Economic Growth

Highlights The ECB's meeting was in line with expectations, the governing council increased its growth forecast, decreased its inflation forecast, removed it easing bias, but maintained that easy policy was key to support its objectives. Going forward, growth will have to remain just as strong for European inflation dynamics to emerge. Financial conditions between the U.S. and the euro area are moving in favor of U.S. growth, and thus, the USD. EUR/USD momentum is stretched, but it can rise further. EUR/USD at 1.15 in the coming weeks is a risk to our view. However, EUR/USD forecasts have already been ratcheted upward, and their capacity to lift the euro is losing steam. Feature The European Central Bank hit the mark yesterday with a performance that was bang on in terms of expectations, as illustrated by the euro's muted response. The governing council increased its growth forecast by 0.1% each year and curtailed its inflation forecast by an average of 0.2% until 2019, inclusively (Table I-1). Moreover, while the ECB statement removed its future easing bias, in the press conference ECB President Mario Draghi made it crystal clear that this was because deflationary risks were evaporating, but the economy still needed extremely easy conditions in order to stay on the trajectory envisioned by the ECB. Chart I- As a result, despite this adjustment in forward guidance, the ECB elected to keep its asset purchases in place, even leaving the door open for time extensions and size increases if conditions warrant. After all, in the eyes of the ECB - and it is an assessment we share - the great performance of the European economy has been and remains dependent on the continuation of a very easy policy stance. In this optic, we study the outlook for growth dynamics in Europe, especially in relation to the U.S., as this is what will determine the future path of relative policy. If European policy can move in a more hawkish fashion relative to the Federal Reserve as well as current expectations, then the euro bear market will be over. Growth And Financial Conditions For the euro to rally further, the ECB has to be able to beat market expectations and the Fed has to continue to underwhelm. So far this has not happened, but markets are forward looking and are behaving as if both central banks will follow these paths. To expect a tightening of ECB policy relative to the Fed's, European growth will have to continue outperforming U.S. growth. As we argued last week, the slack in the European jobs market is much greater than that in the U.S.1 Without outstanding growth, European inflationary dynamics will remain hampered by low wage growth. Meanwhile, the Fed is facing an environment congruent with high rates (Chart I-1), something that markets are ignoring as they are only anticipating two more hikes into June 2019, beyond the one anticipated next week. So what kind of future growth dynamics are we anticipating? World growth may not be about to plunge, but global activity is set to soften as China and the U.S. have been tightening monetary conditions in an environment replete with excess capacity. Indicators are already responding to this policy shift. Our diffusion index of global leading economic indicators has already rolled over sharply, a precursor to softening global LEIs (Chart I-2). This is a bigger problem for Europe than the U.S. Since 2010, the beta of euro area LEIs to global LEIs has been around 0.8, while for the U.S. the sensitivity is around 0.2. Thus, deteriorating growth conditions are a greater handicap for Europe, a region still much more reliant on trade and manufacturing as sources of growth. Chart I-1The Fed And Its Mandate The Fed And Its Mandate The Fed And Its Mandate Chart I-2Global Growth Passing Its Zenith Global Growth Passing Its Zenith Global Growth Passing Its Zenith Meanwhile, purely domestic economic conditions have been buoyant in the euro area and quite morose in the U.S., though the picture seems to be reversing. To make this judgment, we begin by evaluating a global growth factor, a global economic force that lifts or pulls down all boats, similar to a tide. Such a global growth factor should not just affect various countries through trade, but it should also impact their economies through financial linkages. In order to evaluate this phenomenon, we conducted a Principal Component Analysis (PCA) of the LEIs of 21 countries. We found that the combined factor 1 and factor 2 explains nearly 50% of global growth dynamics (Chart I-3). Once we estimated this global growth factor, we then proceeded to estimate how much it contributes to LEI gyrations in the U.S. and euro area, using the factor loadings of both relative to the two main components revealed by the PCA. With that information in hand, we then simply subtracted the European and U.S. impact from their respective LEIs. What is left reflects purely endogenous changes in the LEIs for the euro area and the U.S. This same procedure can be applied to any country. Through this exercise, we can see very well that European domestic conditions have been rebounding sharply since 2012. However, the pure domestic element of the U.S. LEIs has been falling steadily since late 2014, shortly after the U.S. dollar began its 27% rally (Chart I-4). Chart I-3The Tide That##br## Lifts All Boats The Tide That Lifts All Boats The Tide That Lifts All Boats Chart I-4A Look At Purely Domestic##br## Growth Dynamics A Look At Purely Domestic Growth Dynamics A Look At Purely Domestic Growth Dynamics To a large degree, these differentiated dynamics make sense. 2012 marked the apex of the euro area crisis. The improvement in the domestic component of the European LEIs coincided with Mario Draghi's "whatever it takes" speech. This moment was crucial as it resulted in the normalization of private sector borrowing costs across the Eurozone. Thanks to the ensuing compression in break-up risk premia, Italian and Spanish private lending rates collapsed by 110 and 240 basis points over the following 24 months, respectively. Easy money was finally being transmitted to the private sector. Chart I-5Massive Tightening In 2014 Massive Tightening In 2014 Massive Tightening In 2014 In the U.S., the deterioration began after the dollar perked up massively, but also, after the Fed began tapering its purchases of securities, events associated with a 300 basis-point increase in the Wu-Xia shadow fed funds rate (Chart I-5). The combined effect of this monetary tightening resulted in a significant brake on economic activity, one made most evident by the deceleration in the domestic component of the LEIs. These forces seems to be reversing. Today, the dollar is trading in line with its March 2015 level, and while the fed funds rate has increased by 75 basis points, this still pales in comparison to the large increase in the shadow fed funds rates recorded between May 2014 and November 2015. Meanwhile in Europe, the lagged effects of the massive 15% decline in the trade-weighted euro between June 2014 and March 2015 is dissipating. These monetary dynamics partially explain why the domestic element of the European LEIs is rolling over while the U.S. one is improving. However, we think financial conditions play a larger role. U.S. financial conditions have greatly eased in recent months, while financial conditions in Europe have been deteriorating, suggesting domestic growth conditions will follow a similar path (Chart I-6). These crosscurrents are especially evident when looking at the relative European and U.S. domestic growth impulses vis-a-vis their relative financial conditions. Currently, the purely endogenous elements of growth in the euro area look set to roll over against those of the U.S. So if the international and domestic elements of growth in Europe are set to slow relative to the U.S., when should these dynamics begin to affect market pricing? Historically, the German Ifo survey has been one of the most reliable bellwethers of European economic activity. The same can be said of the ISM in the U.S. While the ISM rolled over three months ago, the Ifo is still at all-time highs. However, historically, one of the most reliable leading indicators of the Ifo has been none other than the ISM itself. Hence, the likelihood that the Ifo rolls over sharply by September is high, especially in the context of the observations made above (Chart I-7). With expectations that European growth will remain strong but that the U.S. is incapable of generating inflation, a weak ISM is well known, but a weak Ifo would be a surprise. Chart I-6Follow The Financial Conditions Follow The Financial Conditions Follow The Financial Conditions Chart I-7Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows Where The ISM Goes, The IFO Follows When the Ifo underperforms the ISM, the euro tends to suffer (Chart I-8). This was not true in 2001, but back then the euro was trading 15% below its long-term fair value, and the U.S. was entering a recession. Today, the euro is trading at a more modest 5% discount to its long-term fair value, and BCA believes the U.S. is not on the verge of a recession. Moreover, on a short-term basis, the euro is already trading 6% above its interest rate and risk-aversion implied tactical fair value. Chart I-8If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro These dynamics also imply that the massive positive skew in economic surprises between the euro area and the U.S. should soon end, which is likely to prompt a re-think of the relative monetary policy stance between the ECB and the Fed, and therefore put an end to the recent sharp rally in the euro. Bottom Line: The ECB did not surprise markets this week. Yet, Mario Draghi made it very clear that despite an upgrade to forward guidance, the path toward achieving the central bank's inflation target continues to require very easy policy. How easy? Our view is that based on global dynamics and financial conditions, European growth could slow in the coming months, delaying the point in time when the euro area output gap closes. Meanwhile, investors are too conservative regarding the U.S.'s growth and inflation prospects, and therefore are not anticipating enough rate hikes from the Fed. What To Do With Momentum? The key issue for now is that the euro's momentum is extremely powerful and hard to fight. Indeed, the euro seems to have dissociated from fundamentals. While aggregate real rate differentials continue to move in favor of the U.S. dollar, the euro is ignoring these dynamics and instead has become overtaken by powerful flows into the euro area (Chart I-9). These dynamics may be stretched, but they could still have additional room to run. Non-commercial traders have fully purged their short bets on EUR/USD, and they have accumulated the most long-euro positions in three years. Additionally, our composite sentiment indicator, based on the positioning, sentiment, and 13-week rate-of-change in the currency, is now at elevated levels relative to the past three years (Chart I-10). The violence of these shifts highlights an improving risk-reward ratio to shorting the euro, but this could be of little solace: historically, both the composite sentiment measure and positioning in the euro have hit much higher levels. Technical indicators point to similar dilemmas. Both the EUR/USD intermediate-term technical indicator and its 13-week rate of change have hit levels congruent with a reversal (Chart I-11). However, these indicators have also displayed inertia in the past, with occasions such as in 2013, where their elevated readings did not preclude a higher EUR/USD. Chart I-9EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf EUR/USD Is A Lone Wolf Chart I-10EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) EUR/USD Is Overbought But...(1) Chart I-11EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) EUR/USD Is Overbought But...(2) As a result, we are highly cognizant of the risks to our positive bet on the DXY (which due to its near 60% weighting in the euro is equivalent to a short euro bet). But the good news in the euro seems well priced in. In line with the 8% surge in the euro this year, the average analyst forecast for the euro for Q4 2017 moved from EUR/USD 1.05 to EUR/USD 1.12 (Chart I-12, top panel). Recent peaks in the euro have materialized when these forecasts hit 1.13, which we are very close to. At these levels, the optimism toward Europe seems fully discounted. Chart I-12When To Be Contrarian In FX When To Be Contrarian In FX When To Be Contrarian In FX In fact, the gap between the euro itself and the forecast is now decreasing (Chart I-12, bottom panel). This suggests that each new forecast upgrade is lifting the euro less and less, implying that buyers have already internalized these increasing forecasts and need ever better news, especially on the wage and inflation front, to lift the euro higher. Hence, while worried that the EUR/USD could move to 1.15 in a blink of an eye before reversing, we remain cautiously optimistic on our negative EUR/USD and our positive DXY stances. Bottom Line: At this point, the key problem with our view is that momentum is clearly in the euro's favor, a dangerous position for euro bears. While most indicators highlight that EUR/USD is overbought, these same metrics could in fact remain overbought for longer. However, investors have already massively upgraded their EUR/USD forecasts suggesting that much news is in the price, especially as each successive upgrade is showing diminishing returns in their capacity to lift EUR/USD spot rates. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Capacity Explosion = Inflation Implosion", dated June 2, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The soft patch in the U.S. economy continues: Unit labor costs growth has softened to 2.2%, a less-than-expected pace of 2.5%; Non-Manufacturing/Services sectors are looking weak with both PMI and ISM measures underperforming; Consumer credit also grew by USD 8.2 bn, underperforming the expected USD 15.5 bn. As a result, the dollar remains weak. While the data is worrying, we stand with the Fed's view. The Fed will hike in June, and when this soft patch proves temporary, it is likely that a September hike will materialize. With the ECB constrained in its capacity to move to a hawkish stance, it is possible for the USD to see some upside sooner rather than later. Report Links: Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro has witnessed a particularly strong two months due to positive surprises in data, but momentum somewhat slowed this week due to mixed data: Services PMI in Spain, Italy and France underperformed expectations, while Germany and the overall euro area outperformed; Retail sales increased at a 2.5% annual rate; German factory orders increased by 3.5% annually, which was less than expected. Even worse they contracted by 2.1% on a monthly basis; Overall GDP growth in the euro area outperformed expectations, being revised to 1.9%. Furthermore, Draghi reiterated the need for extremely easy conditions in order to stay on the path to reach the target inflation rate, especially as inflation forecasts were downgraded. If the European data cannot keep up with its current blistering pace, investors should again begin to wonder about the ECB's capacity to move away from what remain a dovish stance. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 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 economic data has been mixed in Japan: Consumer confidence came in at 43.6, increasing from last month. Bank lending annual growth came in at 3.2%, beating expectations. However, GDP annualized growth was greatly revised downward to 1%. Although we continue to be bullish on the yen on a short term basis, it would be preferable to play yen strength by shorting NZD/JPY rather than USD/JPY, as we believe that the correction in the U.S. dollar has run its course. Thus, we are looking to exit our short USD/JPY trade once it reaches 108. On a cyclical basis, the yield curve target implemented by the BoJ, along with a hawkish fed will weigh on Japanese real rates vis-à-vis U.S ones and consequently push the yen downward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data has been mixed in the U.K.: Construction PMI came in at 56, blowing past expectations. Halifax house price annual growth came in at 3.3%, also outperforming expectations. However, Markit Services PMI came below expectations at 53.8. The results of the elections happening as of the date of this writing will create some volatility in the pound. A greater majority government by the conservatives would likely be a boost to the pound, as it will give Prime Minister May more leeway when negotiating the exit of the U.K. from the European Union. On the other hand, if labor wins enough seats to create a hung parliament, the pound could suffer as political uncertainty will once again reign supreme. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 The Aussie experienced an upbeat week, appreciating almost 2.5%. A few positive data was recorded: TD Securities Inflation increased at a 2.8% annual rate, more than the previous 2.6% reading; GDP growth increased 1.7% annually, beating both yearly and quarterly expectations. Chinese imports were very strong, coming in at 22% growth on an annual pace, suggesting continued intake by the Middle Kingdom of what Australia exports. The GDP was a key driver in this week's rally. However, while the headline number was great, the details were more worrisome. Inventories led GDP growth, while exports subtracted most from it. This is peculiar considering that terms of trade increased at a 24.8% annual rate. This also predates the near 40% decline in iron ore futures. The trade balance for April also missed expectations greatly, coming in at 555 million, compared to the expected 1.95 million, setting up a poor start for Australia's second quarter. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi economy continues to improve: Headline and core inflation have both surpassed the 2% threshold, reaching 2.2% and 2.3% respectively in the first quarter of 2017. Meanwhile, nominal retail sales are growing at a healthy 7.5%. Considering the continued strength in the kiwi economy, the NZD should continue to outperform the AUD on a cyclical basis, given that Australia is much more sensitive to a slowdown in Chinese economic activity, which is beginning to suffer in response to the tightening campaign by the PBoC. On the other hand the upside for the NZD against the U.S. dollar remains limited. Not only is NZD/USD overbought on a short term basis, but the tight correlation between the kiwi and commodity prices should eventually weigh on this currency. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD went through a rough patch this week: The seasonally-adjusted measure of PMIs delivered a disappointing 53.8 reading compared to the expected 62; Building permits are contracting at a 0.2% monthly pace; Housing starts increased at 194,700, which was less than expected; On the plus side, house price growth was at 3.9% yoy, beating expectations of 3.3%. Oil was also a big player in the loonie's weakness. Crude oil inventories were higher than expectations by roughly 6 million barrels: a 3.464 million barrels decline in inventories was expected, while inventories increased at a 3.295 million barrels. The CAD remains oversold, but we remain bullish on it in the G10 space as investors have rarely been so short the Canadian currency as they currently are. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent economic data in Switzerland has been very positive: The unemployment rate came in at 3.2%, beating expectations. Headline inflation came in at 0.5%, higher than last month and beating expectations. Yesterday, the ECB underwehlmed bulls, as ECB president Mario Draghi stated that asset purchases will "run until the end of December 2017, or beyond, if necessary". We expect the ECB to ultimately find it very difficult to switch to a hawkish bias, especially relative to relative to other central banks, as pricing power in the euro area remains muted. On the other hand, Switzerland is slowly recovering, and a removal of the implied floor by the SNB on EUR/CHF could happen as early as the end of the year. Thus, we are already shorting this cross to take advantage of such an event. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 On Wednesday, oil inventories rose by 3.3 million against expectations of a 3.5 million draw. This caused oil prices to plunge by almost 4%. Nevertheless, the response of USD/NOK has been somewhat muted. This is in part due to the fact that real rate differentials matter more than oil for USD/NOK. Indeed, while oil is down almost 15% on the year, the NOK has actually appreciated slightly in the year against the dollar, given that rates in the U.S. have decreased substantially during the year. Thus, given that we expect a more hawkish Fed than the market anticipates, we are USD/NOK bulls. Additionally, we are also bullish on CAD/NOK, as the Norges Bank is likely to have a much more dovish bias than the BoC going forward. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 The SEK has been depreciating this week on the back of disappointing industrial production figures, with the yearly measure increasing at a meagre 0.8% pace, much less than the anticipated 4.2%. Moreover, IP experienced a monthly contraction of 2.4%. Additionally, the recent Financial Stability Report also highlighted that "further measures need to be introduced to increase the resilience of the household sector and reduce risks", as well as vulnerabilities in the Swedish banking system. While we think USD/SEK's weakness is nearing its end, EUR/SEK will likely see some weakness in the near future, given its expensive level. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, Along with this brief Weekly Report, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. Marko argues that the U.S. is vulnerable to serious socio-political instability by the 2020 election, as a result of the widening gulf between elites and the rest. Trump, thus far, seems unlikely to bridge this gap. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlight U.S. growth will accelerate over the remainder of the year, thanks to easier financial conditions. This will force the Federal Reserve to raise rates more than the market is currently discounting. In contrast, the BoJ and the ECB will remain on hold. The net result would be a stronger dollar. Solid Chinese growth will support commodity prices. Stay overweight global equities over a cyclical horizon of 12 months. Feature U.S. Growth Will Surprise On The Upside I have been meeting clients in Asia over the past week. The ongoing decline in Treasury yields - the 10-year yield hit a 7-month low of 2.14% this week - was a frequent topic of conversation. Investors are becoming increasingly convinced that the U.S. economy is running out of steam. The OIS curve is pricing in only 48 basis points of rate hikes over the next 12 months. Since a June rate increase is now largely seen as a done deal, the market is essentially saying the Fed will abandon its tightening cycle later this year. We think that's too early. The U.S. economy may not be on fire, but it is hardly floundering. The Blue Chip consensus estimate for Q2 growth stands at 3.1%. The Atlanta Fed's GDPNow model is pointing to growth of 3.4%. There is little reason to think that growth will slow substantially later this year. Financial conditions have eased significantly over the past few months thanks to a weaker dollar, falling bond yields, narrower credit spreads, and higher equity prices (Chart 1). Our research has shown that GDP growth tends to react to changes in financial conditions with a lag of around 6-to-9 months (Chart 2). This means demand growth is likely to strengthen, not weaken, over the remainder of the year. Chart 1Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Chart 2...Which Bodes Well For Growth ...Which Bodes Well For Growth ...Which Bodes Well For Growth Running Out Of Slack If demand growth does accelerate, does the U.S. economy have the supply capacity to fully accommodate it? We do not think so. The headline unemployment rate fell to a 16-year low of 4.3% in May. It is now half a percentage point below the Fed's estimate of full employment. The broader U-6 rate, which includes marginally-attached workers and those working part-time purely for economic reasons, dropped to 8.4%, essentially completing the roundtrip to where it was before the recession (Chart 3). Chart 3A Tight Labor Market A Tight Labor Market A Tight Labor Market Chart 4Wage Growth Is In An Uptrend Wage Growth Is In An Uptrend Wage Growth Is In An Uptrend Chart 5Wage Gains Are Broad Based Wage Gains Are Broad Based Wage Gains Are Broad Based Contrary to popular perception, wages are rising. Looking across the various official wage indices that are published on a regular basis, the underlying trend in wage growth has accelerated from 1.2% in 2010 to 2.4% (Chart 4). The acceleration in wage growth has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 5). Wage Growth: No Mystery Here Granted, wage growth is still about a percentage point lower than it was before the recession, but that can be explained by slower productivity growth and lower long-term inflation expectations (Chart 6). Real unit labor costs, which take both factors into account, are rising at a faster pace than in 2007 and close to the pace in 2000 (Chart 7). Chart 6A Secular Downtrend In Productivity Growth ##br##And Inflation Expectations A Secular Downtrend In Productivity Growth And Inflation Expectations A Secular Downtrend In Productivity Growth And Inflation Expectations Chart 7Rising Real Unit Labor Costs: ##br##A Case Of Deja-Vu Rising Real Unit Labor Costs: A Case Of Deja-Vu Rising Real Unit Labor Costs: A Case Of Deja-Vu Looking out, wage growth is likely to accelerate further. The evidence strongly suggests that the Phillips curve has a "kink" at an unemployment rate of around 5% (Chart 8). In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 6% to 4% does. Chart 8 The Cost Of Waiting One might argue that the Fed can afford to take a "wait and see" approach to raising rates. There is some merit to this view, but it can be taken too far. If the Fed is to have any hope of achieving a soft landing for the economy, it needs to stabilize the unemployment rate at a level close to NAIRU. This may be possible if the unemployment rate is near 4%, but it would be difficult to pull off if the rate slips much below that level. Trying to stabilize the unemployment rate when it has already fallen well below its full employment level means accepting a permanently overheated economy. A standard "expectations-augmented" Phillips curve says that this is not possible to accomplish without accepting persistently rising inflation. If the Fed did find itself in a situation where the economy were overheating, it would have no choice but to jack up rates in order push the unemployment rate to a higher level. Unfortunately, the evidence suggests that once the unemployment rate starts rising, it keeps rising. Indeed, there has never been a case in the post-war era where the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 9). Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The inescapable fact is that modern economies contain numerous feedback loops. When unemployment is falling, this generates a virtuous cycle where rising employment boosts income and confidence, leading to more spending and even lower unemployment. The exact opposite happens when unemployment starts rising. History suggests that trying to raise the unemployment rate by just a little bit is like trying to get a little bit pregnant. It's simply impossible to pull off. The implication is that the Fed will not only raise rates in line with the dots, but could actually expedite the pace of rate hikes if aggregate demand accelerates later this year, as we expect. Remember, it wasn't that long ago that a typical tightening cycle entailed eight rate hikes per year. In this context, the market's expectation of less than two hikes over the next 12 months seems implausibly low. No Tightening In Japan Or Europe Chart 10Inflation Is Way Below The BoJ's Target Inflation Is Way Below The BoJ's Target Inflation Is Way Below The BoJ's Target Could other major central banks follow in the Fed's footsteps and tighten monetary policy more aggressively than what the market is currently discounting? We doubt it. Japanese inflation is nowhere close to the BOJ's 2% target (Chart 10). And even if Japanese growth surprises significantly to the upside, the first step the authorities will take is to tighten fiscal policy by raising the sales tax. Monetary tightening remains some ways off. Likewise, while the ECB might remove a few of its emergency measures, it is nowhere close to embarking on a full-fledged tightening cycle. The ECB's own research department recently put out a paper documenting that the combined unemployment and underemployment rate currently stands at 18% of the labor force across the euro area (Chart 11). This is 3.5 points above where it was in 2008. If one excludes Germany from the picture, the level of unemployment and underemployment is seven points higher than it was in 2008. This is not the stuff of which tightening cycles are made. Meanwhile, on the other side of the English Channel, the BoE must contend with the fact that growth remains underwhelming, partly due to ongoing angst about Brexit negotiations (Chart 12). Chart 11 Chart 12U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers EM Outlook Chart 13Positive Signs For The Chinese Housing Market... Positive Signs For The Chinese Housing Market... Positive Signs For The Chinese Housing Market... The outlook for EM currencies is a tougher call. On the one hand, a more hawkish Fed and broad-based dollar strength have usually been bad news for emerging markets, given that 80% of EM foreign-currency debt is denominated in U.S. dollars. On the other hand, stronger global growth should support commodity prices, even if the dollar is strengthening. Our energy strategists remain particularly convinced that oil prices will rise over the remainder of this year due to robust demand growth for crude and continued OPEC discipline. Strong Chinese growth should also boost metals demand, while limiting the need for further RMB weakness. Chart 13 shows that property developers have been snapping up new land at an accelerating pace. The percentage of households who intend to buy a new home has also surged to record high levels. This bodes well for construction, and by extension, commodity demand. The strong pace of growth in excavator sales - a leading indicator for capex - confirms this trend. Meanwhile, real-time measures of Chinese industrial activity such as rail freight traffic and electricity generation remain buoyant (Chart 14). This is helping to lift producer prices, which, in turn, is fueling a rebound in industrial company profits (Chart 15). And for all the talk about the government's crackdown on credit growth, the reality is that medium-to-long term lending to nonfinancial companies has actually picked up (Chart 16). Chart 14... And Positive Signs For Chinese Capex ... And Positive Signs For Chinese Capex ... And Positive Signs For Chinese Capex Chart 15Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Chart 16A Positive In China's Credit Picture A Positive In China's Credit Picture A Positive In China's Credit Picture Stick With Stocks... For Now In terms of global asset allocation, we continue to recommend a cyclical (12-month) overweight in equities relative to bonds. We have a slight preference for DM over EM stocks, although given some of the positive factors supporting EM economies noted above, we do not regard this as a high-conviction view. Within the DM universe, we favour higher-beta equity markets such Japan and the euro area over the U.S. (currency hedged). In the government bond space, we would underweight U.S. Treasurys, given the likelihood that the Fed will deliver more rate hikes over the coming months than the market is currently discounting. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The latest reading from all the indicators confirms that the growth improvement in the manufacturing sector since early last year has moderated, while the sharp recovery in producer prices has stalled. However, it is premature to be overly alarmed by a pending Chinese growth relapse. Betting on a material Chinese slowdown solely based on some sort of credit "impulse" estimate misses the big picture. The dramatic decline in real interest rates rather than an increase in new lending is what played a pivotal role in Chinese reflation since last year. Strategically we lean against being overly bearish. The Chinese economy will likely continue to moderate, but the downside risk appears low at the moment and overall business activity will remain buoyant. Feature Investors have become less sanguine on China's growth outlook in recent weeks, as the latest macro numbers are no longer unanimously positive. Concerns about a significant relapse in the Chinese economy are re-emerging, and the authorities' recent policy tightening has further heightened investors' anxiety levels. Judging from our recent conversations with clients, "China risk" is now clearly back on the radar. China's growth recovery since early last year played a major role in boosting some global risk assets such as commodities prices and emerging market equities. By the same token, will a China slowdown end the global reflation trade? The Divergence In Manufacturing PMIs Chart 1The Divergences In PMIs The Divergences In PMIs The Divergences In PMIs Investors' anxiety over China's cyclical trend has been amplified by the recent divergence between the official manufacturing Purchasing Manager Index (PMI) and the one compiled by Caixin Media group, a private source. The official survey for May still showed expansion, while the private PMI dropped slightly below the critical 50 threshold (Chart 1, top panel). Historically such divergences are not uncommon, and the private PMI appears to show sharper swings than its official counterpart, probably due to its smaller sample size and its focus on smaller private firms. Meanwhile, there were some commonalities: the sub-indices of output and new orders for both surveys remained above the expansionary threshold, while input costs and output prices for both dropped into contractionary territory. Taken together, the latest reading from all the indicators confirms that the growth improvement in the manufacturing sector since early last year has moderated, while the sharp recovery in producer prices has stalled - consistent with other recent macro variables. Meanwhile, the service industry is still showing solid expansion, according to both surveys, underpinning overall business activity (Chart 1, bottom panel). In short, it is premature to be overly alarmed by a pending Chinese growth relapse. Credit "Price" Versus "Volume": What Matters More? A common narrative to describe the reason behind China's ongoing growth moderation is policy tightening on both the monetary and fiscal fronts. As the argument goes, last year's growth recovery was driven by a massive increase in credit and fiscal spending, which has since been scaled back. As this credit and fiscal "impulse" fades away, the Chinese economy will tumble, sending shockwaves across the world. In our view, betting on a material Chinese slowdown solely based on some sort of credit "impulse" estimate misses the big picture, and is dangerously misguided. At BCA, we have long paid close attention to credit cycles and their impact on the growth outlook. However, there is no evidence that China's growth recovery since early last year was due to a massive increase in credit expansion and fiscal spending. In fact, total new credit provided by commercial banks and the "shadow banking sector" has been largely stable in recent years, and last year's credit "impulse," measured as the annual change in credit flows, was fairly modest - especially compared with previous bouts of sharp spikes (Chart 2). Similarly, Chinese fiscal spending actually decelerated sharply throughout last year, and dropped by over 10% in December, compared with a year earlier. Even if last year's fiscal retrenchment impacts the economy with a time lag, it is important to note that fiscal spending has already rebounded in recent months, which will become a tailwind for growth down the road. In our view, China's growth recovery since last year has a lot more to do with the "price" of credit rather than "volume." (Chart 3) Real interest rates dropped from double-digit levels that prevailed between 2012 and early 2016 to negative, thanks to a sharp increase in producer prices, while credit growth remained in a broad downtrend. In other words, the dramatic decline in real interest rates rather than an increase in new lending is what played a pivotal role in Chinese reflation. Chart 2Not Much 'Impulse' Not Much 'Impulse' Not Much 'Impulse' Chart 3Credit: 'Price' Matters More Than 'Volume' Credit: 'Price' Matters More Than 'Volume' Credit: 'Price' Matters More Than 'Volume' China's PPI has rolled over, which together with the authorities' attempts to tighten has begun to lift real interest rates. This will likely continue to generate some growth headwinds - a risk that clearly warrants close attention. However, monetary conditions currently are still very accommodative, and there is no reason to expect an overkill to choke off the economy. Why Growth Will Not Falter? Moreover, the bearish argument on China's cyclical outlook is fundamentally rooted in the assumption that the country's economy is dangerously imbalanced1 - a shaky house of cards propped up by policy stimulus that will immediately fall down once the policy pump-priming stops. While the structural profile of the Chinese economy will remain a major global macro issue subject to heated debates going forward, the bearish argument underestimates the economy's resilience, and therefore exaggerates the downside risks. First, it is important to note that China's growth challenges in previous years were to a large extent due to excessively tight monetary conditions, a costly policy mistake that amplified deflationary pressures. Real interest rates were kept at double digits for 5 consecutive years between 2012 and early 2016 while other major central banks were all trying desperately to lower borrowing costs within their respective economies. Furthermore, the trade-weighted RMB appreciated by 20% between 2012 and 2015. In fact, the RMB was the only major currency that appreciated in trade-weighted terms during this period (Chart 4), essentially shouldered deflationary stress for the rest of the world. In addition, Chinese regulators tried hard to block credit flows in an ill-conceived attempt to de-lever - which only prolonged credit intermediation channels and pushed loan demand to even costlier "shadow" institutions.2 All of these factors inflicted dramatic deflationary pain on Chinese manufacturers. Indeed, that the Chinese economy did not implode under the double-whammy of weak global demand and draconian domestic policy tightening - and staged a quick turnaround when monetary conditions eased - underscores the surprising resilience of the Chinese corporate sector. Second, the growth recovery since early last year has significantly improved financial conditions within the corporate sector and eased its balance sheet stress. Overall, companies have increased earnings, reduced inventories and beefed up cash positions (Chart 5). The situation can certainly deteriorate, but the sector is also better prepared for deflationary shocks than in previous years. Chart 4The RMB Shift The RMB Shift The RMB Shift Chart 5Inventory Is Still Very Low Inventory Is Still Very Low Inventory Is Still Very Low Third, even if China's corporate sector, especially industrial enterprises, are indeed as fragile as some bearish analysts claim, Chinese households and the service sector have much healthier fundamentals and therefore are less vulnerable. Consumer confidence has improved significantly in recent months following the growth acceleration, which should further help household consumption. The service sector now accounts for 52% of Chinese GDP, 30% larger than manufacturing. Household consumption and the service sector will provide an important anchor for business activity and prevent a major relapse in economic growth, even if the industrial sector slows more than we currently expect. Finally, the global growth environment is also largely supportive for the Chinese economy. The European economy has been showing some remarkable strength of late, and U.S. growth is likely to pick up after the recent soft patch, as per our U.S. specialists - both of which should bode well for Chinese exports. It is worth noting the recent weaker macro numbers out of China have followed growth disappointments in the U.S. (Chart 6). In fact, the ebbs and flows of "growth surprises" in the world's two largest economies in recent years have been largely in sync, albeit with China experiencing more pronounced volatility. In addition, the risk of an immediate escalation of protectionist backlash between the U.S. and China has also been lowered following President Xi's state visit to the U.S. in April.3 Overall, the Chinese economy is unlikely to slow materially, if the U.S. economy does reasonably well. Chart 6U.S. And China: Synchronized 'Surprises' U.S. And China: Synchronized 'Surprises' U.S. And China: Synchronized 'Surprises' All in all, we expect the Chinese economy will likely continue to moderate, but the downside risk appears low at the moment. In a reported titled "Chinese Growth: Testing Time Ahead," dated April 6th, we warned that "growth figures coming out of China in the coming months may be viewed as less market friendly."4 Recent Chinese data and investor reactions confirm this judgment. Nonetheless, we maintain the view that the Chinese economy's growth improvement remains largely intact, which will reinforce the upturn in the global business cycle and support global risk assets. Strategically we lean against being overly bearish, and we remain cyclically positive on Chinese equities, particularly H shares. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Reports, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, and "More On The Chinese Debt Debate," dated April 20, 2017 available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Reports, "Reflecting On The Trump-Xi Summit," dated April 13, 2017 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Will Trump's trade rhetoric damage the U.S. service sector's abilities to generate a trade surplus and create high-paying jobs? Our assessment of the latest Beige Book via the BCA Beige Book Monitor supports the Fed's view that Q1 weakness was an anomaly and inflation is headed higher. This will keep the Fed on track to tighten in June and again later this year. GDP growth in 2017 is poised to exceed the Fed's forecast for the first time in seven years if the recent pattern of 2H GDP beating 1H GDP growth is repeated. Global oil inventories are set to move lower and drive oil prices higher. The odds of a recession remain low even with the economy at full employment. Feature The May employment report fell short of expectations, but the average gain of 121,000 jobs per month over the past 3 months and the drop in the unemployment rate are still enough to tighten the labor market and keep the Fed on track to tighten later this month. The unemployment rate dipped to 4.3% in May and is now 0.4% below the Fed's view of full employment. Wage growth remains stagnant despite the state of health of the labor market, as year-over-year average hourly earnings growth remained at just 2.5% in May (Chart 1). Chart 1Labor Market Still Tightening##BR##Despite Disappointing May Labor Market Still Tightening Despite Disappointing May Labor Market Still Tightening Despite Disappointing May Taking a broader view, the job picture in the service sector remains robust and wages in the export-oriented service industries remain well above wages in the goods sector. In this week's report we examine the impact of trade on the labor market and highlight areas where Trump's rhetoric may hurt trade-related job growth. Trump At Your Service The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market. Trump campaigned on his ability to create high paying manufacturing jobs, but his America First rhetoric is threatening jobs in the high paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side. U.S. imported goods exceeded exports by $1.3 trillion in 2016. Service exports totaled an all-time high of $778 billion in 2016, $270 billion more than imports. Exports of services have increased by 7% per year on average since 2000, which is nearly twice as fast as nominal GDP (Charts 2A & 2B). Chart 2AThe U.S. Runs Trade##BR##Surplus In Services... The U.S. Runs Trade Surplus In Services... The U.S. Runs Trade Surplus In Services... Chart 2B...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods ...But It's Not Large Enough To Offset The Big Trade Deficit in Goods ...But It's Not Large Enough To Offset The Big Trade Deficit in Goods The trade surplus in services added 0.07% to GDP in Q1 2017, 0.04% in 2016, and has consistently added to GDP growth over the past few decades, although it is swamped by the large drag on GDP as a result of the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is more than seven times faster than in industries where the U.S. runs a deficit. In addition, median wages ($29 as of April 2017) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24) where there is a trade deficit, even though wages are rising quicker in the goods-producing sector in the past year (Chart 3). U.S. service sector exports tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast of a 10% rise in the next 6-12 months (Chart 4). Chart 3Wages In Export Led Service Industries##BR##20% Higher Than In Goods Sector Wages In Export Led Service Industries 20% Higher Than In Goods Sector Wages In Export Led Service Industries 20% Higher Than In Goods Sector Chart 4Service Sector Export Orders##BR##At New High Despite Strong Dollar Service Sector Export Orders At New High Despite Strong Dollar Service Sector Export Orders At New High Despite Strong Dollar However, Trump's trade policies may threaten to reduce the U.S.'s global dominance in services. The U.S. has the largest trade surpluses in travel (which includes education), intellectual property, financial services, and legal, accounting and consulting services (Table 1). The U.S. also runs a large surplus in areas such as intellectual property, software and advertising. In 2015, foreigners spent $92 billion more to travel to, vacation in and be educated in America compared with what U.S. residents spent for those services overseas. Anecdotal reports note that travel to the U.S. is down by as much as 15% since the start of the year, and that 40% of U.S. colleges and universities have seen a decline in foreign applications, putting the nearly $100 billion trade surplus at risk. Other Trump policies, such as the proposed travel ban and some of his "America First" campaign-style rhetoric, could jeopardize the trade surpluses in financial services ($77 billion), software services ($30 billion), TV and film right ($13 billion), architectural services ($10 billion) and advertising ($8) billion. Table 1Key Components Of U.S. Trade Surplus In Services Can The Service Sector Save The Day? Can The Service Sector Save The Day? Trump's trade rhetoric potentially threatens U.S. service exports to NAFTA countries (Canada and Mexico), the Eurozone and the emerging markets. President Trump campaigned on renegotiating NAFTA, supporting Brexit and pulling the U.S. out of the Trans Pacific Partnership (TPP). Trade in services are key to all of those treaties, although trade in goods gets more attention. At $56 billion in 2015, Canada is the U.S.'s second largest service export market, and Mexico is a top 10 destination ($31 billion). Forty percent of U.S. service exports go to Europe, and at $66 billion in 2015, the U.K. is the single largest market for U.S. service exports. The U.S. sends half of its service exports to EM nations, with markets in Asia accounting for just under 30% of all U.S. service exports. Thus investors should carefully monitor the progress of all three of these trade deals to help better assess the impact on U.S. trade and jobs in the service sector. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth as long as there is no retaliation from its trading partners (which is unlikely). But any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. Beige Book Backs The Fed For the Fed, policymakers are treating any potential changes to trade and fiscal policy as risks to their outlook. At the moment, they are judging the need for tighter policy based on the evolution of the labor market and inflation. The Beige Book released on May 31 confirmed the FOMC's base-case outlook. It keeps the Fed on track to tighten in June and then again later this year as it begins to trim its balance sheet. Our quantitative assessment of the qualitative Beige Book that we introduced in April 17 found that the economy had rebounded from a weak Q1 and that inflation was in an uptrend despite recent soft readings.1 The dollar seems to have faded as a key concern for small businesses and bankers. Business uncertainty around government policy (fiscal, regulatory and health) remained elevated. Our analysis of the Beige Book also shows that commercial and residential real estate, the former a surprise source of strength in Q1 GDP, remains stout more than halfway through Q2. Chart 5 shows that the BCA Beige Book Monitor ticked up to 71% in May 2017 from 64% in April. The metric is in line with its cycle highs recorded in mid-2014 as oil prices peaked. "Inflation" words in the Beige Book hit a new peak in May and are in sharp contrast to the recent soft readings on CPI and the PCE deflator. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may be turning up soon. Chart 5May Beige Book Points To Solid Growth In Q2 May Beige Book Points To Solid Growth In Q2 May Beige Book Points To Solid Growth In Q2 In Chart 5, panel 4 we track mentions of "strong dollar" in the report. The May Beige Book saw the same number of references to a strong dollar as the May 2016 report. This suggests that the dollar is not as big a concern for business owners as it was from early 2015 through early 2016. Housing added 0.5 percentage points to growth in Q1, and business spending on structures added 0.7 percentage points. The latest Beige Book suggests that both sectors remain robust here in Q2 (Chart not shown). The implication is that the U.S. economy is poised to clear the low hurdle in 2017 set for it by the FOMC in late 2016. The Fed's economic growth target for 2017 (set at the December 2016 FOMC meeting) was just 2.1%, the lowest year ahead forecast since 2009. The projection incorporates the Fed's lowered trajectory for potential output, but may also reflect the fact that actual GDP growth has not exceeded the Fed's forecast every year since 2009 (Chart 6). GDP growth in 1H 2017 is tracking between 2% and 2.5% despite the weak start to the year. In late May, Q1 GDP growth was revised to +1.2% from the 0.7% reading reported in late April. Based on the Atlanta Fed's GDP Now, the NY Fed's Nowcast and readings on ISM, vehicle sales and the Beige Book, GDP in Q2 is tracking to near 3%. If the economy rebounds from the lackluster first quarter as we expect, then real output will be on course to match or exceed the Fed's forecast for the first time since the recession. We expect an acceleration for fundamental reasons and due to poor seasonal adjustment. In 5 of the past 7 years, real GDP growth in Q3 and Q4 was the same or stronger than the pace of expansion in the first half of the year (Table 2). During that period, 2H output growth averaged 2.4%, while 1H growth was an anemic 1.8%. In the years when Q1 GDP was weak,2 as it was this year, real economic output in the second half of the year accelerated from 1H growth nearly every time. Chart 6 Table 2GDP Growth In 2H Has Met Or Exceeded 1H Growth In 5 Of Past 7 Years Can The Service Sector Save The Day? Can The Service Sector Save The Day? Bottom Line: The latest Beige Book (prepared for the June 13-14 FOMC meeting) confirms policymakers' assessment that the weak growth in Q1 was transitory and inflation is in an uptrend. The economy remains on target to hit or exceed the Fed's growth objectives. The FOMC is poised to raise rates in June and one more time by year end. This view is not discounted in the bond market, implying that Treasury yields are too low. Equity prices could be undermined by higher yields and the dollar, but this will be offset by rising growth (and profit) expectations if our base-case view pans out. Oil Prices: Fade The Recent Weakness A pickup in U.S. growth will also be positive for oil prices, although it is OPEC's efforts to curtail excess inventories that is the main driver of our bullish view. Our commodity strategists believe that OPEC 2.0's recent production cut extension will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating).3 Shale production is bouncing back quickly. OPEC's November 2016 agreement signaled to the world that OPEC (and Russia) would abandon Saudi Arabia's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers to pour money into vastly increased drilling programs. Nonetheless, global oil demand continues to grow robustly. Moreover, production is eroding for oil producers outside of (Middle East) OPEC, Russia and U.S. Shale, which collectively supply half the market. The cumulative effects of spending constraints during 2015-18 will result in falling output in the coming years for this group of producers. Adding it all up, we expect demand to exceed supply for the remainder of 2017, which will result in a significant drawdown in oil inventories (Chart 7). Our strategists think the inventory adjustment will push the price of oil up to US$60 by year end. They expect a trading range of US$45-65 to hold between now and 2020. Chart 8 shows a simple model for oil prices, based on global industrial production, oil production, OECD oil inventories and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, the model implies that oil prices will surge by more than US$10! The coefficient on oil inventories in the model is probably overly influenced by the one major swing in inventories we have seen in the last couple of decades, suggesting that we must take the results with a grain of salt. Nonetheless, our point is that oil prices have significant upside potential if the excessive inventory problem is solved. Chart 7Significant Drawdown##BR##In Inventories Is Coming Significant Drawdown In Inventories Is Coming Significant Drawdown In Inventories Is Coming Chart 8Upside Potential For Oil##BR##If Inventory Issue Is Resolved Upside Potential For Oil If Inventory Issue Is Resolved Upside Potential For Oil If Inventory Issue Is Resolved Bottom Line: The extension of OPEC 2.0 production cuts reinforces our bullish view for oil prices. Revisiting The Odds Of A Recession It seems odd at first glance to be discussing recession risks at a time when growth is poised to accelerate. Nonetheless, BCA's Global Investment Strategy service recently noted that investors should be on watch for recession now that the economy has reached full employment.4 Historically, once the unemployment rate reached estimates of full employment, the odds of a recession in the subsequent 12 months increased four-fold. In last week's report, we maintained that the lack of progress on fiscal policy by the Trump administration may actually be positive for risk assets in the medium term because it would stretch out the cycle and thus lower recession risks.5 The economic data have disappointed so far this year, as highlighted by the economic surprise index (Chart 9). Despite this, there is not much talk of recession in the news media and various models also show slim chances of recession this year (Chart 10). Only one of eight components in our BCA model is flashing recession: the three-year moving average of the Fed funds rate is rising because the Fed rate hike cycle began in late 2015. Chart 9Economic Data Still Disappointing, But Does Not Signal A Recession Economic Data Still Disappointing, But Does Not Signal A Recession Economic Data Still Disappointing, But Does Not Signal A Recession Chart 10Odds Of A Recession This Year Remain Low Odds Of A Recession This Year Remain Low Odds Of A Recession This Year Remain Low In a prior report we dismissed the rollover in commodity prices as a recessionary signal and noted that Trump's political woes would only slow the GOP's legislative agenda. Nonetheless, even without fiscal stimulus, the U.S. economy will still grow above its long-term potential, tighten the labor market and push up wages and inflation in the coming quarters. Bottom Line: The odds of recession remain low despite the U.S. economy being at full employment. The delay in Trumponomics' will prolong the expansion and will support risk assets over the next 6-12 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 1 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 3 Please see Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", dated June 1, 2017, available at ces.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight", dated May 26, 2017, available at gis.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Corporate Earnings Versus Trump Turbulence", dated May 29, 2017, available at usis.bcaresearch.com.

Feature Table 1 Monthly Portfolio Update Monthly Portfolio Update Growth And Its Implications We still see little on the horizon to undermine a continued rally in risk assets over the next 12 months. U.S. economic growth will be propelled by an acceleration in both consumption and capex - leading indicators for both point to further upside (Chart 1). The weak U.S. GDP growth in Q1, just 1.2% annualized, was dragged down by two, less meaningful elements: inventories (which fell, deducting 1 ppt from growth) and imports (which rose, deducting 0.6 ppt). Regional Fed GDP "nowcasts" are pointing to 2.2-3.8% growth in Q2. Corporate earnings had their best quarter in five years in Q1, with S&P500 sales up 8% and EPS up 14% - but, despite this, analysts have barely revised up their calendar year EPS growth forecast, which stands at 10%. In Europe, loan growth has picked up to 2.5% YoY, with the credit impulse indicating that GDP growth is likely to remain above trend at around the 2% it achieved in Q1 (Chart 2). But the stronger growth has implications. It suggests the market is too complacent about the probability of Fed tightening. Futures are pricing a hike on June 14 as a near certainty but, after that, imply little more than one further 25bp rise by end-2019 (Chart 3). We expect two hikes before the end of 2017. Not least, the Fed will be cognizant of how financial conditions have recently eased, not tightened, despite its raising rates in December and March (Chart 4) and will want to put in place insurance against inflation rising sharply in 12 months' time, especially given that it may wish to hold back from hikes early next year as it begins to reduce its balance-sheet. Chart 1Consumption And Capex On Track to Rebound Consumption And Capex On Track to Rebound Consumption And Capex On Track to Rebound Chart 2Euro Credit Growth Looks Good For GDP Euro Credit Growth Looks Good For GDP Euro Credit Growth Looks Good For GDP Chart 3 Will The Fed Really Be This Slow? Will The Fed Really Be This Slow? Will The Fed Really Be This Slow? As a result, 10-year U.S. Treasury bond yields are likely to move back up. The 40bp fall from the peak of 2.6% in March was caused partly by softer growth and inflation data, but also reflected a correction after the excessive pace at which rates had run up - the fastest in 30 years (Chart 5). The combination of stronger growth, a 50bp higher Fed Funds Rate, and a moderate acceleration of inflation as wages begin to pick up again, should push the 10-year yield to above 3% by year-end. Chart 4Fed Must Worry About Easing Conditions Fed Must Worry About Easing Conditions Fed Must Worry About Easing Conditions Chart 5Rates Couldn't Keep Rising This Fast Rates Couldn't Keep Rising This Fast Rates Couldn't Keep Rising This Fast Momentum for risk assets over the coming months is likely to slow a little. Global PMIs have probably peaked for now (Chart 6) and investors should not expect to repeat the 19% total return from global equities they have enjoyed over the past 12 months. And there are potential pitfalls: China could continue to slow, and European politics could come into focus again (with early Austrian and Italian parliamentary elections looking increasingly possible for the fall). Investors may also worry about the chaotic state of the Trump White House. However, we never believed the U.S. presidential election had much impact on markets (the S&P500 has risen by 2% a month since then, whereas it had risen by 4% a month over the previous nine months). If anything, there could still be a positive catalyst if Congress is able to pass a tax cut before year-end - which we see as likely - since this is no longer priced in (Chart 7). Chart 6Momentum For Equities Will Slow A Little Momentum For Equities Will Slow A Little Momentum For Equities Will Slow A Little Chart 7No One Expects A Corporate Tax Cut No One Expects A Corporate Tax Cut No One Expects A Corporate Tax Cut On balance, then, we continue to see equities outperforming bonds comfortably over the next 12 months, and so keep an overweight on equities within our asset class recommendations. We also maintain the generally pro-cyclical, pro-risk and higher-beta tilts within our multi-asset global portfolio. Equities: The combination of cyclical economic growth, accelerating earnings, and easy monetary conditions represents a positive environment for global equities. Valuations are not particularly stretched: forward PE for the MSCI All Country World Index is 15.9x, almost in line with the 30-year average of 15.7x (Chart 8). The Vix (30-day implied volatility on S&P500 options) may look low - famously it dipped below 10 last month, raising fears of complacency - but the Vix term structure is fairly steep, implying that investors are hedging exposure three and six months out (Chart 9). Within equities, our preference remains for DM over EM. The latter will be hurt by the slowdown in China (Chart 10), a rising dollar, the ongoing slowdown in credit growth in most EM economies, and continual political disappointments (most recent example: Brazil). We like euro zone equities, on the grounds of their high beta and greater cyclicality of earnings. We are overweight Japan (with a currency hedge), since rising global rates will weaken the yen and boost earnings. Chart 8Global Equity Valuations Are Not So High Global Equity Valuations Are Not So High Global Equity Valuations Are Not So High Chart 9 Chart 10China's Slowdown Should Hurt EM China's Slowdown Should Hurt EM China's Slowdown Should Hurt EM Fixed Income: As described above, we expect the U.S. 10-year Treasury yield to reach 3% by year-end. This should mean a negative return from global sovereign bonds for the year as a whole, for the first time since 1994. Accordingly, we remain underweight duration and prefer inflation-linked over nominal bonds in most markets. In this positive cyclical environment, we continue to overweight credit, with a preference for U.S investment grade (which trades at a 100 bp spread over Treasuries) over high-yield bonds (where valuations are not as attractive) and euro area credit (which will be hurt when the ECB starts to taper its bond purchases). Currencies: The temporary softness in the dollar has probably run its course. Interest rate differentials between the U.S. and other G7 countries point to further dollar appreciation (Chart 11). At the same time as we expect the Fed to tighten more quickly than the market is pricing in, we see the ECB setting monetary policy for the euro periphery (especially Italy) which, given weak fundamentals (Chart 12), cannot bear much tightening. The Bank of Japan, too, will stick to its yield curve control policy which, as global rates rise, ought to significantly weaken the yen. Chart 11Interest Differentials Point To Stronger USD Interest Differentials Point To Stronger USD Interest Differentials Point To Stronger USD Chart 12Italy Can Not Bear A Rate Hike Italy Can Not Bear A Rate Hike Italy Can Not Bear A Rate Hike Chart 13OPEC Cut Agreement Showing Through OPEC Cut Agreement Showing Through OPEC Cut Agreement Showing Through Commodities: The recently agreed extension of the OPEC agreement should push crude oil prices up to around $60 a barrel in the second half. OPEC production has already fallen noticeably since the start of the year, but the response from non-OPEC producers - including North American shale - to boost output has so far been subdued (Chart 13). Metals prices have fallen sharply over the past two months (iron ore, for example, by 36% since March) as Chinese growth slowed as a result of moderate fiscal and monetary tightening. They could have further to fall. But China, with its key five-year Party Congress scheduled for the fall, is likely to take measures to boost activity if economic growth slows much further, which would help commodities prices stabilize. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation

Dear Client, I will be visiting clients in Asia over the next ten days, so we are sending you this week's report a bit ahead of schedule. In addition, at the end of this report, we are including the recommendations from our tactical asset allocation model. Going forward, we will be updating these recommendations on our website at the end of every month. Please feel free to contact us if you have any questions. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Feature Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart 1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart 1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart 2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart 3 shows that productivity gains in the latter category have been much smaller than in the former. Chart 2The Great Recession Hit##BR##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation Chart 3The Shift Towards Software Has##BR##Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 5). Test scores tend to be much lower in countries with rapidly growing populations (Chart 6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 4 Chart 5 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart 7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart 6 Chart 7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart 8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart 9). Chart 8 Chart 9U.S. Interest Rates Soared In The 1970s##BR##While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Chart 10The Fed Continuously Overstated The Magnitude##BR##Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart 10 shows that the Fed consistently overestimated the size of the output gap during that period. Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart 11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart 12). Chart 11Asian Tigers: Growth Took Off First,##BR##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart 12China: Productivity Growth Accelerated,##BR##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart 13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart 14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart 15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart 13China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart 14 Chart 15Aging Will Reduce##BR##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart 16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart 17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart 18). This will result in a lower neutral rate. Chart 16U.S.: Real Wages Have Been##BR##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart 17 Chart 18Savings Heavily Skewed##BR##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart 19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart 20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart 21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart 19Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Chart 20 Chart 21The Low-Hanging Fruits Of##BR##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. Chart 22Output Gap Has Narrowed##BR##Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart 22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. APPENDIX: Tactical Global Asset Allocation Monthly Update To complement our analysis and intuition, we use a variety of time-tested models to assess the global investment outlook. Compared to last month, our tactical (3-month) model is recommending an upgrade to global equities at the expense of government bonds. Global equities have consolidated their gains, removing some of the overbought conditions that prevailed earlier in May. Bullish equity sentiment has also waned somewhat, while net speculative positioning in U.S. stocks has moved from being net long to net short. In contrast, speculative positioning in Treasurys has jumped into net long territory (Chart A1). Our models say that government bonds in most economies remain overbought. Image Regionally, we continue to favor higher-beta developed equity markets such as Europe and Japan. Canada, Australia, and most emerging markets have also received an upgrade, owing to a more favorable near-term outlook for commodity prices. Within the bond universe, U.S. Treasurys are most vulnerable to a selloff, given that the market is pricing in only two rate hikes over the next 12 months. Image Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation Chart II-3The Shift Towards Software Has ##br##Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-4 Chart II-5 Chart II-6 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8 Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14 Chart II-15Aging Will Reduce ##br##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17 Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. Chart II-19Falling Capital Goods Prices Have ##br##Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Chart II-20 As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed Thanks ##br##To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com.

Highlights EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS. BCA's Emerging Markets Strategy team has a more pessimistic outlook than the BCA house view, which is upbeat on the prospects for China's capex growth and commodity prices. The ongoing liquidity tightening in China amid lingering credit excesses is bound to produce major negative growth surprises. The authorities will reverse the ongoing monetary tightening only if the pain on the ground becomes visible or the economic data deteriorates significantly. Financial markets will sell off considerably in advance. In Chile, take profits on the receiving 3-year swap rate trade; stay neutral on this bourse within an EM equity portfolio. Feature EM Profit Recovery: How Enduring? EM equities have not only advanced in absolute terms but have also outperformed developed market (DM) share prices considerably since early this year. This outperformance has been rationalized by a recovery in EM earnings per share (EPS). Indeed, EM EPS has revived briskly in recent months (Chart I-1A). Chart I-1AEM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) EM/China Profits Growth To Roll Over (I) Chart I-1BEM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) EM/China Profits Growth To Roll Over (II) For this rally to continue, EM EPS would need to continue to expand further. We do not expect this. On the contrary, our bet is that EM EPS growth will slow considerably later this year and most likely contract in early 2018. Our basis is that the growth (first derivative) and impulse (second derivative) of EM & Chinese narrow money (M1) has in the past led their respective profit cycle (Chart I-1A and Chart I-1B). If these relationships hold and EM EPS growth dwindles later this year, EM share prices should begin to sense it now, and start falling back very soon. Interestingly, EM EPS net revisions have failed to rise above the zero line despite the recent rebound in profits (Chart I-2, top panel). This is in contrast to DM EPS net revisions, which have surged well above zero (Chart I-2, middle panel). As a result, recent EM relative outperformance against their DM peers has occurred despite the drop in relative net EPS revisions (Chart I-2, bottom panel). This presages EM equity analysts are not revising upward their forward estimates for EM EPS, despite the ongoing rally in share prices. This is extremely puzzling (and rare) and may be a reflection of recent weakness in commodities prices - or the fact that expectations for EM EPS growth were already elevated. We do not place much emphasis on analysts' EPS revisions because the latter swing with stock prices - they have zero forecasting power for share prices. We highlight this fact simply to counter the common market narrative that EM corporate earnings growth expectations are improving, driving EM bourses higher. Bottom Line: EM EPS has recovered, supporting the current rally. However, forward-looking indicators portend a reversal and potential renewed contraction in EM EPS nine months ahead. Importantly, EM equity prices relative to DM shares are at a major technical juncture (Chart I-3). A decisive breakout would be a very bullish technical signal, whereas a failure to break out would be an important warning sign. We continue to bet on the latter. Chart I-2EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM EPS Net Revisions: EM And DM Chart I-3Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM Relative Equity Performance: EM Versus DM China's Credit Cycle And Commodities Redux Our overarching theme has been and remains that China is tightening liquidity amid a lingering credit bubble. This cannot end well for financial markets that are exposed China's growth. Here we revisit our rationale for a credit slowdown in China and its impact on EM. Chinese interest rates have risen dramatically since last November across the entire yield curve. The 3-month interbank rate and AA- on-shore corporate bond yields both have risen by about 200 basis points since November 1, 2016. Monetary policy works with a time lag, and higher interest rates warrant a slowdown in credit growth (Chart I-4). In turn, it takes only a deceleration in credit growth for the credit impulse - the second derivative of outstanding credit - to turn negative. The falling credit and fiscal impulse will consequently lead to a relapse in Chinese import volumes and EM EPS (Chart 5), in turn weighing on commodity prices and non-commodity producing countries like Korea and partially Taiwan. Mainland import volumes contracted mildly in the second half of 2015, as demonstrated in Chart I-5. De facto, from the perspective of the rest of the world, China was in mild recession in late 2015. Not surprisingly, global risk assets in general, and particularly those exposed to China, tumbled. Chart I-4China: Higher Rates Point To##br## Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse China: Higher Rates Point To Negative Credit Impulse Chart I-5China's Credit Impulse Heralds ##br##Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports China's Credit Impulse Heralds Slowdown In Its Imports We expect China import volumes to shrink again by the end of this year or early next. Some sort of replay of 2015 is a real possibility. The broad-based yet mild selloff in commodities since early this year (Chart I-6) amid weakness in the U.S. dollar exchange rate gives us confidence in our view. Chart I-6ABroad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Broad-Based Selloff In Commodities (I) Chart I-6BBroad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Broad-Based Selloff In Commodities (II) Our colleagues at BCA have attributed the selloff in commodities this year to deleveraging in China's shadow banking system, and to traders worldwide closing their long positions. They expect an improving commodities supply-demand balance to support prices going forward. It makes sense to us to explain the selloff in commodities as having been caused by deleveraging in China's shadow banking system. Yet to be consistent, we should also acknowledge that the rally in commodities last year was to a large extent driven by the same forces in reverse: non-commercial buyers (investors) buying commodities both in China and elsewhere. In short, this signifies there was little improvement in worldwide commodities demand last year. In 2016, rising commodities prices provided a significant boost to commodity-producing countries and underlying corporate profits - and ultimately EM risk assets. The drop in commodities prices this year, if sustained, should lead to the opposite dynamic: income/profits among commodities countries/companies will drop. As such, falling commodities prices amid diminishing investor demand for commodities is bearish for EM risk assets. Where we differ from the majority of our colleagues at BCA is that we expect Chinese credit growth to decelerate, thereby weighing on its capital spending and depressing demand for commodities (please refer to Chart I-5). We have written extensively1 on this topic and will not fully rehash our view that China's annual credit growth will decelerate from the current 12% to somewhere around 8% in the next 12-18 months. In short, China's corporate and household credit-to-GDP ratio cannot rise indefinitely from an already high level of 225% of GDP. Credit growth will likely downshift to a level of sustainable nominal GDP growth, which is probably around 8%. Our main disagreement with our colleagues on structural issues is as follows: we believe China's credit excesses are not a natural outcome of the nation's high savings rate but rather the outcome of a speculative credit boom driven by high-risk behavior among creditors and debtors.2 Tightening liquidity amid such speculative excesses creates a very bearish backdrop for risk assets exposed to China's credit cycle. The bullish camp on China has recently pointed to a strong recovery in mainland nominal GDP growth, which in their view suggests that double-digit credit growth in China is not excessive (Chart I-7). However, such a surge in nominal GDP growth has been due to the GDP deflator rising from zero in the fourth quarter of 2015 to 5% in the first quarter of this year. Importantly, the swings in the GDP deflator almost perfectly correlate with the fluctuation in commodities prices (Chart I-8). This proves how much China's economy is exposed to commodities cycles and how much of nominal GDP swings are stipulated by resource price swings. Chart I-7China: Credit And ##br##Nominal GDP Growth China: Credit And Nominal GDP Growth China: Credit And Nominal GDP Growth Chart I-8China's GDP Deflator Is Very Sensitive##br## To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices China's GDP Deflator Is Very Sensitive To Commodities Prices As commodities prices decline, China's GDP deflator, producer prices and nominal GDP growth will all dwindle. Thereby, China's underlying steady state nominal GDP growth is probably around 8% at best (5.5-6% real growth), with inflation of 2-2.5% (assuming flat commodities prices). If this is indeed the case, corporate and household credit growth of 12% entails a further build-up of leverage and an escalating non-public credit-to-GDP ratio, which already stands at 225% of GDP: corporate debt is 180% and household debt is at 45% of GDP. Bank loans account for 70%, while shadow (non-bank) funding channels (corporate bonds, trust products, entrusted loans, and banker's acceptance) constitute 30% of outstanding non-public credit or 65% of GDP. Both are growing at an annual rate of 11-12.5% (Chart I-9). On the whole, the share of shadow banking is non-trivial and its current growth pace is unsustainable amid ongoing regulatory tightening and rising interest rates. Furthermore, banks are themselves exposed to shadow banking as their claims on non-depository financial institutions have risen exponentially from RMB 3 trillion to RMB 27 trillion over the past five years. In regard to non-standard credit assets,3 our estimates are that banks' off-balance-sheet exposure is RMB 10 trillion compared with RMB 18.3 trillion of their balance-sheet non-standard credit assets. The off-balance-sheet credit exposure to non-standard credit assets is much larger for medium and small banks than the largest five (Table I-1). We discussed these issues in greater detail in our June 15, 2016 Special Report titled "Chinese Banks' Ominous Shadow". Chart I-9Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Bank Loans And Non-Bank (Shadow) Credit Growth Chart I- With banks being forced by regulators to bring off-balance-sheet assets onto their balance sheets, their capital adequacy ratios will drop and their ability to sustain double-digit credit growth will be curtailed. Chart I-10Stay With Short Small / Long Large ##br##Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade Stay With Short Small / Long Large Banks Equity Trade The risks to medium and small banks is greater than to the large five banks. That is why we reiterate our recommendation from October 26, 2016 to short small banks versus large ones (Chart I-10). As a final note, we are often asked whether the government will provide a bail out if things deteriorate. Yes, we concur that policymakers will step in and backstop a financial system to preclude a systemic crisis. However, they are tightening now, and like the rest of us have little visibility. The authorities will meaningfully reverse the ongoing monetary tightening only if the pain on ground becomes visible or economic data deteriorate considerably. Financial markets will sell off materially in advance. Bottom Line: Investors should not be long China-plays, commodities and EM risk assets when mainland policy tightening is occurring amid lingering speculative credit excesses. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Strategy For Chilean Markets We recommended receiving 3-year swap rates on November 2, 2016 and this position has panned out with rates dropping by 30 basis points. We now recommend booking profits. The following has led us to conclude that the risk-reward profile of this position is no longer attractive: The improvement in narrow money (M1) growth points in a bottom in the economic activity indicator (Chart II-1). Mining production plunged amid the strikes in the world's largest copper producer Codelco (Chart II-2, top panel) and manufacturing production has also been contracting (Chart II-2, bottom panel). A period of improvement in mining and manufacturing output from a very low base is likely. Chart II-1Book Profits On Receiving ##br##3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Book Profits On Receiving 3-Year Swap Rate Position Chart II-2Chile: Money And Economic##br## Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out Chile: Money And Economic Activity Are Bottoming Out This will ameliorate overall business conditions and cause the central bank, at least for the time being, to halt the easing cycle. The pace of expansion in employment, wage growth, and consumer credit remains decent (Chart II-3). This will put a floor under household spending growth for now. Odds are that copper prices will decline meaningfully in the next nine months or so, which will cause the Chilean peso to depreciate. Although a depreciating currency will not to lead to materially higher interest rates in Chile, it will limit downside in local rate expectations. Finally, local 3-year swap rates and their spread over U.S. 3-year bond yields are extremely low from a historical perspective (Chart II-4). At this point, there is little value left in Chilean local rates. Chart II-3Chile's Mining And Manufacturing ##br##A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chile's Mining And Manufacturing A Period Of Stabilization Ahead Chart II-4Chile: Consumer Spending##br## Is Holding Up Chile: Consumer Spending Is Holding Up Chile: Consumer Spending Is Holding Up Investment Conclusions Chart II-5Chilean Local Rates Spreads Over ##br##U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left Chilean Local Rates Spreads Over U.S. Treasurys: Not Much Value Left We do not expect the central bank to hike but the downside in local rates is limited for the time being. Take profits on the receiving 3-year swap rate trade. As to equities, the outlook for relative performance is balanced; we continue recommending a benchmark weight in Chile for dedicated EM equity portfolios. For absolute return investors, the risk-reward profile is not attractive because our profit margin proxy points to a relapse in corporate earnings (Chart II-5). Unit labor costs are rising faster than the core inflation rate, producing a profit margin squeeze (Chart II-5, bottom panel). Finally, we continue shorting the peso versus the U.S. dollar as a bet on lower copper prices. 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Reports titled, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?", dated March 23, 2017, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, "Misconceptions About China's Credit Excesses", dated October 26, 2016 and "China's Money Creation Redux And The RMB", dated November 23, 2016, available at ems.bcaresearch.com 3 Non-standard credit assets are banks' claims on corporates that are not classified as loans. For more details please refer to the Emerging Markets Strategy Special Report titled, "Chinese Banks' Ominous Shadow", dated June 15, 2016, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Reflation Trade: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. New Zealand: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean government bond market. Feature "I know it makes no difference to what you're going through; but I see the tip of the iceberg, and I worry about you." - Rush Is The Liquidity Party Starting To Wind Down? Global financial markets continue to enjoy the "sweet spot" of a solidly expanding global economy, but without enough inflation pressure to force central banks to slam on the monetary brakes. That backdrop is starting to change, though. Odds are rising that the European Central Bank (ECB) will begin tapering its bond buying next year, with some hints of that possibly being announced as soon as next week's monetary policy meeting. At the same time, the Bank of Japan (BoJ) - faced with the operational constraints of buying an ever-increasing share of Japanese financial assets - is focused on targeting long-term interest rates rather than increasing liquidity. Even the Federal Reserve is now talking about reducing its massive balance sheet later this year. The liquidity tailwind to global growth and risk assets is now at risk of becoming a headwind. Already, the growth rate of the major central bank balance sheets has rolled over and is on course to decelerate further over the next year (Chart of the Week). Importantly, this downshift in global liquidity momentum is happening as signs of slowing growth have appeared in some major economies like China and the U.S. (Chart 2). Chart of the WeekLiquidity Tailwind To Risk##BR##Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Liquidity Tailwind To Risk Assets Is Fading Chart 2Growth Momentum##BR##Already Starting To Cool Off Growth Momentum Already Starting To Cool Off Growth Momentum Already Starting To Cool Off We remain concerned that the Chinese economy will see a policy-induced deceleration in the 2nd half of the year. However, we still expect the U.S. to rebound after the soft patch of growth in the first quarter, and we see nothing in the Euro Area data to suggest that the current solid expansion is at risk of fading quickly. This should allow inflation expectations to drift upward toward the central bank targets given the apparent lack of spare capacity on both sides of the Atlantic (Chart 3). Chart 3Fed & ECB Facing##BR##Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints Fed & ECB Facing Economic Capacity Constraints We still expect the Fed to deliver another two rate hikes before year-end and the ECB to begin its exit strategy from the current extraordinary monetary policies by slowing the pace of asset purchases starting early next year. For now, the backdrop will remain supportive for the outperformance of growth-sensitive assets like corporate credit and equities over government bonds in the U.S. and Europe over the balance of 2017. However, the early signals sent by "leading leading" indicators such as our Global Leading Economic Indicator diffusion index (Chart 2, top panel) suggests that liquidity and growth trends will become far more challenging for the markets in 2018. Bottom Line: The backdrop for global growth and monetary liquidity remains positive, and suggests that risk assets will outperform government debt for the balance of 2017. However, there are some early signs of fading momentum which raises risks for financial markets in 2018. Maintain a below-benchmark duration exposure and an overweight allocation to corporate debt in global fixed income portfolios. New Zealand: Safety From A Global Bond Apocalypse? A growing number of the world's most wealthiest (and, arguably, most paranoid) people are reportedly buying real estate in New Zealand as a safe haven place to live if modern civilization collapses.1 While the immediate need for taking such precautions can be debated, there is sound logic in treating New Zealand as a location far removed from the current geopolitical and socio-economic problems of the world. We now see a case for treating New Zealand bonds as a potential "safe haven" market for global fixed income investors. The Economic Backdrop Has Become More Muddled We have been running a SHORT position in New Zealand (paying 12-month OIS rates) in our Tactical Overlay portfolio since last November. Our view then was that the New Zealand economy would surprise to the upside in 2017 and inflation was likely to start drifting upward. This would pressure the Reserve Bank of New Zealand (RBNZ) to raise the Official Cash Rate (OCR) from the highly accommodative level of 1.75%. So far, that expectation has not panned out as the RBNZ has held rates steady amid a more uncertain outlook for the New Zealand economy. Growth indicators have been a bit mixed over the past few months, but the current uptick in the manufacturing purchasing managers' index (PMI) is pointing to real GDP expanding around 3% on a year-over-year basis (Chart 4). If maintained for the full year, this would be slightly above the RBNZ's estimate of potential growth at 2.8%. There are some downside risks, however, given that consumer and business confidence are both below previous cyclical peaks and fiscal policy is expected to be mildly restrictive in 2017 (bottom three panels). The housing market remains a key cyclical wild card. Residential construction has been a significant source of growth over the past few years, driven by a surge in net immigration into New Zealand and declining interest rates (Chart 5). However, the RBNZ is projecting immigration inflows to slow from the current high level, largely due to improving labor market conditions in the developed economies (most notably, Australia, which is the largest source of New Zealand immigrants). Chart 4Stable NZ Growth...For Now Stable NZ Growth...For Now Stable NZ Growth...For Now Chart 5NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out NZ Housing Activity Starting To Peak Out Slower immigration would reduce the demand for New Zealand housing at a time when mortgage rates have already been rising off the record lows seen in 2016 (bottom panel). This has occurred without any rate hikes from the RBNZ, as rising global bond yields have put upward pressure on New Zealand bank funding costs, which have been passed through to higher mortgage rates. The RBNZ is currently projecting growth in house prices to slow sharply from last year's robust 15% pace to just 5% in 2017. The main drivers are higher borrowing costs and the ongoing impact of macro-prudential regulations against high loan-to-value ratio mortgage lending. Importantly, slower housing activity will not only have a direct impact on GDP growth through softer construction, but will also indirectly dampen consumer spending growth via wealth effects. Yet even with this expected drag on growth from housing, the New Zealand economy is still expected to face capacity constraints over the rest of the year. Higher Uncertainty Over Price Pressures Both the RBNZ and the International Monetary Fund estimate that the output gap has fully closed and is projected to move into positive territory this year (Chart 6). At the same time, the current unemployment rate of 4.9% is below the OECD's estimate of the full employment level and the RBNZ projects a further decline in joblessness in 2017 (third panel). Despite this evidence of the economy reaching capacity constraints, both wage growth and price inflation remain subdued and inflation expectations remain well-anchored around 2% - the midpoint of the RBNZ's 1-3% target range. Wage costs are particularly depressed, growing only 1% on a year-over-year basis in Q1. This may be related to the rise in the labor force participation rate - up to an all-time high of 70.6% in Q1 from a cyclical low of 68.2% at the end of 2015 - that has increased the available supply of labor. The most recent headline inflation print for Q1 was quite strong, taking the year-over-year growth rate up to 2.2%. Yet in the RBNZ's April Monetary Policy Statement (MPS), the central bank took a surprisingly dovish tone, citing uncertainty over the true degree of slack in the economy and downside risks to growth that would prevent a further acceleration of inflation.2 The RBNZ now forecasts inflation to not rise above 2.2% this year and to fall back to 1.1% in both 2018, led by a sharp decline in growth for tradeables, mostly energy and food inflation (Chart 7). Importantly, this forecast includes the recent decline in the trade-weighted New Zealand Dollar (NZD). Non-tradeables inflation is also expected to stabilize on the back of slower housing-related items in the consumer price index. Chart 6RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... RBNZ Not Expecting A Big Rise In Inflation... Chart 7...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools ...As Growth In Tradeables Prices Cools A Weaker Case For Tighter Monetary Policy The official RBNZ projection is that the OCR will stay unchanged at 1.75% until September 2019. The market expectation priced into the NZD OIS curve calls for 27bps of hikes over the next twelve months (Chart 8). Our New Zealand Central Bank Monitor has been suggesting the need for tighter monetary policy since mid-2016, but appears to be rolling over (2nd panel). The diminished rate hike expectations have coincided with a decline in the NZD and a sharp underperformance of New Zealand equities. The markets are giving a consistent signal on softening growth prospects in New Zealand, confirming the central bank's more recent dovish turn. Chart 8Market Expectations Of##BR##RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Market Expectations Of RBNZ Hikes Are Fading Given the newfound uncertainties over the New Zealand growth and inflation outlook, the case for owning New Zealand interest rate exposure has grown a little bit stronger. Admittedly, we do not envision a major pullback in growth, and inflation may not fall by as much as the RBNZ is expecting given how little spare capacity there appears to be in the economy. Yet there is now just enough uncertainty to keep the central bank on hold for longer than expected, as was noted in the "scenario analysis" section of the April MPS.3 The RBNZ noted that if the level of spare capacity is smaller than currently assumed, then the latest growth forecast will result in inflation eventually moving to 2.0% in 2018 and 2.3% in 2019, resulting in the OCR needing to rise to 2.25% in two years. Alternatively, if housing demand slows even faster than current projections, inflation would be below the 2% target during the next two years and the OCR would need to fall to 1.25% by the end of 2018. Our takeaway from this is that, even in the more positive scenario, interest rates are not expected to rise by much more than the markets are currently discounting. Position For Tighter New Zealand Spreads Versus Treasuries & Bunds The economic risks in New Zealand now appear evenly balanced. This argues for stable monetary policy and diminished bond volatility. Current market forwards for both government bonds and NZD swaps shows that very little movement in interest rates is expected over the next year (Chart 9). We generally agree with this pricing, although the uncertainty over the degree of spare capacity, and underlying inflation pressures, make a directional view on interest rates or the shape of the yield curve an unattractive risk proposition. A more interesting opportunity presents itself in looking at spread trades between New Zealand government bonds versus other developed market sovereign debt. The yield betas for New Zealand versus the U.S. and Germany have fallen steadily over the past year (Chart 10), indicating that New Zealand bonds can be more insulated from the rise in yields that we expect for U.S. Treasuries and German Bunds over the latter half of 2017. Given the competitively high yields on offer in New Zealand, even on a currency-hedged basis (bottom panel), we see a case for going long New Zealand interest rate exposure versus U.S. and Germany. Chart 9Higher NZ Bond Yields##BR##Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Higher NZ Bond Yields Priced Into Forwards Chart 10NZ Bonds: Now Lower Beta##BR##With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields NZ Bonds: Now Lower Beta With Higher Hedged Yields At current yield levels, going long New Zealand versus Germany looks more compelling relative to spread compression trades versus U.S. Treasuries. We see strong potential for New Zealand-Germany spreads to tighten faster than the forwards over the next six months (Chart 11), largely through rising German yields as the ECB signals that a tapering of bond purchases is set to begin next year. The downside potential for New Zealand-U.S. spread compression looks less likely from current tight levels, although if Treasury yields rise by as much as we expect in the coming months, some spread tightening should occur here, as well. Chart 11Go Long 5Yr NZ Bonds Vs##BR##USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Go Long 5yr NZ Bonds vs USTs and German OBLs Based on our analysis, we are closing our current NZD rates trade in our Tactical Overlay portfolio with a tiny profit of +3bps , and entering two new trades: long 5-year NZD government bonds versus 5-year U.S. Treasuries, on a currency-hedged basis; and long 5yr NZD government bonds versus 5-year German government debt, on a currency-unhedged basis.4 We are choosing to hedge the currency exposure back into USD for the former given the view of BCA's currency strategists that the EUR/USD exchange rate is now stretched too far to the upside and is at risk of declining as the Fed delivers on additional rate hikes in the coming months.5 In other words, we see a greater potential for a decline in NZD/USD than NZD/EUR in the next 3-6 months. Bottom Line: The more dovish tone taken by the RBNZ reflects the more uncertain outlook for New Zealand growth and inflation, in contrast to the strong likelihood of additional Fed rate hikes and an ECB taper announcement in the next few months. Go long 5-year New Zealand government bonds versus 5-year U.S. Treasuries (currency-hedged) and also versus 5-year German government debt (currency-unhedged). South Korea: A Bad Moon Rising For Bond Yields Chart 12Markets Not Worried##BR##About The New President Markets Not Worried About The New President Markets Not Worried About The New President The new South Korean president, Moon Jae-In was elected on May 9th, ending a year of political turmoil after the previous president's scandal and impeachment. Our colleagues at BCA Geopolitical Strategy view Moon and his Democratic Party as a major shift to the political left.6 The new president's policy agenda is aimed at economic stimulus for the working class alongside reforms of the country's chaebol industrial giants. Korean financial markets have greeted the election result positively, with the benchmark KOSPI equity index up 2.7%, and the Korean won up 1% versus the U.S. dollar, from the pre-election levels on May 8th. (Chart 12). This is consistent with past market behavior, as the won tends to be less reactive toward domestic events (i.e. after the previous president's impeachment, the won actually strengthened) and more sensitive to international uncertainties (i.e. North Korea-U.S. military tensions, as occurred in mid-March). Korean interest rates, however, have shown little response to the change in leadership in Seoul, with bond yields unchanged since the election. We see this as presenting an opportunity for fixed income investors. Clearly, the new regime in Seoul represents a real change for the Korean people, but it also represents a potential shift in the economic backdrop - namely, through an expected large fiscal stimulus from the new government - that will impart a steepening bias to the Korean interest rate curve. A Sluggish Economy Greets The New President While the steady, if unspectacular, pace of global growth in the past few years has been enough to absorb spare capacity in many countries, South Korea's sub-par economic performance has left the country with a widening output gap (Chart 13). Policymakers are well aware that consumer spending, which contributes about 60% of GDP, has been steadily weakening alongside slowing credit growth. Chart 13Sluggish Growth In South Korea Sluggish Growth In South Korea Sluggish Growth In South Korea The new government will attempt to boost domestic consumption, and thus overall growth, by increasing social welfare spending. Moon's economic agenda calls for raising the minimum wage by 55% by 2020, increasing subsidies for education costs and parental leave, and doubling the basic pension payment for the elderly regardless of their income level. It might prove to be very effective in the short term at boosting consumer spending, but this may not prove to be a sustainable driver of growth in South Korea, where the marginal swings in the economy have historically been driven more by exports. Youth joblessness is another problem that Moon will attempt to tackle with his ambitious economic program. While the labor market may appear healthy, with an overall unemployment rate of only 3.7%, the situation is far more challenging for young adults in South Korea - the jobless rate for those aged 20-29 is 11.3%. One of the reasons for such a high unemployment rate among young South Koreans is that university graduates, of which there are many in this highly-educated nation, expect (and look for) high-paying jobs, but cannot find enough of them.7 The labor market has become more competitive in recent years as weak economic growth has limited the ability of private sector, especially large corporations, to hire as much. To solve this problem, the new government has promised to create 810,000 jobs in the public sector. Creating public sector jobs may temporarily solve the high unemployment rate, but in the long run, this will also cause larger fiscal burdens for taxpayers. Position For A Steeper South Korean Yield Curve Headline CPI inflation in South Korea is currently hovering around the 2% target of the Bank of Korea (BoK), while core CPI growth is lower at 1.3%. The BoK has maintain the policy rate at 1.25% since June 2016, with a bias towards additional easing given the lack of sustained inflationary pressure amid weak domestic demand. The BoK did sound a slightly more upbeat tone on the economy at last week's monetary policy meeting, led by the spillover effects from improving global growth rather than a more bullish expectation on the Korean consumer. Importantly, the central bank still expects inflation pressures to remain subdued - no surprise given the large output gap. The BoK did note that it is monitoring several factors in judging future policy decisions: the pace of rate hikes by the Fed, trends in global trade, geopolitical tensions, the pace of household debt accumulation and "the directions of the new government's fiscal policies." The latter may end up being the most important factor, as President Moon is proposing an increase in government spending equal to 0.7% of GDP - an amount equal to ½ of the estimated output gap coming after a 2016 budget surplus of 1% of GDP. This increase in fiscal spending could directly drive up the longer-end of Korean yield curve, as this would result in a narrower budget surpluses and greater KGB issuance. At the same time, the lack of domestic inflation pressures, even with the fiscal stimulus, will keep the BoK on an easing bias that will keep short dated yields well anchored. Therefore, we see the potential for the Korean yield curve to eventually steepen and break the downward-sloping trendline in place since 2014 (Chart 14). We recommend positioning for this move by entering a 2-year/10-year steepening trade in the Korean yield curve. Admittedly, this trade is more structural than tactical in nature, as the Moon stimulus policies will take time to unfold. Importantly, a flattening of the 2-year/10-year KGB curve is currently priced into the forwards, meaning that positioning now for a steepener does not incur negative carry (Chart 15). Chart 14More Fiscal Stimulus =##BR##Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve More Fiscal Stimulus = Steeper Korea Curve Chart 15Enter A 2Yr/10Yr##BR##Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Enter a 2yr/10yr Korean Bond Curve Steepener Also, Korean 10-year bond yields are currently exhibiting a strong correlation to similar maturity U.S. Treasuries with a yield beta around 1.0 (bottom panel). Given our view that longer-dated U.S. yields have upside risk from both additional Fed rate increases and higher U.S. inflation expectations, that high yield beta suggests that the Korean yield curve could suffer some of the same cyclical bear-steepening pressures that we expect for U.S. Treasuries in the next 3-6 months. Bottom Line: Large expected increases in fiscal spending from the new government in Seoul will drive up the longer end curve of the South Korean government bond curve, while the Bank of Korea's easing stance and weak domestic economy will anchor the short-end of the curve. Position for this by entering a 2-year/10-year steepening trade in the South Korean bond curve. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 https://www.theguardian.com/technology/2017/jan/29/silicon-valley-new-zealand-apocalypse-escape 2 The central bank noted that its "suite" of output gap estimates, using varying methodologies, have an unusually wide range at the moment between -1.5% and +2%. 3 http://www.rbnz.govt.nz/monetary-policy/monetary-policy-statement 4 These trades can be done using interest rate swaps as well (receiving NZD rates vs paying USD & EUR rates), as swap spreads are expected to remain broadly stable in all three regions. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "Bloody Potomac", dated May 19 2017, available at fes.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets" dated May 24 2017, available at gps.bcaresearch.com. 7 According to the OECD, Korea's college enrollment rate was a whopping 87% as recently as 2014. 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