defaulting - is a desperate measure that would be the very last resort after all other approaches had failed. In this case, we are talking mainly about government debt, because private debt always has to be written off when borrowers become bankrupt. Japan is the one developed country where government debt probably will be written off eventually. Given that the Bank of Japan owns around 45% of outstanding government debt, those holdings can be neutralized by converting them to perpetuals - securities that are never redeemed. If the first two options are not viable, then inflation becomes the preferred solution to over-indebtedness. To make a big impact, inflation would need to rise far above the 2% level currently favored by central banks, and it would have to stay elevated for quite some time. Central banks are not yet ready to allow such an environment, but that could change after the next economic downturn. Central banks have made it clear that they are prepared to pursue radical policies in order to prevent deflation. This sets the scene for increasingly aggressive actions after the next recession and the end result could be a period of significantly higher inflation. Mr. X: I don't disagree with that view which is why I always like to hold some physical gold in my portfolio. It is interesting that you are worried about a looming setback for risk assets because you are positive on the near-run economic outlook. That is contrary to the typical view that sees a decent economy as supporting higher equity prices. Let's spend a bit more time on your view of the economic outlook. Ms. X: Before we do that, I would just emphasize that it is far too early to worry about debt end games and the potential for sharply rising inflation. I don't disagree that monetary policy could be forced to embrace massive reflation during the next downturn and perhaps that will make me change my view of the inflation outlook. But the sequencing is important because we would first have to deal with a recession that could be a very deflationary episode. And before the next recession we could have period of continued decent growth, which would be positive for risk assets. So I agree that the near-term view of the economic outlook is important. The Economic Outlook BCA: This recovery cycle has been characterized by a series of shocks and headwinds that constrained growth in various regions. In no particular order, these included fiscal austerity, the euro crisis, a brief U.S. government shutdown, the Japanese earthquake, and a spike in oil prices above $100. As we discussed a year ago, in the absence of any new shocks, we expected global growth to improve and that is what occurred in 2017. A broad range of indicators shows that activity has picked up steam in most areas. Purchasing managers' indexes are in an uptrend, business and consumer confidence are at cyclical highs and leading indicators have turned up (Chart 14). This is hardly a surprise given easy monetary conditions and a more relaxed fiscal stance almost everywhere. Chart 14Global Activity On An Uptrend Global Activity On An Uptrend Global Activity On An Uptrend The outlook for 2018 is positive and the IMF's projections for growth is probably too low (see Table 2). So, for the second year in a row, the next set of updates due in the spring are likely to be revised up. Ms. X: Let's talk about the U.S. economy. You are concerned that tax cuts could contribute to overheating, tighter monetary policy and an eventual collision with the markets. But there are two alternative scenarios, both quite optimistic for risk assets. On the one hand, a cut in the corporate tax rate could trigger a further improvement in business confidence and thus acceleration in capital spending. This would boost the supply side of the economy and mean that faster growth need not lead to higher inflation. It would be the perfect world of a low inflation boom. At the other extreme, if political gridlock prevents any meaningful tax cuts, we will be left with the status quo of moderate growth and low inflation that has been very positive for markets during the past several years. Mr. X: You can always rely on my daughter to emphasize the potential for optimistic outcomes. I would suggest another entirely different scenario. The cycle is very mature and I fear it would not take much to tip the economy into recession, even if we get some tax relief. So I am more concerned with near-term downside risks to the U.S. economy. A recession in the coming year would be catastrophic for the stock market in my view. BCA: Before we get to the outlook, let's agree on where we are right now. As we already noted, the U.S. economy currently is operating very close to its potential level. The Congressional Budget Office estimates potential growth to be only 1.6% a year at present, which explains why the unemployment rate has dropped even though growth has averaged a modest 2% pace in recent years. The consumer sector has generally been a source of stability with real spending growing at a 2¾% pace over the past several years (Chart 15). And, encouragingly, business investment has recently picked up from its earlier disappointing level. On the negative side, the recovery in housing has lost steam and government spending has been a source of drag. Looking ahead, the pattern of growth may change a bit. With regard to consumer spending, the pace of employment growth is more likely to slow than accelerate given the tight market and growing lack of available skilled employees. According to the National Federation of Independent Business survey, 88% of small companies hiring or trying to hire reported "few or no qualified applicants for the positions they were trying to fill". Companies in manufacturing and construction say that the difficulty in finding qualified workers is their single biggest problem, beating taxes and regulations. In addition, we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 16). On the other hand, wage growth should continue to firm and there is the prospect of tax cuts. Overall, this suggests that consumer spending should continue to grow by at least a 2% pace in 2018. Chart 15Trends In U.S. Growth Trends In U.S. Growth Trends In U.S. Growth Chart 16Personal Saving At A Recovery Low Personal Saving At A Recovery Low Personal Saving At A Recovery Low Survey data suggests that business investment spending should remain strong in the coming year, even without any additional boost from corporate tax cuts. Meanwhile, rebuilding and renovations in the wake of Hurricanes Harvey and Irma should provide a short-term boost to housing investment and a more lasting improvement will occur if the millennial generation finally moves out of their parents' basements. On that note, it is encouraging that the 10-year slide in the homeownership rate appears to have run its course (Chart 17). And although housing affordability is down from its peak, it remains at an attractive level from a historical perspective. Chart 17A Weak Housing Recovery A Weak Housing Recovery A Weak Housing Recovery Last, but not least, government spending will face countervailing forces. The Administration plans to increase spending on defense and infrastructure but there could be some offsetting cutbacks in other areas. Overall, government spending should make a positive contribution to 2018 after being a drag in 2017. Putting all this together, the U.S. economy should manage to sustain a growth rate of around 2.5% in 2018, putting GDP further above its potential level. And it could rise above that if tax cuts are at the higher end of the range. You suggested three alternative scenarios to our base case: a supply-side boom, continued moderate growth and a near-term recession. A supply-side revival that leads to strong growth and continued low inflation would be extremely bullish, but we are skeptical about that possibility. The revival in capital spending is good news, but this will take time to feed into faster productivity growth. Overall, any tax cuts will have a greater impact on demand than supply, putting even greater pressure on an already tight labor market. The second scenario of a continuation of the recent status quo is more possible, especially if we end up with a very watered-down tax package. However, growth would actually have to drop below 2% in order to prevent GDP from rising above potential. We will closely monitor leading indicators for signs that growth is about to lose momentum. The bearish scenario of a near-term recession cannot be completely discounted, but there currently is no compelling evidence of such a development. Recessions can arrive with little warning if there is an unanticipated shock, but that is rare. Historically, a flat or inverted yield curve has provided a warning sign ahead of most recessions and the curve currently is still positively sloped (Chart 18). Another leading indicator is when cyclical spending1 falls as a share of GDP, reflecting the increased sensitivity of those items to changes in financial conditions. Cyclical spending is still at a historically low level relative to GDP and we expect this to rise rather than fall over the coming quarters. While a near-term recession does not seem likely, the odds will change during the course of 2018. By late year, there is a good chance that the yield curve will be flat or inverted, giving a warning signal for a recession in 2019. Our base case view is for a U.S. recession to start in the second half of 2019, making the current expansion the longest on record. At this stage, it is too early to predict whether it would be a mild recession along the lines of 1990-91 and 2000-01 or a deeper downturn. Chart 18No Recession Signals For The U.S. ...Yet No Recession Signals For The U.S. ...Yet No Recession Signals For The U.S. ...Yet Mr. X: I hope that you are right that a U.S. recession is more than a year away. I am not entirely convinced but will keep an open mind, and my daughter will no doubt keep me fully informed of any positive trends. Ms. X: You can be sure of that. Although I lean toward the optimistic side on the U.S. economy, I have been rather surprised at how well the euro area economy has done in the past year. Latest data show that the euro area's real GDP increased by 2.5% in the year to 2017 Q3 compared to 2.3% for the U.S. Can that be sustained? BCA: The relative performance of the euro area economy has been even better if you allow for the fact that the region's population growth is 0.5% a year below that of the U.S. So the economic growth gap is even greater on a per capita basis. The euro area economy performed poorly during their sovereign debt crisis years of 2011-13, but the subsequent improvement has meant that the region's real per capita GDP has matched that of the U.S. over the past four years. And even Japan's GDP has not lagged much behind on a per capita basis (Chart 19). Chart 19No Clear Winner On Growth No Clear Winner On Growth No Clear Winner On Growth The recovery in the euro area has been broadly based but the big change was the end of a fiscal squeeze in the periphery countries. Between 2010 and 2013, fiscal drag (the change in the structural primary deficit) was equivalent to around 10% of GDP in Greece and Portugal and 7% of GDP in Ireland and Spain. There was little fiscal tightening in the subsequent three years, allowing those economies to recover lost ground. Meanwhile, Germany's economy has continued to power ahead, benefiting from much easier financial conditions than the economy has warranted. That has been the inevitable consequence of a one size fits all monetary policy that has had to accommodate the weakest members of the region. The French and Italian economies have disappointed, but there are hopes that the new French government will pursue pro-growth policies. And Italy should also pick up given signs that it is finally starting to deal with its fragile banking system. Both Spain and Italy faced a sharp rise in non-performing bank loans during the great recession, but Italy lagged Spain in dealing with the problem (Chart 20). That goes a long way to explaining why the Italian economic recovery has been so poor relative to Spain. With Italian banks raising capital and writing off non-performing loans more aggressively, the Italian economy should start to improve, finally catching up with the rest of the region. Overall, the euro area economy should manage to sustain growth above the 2.1% forecast by the IMF for 2018. Overall financial conditions are likely to stay favorable for at least another year and we do not anticipate any major changes in fiscal policy. If, as we fear, the U.S. moves into recession in 2019, there will be negative fallout for Europe, largely via the impact on financial markets. However, in relative terms, the euro area should outperform the U.S. during the next downturn. Mr. X: A year ago, you said that Brexit posed downside risks for the U.K. economy. For a while, that seemed too pessimistic as the economy performed quite well, but recent data show things have taken a turn for the worse. How do you see things playing out with this issue? BCA: It was apparent a year ago that the U.K. government had no concrete plans to deal with Brexit and little has changed since then. The negotiations with the EU are not going particularly well and the odds of a "hard" exit have risen. This means withdrawing from the EU without any agreement on a new regime for trade, labor movements or financial transactions. A growing number of firms are taking the precaution of shifting some operations from the U.K. to other EU countries. As you noted, there are signs that Brexit is starting to undermine the U.K. economy. For example, London house prices have turned down and the leading economic index has softened (Chart 21). The poor performance of U.K. consumer service and real estate equities relative to those of Germany suggest investors are becoming more wary of the U.K. outlook. Of course, a lot will depend on the nature of any deal between the U.K. and the EU and that remains a source of great uncertainty. Chart 20A Turning Point For Italian Banks? A Turning Point For Italian Banks? A Turning Point For Italian Banks? Chart 21U.K. Consumer Services Equities Are ##br##Underperforming Brexit Effects Show Up U.K. Consumer Services Equities Are Underperforming Brexit Effects Show Up U.K. Consumer Services Equities Are Underperforming Brexit Effects Show Up At the moment, there are no real grounds for optimism. The U.K. holds few cards in the bargaining process and the country's strong antipathy toward the free movement of people within the EU will be a big obstacle to an amicable separation agreement. Ms. X: I think the U.K. made the right decision to leave the EU and am more optimistic than you about the outlook. There may be some short-term disruption but the long-term outlook for the U.K. will be good once the country is freed from the stifling bureaucratic constraints of EU membership. The U.K. has a more dynamic economy than most EU members and it will be able to attract plenty of overseas capital if the government pursues appropriate policies toward taxes and regulations. It will take a few years to find out who is correct about this. In the meantime, given the uncertainties, I am inclined to have limited exposure to sterling and the U.K. equity market. Let's now talk about China, another country facing complex challenges. This is a topic where my father and I again have a lot of debates. As you might guess, I have been on the more optimistic side while he has sided with those who have feared a hard landing. And I know that similar debates have occurred in BCA. BCA: It is not a surprise that there are lots of debates about the China outlook. The country's impressive economic growth has been accompanied by an unprecedented build-up of debt and supply excesses in several sectors. The large imbalances would have led to a collapse by now in any other economy. However, China has benefited from the heavy state involvement in the economy and, in particular, the banking sector. The big question is whether the government has enough control over economic developments to avoid an economic and financial crisis. The good news is that China's government debt is relatively low, giving them the fiscal flexibility to write-off bad debts from zombie state-owned enterprises (SOEs). The problems of excessive leverage and over-capacity are particularly acute in SOEs that still comprise a large share of economic activity. The government is well aware of the need to reform SOEs and various measures have been announced, but progress has been relatively limited thus far. The IMF projects that the ratio of total non-financial debt to GDP will remain in an uptrend over the next several years, rising from 236% in 2016 to 298% by 2022 (Chart 22). Yet, growth is expected to slow only modestly over the period. Of course, one would not expect the IMF to build a crisis into their forecast. Some investors have been concerned that a peak in China's mini-cycle of the past two years may herald a return to the economic conditions that prevailed in 2015, when the industrial sector grew at a slower pace than during the acute phase of the global financial crisis. These conditions occurred due to the combination of excessively tight monetary conditions and weak global growth. While China's export growth may slow over the coming year, monetary policy remains accommodative. Monetary conditions appear to have peaked early this year but are still considerably easier than in mid-2015. Shifts in the monetary conditions index have done a good job of leading economic activity and they paint a reasonably positive picture (Chart 23). The industrial sector has finally moved out of deflation, with producer prices rising 6.9% in the year ended October. This has been accompanied by a solid revival in profits. Chart 22China: Debt-Fueled Growth To Continue China: Debt-Fueled Growth To Continue China: Debt-Fueled Growth To Continue Chart 23China Leaves Deflation Behind China Leaves Deflation Behind China Leaves Deflation Behind On balance, we assume that the Chinese economy will be able to muddle through for the foreseeable future. President Xi Jinping has strengthened his grip on power and he will go to great lengths to ensure that his reign is not sullied with an economic crisis. The longer-term outlook will depend on how far the government goes with reforms and deleveraging and we are keeping an open mind at this point. In sum, for the moment, we are siding with Ms. X on this issue. Mr. X: I have been too bearish on China for the past several years, but I still worry about the downside risks given the massive imbalances and excesses. I can't think of any example of a country achieving a soft landing after such a massive rise in debt. I will give you and my daughter the benefit of the doubt, but am not totally convinced that you will be right. BCA has been cautious on emerging economies in general: has that changed? BCA: The emerging world went through a tough time in 2015-16 with median growth of only 2.6% for the 23 constituent countries of the MSCI EM index (Chart 24). This recovered to 3% in 2017 according to IMF estimates, but that is still far below the average 5% pace of the period 2000-07. Chart 24Emerging Economy Growth: ##br##The Boom Years Are Over Emerging Economy Growth: The Boom Years Are Over Emerging Economy Growth: The Boom Years Are Over It is always dangerous to generalize about the emerging world because the group comprises economies with very different characteristics and growth drivers. Two of the largest countries - Brazil and Russia - went through particularly bad downturns in the past couple of years and those economies are now in a modest recovery. In contrast, India has continued to grow at a healthy albeit slowing pace, while Korea and the ASEAN region have not suffered much of a slowdown. If, as seems likely, Chinese growth holds above a 6% pace over the next year, then those countries with strong links to China should do fine. And it also points to reasonably steady commodity prices, supporting resource-dependent economies. Longer-run, there are reasons to be cautious about many emerging economies, particularly if the U.S. goes into recession 2019, as we fear. That would be associated with renewed weakness in commodity prices, and capital flight from those economies with high external debt such as Turkey and South Africa. As we stated a year ago, the heady days of emerging economy growth are in the past. Mr. X: It seems that both my daughter and I can find some areas of agreement with your views about the economic outlook. You share her expectation that the global growth outlook will stay healthy over the coming year, but you worry about a U.S.-led recession in 2019, something that I certainly sympathize with. But we differ on timing: I fear the downturn could occur even sooner and I know my daughter believes in a longer-lasting upturn. Let's now move onto what this all means for financial markets, starting with bonds. Bond Market Prospects Ms. X: I expect this to be a short discussion as I can see little attraction in bonds at current yields. Even though I expect inflation to stay muted, bonds offer no prospect of capital gains in the year ahead and even the running yield offers little advantage over the equity dividend yield. BCA: As you know, we have believed for some time that the secular bull market in bonds has ended. We expect yields to be under upward pressure in most major markets during 2018 and thus share your view that equities offer better return prospects. By late 2018, it might well be appropriate to switch back into bonds against a backdrop of higher yields and a likely bear market in equities. For the moment, we recommend underweight bond exposure. It is hard to like government bonds when the yield on 10-year U.S. Treasuries is less than 50 basis points above the dividend yield of the S&P 500 while the euro area bond yield is 260 basis points below divided yields (Chart 25). Real yields, using the 10-year CPI swap rate as a measure of inflation expectations, are less than 20 basis points in the U.S. and a negative 113 basis points in the euro area. Even if we did not expect inflation to rise, it would be difficult to recommend an overweight position in any developed country government bonds. One measure of valuation is to compare the level of real yields to their historical average, adjusted by the standard deviation of the gap. On this basis, the most overvalued markets are the core euro area countries, where real yields are 1.5 to 2 standard deviations below their historical average (Chart 26). There are only two developed bond markets where real 10-year government yields currently are above their historical average: Greece and Portugal. This is warranted in Greece where there needs to be a risk premium in case the country is forced to leave the single currency at some point. This is less of a risk for Portugal, making it a more interesting market. Real yields in New Zealand are broadly in line with their historical average, also making it one of the more attractive markets. Chart 25Bonds Yields Offer Little Appeal Bonds Yields Offer Little Appeal Bonds Yields Offer Little Appeal Chart 26Valuation Ranking Of Developed Bond Markets 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course Mr. X: Given your expectation of higher inflation, would you recommend inflation-protected Treasuries? BCA: Yes, in the sense that they should outperform conventional Treasuries. The 10-year TIPS are discounting average inflation of 1.85% and we would expect this to be revised up during the coming year. However, the caveat is that absolute returns will still be mediocre. Ms. X: You showed earlier that corporate bonds had a reasonable year in 2017, albeit falling far short of the returns from equities. A year ago, you recommended only neutral weighting in investment-grade bonds and an underweight in high yield. But you became more optimistic toward both early in 2017, shifting to an overweight position. Are you thinking of scaling back exposure once again, given the tight level of spreads? BCA: Yes, we were cautious on U.S. corporates a year ago because valuation was insufficient to compensate for the deterioration in corporate balance sheet health. Nonetheless, value improved enough early in 2017 to warrant an upgrade to overweight given our constructive macro and default rate outlook. The cyclical sweet spot for carry trades should continue to support spread product for a while longer. Moreover, value is better than it appears at first glance. The dotted line in Chart 27 shows the expected 12-month option-adjusted spread for U.S. junk bonds after adjusting for our base case forecast for net default losses. At 260 basis points, this excess spread is in line with the historical average. In the absence of any further spread narrowing, speculative-grade bonds would return 230 basis points more than Treasurys in 2018. If high-yield spreads were to tighten by another 150 basis points, then valuations would be at a historical extreme, and that seems unwarranted. An optimistic scenario would have another 100 basis point spread tightening, delivering excess returns of 5%. Of course, if spreads widen, then corporates will underperform. If financial conditions tighten in 2018 as we expect then it will be appropriate to lower exposure to corporates. In the meantime, you should favor U.S. and U.K. corporate bonds to issues in the Eurozone because ECB tapering is likely to spark some spread widening in that market. Mr. X: What about EM hard-currency bonds? BCA: The global economic background is indeed positive for EM assets. However, EM debt is expensive relative to DM investment-grade bonds which, historically, has heralded a period of underperformance (Chart 28). We expect that relative growth dynamics will be more supportive of U.S. corporates because EM growth will lag. Any commodity price weakness and/or a stronger U.S. dollar would also weigh on EM bonds and currencies. Chart 27Not Much Value In U.S. Corporates Not Much Value In U.S. Corporates Not Much Value In U.S. Corporates Chart 28Emerging Market Bonds Are Expensive Emerging Market Bonds Are Expensive Emerging Market Bonds Are Expensive Mr. X: We have not been excited about the bond market outlook for some time and nothing you have said changes my mind. I am inclined to keep our bond exposure to the bare minimum. Ms. X: I agree. So let's talk about the stock market which is much more interesting. As I mentioned before, I am inclined to remain fully invested in equities for a while longer, while my father wants to start cutting exposure. Equity Market Outlook BCA: This is one of those times when it is important to draw a distinction between one's forecast of where markets are likely to go and the appropriate investment strategy. We fully agree that the conditions that have driven this impressive equity bull market are likely to stay in place for much of the next year. Interest rates in the U.S. and some other countries are headed higher, but they will remain at historically low levels for some time. Meanwhile, in the absence of recession, corporate earnings still have upside, albeit not as much as analysts project. However, we have a conservative streak at BCA that makes us reluctant to chase markets into the stratosphere. For long-term investors, our recommended strategy is to gradually lower equity exposure to neutral. However, those who are trying to maximize short-term returns should stay overweight and wait for clearer signs that tighter financial conditions are starting to bite on economic activity. Chart 29Reasons For Caution On U.S. Stocks Reasons For Caution On U.S. Stocks Reasons For Caution On U.S. Stocks Getting down to specifics, here are the trends that give us cause for concern and they are all highlighted in Chart 29. Valuation: Relative to both earnings and book value, the U.S. equity market is more expensive than at any time since the late 1990s tech bubble. The price-earnings ratio (PER) for the S&P 500 is around 30% above its 60-year average on the basis of both trailing operating earnings and a 10-year average of earnings. The market is not expensive on a relative yield basis because interest rates are so low, but that will change as rates inevitably move higher. Other developed markets are not as overvalued as the U.S., but neither are they cheap. Earnings expectations: The performance of corporate earnings throughout this cycle - particularly in the U.S. - has been extremely impressive give the weaker-than-normal pace of economic growth. However, current expectations are ridiculously high. According to IBES data, analysts expect long-run earnings growth of around 14% a year in both the U.S. and Europe. Even allowing for analysts' normal optimistic bias, the sharp upward revision to growth expectations over the past year makes no sense and is bound to be disappointed. Investor complacency: We all know that the VIX index is at a historical low, indicating that investors see little need to protect themselves against market turmoil. Our composite sentiment indicator for the U.S. is at a high extreme, further evidence of investor complacency. These are classic contrarian signs of a vulnerable market. Most bear markets are associated with recessions, with the stock market typically leading the economy by 6 to 12 months (Chart 30). The lead in 2007 was an unusually short three months. As discussed earlier, we do not anticipate a U.S. recession before 2019. If a recession were to start in mid-2019, it would imply the U.S. market would be at risk from the middle of 2018, but the rally could persist all year. Of course, the timing of a recession and market is uncertain. So it boils down to potential upside gains over the next year versus the downside risks, plus your confidence in being able to time the top. Chart 30Bear Markets And Recessions Usually Overlap Bear Markets And Recessions Usually Overlap Bear Markets And Recessions Usually Overlap We are not yet ready to recommend that you shift to an underweight position in equities. A prudent course of action would be to move to a broadly neutral position over the next few months, but we realize that Ms. X has a higher risk tolerance than Mr. X so we will leave you to fight over that decision. The timing of when we move to an underweight will depend on our various economic, monetary and market indicators and our assessment of the risks. It could well happen in the second half of the year. Mr. X: My daughter was more right than me regarding our equity strategy during the past year, so maybe I should give her the benefit of the doubt and wait for clearer signs of a market top. Thus far, you have focused on the U.S. market. Last year you preferred developed markets outside the U.S. on the grounds of relative valuations and relative monetary conditions. Is that still your stance? BCA: Yes it is. The economic cycle and thus the monetary cycle is far less advanced in Europe and Japan than in the U.S. This will provide extra support to these markets. At the same time, profit margins are less vulnerable outside the U.S. and, as you noted, valuations are less of a problem. In Chart 31, we show a valuation ranking of developed equity markets, based on the deviation of cyclically-adjusted PERs from their historical averages. The chart is not meant to measure the extent to which Portugal is cheap relative to the U.S., but it indicates that Portugal is trading at a PER far below its historical average while that of the U.S. is above. You can see that the "cheaper" markets tend to be outside the U.S. Japan's reading is flattered by the fact that its historical valuation was extremely high during the bubble years of the 1980s, but it still is a relatively attractive market. Chart 31Valuation Ranking Of Developed Equity Markets 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course From a cyclical standpoint, we are still recommending overweight positions in European and Japanese stocks relative to the U.S., on a currency-hedged basis. Nevertheless, market correlations are such that a sell-off in the U.S. will be transmitted around the world (Chart 32). Chart 32When the U.S. Market Sneezes, The World Catches A Cold When the U.S. Market Sneezes, The World Catches A Cold When the U.S. Market Sneezes, The World Catches A Cold Ms. X: I would like to turn the focus to emerging equity markets. You have been cautious on these for several years and that worked out extremely well until 2017. I note from your regular EM reports that you have not changed your stance. Why are you staying bearish given that you see an improvement in global growth and further potential upside in developed equity prices? BCA: The emerging world did extremely well over many years when global trade was expanding rapidly, China was booming, commodity prices were in a powerful bull market and capital inflows were strong. Those trends fostered a rapid expansion in credit-fueled growth across the EM universe and meant that there was little pressure to pursue structural reforms. However, the 2007-09 economic and financial crisis marked a major turning point in the supports to EM outperformance. As we noted earlier, the era of rapid globalization has ended, marking an important regime shift. Meanwhile, China's growth rate has moderated and the secular bull market in commodities ended several years ago. We do not view the past year's rebound in commodities as the start of a major new uptrend. Many emerging equity markets remain highly leveraged to the Chinese economy and to commodity prices (Chart 33). Although we expect the Chinese economy to hold up, growth is becoming less commodity intensive. Finally, the rise in U.S. interest rates is a problem for those countries that have taken on a marked increase in foreign currency debt. This will be made even worse if the dollar appreciates. Obviously, the very term "emerging" implies that this group of countries has a lot of upside potential. However, the key to success is pursuing market-friendly reforms, rooting out corruption and investing in productive assets. Many countries pay only lip service to these issues. India is a case in point where there is growing skepticism about the Modi government's ability to deliver on major reforms. The overall EM index does not appear expensive, with the PER trading broadly in line with its historical average (Chart 34). However, as we have noted in the past, the picture is less compelling when the PER is calculated using equally-weighted sectors. The financials and materials components are trading at historically low multiples, dragging down the overall index PER. Emerging market equities will continue to rise as long as the bull market in developed markets persists, but we expect them to underperform on a relative basis. Chart 33Drivers Of EM Performance Drivers of EM Performance Drivers of EM Performance Chart 34Emerging Markets Fundamentals Emerging Markets Fundamentals Emerging Markets Fundamentals Mr. X: One last question on equities from me: do you have any high conviction calls on sectors? BCA: A key theme of our sector view is that cyclical stocks should outperform defensives given the mature stage of the economic cycle. We are seeing the typical late-cycle improvement in capital spending and that will benefit industrials, and we recommend an overweight stance in that sector. Technology also is a beneficiary of higher capex but of course those stocks have already risen a lot, pushing valuations to extreme levels. Thus, that sector warrants only a neutral weighting. Our two other overweights are financials and energy. The former should benefit from rising rates and a steeper yield curve while the latter will benefit from firm oil prices. If, as we fear, a recession takes hold in 2019, then obviously that would warrant a major shift back into defensive stocks. For the moment, the positive growth outlook will dominate sector performance. Ms. X: I agree that the bull market in equities, particularly in the U.S., is very mature and there are worrying signs of complacency. However, the final stages of a market cycle can sometimes be very rewarding and I would hate to miss out on what could be an exciting blow-off phase in 2018. As I mentioned earlier, my inclination is to stay heavily invested in equities for a while longer and I have confidence that BCA will give me enough of a warning when risks become unacceptably high. Of course, I will have to persuade my father and that may not be easy. Mr. X: You can say that again, but we won't bother our BCA friends with that conversation now. It's time to shift the focus to commodities and currencies and I would start by commending you on your oil call. You were far out of consensus a year ago when you said the risks to crude prices were in the upside and you stuck to your guns even as the market weakened in the first half. We made a lot of money following your energy recommendations. What is your latest thinking? Commodities And Currencies BCA: We had a lot of conviction in our analysis that the oil market would tighten during 2017 against a backdrop of rising demand and OPEC production cuts, and that view turned out to be correct. As we entered the year, the big reason to be bearish on oil prices was the bloated level of inventories. We forecast that inventories would drop to their five-year average by late 2017, and although that turned out to be a bit too optimistic, the market tightened by enough to push prices higher (Chart 35). Chart 35Oil Market Trends Oil Market Trends Oil Market Trends The forces that have pushed prices up will remain in force over the next year. Specifically, our economic view implies that demand will continue to expand, and we expect OPEC 2.0 - the producer coalition of OPEC and non-OPEC states, led by Saudi Arabia and Russia - to extend its 1.8 million b/d production cuts to at least end-June. On that basis, OECD inventories should fall below their five-year average by the end of 2018. We recently raised our 2018 oil price target to an average of $65 in 2018. Of course, the spot market is already close to that level, but the futures curve is backwardated and that is likely to change. We continue to see upside risks to prices, not least because of potential production shortfalls from Venezuela, Nigeria, Iraq and Libya. Mr. X: The big disruptor in the oil market in recent years was the dramatic expansion in U.S. shale production. Given the rise in prices, could we not see a rapid rebound in shale output that, once again, undermines prices? BCA: Our modeling indicates that U.S. shale output will increase from 5.1 mb/d to 6.0 mb/d over the next year, in response to higher prices. This is significant, but will not be enough to materially change the global oil demand/supply balance. Longer run, the expansion of U.S. shale output will certainly be enough to prevent any sustained price rise, assuming no large-scale production losses elsewhere. A recent report by the International Energy Agency projected that the U.S. is destined to become the global leader in oil and gas production for decades to come, accounting for 80% of the rise in global oil and gas supply between 2010 and 2025. Ms. X: You have suggested that China's economic growth is becoming less commodity intensive. Also, you have shown in the past that real commodity prices tend to fall over time, largely because of technological innovations. What does all this imply for base metals prices over the coming year? BCA: The base metals story will continue to be highly dependent on developments in China. While the government is attempting to engineer a shift toward less commodity-intensive growth, it also wants to reduce excess capacity in commodity-producing sectors such as coal and steel. Base metals are likely to move sideways until we get a clearer reading on the nature and speed of economic reforms. We model base metals as a function of China's PMIs and this supports our broadly neutral stance on these commodities (Chart 36). Chart 36China Drives Metals Prices 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course Mr. X: As usual, I must end our commodity discussion by asking about gold. Last year, you agreed that an uncertain geopolitical environment coupled with continued low interest rates should support bullion prices, and that was the case with a respectable 12% gain since the end of 2016. You also suggested that I should not have more than 5% of my portfolio in gold which is less than I am inclined to own. It still looks like a gold-friendly environment to me. Ms. X: Let me just add that this is one area where my father and I agree. I do not consider myself to be a gold bug, but I think bullion does provide a good hedge against shocks in a very uncertain economic and political world. I would also be inclined to hold more than 5% of our portfolio in gold. BCA: There will be opposing forces on gold during the coming year. On the positive side, it is safe to assume that geopolitical uncertainties will persist and may even intensify, and there also is the potential for an increase in inflation expectations that would support bullion. On the negative side, rising interest rates are not normally good for gold and there likely will be an added headwind from a firmer U.S. dollar. Gold appears to be at an important point from a technical perspective (Chart 37). It currently is perched just above its 200-day average and a key trend line. A decisive drop below these levels would be bearish. At the same time, there is overhead resistance at around 1350-1360 and prices would have to break above that level to indicate a bullish breakout. Traders' sentiment is at a broadly neutral level, consistent with no clear conviction about which way prices will break. There is no science behind our recommendation of keeping gold exposure below 5%. That just seems appropriate for an asset that delivers no income and where the risk/reward balance is fairly balanced. Ms. X: You referred to the likelihood of a firmer dollar as a depressant on the gold price. You also were bullish on the dollar a year ago, but that did not work out too well. How confident are you that your forecast will fare better in 2018? BCA: We did anticipate that the dollar would experience a correction at the beginning of 2017, but we underestimated how profound this move would be. A combination of factors explains this miscalculation. Chart 37Gold At A Key Level Gold At A Key Level Gold At A Key Level It first began with positioning. We should have paid more attention to that fact that investors were massively bullish and long the dollar at the end of 2016, making the market vulnerable to disappointments. And disappointment did come with U.S. inflation weakening and accelerating in the euro area. Additionally, there were positive political surprises in Europe, especially the presidential victory of Emmanuel Macron in France. In the U.S., the government's failure to repeal Obamacare forced investors to lower expectations about fiscal stimulus. As a result, while investors were able to price in an earlier first hike by the ECB, they cut down the number of rate hikes they anticipated out of the Fed over the next 24 months. In terms of the current environment, positioning could not be more different because investors are aggressively shorting the dollar (Chart 38). The hurdle for the dollar to deliver positive surprises is thus much lower than a year ago. Also, we remain confident that tax cuts will be passed in the U.S. by early 2018. As we discussed earlier, U.S. GDP will remain above potential, causing inflation pressures to build. This will give the Fed the leeway to implement its planned rate hikes, and thus beat what is currently priced in the market. This development should support the dollar in 2018. Ms. X: A bullish view on the U.S. dollar necessarily implies a negative view on the euro. However, the European economy seems to have a lot of momentum, and inflation has picked up, while U.S. prices have been decelerating. To me, this suggests that the ECB also could surprise by being more hawkish than anticipated, arguing against any major weakness in the euro. BCA: The European economy has indeed done better than generally expected in the past year. Also, geopolitical risks were overstated by market participants at the beginning of 2017, leaving less reason to hide in the dollar. However, the good news in Europe is now well known and largely discounted in the market. Investors are very long the euro, by both buying EUR/USD and shorting the dollar index (Chart 39). In that sense, the euro today is where the dollar stood at the end of 2016. Chart 38Too Much Pessimism On The Dollar Too Much Pessimism On The Dollar Too Much Pessimism On The Dollar Chart 39Positioning Risk In EUR/USD Positioning Risk In EUR/USD Positioning Risk In EUR/USD Valuations show a similar picture. The euro might appear cheap on a long-term basis, but not so much so that its purchasing power parity estimate - which only works at extremes and over long-time periods - screams a buy. Moreover, the euro has moved out of line with historical interest rate parity relationships, warning that the currency is at risk if the economy disappoints. Overall, we expect EUR/USD to trade around 1.10 in 2018. Long-run, the picture is different because a U.S. recession in 2019 would trigger renewed broad-based weakness in the dollar. Mr. X: I have been perplexed by the yen's firmness in the past year, with the currency still above its end-2016 level versus the dollar. I expected a lot more weakness with the central bank capping bond yields at zero and more or less monetizing the government deficit. A year ago you also predicted a weak yen. Will it finally drop in 2018? BCA: We were not completely wrong on the yen as it has weakened over the past year on a trade-weighted basis and currently is about 2% below its end-2016 level. But it has risen slightly against the U.S. dollar. In the past couple of years, the yen/dollar rate has been highly correlated with real bond yield differentials (Chart 40). These did not move against the yen as much as we expected because U.S. yields drifted lower and there was no major change in relative inflation expectations. Chart 40Bond Yield Differentials Drive The Yen Bond Yield Differentials Drive The Yen Bond Yield Differentials Drive The Yen The real yield gap is likely to move in the dollar's favor over the next year, putting some downward pressure on the yen. Meanwhile, the Bank of Japan will continue to pursue a hyper-easy monetary stance, in contrast to the Fed's normalization policy. However, it is not all negative: the yen is cheap on a long-term basis, and Japan is an international net creditor to the tune of more than 60% of GDP. Investors are also quite short the yen as it remains a key funding currency for carry trades. Thus, it will continue to benefit each time global markets are gripped with bouts of volatility. It remains a good portfolio hedge. Ms. X: Are any other currency views worth noting? BCA: The outlook for sterling obviously will be tied to the Brexit negotiations. Having fallen sharply after the Brexit vote, sterling looks cheap relative to its history. This has allowed it to hold in a broad trading range over the past 18 months, even though the negotiations with the EU have not been going well. At this stage, it is hard to know what kind of deal, if any, will emerge regarding Brexit so we would hedge exposure to sterling. Our optimism toward the oil price is consistent with a firm Canadian dollar, but developments in the NAFTA negotiations represent a significant risk. At the moment, we are overweight the Canadian dollar, but that could change if the NAFTA talks end badly. We still can't get enthusiastic about emerging market currencies even though some now offer reasonable value after falling sharply over the past few years. Mr. X: We can't leave currencies without talking about Bitcoin and cryptocurrencies in general. I like the idea of a currency that cannot be printed at will by governments. There are too many examples of currency debasement under a fiat money system and the actions of central banks in recent years have only served to increase my mistrust of the current monetary system. But I can't profess to fully understand how these cryptocurrencies work and that makes me nervous about investing in them. What are your thoughts? BCA: You are right to be nervous. There have been numerous cases of hackers stealing Bitcoins and other cryptocurrencies. Also, while there is a limit to the number of Bitcoins that can be issued, there is no constraint on the number of possible cryptocurrencies that can be created. Thus, currency debasement is still possible if developers continue creating currencies that are only cosmetically different from the ones already in existence. Moreover, we doubt that governments will sit idly by and allow these upstart digital currencies to become increasingly prevalent. The U.S. Treasury derives $70 billion a year in seigniorage revenue from its ability to issue currency which it can then redeem for goods and services. At some point, governments could simply criminalize the use of cryptocurrencies. This does not mean that Bitcoin prices cannot rise further, but the price trend is following the path of other manias making it a highly speculative play (Chart 41). If you want more detail about our thoughts on this complex topic then you can read the report we published last September.2 Chart 41Bitcoin Looks Like Other Bubbles Bitcoin Looks Like Other Bubbles Bitcoin Looks Like Other Bubbles Ms. X: I don't fear bubbles and manias as much as my father and have made a lot of money during such episodes in the past. But I am inclined to agree that Bitcoin is best avoided. The topic of manic events presents a nice segue into the geopolitical environment which seems as volatile as ever. Geopolitics Ms. X: Which geopolitical events do you think will have the biggest impact on the markets over the coming year? BCA: Domestic politics in the U.S. and China will be very much in focus in 2018. In the U.S., as we discussed, the Republicans will pass tax cuts but it is unclear whether this will help the GOP in the November midterm elections. At this point, all of our data and modeling suggests that Democrats have a good chance of picking up the House of Representatives, setting a stage for epic battles with President Trump about everything under the sun. In China, we are watching carefully for any sign that Beijing is willing to stomach economic pain in the pursuit of economic reforms. The two reforms that would matter the most are increased financial regulation and more aggressive purging of excess capacity in the industrial sector. The 19th Party Congress marked a serious reduction in political constraints impeding President Xi's domestic agenda. This means he could launch ambitious reforms, akin to what President Jiang Zemin did in the late 1990s. While this is a low-conviction view, and requires constant monitoring of the news and data flow out of China, it would be a considerable risk to global growth. Reforms would be good for China's long-term outlook, but could put a significant damper on short-term growth. The jury is out, but the next several months will be crucial. Three other issues that could become market-relevant are the ongoing North Korean nuclear crisis, trade protectionism, and tensions between the Trump administration and Iran. The first two are connected because a calming of tensions with North Korea would give the U.S. greater maneuvering room against China. The ongoing economic détente between the U.S. and China is merely a function of President Trump needing President Xi's cooperation on pressuring North Korea. But if President Trump no longer needs China's help with Kim Jong-Un, he may be encouraged to go after China on trade. As for Iran, it is not yet clear if the administration is serious about ratcheting up tensions or whether it is playing domestic politics. We suspect it is the latter implying that the market impact of any brinkmanship will be minor. But our conviction view is low. Mr. X: We seem to be getting mixed messages regarding populist pressures in Europe. The far right did not do as well as expected in the Netherlands or France, but did well in Austria. Also, Merkel is under some pressure in Germany. BCA: We don't see much in the way of mixed messages, at least when it comes to support for European integration. In Austria, the populists learned a valuable lesson from the defeats of their peers in the Netherlands and France: stay clear of the euro. Thus the Freedom Party committed itself to calling a referendum on Austria's EU membership if Turkey was invited to join the bloc. As the probability of that is literally zero, the right-wing in Austria signaled to the wider public that it was not anti-establishment on the issue of European integration. In Germany, the Alternative for Germany only gained 12.6%, but it too focused on an anti-immigration platform. The bottom line for investors is that the European anti-establishment right is falling over itself to de-emphasize its Euroskepticism and focus instead on anti-immigration policies. For investors, the former is far more relevant than the latter, meaning that the market relevance of European politics has declined. One potential risk in 2018 is the Italian election, likely to be held by the end of the first quarter. However, as with Austria, the anti-establishment parties have all moved away from overt Euroskepticism. At some point over the next five years, Italy will be a source of market risk, but in this electoral cycle and not with economic growth improving. Ms. X: The tensions between the U.S. and North Korea, fueled by two unpredictable leaders, have me very concerned. I worry that name-calling may slide into something more serious. How serious is the threat? BCA: The U.S.-Iran nuclear negotiations are a good analog for the North Korean crisis. The U.S. had to establish a "credible threat" of war in order to move Iran towards negotiations. As such, the Obama administration ramped up the war rhetoric - using Israel as a proxy - in 2011-2012. The negotiations with Iran did not end until mid-2015, almost four years later. We likely have seen the peak in "credible threat" display this summer between the U.S. and North Korea. The next two-to-three months could revisit those highs as North Korea responds to President Trump's visit to the region, as well as to the deployment of the three U.S. aircraft carriers off the coast of the Korean Peninsula. However, we believe that we have entered the period of "negotiations." It is too early to tell how the North Korean crisis will end. We do not see a full out war between either of the main actors. We also do not see North Korea ever giving up its nuclear arsenal, although limiting its ballistic technology and toning down its "fire and brimstone' rhetoric is a must. The bottom line is that this issue will remain a source of concern and uncertainty for a while longer. Conclusions Mr. X: This seems a good place to end our discussion. We have covered a lot of ground and your views have reinforced my belief that it would make good sense to start lowering the risk in our portfolio. I know that such a policy could leave money on the table as there is a reasonable chance that equity prices may rise further. But that is a risk I am prepared to take. Ms. X: I foresee some interesting discussions with my father when we get back to our office. At the risk of sounding reckless, I remain inclined to stay overweight equities for a while longer. I am sympathetic to the view that the era of hyper-easy money is ending and at some point that may cause a problem for risk assets. However, timing is important because, in my experience, the final stages of a bull market can deliver strong gains. BCA: Good luck with those discussions! We have similar debates within BCA between those who want to maximize short-run returns and those who take a longer-term view. Historically, BCA has had a conservative bias toward investment strategy and the bulk of evidence suggests that this is one of these times when long-run investors should focus on preservation of capital rather than stretching for gains. Our thinking also is influenced by our view that long-run returns will be very poor from current market levels. Our estimates indicate that a balanced portfolio will deliver average returns of only 3.3% a year over the coming decade, or 1.3% after inflation (Table 3). That is down from the 4% and 1.9% nominal and real annual returns that we estimated a year ago, reflecting the current more adverse starting point for valuations. There is a negligible equity risk premium on offer, implying that stock prices have to fall at some point to establish higher prospective returns. Table 310-Year Asset Return Projections 2018 Outlook - Policy And The Markets: On A Collision Course 2018 Outlook - Policy And The Markets: On A Collision Course The return calculations for equities assume profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or PERs stay at historically high levels. In that case, equities obviously would do better than our estimates. In terms of the outlook for the coming year, a lot will depend on the pace of economic growth. We are assuming that growth is strong enough to encourage central banks to keep moving away from hyper-easy policies, setting up for a collision with markets. If growth slows enough that recession fears spike, then that also would be bad for risk assets. Sustaining the bull market requires a goldilocks growth outcome of not too hot and not too cold. That is possible, but we would not make it our base case scenario. Ms. X: You have left us with much to think about and I am so glad to have finally attended one of these meetings. My father has always looked forward to these discussions every year and I am very happy to be joining him. Many thanks for taking the time to talk to us. Before we go, it would be helpful to have a recap of your key views. BCA: That will be our pleasure. The key points are as follows: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflation pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets. The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the odds of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the euro area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China's economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their "dots" projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal currently have 10-year government bond real yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The euro area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 20, 2017 1 This comprises consumer spending on durables, housing and business investment in equipment and software. 2 Please see 'Bitcoin's Macro Impact', BCA Global Investment Strategy Special Report, September 15, 2017.

Highlights The recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Credit spreads would need to widen significantly more to signal that a recession is imminent. What asset classes would benefit if the curve steepens and oil prices rise? Risk assets tend to do better the year before a tax cut than they do the year after. Feature BCA's view is that global growth is on solid footing. EPS growth in the U.S. is in the process of peaking, but will be relatively robust through the end of 2018. If our view is correct, U.S. stocks will outperform bonds in the next 12 months. Nonetheless, last week investors took profits in oil, the dollar, high-yield bonds and U.S. equities as the 2/10 Treasury curve flattened to just 65 bps, the lowest reading in 10 years (Chart 1). The risk aversion occurred amid concern about global growth, waning prospects for the GOP tax cut, and higher odds of a Fed policy mistake. Moreover, financial conditions tightened last week. Chart 1BCA Expects The Curve To Steepen In The Next 12 Months BCA Expects The Curve To Steepen In The Next 12 Months BCA Expects The Curve To Steepen In The Next 12 Months Even so, the recent price action in the credit markets is disconcerting; it challenges BCA's bullish view and raises the odds of an equity market correction in the near term. Junk bonds have sold off in recent weeks, along with EM credit and currencies. In general, credit trends lead the stock market. Moreover, a recent Bank of America Merrill Lynch Survey found that a record share of fund managers are overweight risk assets. Any delay in passage of the tax plan could be the trigger for a correction. BCA's U.S. Equity strategists' views on financial and energy sectors run counter to the recent market action.1 Our position is that financials will benefit from a steeper yield curve and that a drawdown in inventories and robust global oil demand will allow oil prices to rise and energy shares to outperform the S&P 500. Later in this report, we will examine how other risk assets perform as the yield curve steepens and oil prices climb. We also investigate the efficacy of using the high-yield bond market to time equity market pullbacks and recessions. In addition, with investors concerned about the GOP tax bill, we evaluate the performance of U.S. financial market assets, commodities and earnings before and after stimulative fiscal policy is enacted. Slack Is Disappearing The health of the U.S. economy in Q4 is not a concern. Data released last week was solid on October's retail sales, small business optimism and industrial production. Moreover, the November readings on the Empire State and Philadelphia Fed's manufacturing indices support BCA's view that the output gap is narrowing. However, some of the bright readings on the economy in October may reflect a snap back from Hurricanes Harvey and Irma. The November 17 readings on Q4 real GDP from both the Atlanta Fed's GDP Now (+3.4%) and the New York Fed's Nowcast (+3.8%) show the economy is running hot. Inflation-adjusted GDP growth of 3.0% or more in Q4 indicates year-over-year GDP growth is well above the Fed's view of both potential GDP growth (1.8%) and its estimate for 2017 (2.4%). Above-potential economic expansion will ultimately lead to higher inflation, given the ever tightening labor market. Despite tightening in the past week, financial conditions have eased in the past year. The implication is that GDP growth in the U.S. is set to accelerate in the coming quarters (Chart 2). The October CPI data provide the Fed with enough reason to bump up rates again next month. The annual core inflation rate ticked up to 1.8% from 1.7%. However, it is still below the roughly 2.4% pace that would be consistent with the core PCE deflator reaching the Fed's 2% target. While inflation is still below-target, there were two encouraging signs in the report. First, BCA's CPI diffusion index nudged back above the zero line. Secondly, core services (ex-shelter and medical care) are showing signs of accelerating. This sub-component of core CPI is the most correlated with wages (Chart 3, panel 4). Fed officials will get one additional reading each on CPI (December 13), the PCE deflator (November 30), and wage inflation (December 8), before the end of the December 12-13 FOMC meeting. Chart 2Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 3October CPI Provides Cover For The Fed October CPI Provides Cover For The Fed October CPI Provides Cover For The Fed Bond Market Message The recent widening of credit spreads is not a signal that a recession is imminent. Chart 4 shows that peaks in key credit market metrics are lagging indicators of recession. While the recent spread widening is worrisome on its own, spreads would need to widen significantly more to signal that a recession is imminent. BAA quality spreads, the prepayment and liquidity risk spread (AAA corporate bond yield less 10-year Treasury) and the default risk spread (BAA minus AAA quality spread) are at or close to multi-decade lows.2 BCA does not believe that the spike in all these metrics in late 2015 was a signal that the economy was in or just exiting recession. Rather, the spread widening was related to the collapse in oil prices between mid-2014 and early 2016. BCA's Commodity & Energy Strategy service forecasts oil prices to rise as high as $70 per barrel in 2018.3 Chart 4Spreads Would Need To Widen Significantly More To Signal A Recession Spreads Would Need To Widen Significantly More To Signal A Recession Spreads Would Need To Widen Significantly More To Signal A Recession That said, these spreads tend to trough just prior to the onset of a recession. In longer expansions in the '60s, '80s, and '90s, bottoms in spreads occurred in mid-cycle. Credit spreads bottomed at the onset of recessions in the early 1960s, late 1960s, mid-1970s and early 1980s. The BAA quality spread and the prepayment and liquidity risk spreads bottomed six months before the onset of the 2007-2009 recession. However, the default risk spread formed a bottom in late 2004, three years before the end of a cycle (Chart 4). Spreads on lower-rated high-yield debt provide slightly earlier signals than those listed above. In the mid-1990s, spreads on BB- and CCC-rated U.S. corporate debt troughed in late 1998 as Russia defaulted, oil prices collapsed and LTCM failed. The signal came more than two years before the onset of the 2001 recession. In the mid-2000s, these spreads formed a bottom in late 2004/early 2005, three years before the 2007-2009 recession. The CCC- and BB-rated OAS spreads in this cycle initially bottomed in mid-2014 as oil price peaked. BB-rated spreads are below their mid-2014 trough, but spreads on CCC-rated debt are not (Chart 5). Chart 5HY Credit Still Outperforming Treasuries HY Credit Still Outperforming Treasuries HY Credit Still Outperforming Treasuries Investors question if the widening of spreads is a signal for other markets, especially the equity market. BCA finds that signals from the credit markets for equity markets are short-lived. Table 1 shows that the 13-week change in high-yield OAS is coincident to changes in S&P 500 prices. Often, stocks have already changed direction before any significant sell-off in the high-yield market. Rising spreads of more than 100 basis points tend to last for an average of 16 weeks and are accompanied by a 6% drop in the S&P 500. The only episode when a peak in spreads was not associated with a drop in equity prices occurred in 2001, as the S&P 500 rebounded in the wake of the 9/11 terrorist attacks. Table 1Stock Market Warning? Time To Worry? Time To Worry? Rising default rates are a necessary pre-condition for a prolonged interval of escalating spreads. Chart 6 shows the peaks in high-yield OAS spreads, along with the S&P, the VIX and Moody's trailing and forward default rates. In seven of the eight periods, spread widening occurred alongside a rising default rate. The only exception was in 2002 when spreads widened despite a fall in the default rate as accounting scandals rocked corporate America. Today, the default rate is low and falling. BCA's U.S. Bond Strategy team expects the default rate to move modestly lower in the next 12 months.4 Chart 6Spread Widening, Recessions, S&P 500 And Vol Spread Widening, Recessions, S&P 500 And Vol Spread Widening, Recessions, S&P 500 And Vol Bottom Line: The recent widening in credit spreads is one of the factors driving our cautious tactical stance on the U.S. equity market. Despite our near-term concern, BCA favors investment-grade credit and high-yield bonds over Treasuries in the next 12 months. Rising Oil And A Steeper Yield Curve BCA expects that oil prices will move 25% higher to $70/bbl in the next 12 months and that the yield curve will steepen. Above potential economic growth, tightening labor markets and rising inflation expectations will push up the long end of the Treasury curve, while the Fed lags the inflation upturn, leading initially to a steeper curve. What other asset classes would benefit if BCA's call is accurate? Chart 7 and Chart 8 show periods when oil prices rise and the yield curve steepens along with the performance of several key financial markets. Since 1970, there were five periods when oil prices moved higher and seven when the curve steepened. There are several years when both occurred at the same time, and many of these intervals also overlapped with recessions. Chart 7Lessons From Periods Of Rising Oil Prices Lessons From Periods Of Rising Oil Prices Lessons From Periods Of Rising Oil Prices Chart 8Lessons From Periods Of A Steepening Yield Curve Lessons From Periods Of A Steepening Yield Curve Lessons From Periods Of A Steepening Yield Curve The stock-to-bond ratio climbs when oil prices are rising, including the most recent episode. The S&P 500 outperformed the 10-year Treasury between 2009 and 2014 alongside oil prices, in the second half of the 1998-2008 run up in prices, and in the mid-1980s. However, during the rally in oil in the mid-to-late 1970s, stocks and bonds performed similarly. Both investment-grade and high-yield bonds outpace Treasuries as oil prices escalate. Investment-grade corporates outperformed in each of the five periods. Junk bonds struggled in the late 1980s as oil prices rose and then cruised in the 1990s, but trailed Treasuries in the first half of the 1998-2008 oil boom, finally catching up late in the cycle. The peak in both investment-grade and high-yield's performance versus Treasuries came in June 2007, providing a 12-month advance warning that oil prices had peaked for the cycle. Credit outpaced Treasuries in both oil rallies since the end of the 2007-2009 recession. Small cap performance during oil price rallies is mixed. Small caps beat large caps in the late 1970s, but underperformed in the mid-1980s. Small caps trounced large caps in the first half of the 1998-2008 energy price rally; large caps ran up and then back down again as the tech bubble swelled and then burst. Small caps only kept pace with large as energy prices soared between 2005 and 2008. Small caps eked out modest gains versus large between 2009 and 2014, and since 2016. Today, the energy sector's weight in the small cap sector is 3%, but it has ranged from 2% (2015) to 13% (2008) since 2001. Gold performs well as energy prices increase, aided in part by a weaker dollar. Gold climbed and the dollar fell during all five periods of expanding oil prices. There were several phases (mid-to-late 1980s, early 2000s and earlier this year) when the dollar mounted along with oil prices. Gold moved sideways at times as oil rose, but ultimately gold trended higher. BCA's stock-to-bond ratio generally moves lower as the curve steepens. Nonetheless, there are a few distinct but brief stages (late 1970s, mid 2000s, and 2009-10) when stocks beat bonds. There is not much difference between the performance of either investment-grade or high-yield credit in each of the six periods of curve steepening, but several shifts in a few of these cycles that overlapped with recessions are notable. Credit underperformed Treasuries in the early 1990s, early 2000s and mid-2000s as the economy entered recession, but then outperformed as the recession ended and the curve continued to steepen. Small cap performance as the curve steepens is mixed. As with credit, small caps underperform large on the way into recession as the curve steepens, but outperform after the recession ends. Recessions were not a significant factor in the performance pattern for gold and the dollar during curve steepening. Gold climbed in four of the seven periods of curve steepening, but changed little in the late 1980s/early 1990s episode. Gold declined sharply along with inflation and inflationary expectations in the early 1980s. The dollar moved significantly higher in just one of the seven periods (early 1980s) and was mixed-to-lower in the others. Bottom Line: BCA's bullish stance on the energy and financials sectors in the next 12 months is driven by our view that oil prices will continue to rally and that the Treasury yield curve will steepen as U.S. economic growth accelerates and inflation moved back to the Fed's 2% target. Stocks typically beat bonds as oil prices rally, but stocks generally underperform as the curve steepens. Gold advances under either scenario, while the dollar moves lower when the curve steepens and oil prices rise. The performance of credit and small caps in these episodes is sensitive to the business cycle. Hooray For Tax Cuts? BCA's Geopolitical Strategy team expects the GOP to pass a tax cut bill by the end of Q1 2018.5 Furthermore, the bill should provide a small but positive boost for the U.S. economy, and be neutral for EPS in the 10-year lifetime of the cuts. Chart 9 and Table 2 show that there have been seven periods since 1970 when the OECD's measure of "fiscal thrust"6 climbed. On average, stocks underperform bonds, although both are higher on average. Investment-grade corporate debt beats Treasuries, but high-yield underperforms as fiscal stimulus swells. Small caps (relative to large), gold, oil and the dollar, all are winners. Chart 9Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Equities, Bonds, Commodities And The Dollar Vs. Fiscal Stimulus Treasuries are the most consistent performers when fiscal policy boosts the economy, advancing in each of the seven episodes. Small caps beat large and the S&P 500 rises in five of the seven periods. The process to propose, debate, and enact significant fiscal stimulus can be a long one, and in many cases, investors deduce that a fiscal boost is on the way well before it is passed into law. Accordingly, risk assets tend to outperform a year before a tax plan is passed. On average, stocks beat bonds, small caps do better than large caps, and both gold and oil accelerate a year before fiscal thrust starts to intensify. Corporate and high-yield bonds keep pace with Treasuries during these episodes. The S&P 500 jumps nearly 10% a year prior to an increase in fiscal thrust, while the total return on Treasuries rises by 5% and the dollar is flat (Table 3). Table 2 and 3Impact Of Fiscal Policy On Markets, The Dollar And Earnings Time To Worry? Time To Worry? The most consistent performers as fiscal thrust is priced in are small caps over large, oil prices, the S&P 500 and the 10-year Treasury. Each of these asset classes strengthens in five of the seven periods mentioned above. Chart 10 shows the Trump trades in the past year. The performance matches the historical experience a year before the economy receives a boost from tax and spending legislation. The tax proposal before Congress provides fiscal stimulus via tax cuts, but does not provide any economic lift from an increase in government spending. Therefore, it may be more useful to review asset class performance after personal income tax rates are lowered. The GOP plan also proposes corporate tax cuts, but the historical evidence is scant; corporate tax rates have been lowered only three times in the past 45 years. There is no clear pattern of performance for U.S. financial assets and commodities in the wake of a reduction in the top marginal personal tax rate. Chart 11 shows the performance of the primary U.S. dollar asset classes and financial markets since 1970. Stocks outperformed bonds in the year after the top marginal tax rate fell in only one of the four periods (mid-1980s). The track record for corporate bonds is also mixed at best. Investment-grade either matches or beats the performance of Treasuries in each of the four periods. High-yield outperformed in the mid-1980s, but subsequently underperformed in the wake of the early 2000s tax cut. Gold was the most consistent winner, climbing in three of the four intervals. The dollar was higher in two of the three periods since moving off the gold standard in the early 1970s. There is no consistent pattern for small caps after a decrease in personal tax rates. Chart 10Market Remains Skeptical That Tax Package Will Pass Market Remains Skeptical That Tax Package Will Pass Market Remains Skeptical That Tax Package Will Pass Chart 11Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Tax Cuts Vs. Equities, Bonds, Commodities And Earnings Bottom Line: BCA's stance is that by the end of Q1 2018 the GOP will pass a tax cut that will provide a small lift to the economy. History shows that investing in risk assets in the year before fiscal thrust passes would provide the best returns. That said, the GOP plan only has tax cuts, and the performance of risk assets is mixed in the year following reduced personal tax rates, at best. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Later Cycle Dynamics", dated October 23, 2017. Available at uses.bcarearch.com. 2 "One component of the Baa-Treasury spread is the prepayment premium (Aaa-Treasury) to investors for the risk that if interest rates fall in the future, borrowers might retire old debt with new debt at lower rates. Another component of the Baa-Treasury spread is a liquidity premium (Aaa-Treasury) that compensates investors for the fact that private instruments are less desirable to hold relative to U.S. Treasuries when financial markets are turbulent and investors are very risk averse. The Baa-Treasury spread also contains a default risk premium (Baa-Aaa) to compensate lenders for the risk that borrowers may not repay, reflecting the amount of default risk posed and the price of risk."; Source: "What Credit Market Indicators Tells US", John V. Duca, Federal Reserve Bank of Dallas, October 1999 3 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary, "Into The Fire," November 7, 2017. Available at usbs.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much For Populism," November 8, 2017. Available at gps.bcaresearch.com. 6 The change in general government cyclically-adjusted balance as percent of potential GDP, Source: OECD.

Highlights Clients frequently ask us what long-term returns they should assume when constructing strategic portfolios. In this report, we use a range of methodologies to arrive at reasonable return assumptions for bonds, equities, alternative assets, and currencies on a 10-15 year investment horizon. We conclude that global bonds are likely to return around 1.5% in nominal terms (compared to 5.3% over the past 20 years), and global equities 4.6% (compared to 6.1%). Alternative assets look rather more attractive with, for example, private equity projected to return 9% and real estate 7.1%. Nonetheless, the typical pension fund portfolio, consisting of 50% equities, 30% fixed income, and 20% alts, will be unable to achieve its return target (still typically 7% or higher). Feature Pension plan sponsors and wealth managers need realistic assumptions about the likely returns from different assets in order to construct strategic portfolios, for example when calculating the efficient frontier using a mean-variance optimizer (MVO). Using historical data is the simplest way to do this, but can be very misleading: for example, global bonds have delivered an annual nominal return of 5.3% over the past 20 years but, with bond yields currently so low, it is almost mathematically impossible for them to return anything close to that over coming years (our estimate for future returns is 1.5%). This Special Report is our attempt to produce long-run return assumptions for strategic portfolios, something that GAA clients frequently ask us for. We want to emphasize that these are reasonable assumptions, not forecasts. The value of forecasting the world economy over the next decade or more is questionable. Consider if we had carried out this exercise in 2002: how likely is it that we would have predicted the rise and fall of emerging markets, the U.S. housing crisis, and the subsequent "secular stagnation"? Our analysis, therefore, is mostly based on the philosophy that long-run historical relationships (for example, credit spreads, or the excess return of small cap stocks) are fairly constant, and that most variables (profit margins, valuation, productivity) mean revert over the long term. Our time horizon is 10-15 years. We chose this - rather than the five or seven years that is perhaps more common in such analyses - because it is closer to the investment horizon of pension funds and most individual investors. It also allows us to avoid making a call on where we are currently in the cycle, and how long the next recession and expansion will last. It is likely we are close to the peak of the current economic expansion and equity bull market (the "X" on Chart 1): choosing a shorter time horizon would mean making judgements about the timing of the cycle. Conceptually, we prefer to forecast the trend line on the chart. Chart 1Stylized Trend Versus Cyclical Movements What Returns Can You Expect? What Returns Can You Expect? Our assumptions are inevitably approximate. In many cases (particularly for equity returns), we use multiple methodologies and take the average result. Does it matter that the estimation error of our assumptions is likely to be large? Most academic evidence finds not.1 The reason is that, for closely correlated assets, errors in the return estimates (and therefore the optimal weights in a portfolio) will not greatly affect a portfolio's risk and return; while, for assets that are very different, errors in the estimates will not have much effect on the optimal portfolio weights. Rough estimates, therefore, are sufficient for portfolio construction purposes. In any case, using common-sense projections is better than unrealistic historical averages, and investors do need some assumptions to work with when constructing portfolios. How To Forecast Economic Growth A key input (especially when considering earnings growth, which is one factor driving equity returns) is the likely rate of economic growth in various countries and regions over our time horizon. Our simplified way of deriving this is to assume that GDP growth is a factor of (1) demographics (specifically, the growth in the population of working age), and (2) productivity growth. (We assume that capital intensity is steady.) For the demographic assumptions, we use the United Nations' median forecast of the annual growth in population aged 25-64 between 2015 and 2030 (Table 1). Productivity growth is harder to estimate. Productivity has been poor in recent years compared to history (Chart 2). There is significant uncertainty about whether this is caused by cyclical factors (the Great Recession, for example) or structural factors (the end of positive effects from the IT revolution etc.), and whether a potential new wave of technology (artificial intelligence, self-driving vehicles) will raise productivity in future. Table 1Demographic Assumptions What Returns Can You Expect? What Returns Can You Expect? Chart 2Productivity Growth Productivity Growth Productivity Growth Our approach is to assume that productivity in the U.S. will return to its 40-year average, and that productivity growth in the main European economies will be 50 bp lower than the U.S. and in Japan 80 bp lower (in line with recent averages). The estimate is harder for emerging markets, so we use two scenarios: one in which structural reforms, particularly in China, bring productivity growth back up to the average of the past 10 years, 3.5%; and a second scenario in which governments fail to reform, and therefore productivity growth continues to fall to only 1%. For inflation, we assume that central banks over the long-term largely achieve their current inflation goals. The results of our assumptions for GDP growth are shown in Table 2. Table 3 shows the summary of our results: the 10-15 year return assumptions for all the assets in our analysis. We also show historic returns and volatility for comparison (for the past 20 years, where data is available). Below, we describe in detail how we arrived at these numbers. Table 2GDP Growth Assumptions What Returns Can You Expect? What Returns Can You Expect? Table 3BCA Assumed Returns What Returns Can You Expect? What Returns Can You Expect? All our results are shown in nominal terms and in local currencies. While strictly speaking, it might be theoretically better to estimate real returns, in practice most investors and advisers tend to work on a nominal basis. Moreover, since we have made assumptions for inflation in each region, it is simple to translate our nominal returns into real ones. There is also a trade-off between inflation and currency movements (and interest rates). At the end of the report, we consider the impact of relative inflation rates on currency returns, allowing investors to work the returns back into their own currencies. 1. Fixed income We start from a base that is known: the return on long-term government bonds. If an investor today buys a 10-year U.S. Treasury bond, his or her annual nominal return over the next 10 years will almost certainly be 2.3% (today's yield). The only uncertainties come from (1) reinvesting coupons at the future rate of interest, but the impact of this is small, and (2) the (presumably minimal) risk of a U.S. government default. Of course, investors do not own just 10-year bonds, and indeed the average duration of U.S. Treasuries is currently 5.7 years. But changes in interest rates make relatively little difference to future returns: a rise in interest rates causes a capital loss but a higher yield on rolled-over positions after bonds mature (though, admittedly, the convexity effect is greater when rates are low, as they are now). Even if interest rates were to double over the next decade, the return from U.S. Treasuries would fall only to around 1.5% and, if interest rates fell to 0%, the return would be only about 3%. Moreover, the effect diminishes over time as more bonds are redeemed at par. Empirically, we can see that there is a strong correlation between starting yield on 10-year bonds and long-term returns from U.S. Treasuries (Chart 3). Chart 3Government Bond Returns Driven By The Starting Yield What Returns Can You Expect? What Returns Can You Expect? For our cash assumption, we first calculate a proxy for the current cash yield using the average spread between 10-year government bonds and three-month bills over a long-run history (using data from Dimson, Marsh and Staunton which goes back to 1900 and covers a range of countries, Table 4).2 While it is true that the yield curve steepens and flatten along with the cycle, the average yield curve shape should be a good proxy for long-term future expected returns. Of course, this assumes that the term premium comes back. It may not if bonds now are a good hedge against recession risk. However, we also need to take into account that interest rates and inflation are likely to change over the next 10-15 years. We assume that both will rise to an equilibrium level over that time. Our assumption is that central banks will get close to hitting their inflation targets (in the U.S., 2% on PCE inflation, which translates into 2.5% on CPI; in Europe, "around but below 2%"; and in Japan, 2%). For the equilibrium real rate, we take BCA's current estimate (Chart 4) and assume a small rise over the next decade as some of the after-effects of the Great Recession and secular stagnation wear off: to 0.4% in the U.S., -0.1% in the euro area, and -0.2% in Japan. Table 4Historic Spread Government Bonds To Bills (1900-2016) What Returns Can You Expect? What Returns Can You Expect? Chart 4Current Equilibrium Real Rates Current Equilibrium Real Rates Current Equilibrium Real Rates Our calculation of the return from cash over the 10-15 year horizon is based on a steady rise from the current cash return to that implied by the inflation and equilibrium real rate assumptions (Table 5). Table 5Calculation Of Assumption For Cash Return What Returns Can You Expect? What Returns Can You Expect? For other fixed-income instruments, we make the following assumptions: Government bonds. We assume that the spread between 10-year and 7-year bonds and 3-month bills will be similar to the historical average (Chart 5), and calculate the return from the government bond index based on this and our estimate for 10-year returns, adjusted by the duration of outstanding bonds in the index: 5.7 years for the U.S., 7.1 for Europe and 8.6 for Japan. For U.S. investment-grade and high-yield corporate bonds, we take the average spread, default rate, and recovery rate in history (Table 6). Obviously, spreads and default rates, especially for high-yield bonds, also jump around massively over the cycle (Chart 6), but we think it is reasonable to assume in our long-term projections that they revert to the mean. Reliable data for European and Japanese credit has a short history but, over the past 10 years, spreads and default rates have been similar to the U.S., so we use the U.S. assumptions for these markets too. Chart 5Yield Curves Yield Curves Yield Curves Table 6U.S. Corporate Credit Assumptions What Returns Can You Expect? What Returns Can You Expect? Chart 6Credit Spreads And Default Rates Move With The Cycle Credit Spreads And Default Rates Move With The Cycle Credit Spreads And Default Rates Move With The Cycle Government-related bonds and securitized bonds (MBS, ABS etc.) are an important part of the Barclay's Aggregate Bond indexes: in the U.S., for example, securitized bonds comprise 31% of the index, and government-related ones 7%; in Europe, the weights are 8% and 17% respectively. For our projections of government-related bonds, we assume historic average spreads will continue (Table 7). For securitized bonds, we assume that the historic average spread in the U.S. will continue, and will be the same in Europe and Japan (where historic data is less readily available). Inflation-linked bonds. We assume that the average real yield of the past 10 years, 0%, will continue in future (Chart 7). Table 7Spreads Over Government Bonds What Returns Can You Expect? What Returns Can You Expect? Chart 7Real Yield On U.S. TIPs Real Yield On U.S. TIPs Real Yield On U.S. TIPs 2. Equities There are a number of ways to think about forward equity returns, all with a high degree of uncertainty. These could be based on starting valuations (but which valuation measure to use?); related to likely earnings growth in future years (hard to forecast); or based on a reversion to the mean of valuations and profits. We decided to take a range of different measures, and average the results. In practice, the results are similar, except for emerging markets (see below for more on EM). Table 8 summarizes the equity return calculations. Table 8Equity Return Calculations AVERAGE EQUITY What Returns Can You Expect? What Returns Can You Expect? The thinking behind the six measures we use is as follows. Equity risk premium (ERP). The most obvious methodology: historically, over the long run equities have returned more than government bonds. But which risk premium to use? Dimson, Marsh and Staunton's work includes the excess performance of equities over bonds since 1900 for a range of countries (Table 9). We decided not to choose a different ERP for each developed region, as the historical data would suggest, since it is difficult to argue that the U.S. is likely to be riskier in future than Europe and since, for parts of this history, Japan and the U.S. were essentially emerging markets. We, therefore, take a rounded average of world ERP over the past 116 years, 3.5%. For emerging markets, we multiply this by the average beta of EM relative to global equities over the past 30 years, 1.2, to give an ERP of 4.2%. Growth model. Think of a Gordon Growth Model, which defines the return from equities as the starting dividend yield plus future earnings growth (strictly speaking, dividend growth; we are assuming that the payout ratio will stay constant). We need to make a couple of adjustments to this. First, earnings growth has historically been correlated to nominal GDP growth but has lagged it - in the U.S. by 1.5 percentage points in the period 1918-2016 - although, since 1981, earnings have grown significantly faster than GDP (Chart 8). For the future, we assume that the long-run lag returns. Second, we need to add share buybacks to the dividend yield since, in some countries, such as the U.S., for tax reasons companies prefer to buy back shares rather than increase dividends. However, we should do this on a net basis since equity holders are penalized by companies that issue new shares. In the U.S. net equity withdrawal has been 0.3% over the past 10 years, but in both Europe and Japan, annual net new equity issuance has averaged 1.6% (Chart 9). In EM, the dilution has been even more extreme, averaging 6% over the past 10 years (and much more over the past 25 years). We subtract this dilution from future returns. Table 9Equity Excess Return Over Bonds What Returns Can You Expect? What Returns Can You Expect? Chart 8U.S. EPS Growth Versus Nominal GDP Growth What Returns Can You Expect? What Returns Can You Expect? Chart 9Net Equity Issuance Net Equity Issuance Net Equity Issuance Growth plus reversion to the mean. This takes the Gordon Growth Model but adds to it an assumption that PE multiples and profit margins revert to the historical mean. We again use dividend yield adjusted by net equity issuance. We assume that the current trailing PE and profit margin revert to the average since 1980 (see Table 8 above for the data) over the next 10 years. In the U.S., PE and margins are currently somewhat higher than history, but this is less the case in Europe or Japan (Charts 10 and 11). Additionally, assuming that the mean reversion happens over 10 years means that the effect on annual returns is not especially large, even for the U.S. Chart 10Net Profit Margin Net Profit Margin Net Profit Margin Chart 11Trailing PE History Trailing PE History Trailing PE History Earnings yield (EY). The simplest of the three valuation measures we use, the assumption is that companies reward shareholders either by paying them a dividend this year, or by reinvesting retained earnings to pay dividends in future. If you assume (admittedly a rash assumption) that the future return on investment will be similar to the current return on investment, it should be immaterial how the company pays out to shareholders. Therefore, the trailing earnings yield (1/PE ratio) should be a good proxy for future returns. Empirically, the relationship between earnings yield and 10-year future returns has been quite strong (Chart 12). However, returns have been somewhat higher on average than the EY would indicate (between 1900 and 2006, 9.7% versus an average EY of 7.5%) mainly because of rising PE multiples since 1980 (Chart 13). We think it unlikely that valuations will continue to rise, and so the EY should be a reasonable guide to future returns. Chart 12Earnings Yield And 10-Year Future Returns What Returns Can You Expect? What Returns Can You Expect? Chart 13Trailing Price/Earnings Multiple S&P500 What Returns Can You Expect? What Returns Can You Expect? Shiller PE. The cyclically-adjusted price/earnings ratio (CAPE, or Shiller PE) - the current share price divided by the 10 year average of historic inflation-adjusted earnings - has historically had a good correlation with future long-term returns (Chart 14). A regression model of this indicates that the current Shiller PE points to long-run forward returns for the U.S. of 4.9%, for Japan 3.6%, Europe 8.5% and EM 10.8%. Valuation composite. The Shiller PE has some flaws, for example in using a fixed 10-year period for earnings when the length of cycles varies. It has not necessarily mean-reverted in history (perhaps because of long-term trends in interest rates, which it doesn't take into account). It may be more reasonable, then, to use a mixture of different valuation metrics. BCA's Composite Valuation Indicator has had a good correlation with long-run future returns (Chart 15).3 A regression model of this indicator against 15-year returns currently points to returns from the U.S. of 5.2%, Europe of 4.1%, Japan 5.1% and EM 11.0%. Small-cap stocks. We take the 2.4% excess annual return of small cap stocks over large caps in the U.S. for 1926-2016, as calculated by Dimson, Marsh & Staunton. Chart 14Shiller PE Versus ##br##15-Year Equity Return Shiller PE Versus 15-Year Equity Return Shiller PE Versus 15-Year Equity Return Chart 15Composite Valuation Measure Versus ##br##Long-Run Future Returns Composite Valuation Measure Versus Long-Run Future Returns Composite Valuation Measure Versus Long-Run Future Returns Emerging Markets The return assumption for emerging market equity returns has a much higher degree of uncertainty. On our three valuation measures, EM equities look attractive: the average return expectation of the three valuation indicators points to an annual return of 9.4%. However, the growth outlook is murky: as described above, a wave of structural reform in emerging markets, especially China, would be necessary to keep productivity - and, therefore, earnings growth - up, in order for returns to be as good as the current valuation level suggests. Another worry is the degree of equity dilution: it has averaged 6% a year over the past 10 years, and is unlikely to fall much unless corporate governance improves significantly. The range of expected returns derived from our various methodologies, therefore, varies from -1% to +11% a year. Moreover, as described in the currency section below, investors should expect a depreciation in some EM currencies over the next decade, which will also eat into returns. However, due to the influence of China, where the currency is projected to appreciate almost 2% a year against the USD, the EM equity index will see an overall boost to USD-based returns due to the currency effect. 3. Alternative Assets We consider the likely future returns for nine of the 10 alternative assets that Global Asset Allocation regularly covers (we omit wine, which is hard to value on the basis of fundamental macro factors and, anyway, is owned by few institutional investors).4 Alts are harder to forecast than public securities since data is less easily available (and may be only quarterly and based on estimated values), and since some alternative assets have not existed in their current form for very long (venture capital, for example). Moreover, alternative assets tend to have non-normal returns with skewed distributions. Table 10 shows the historical returns and volatility of the nine alternative asset classes both over the longest period for which we have data, and since 1997, when we have data for all of them. Table 10Returns And Volatility For Alternative Assets What Returns Can You Expect? What Returns Can You Expect? We, therefore, take a more ad hoc approach, projecting each asset class differently. Generally, we assume that future returns will look similar to historical ones. Specifically, the assumptions we use are as follows. Hedge funds. We assume a return of cash + 3.5%. Hedge fund returns have trended down over time (Chart 16), as more entrants have arbitraged away alpha. We choose to use the average return over cash of the past 10 years, 3.5% (net of fees). It is unlikely that hedge funds returns will rise back anywhere close to earlier levels, for example that of the 1990s when they returned cash +14%. Chart 16Hedge Fund Historic Returns Hedge Fund Historic Returns Hedge Fund Historic Returns U.S. Direct real estate. We find reasonably good results (R2 = 24%) from regressing U.S. nominal GDP growth against real estate returns. The regression equation is 1.25 x nominal GDP growth + 1.9%. Conceptually, this probably represents a cap rate plus growth of capital values slightly higher than economic growth due to supply shortages in certain key locations. We project real estate to return 7.2% annually. One risk to this assumption, however, is that commercial real estate prices are already above the previous peak from 2007; high valuations may dampen future returns. U.S. REITs. We find only weak correlations with direct real estate investment, although REITs have outperformed real estate over time (perhaps because of the inbuilt leverage of REITs). Over time, REITs have become increasingly correlated with equities. We, therefore, use a regression against U.S. equity returns (R2 = 42%), with REIT returns 0.49 x equity returns + 7.7%. This indicates 10.1% annual return from REITs in the long run. U.S. Private equity (PE). In the past, returns from private equity have been 5 or 6 percentage points higher than from public equities. This is most likely due to their higher leverage, bias towards small-cap companies, and stronger shareholder control over the companies they invest in; it can also be thought of as an illiquidity premium. However, it seems likely that excess returns will be lower in future given the bigger size of the PE industry now and relatively high valuations currently. Moreover, the PE industry currently has almost USD 1 Trn in dry power (uninvested capital), a sign that investment opportunities are limited. We assume, therefore, a slightly lower premium over public equities in future of 4 ppts. This results in a total annual return of 9.5%. U.S. Venture capital (VC). Historically (using data since 1986) VC returns have been 0.6 ppts higher than for PE (probably representing a premium for greater risk and smaller size of the companies invested in). We assume 0.5 ppt higher return in future. This leads to a return assumption of 10%. U.S. Structured products. As discussed in the fixed income section above, we use the 20-year average spread over the aggregate bond index of 0.7 ppt. Total assumed return, therefore, is 3.3%. U.S. Farmland. The value of farmland has risen by an average of 4.4% a year since 1920, a period which included five agricultural cycles. We assume that the value of land will continue to rise at the same rate. We think this is a reasonable assumption since, although nominal GDP growth in the U.S. may be lower in future than in the past, global demand for food is likely to continue to grow rapidly. The total return from investment in farm land, using a regression, produces: growth of farm land value x 1.81 + 0.64% = 8.6%. Chart 17Long-Term Commodity Prices Long-Term Commodity Prices Long-Term Commodity Prices U.S. Timberland is more defensive than farmland since trees can be stored "on the stump" and don't need to be harvested each year in the way that crops do even when prices are unattractive. Historically, timberland has returned about 1 ppt less a year than farmland, and we assume that this will continue. Commodities move in long-run cycles, with a commodity super-cycle of around 10 years, in which prices rise by 3-4x, followed by a bear market of 20 or 30 years in which they fall or stagnate (Chart 17). This is driven by a build-up of excess supply, because of the capex done during the super-cycle, and often by a structural shift on the demand side too. We see no reason why this pattern should change, with China's re-engineering of its economy away from dependence on infrastructure spending likely to be a particularly important factor over the next decade. We assume that commodity prices will, over the current bear market (now about five years old), fall by the same amount and over the same number of years as the average of previous bear markets since the 19th century. This means they have 16% further to fall over 200 months, giving a return of -1% a year. 4. Currencies Most investors are unable or unwilling to fully hedge currency exposure over very long periods. So, a consideration of how returns from different countries' assets might be affected by relative currency movements over the next 10-15 years is an important element in calculating likely returns. Fortunately, for developed market currencies at least, there is a simple, and historically fairly reliable, way to make assumptions of currency movements: reversion to purchasing power parity. As shown in Chart 18, major currencies have fairly consistently reverted to their PPP over the long run. So we can forecast likely future currency movements as a combination of 1) how far away the currency is currently from PPP against the U.S. dollar, and 2) the likely change in the PPP over the period. The latter we calculate from the IMF's forecasts of relative consumer inflation between each country and the U.S. (the IMF makes this forecast only for the next five years, but we assume that the differential continues at the same rate after 2022). Table 11 shows that most major currencies are expected to rise against the U.S. dollar over the coming decade or so. Except for Australia, they are likely to have slightly lower inflation. And - again with the exception of Australia - they all look a little undervalued currently relative to the USD. Table 11Assumed Annual Change Versus U.S. Dollar Over Next 10-15 Years What Returns Can You Expect? What Returns Can You Expect? Unfortunately, this approach does not work for EM currencies. They have historically traded at a level consistently well below PPP. This is mainly because, while tradable goods prices tend to be driven by international prices movements and relative unit labor costs, local services prices (which cannot be arbitraged across borders) do not. Also, inflation in emerging markets has historically been much higher than in the U.S. (Chart 19), meaning that their PPP has shifted significantly lower over time. However, China's inflation is now not dissimilar to that of the U.S. (the IMF forecasts it will be only 50 basis points a year higher over the coming five years). And China has shown some tendency for the currency to move towards PPP - 20 years ago the RMB was 190% below PPP; now it is "only" 97% below. Chart 18Reversion To PPP Reversion To PPP Reversion To PPP Chart 19U.S. And Emerging Market Inflation U.S. And Emerging Market Inflation U.S. And Emerging Market Inflation We, therefore, take an alternative approach to estimating currency returns for EM economies. We run a regression analysis of the annual change in each country's exchange rate versus the U.S. dollar against its CPI inflation relative to the U.S. We find mostly acceptable r-squared scores (ranging from 57% for Turkey to 1% for Taiwan). For most countries, the intercept is positive (suggesting the currency is trending over time towards PPP) and the coefficient for CPI is, as expected, negative (Table 12). Table 12Calculations For EM Currency Moves What Returns Can You Expect? What Returns Can You Expect? A number of EM currencies, on this analysis, would be expected to depreciate against the U.S. dollar over coming years, including Indonesia, Mexico and Turkey. But, weighting the countries by their weights in the MSCI ACWI index, on average the EM universe would be expected to see a currency appreciation against the U.S. dollar of around 2% a year. This is largely due to the influence of China, which has a 29% weight in the EM index. This would be a much better result than the past 10 years when, for example, the Brazilian real has depreciated by 12% a year, the Indonesian rupiah by 16% and the Turkish lira by 37%. This could be because the IMF forecasts of future inflation (4.9% for India, 4.5% for Brazil and 4.1% for Russia), are too optimistic. They are certainly much better than these countries have achieved in the past 10 years (8.0% in India, 6.2% in Brazil, and 9.2% in Russia). Conclusion Arriving at assumptions for future returns is as much an art as a science. Our analysis is based principally on the concept that the future will be similar to long-term history (but not necessarily to the history of the past 30 years, which in many ways were abnormal for financial markets with, for example, a continuous decline in interest rates and inflation). Obviously, therefore, a very different macro environment over the next 10-15 years (for example, one in which inflation spiked, or secular stagnation deepened) would produce a very different results for economic growth and interest rates. However, it will be clear from our analysis that a great deal of the long-term return for equities and bonds is derived from the valuation at the start. Given that current valuations in almost all asset classes are expensive relative to history, this implies that future portfolio returns will be poor compared to recent, and long-term, history. Based on our return assumptions, a typical global portfolio (with 50% equities, 30% bonds, and 20% alternatives) will produce a nominal return of only 4.1% a year over the next decade or so, and a similar U.S. portfolio only 4.6%. This compares to 6.3% and 7.0% over the past 20 years. For pension funds which assume an 7.5% or 8% annual return (as many in the U.S. do), or individual investors planning their retirement on the basis of, say, a 5% annual real return, that outcome would come as a nasty shock. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For the best summary of the evidence on this, please see A Practitioner's Guide To Asset Allocation, by William Kinlaw, Mark Kritzman and David Turkington, Wiley 2017. 2 Please see Credit Suisse Global Investment Returns Yearbook 2017 by Elroy Dimson, Paul Marsh and Mike Staunton, February 2017 3 BCA's Composite Valuation Indicator comprises, for the U.S.: market value of equities / non-financial gross value added adjusted for foreign revenues, trailing PE, Shiller PE, and price to sales. And for other regions: divided yield, market Cap/GDP, trailing PE, price to book, forward PE, price to cash flow, price to sales, and enterprise value/total assets. 4 Please see Global Asset Allocation Special Report, "Alternative Assets: More Important Than Ever", dated 11 March 2016, available at gaa.bcaresearch.com Appendix Correlation Matrix What Returns Can You Expect? What Returns Can You Expect?

Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Patience Required Patience Required Chart 1Managements Focused On The Message##BR##Not The Man In DC Managements Focused On The Message Not The Man In DC Managements Focused On The Message Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global Growth Estimates Accelerating Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Global LEI's Pointing Higher Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Supports For Global Growth In Place Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe Patience Required Patience Required While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators China: Healthy Growth Indicators China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet NAIRU is Not Dead Yet NAIRU is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag Patience Required Patience Required The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation In the 80s And 90s Wage Growth Did Not Provide And Early Warning On Inflation In the 80s And 90s Wage Growth Did Not Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Patience Is Required On Inflation In Long Cycles Patience Is Required On Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Labor Market Is Tight Enough To Push Up Inflation Labor Market Is Tight Enough To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU 70%+ Of States Have Unemployment Rates Below NAIRU 70%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Wage Pressures Mounting Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Return Of The Great Moderation? Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! The Great Moderation: A Global Phenomenon Too! The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks Back To Low Correlations Among Stocks Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Broad-Based Growth Lowers Implied Volatility Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Patience Required Patience Required Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.

Highlights A growing list of indicators is pointing to a potential slowdown to the strong global growth. However, the key deflationary anchors in the global economy - U.S. deleveraging, Europe's crisis, and Chinese excess capacity - have been mostly slayed. Any slowdown is likely to be brief and shallow, generating a buying opportunity in risk assets. In the meantime, commodity currencies, especially the AUD, could suffer. EUR/JPY is also at risk. Buy CAD/SEK. Feature Chart 1-1Global Growth Has Boomed Global Growth Has Boomed Global Growth Has Boomed Global growth has continued to fire on all cylinders, and global industrial activity is at its strongest in 13 years (Chart I-1). However, five weeks ago, we highlighted three yellow flags that we believe are pointing toward a period of cooling in the global economy.1 One month later, it is time to look at the data and evidences to see if these yellow flags are being followed by additional symptoms. We posit that yes, a temporary and mild slowdown will materialize. But the global economy remains fundamentally sound. Yet, this cooling of growth could have implications for commodity currencies and EM assets. The Original Worries The key original worry that we highlighted in early October was that global money growth had been decelerating, which has historically presaged a slowdown in global industrial production, global trade and commodities prices (Chart I-2). This deceleration in money growth has only deepened since, adding further saliency to our original concern. Moreover, Chinese monetary and fiscal conditions are being tightened. The Chinese economy continues to hum at a healthy pace, and deflation has been vanquished as producer prices are expanding at a nearly 7% pace and core CPI continues to accelerate to its highest levels since 2010. This is giving Chinese policymakers an opportunity to tighten policy. Chinese monetary condition indices (MCI) are becoming less supportive of industrial activity and fiscal spending has decelerated. These policy moves potentially explain the recent rollover in the Keqiang index - which approximates industrial growth -- and the contraction in new capex projects (Chart I-3). Chart I-2Money Growth Points To A Pause Money Growth Points To A Pause Money Growth Points To A Pause Chart I-3China Is Tightening Policy China Is Tightening Policy China Is Tightening Policy Bottom Line: Global money growth continues to decelerate, and Chinese monetary and fiscal conditions are tightening. This could create a dent in global industrial activity. The Additional Worries Some other key growth indicators are also raising the alarm bell: The average of Korean and Taiwanese exports growth decelerated sharply. After having hit a peak of 32% in September, they have now decelerated to 5%. Additionally, Swedish and Australian manufacturing PMIs have also rolled over (Chart I-4). Korean and Taiwanese exports as well as Swedish and Australian PMIs are highly sensitive to global trade and the global industrial cycle. Our global growth indicator has rolled over. This indicator did forecast the rebound in industrial production in 2016 and 2017. It is now pointing toward a slowdown in global activity (Chart I-5). Likewise, our boom/bust indicator has rolled over, further highlighting the risks to global industrial production (Chart I-6). Chart I-4Key Barometers Have Turned Significantly Lower Key Barometers Have Turned Significantly Lower Key Barometers Have Turned Significantly Lower Chart I-5One Growth Indicator Slowing... One Growth Indicator Slowing... One Growth Indicator Slowing... Chart I-6...And Another One Too ...And Another One Too ...And Another One Too BCA's German industrial production model has turned down (Chart I-7). Germany is at the forefront of the global industrial cycle, and its own industrial production is highly geared to global trade. This is because manufacturing represents 23% of Germany's output and Germany's exports account for 38% of GDP. Furthermore, 30% of German exports are destined to EM economies, the epicenter of the global secondary sector. Thus, if German IP weakens, it will reflect an ebbing in the global industrial cycle. The global yield curve has continue to flatten in recent weeks (Chart I-8). This could be a reflection of the deceleration in global money growth. The weakness of banks across the world in recent days suggests the message from the yield curve should not be ignored. Chart I-7Manufacturing-Sensitive Germany Set To Slow Manufacturing-Sensitive Germany Set To Slow Manufacturing-Sensitive Germany Set To Slow Chart I-8Global Yield Curve Still Flattening Global Yield Curve Still Flattening Global Yield Curve Still Flattening Bottom Line: Beyond the slowdown in global money growth and tightening in Chinese policy, additional signs of softness have begun to emerge. Korea and Taiwanese exports as well as Swedish and Australian PMIs have weakened, our global growth indicator has rolled over, our boom/bust indicator is also softening. Likewise, our German IP model is pointing south and the global yield curve is flattening. A deceleration in global activity is likely in the cards. Reading Market Tea Leaves A few market developments are likely to be reflecting some of the underlying shifts in growth pinpointed by the set of worries highlighted above. First, commodity currencies have begun to soften, which normally herald a period of softening growth (Chart I-9). What is very interesting is the context in which this currency weakness has begun to emerge: The Australian dollar has weakened despite strengthening metals prices (Chart I-10); Chart I-9The Message From Commodity Currencies The Message From Commodity Currencies The Message From Commodity Currencies Chart I-10Why Is The AUD Weak? Why Is The AUD Weak? Why Is The AUD Weak? The Canadian dollar has weakened despite Brent breaking out above US$60/bbl; The Norwegian krone has weakened against the euro despite the same rise in oil prices and despite a 12% surge in industrial production. Chart I-11Global High Yield Experiencing Weakness Global High Yield Experiencing Weakness Global High Yield Experiencing Weakness Second, the breadth of EM equities has rolled over and is falling below the zero line, indicating that more stocks within EM have begun weakening than appreciating, pointing toward a very narrow participation in the current rally. Third, junk bond prices have started to fall in the U.S., with the JNK ETF breaking significantly below its 200-day moving average, the first time since September 2014. EM high yield bond prices have also broken below their moving average, and have further punched below a key upward sloping trend line that had been in place since the beginning of 2016 (Chart I-11). The EM bond ETF (EMB) is also testing its 200-day moving average. The last point bears particular significance. If EM bonds continue to weaken, this will represent a significant tightening in EM financial conditions. EM financial conditions have eased since 2016, which was a key factor underpinning the improvement in global IP. If EM financial conditions begin deteriorating now, a crucial support to the global economy will dissipate. Moreover, falling EM bond prices tend to be synonymous with falling EM exchange rates. In fact, the Russian ruble, the Turkish lira, the South African rand, the Brazilian real and the Mexican peso have all been weakening since the end of the summer. This suggests outflows out of these markets have begun. As investors pull money out of these markets, liquidity conditions in these economies will tighten, which will hurt their economic activity. This could be the mechanism that catalyzes the softening in global industrial activity highlighted above. All these developments are also emerging at a time when new, untested leadership will soon take hold of the Federal Reserve. Now that U.S. President Donald Trump has selected Jay Powell to helm the Fed, he still has three seats to fill on the board. Historically, transition periods at the Fed can be associated with market volatility. This time around may not be an exception. Bottom Line: Commodity currencies are weakening, market breadth in EM equities is deteriorating rapidly and junk bonds as well as various EM fixed income products are experiencing weakness. Not only do these developments tend to foreshadow ebbing global industrial activity, the weakness in EM bonds could in of itself tighten financial and liquidity conditions. The latter has been a key driver of the global industrial cycle. This represents a potentially dangerous environment. How Dangerous Exactly? Chart I-12Global Utilization Not##br## Deflationary Anymore Global Utilization Not Deflationary Anymore Global Utilization Not Deflationary Anymore All of this sounds very dire, but the reality is more nuanced. This softness in economic activity is unlikely to be very pronounced. As we argued last week, the three key factors that have created a strong deflationary anchor in the global economy seem to have been vanquished: U.S. deleveraging is over, the euro area has healed as banks have been cleaned up, and Chinese excess capacity has been purged.2 As a result of these developments, global capacity utilization is in a much better spot than it was in 2015 (Chart I-12). This means the deflationary impulse likely to emerge out of the dynamics described above should be much more muted than it was two years ago. Moreover, commodities markets are not as oversupplied as they once were; in fact, oil inventories are falling as the OPEC 2.0 setup is proving stable. This implies that commodities prices are unlikely to weaken as much as they did back then. This obviously corroborates the idea that the deflationary impact of this slowdown is likely to be smaller and also suggests that the impact on global capex should be more muted. Thus, since growth and inflation are likely to prove more resilient than in 2015, the impact on asset prices of the slowdown is likely to be short lived. If anything, it is likely to provide a buying opportunity in risk assets. Some markets are more out of line with fundamentals than others, which implies that they will suffer more. Below, we discuss key tactics that could be used to navigate this environment. Bottom Line: Because the U.S. deleveraging is over, the euro area has healed and because Chinese excess capacity has been curtailed, the global economy is less prone to deflationary tendencies than two years ago. This means that any growth slowdown will be shallow and brief. Thus, only in the assets most mispriced or most exposed to the risks above will there be playable moves that we will seek to exploit. The relevant currency market implications are explored below. Investment Implications The most mispriced asset in the face of this potential slowdown in global growth seems to be EM equities. EM stocks are very sensitive to the global industrial cycle and EM financial conditions. Both are set to deteriorate. Moreover, since 2008, EM stocks have traded closely with junk bonds, but currently EM equity prices seem very pricey relative to U.S. high yield bonds (Chart I-13). Weakening EM stock prices continue to be a negative for commodity currencies, as it implies a slowdown in global industrial activity. Moreover, commodity currencies remain over-owned. As Chart I-14 illustrates, speculators are very long "risky currencies" versus "safe currencies," implying that a slowdown in global growth, however minute it may be, is likely to be a negative shock for these investors. When these relative net speculative positions roll over, it tends to be associated with violent weakness in commodity currencies. Thus, the recent bout of weakness could only be the first innings. We think the AUD is the worst-placed commodity currency right now. Not only are speculators very long the Aussie, but as we have shown in recent weeks, the AUD is expensive against the USD, the NZD and the CAD. Its premium is so pronounced relative to other commodity currencies that, at current levels, valuations alone warrant shorting the AUD against the CAD or NZD. We are already short these crosses. It therefore follows that if we anticipate commodity currencies in general to weaken, AUD/USD also has downside. Chart I-15 makes this case. Australian equities relative to U.S. equities have historically led AUD/USD. Nearly half of the Australian equity market is financials, and Australian equities have been underperforming. This suggests investors continue to foresee a negative output gap in Australia both in absolute terms and relative to the U.S. - and thus a dovish Reserve Bank of Australia relative to the Fed, which hurts AUD/USD. Moreover, AUD/USD has overshot the mark implied by relative equity prices. Additionally, AUD/USD is expensive relative to interest rate differentials at both the short- and long-end of the yield curve. Chart I-13EM Stocks Offer##br## No Cushion EM Stocks Offer No Cushion EM Stocks Offer No Cushion Chart I-14Speculators In Commodity ##br##Currencies Are Not Ready Speculators In Commodity Currencies Are Not Ready Speculators In Commodity Currencies Are Not Ready Chart I-15AUD Is Most ##br##Vulnerable AUD Is Most Vulnerable AUD Is Most Vulnerable The euro could also experience some weakness. We have argued that as European financial conditions tighten relative to the U.S., this will hurt euro area inflation relative to the U.S., pointing to an environment where investors will likely once again price in monetary divergences in favor of the USD.3 Growth dynamics between Europe and the U.S. could also be affected by the tightening in China. As Chart I-16A and Chart 16B illustrates, tightening Chinese MCI or slowing Chinese M1 relative to M2 - which proxies a faster growth in savings deposits than checking deposits, and thus a rising marginal propensity to save tends to translate into slowing PMIs and industrial production in the euro area relative to the U.S. This is because Europe has a larger manufacturing sector and export sector as a share of GDP than the U.S. German exports, Europe's growth locomotive, are also highly geared to the Chinese industrial sector. Thus, when Chinese investment slows, Europe feels it more acutely than the U.S. With investors still very long the euro relative to the USD, a negative relative growth surprise on top of a negative relative inflation surprise will hurt EUR/USD. Chart I-16AEuro Area Versus U.S. Growth: ##br##Don't Ignore China (I) Euro Area Versus U.S. Growth: Don't Ignore China (I) Euro Area Versus U.S. Growth: Don't Ignore China (I) Chart I-16BEuro Area Versus U.S. Growth: ##br##Don't Ignore China (II) Euro Area Versus U.S. Growth: Don't Ignore China (II) Euro Area Versus U.S. Growth: Don't Ignore China (II) The picture for the yen is more complex. Falling EM assets and a temporary growth slowdown are positive for the yen. But bond yield differentials remain the key driver of USD/JPY. Since we anticipate the global growth slowdown to be shallow and brief, any weakness in U.S. bond yields will also be shallow and brief. Since we expect U.S. bond yields to regain vigor fast, and we doubt the global slowdown will affect the Fed's path much, the effect on USD/JPY will also be quick. Thus, we are keeping our cyclical long bet on USD/JPY. In fact, a positive U.S. inflation surprise is a growing risk that could cause bonds to sell off, hurting global liquidity conditions in the process. Chart I-17EUR/JPY: Ripe For A Correction EUR/JPY: Ripe For A Correction EUR/JPY: Ripe For A Correction Instead, we will hedge our long USD/JPY exposure by tactically shorting EUR/JPY. Japan will also suffer from a slowdown in global industrial activity, especially as 43% of its exports are shipped to emerging markets. Moreover, Japan has a very large manufacturing sector. However, Japanese yields have no downside from here. This means the deflationary impact of a global growth slowdown, however small it may be, will weigh on Japanese inflation expectations more than it will hurt nominal rates, resulting in higher Japanese real rates.4 This support for the JPY is likely to get magnified in EUR/JPY. Currently, speculators have been massive buyers of the euro against the yen, betting on growing monetary divergence between Europe and Japan. This has pushed net speculative positions in the euro versus the yen to levels historically associated with a reversal in this cross (Chart I-17). This pair is thus a coiled spring in the face of the risk that Japanese real rates rise against European ones, especially if investors begin pushing back expectations surrounding the first ECB rate hike. Investors have already given up hope of any tightening of policy in Japan in the foreseeable future, implying a very minimal chance of them pricing in any easing by the Bank of Japan in response to a temporary global growth slowdown. The last factor supporting shorting EUR/JPY is that Japan has a net international investment position of 60% of GDP, while Europe's NIIP stands at -3% of GDP. Also, Japanese investors have been aggressive buyers of European assets, especially since Emanuel Macron secured the French presidency, causing a positive reassessment of European political risk. In an environment where global volatility increases, Japanese investors are likely to retreat to their home market, accentuating EUR/JPY selling. Finally, CAD/SEK is likely to benefit in this environment as well, as Sweden is more exposed to EM conditions than Canada is. We are buying this cross this week, but we'll explore the reasoning behind it in greater detail next week. Bottom Line: Commodity currencies are likely to be the main casualty of the slowdown we expect to occur over the next 3 to 6 months. The AUD seems particularly vulnerable as it is expensive and investors are still very long this currency. USD/JPY could experience some downside, but we do not anticipate the growth slowdown to be strong enough to permanently knock Treasury yields off their course toward 3%. Instead, we will short EUR/JPY to protect our gains in our long USD/JPY. CAD/SEK has upside. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Melanie Kermadjian, Senior Analyst melanie@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "The Best Of Possible Worlds?" dated October 6, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How To Transform Gold Into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "All About Credit" dated October 20, 2017, available at fes.bcaresearch.com and Foreign Exchange Strategy Weekly Report, "Are Central Banks Behind the Curve Or Ahead of It?," dated July 21, 2017, available at fes.bcaresearch.com 4 For a more detailed discussion of the interplay between growth and the yen, please see Foreign Exchange Strategy Weekly Report, titled "Down The Rabbit Hole" dated April 15, 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 mixed: Initial and continuing jobless claims underperformed expectations coming in at 1.901 mn and 239,000 respectively; JOLTS job openings climbed to 6.093 mn, beating expectations of 6.091 mn, and more than the previous 6.09 mn openings; Consumer credit increased to USD 20.83 bn from USD 13.14 bn, also beating expectations of USD 18 bn. The DXY enjoyed an up week, but a large spike in German Bund yields on Thursday caused the DXY to weaken. This is most likely a temporary event prompted by the unwinding of dovish ECB trades. We expect the greenback to continue its climb alongside stronger U.S. data. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data has generally been upbeat: The German trade balance and current account improved to EUR 21.8 bn and EUR 25.4 bn, but this first and foremost reflected a 1% contraction in imports; French trade balance also improved to EUR -4.668 bn, beating expectations of EUR -4.8 bn; European retail sales increased by 3.7% on a yearly basis, and 0.7% monthly; However, German industrial production growth slowed to 3.6%. This allowed the euro to regain some of its lost value. However, we believe that euro area inflation will disappoint going forward - especially relative to the U.S. This will limit any appreciation in the euro as investors will begin pricing in a tightening of the Fed's policy relative to the ECB. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent Japanese data has surprised to the downside: Core machinery orders massively underperformed expectations, as they contracted by 8.1% on a month-on-month basis and by 3.5% on an annual basis. Moreover, bank lending yearly growth also underperformed, coming in at 2.8%, and declining from last month's reading. Moreover, the leading economic indicator came below expectations, at 106.7. It also declined from last month's number. After 2 years into the recovery from the 2015 commodity/ EM carnage, global growth seems prime for some slowdown. Indeed, many indicators like high yield and EM bond yields have started to break down. This is could be positive for the yen, given its risk-off currency status. However we prefer to not play this strength though USD/JPY. Instead we are shorting EUR/JPY, a cross which cancels the exposure to the dollar. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day -August 25, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed Markit Services PMI outperformed expectations, coming at 55.6. It also increased from 53.6 last month. Halifax House Prices Month-on-Month growth also outperformed, coming in at 0.3%. However, the RICS Housing Price Balance underperformed expectations, coming in at 1%. The pound has been relatively flat after plunging following the "dovish" hike by the Bank of England. Overall, we see very little upside from here on for cable, as the BoE has little incentive to hike beyond what is priced into the SONIA curve, as both consumer confidence and real retail sales yearly growth are near 3-year lows. Meanwhile, the Fed will likely surprise the market by following its projected path. This will increase rate differentials between these two countries, and put downward pressure on GBP/USD. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 It has been quite an uneventful week for the AUD, as it has stayed flat relative to the USD. The following data came out: TD Securities Inflation increased to 2.6% from 2.5% on a yearly basis, and 0.3% on a monthly basis; ANZ Job Advertisements increased by 1.4% in September; AiG Performance of Construction Index declined to 53.2 from 54.7; Home loans contracted b 2.3%. The RBA rate decision and statement were in line with expectations, and the AUD saw little to no movement. Governor Lowe identified several capacity issues with the economy, noting that "In underlying terms, inflation is likely to remain low for some time, reflecting the slow growth in labour costs and increased competitive pressures", and that inflation is only being boosted by tobacco and electricity. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 On Wednesday, New Zealand decided to keep its reference rate unchanged at 1.75%. The kiwi rose after the announcement, as the Reserve Bank of New Zealand brought forward their expectations for a hike from the third quarter of 2019 to the second quarter of 2019. Furthermore, the RNZ now expects inflation to hit the mid-point of its target range by the second quarter of 2018, nine months sooner than before. The RBNZ also toned down its rhetoric on the currency as governor Grant Spencer stated that "the exchange rate has eased since the August statement, and if sustained, will increase tradable inflation and promote more balance growth". Overall we expect the NZD to outperform the AUD. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 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 Data in Canada has been positive: Ivey PMI moved up to 63.8 from 59.6, also outperforming the expected 60.2; Housing Starts increased by 222,800 annually, beating expectations of 210,000; Building permits also increased by 3.8% on a monthly basis; The most recent Business Outlook Survey report indicates that more than 40% of the surveyed businesses believe the shortage of labor has become worse, which is usually a reliable indicator of wage growth. This will allow the BoC to continue on its hiking path next year, which will mean that CAD will outperform other G10 currencies. NAFTA negotiations remain the greatest risk to the BoC view and the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation underperformed expectations, coming in at 0.7%. It stayed constant from last month's number. Meanwhile, unemployment was unchanged from last month at 3.1%. This number was in line with expectations. After peaking in late October, EUR/CHF has depreciated slightly, mainly due to the weakness in the euro. However, betting for CHF strength still means fighting against the SNB. Inflation in Switzerland is still too tepid for the SNB to stop their interventions in currency markets. Meanwhile, real retail sales yearly growth is still in negative territory. Thus, until we see a significant improvement in economic activity in the alpine country, we are reluctant to bet against the SNB. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Registered unemployment declined from 2.5% in September to 2.4% in October However, industrial production surged to more than 12% on an annual basis Since the Norges Bank policy statement at the end of October, USD/NOK has been flat. This has been because this cross has been squeezed between two conflicting forces: On one hand, oil has gone up nearly 5% just this month. On the other hand, the rise in the dollar has counteracted any downside that rising oil prices could provide to USD/NOK. Although we continue to be bullish on oil, we are bullish on USD/NOK, as this cross is more correlated to real rate differentials than it is to oil. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data was positive this week: Industrial production's monthly growth increased to 2.2% from a 1.6% contraction; the yearly measure is growing at a 4.5% pace, albeit less than the previous 7.5%; New orders are increasing at a very high 11.2% annual pace, a good forward-looking indicator for industrial production. While the Swedish economy remains robust, the SEK will see some downside against the USD and the EUR due to the Riksbank's dovishness. Also, the recent dip in EM high yield bonds could be a risk for the Swedish economy. We are therefore opening a long CAD/SEK trade. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

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