Economic Growth

Highlights The strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. China's PPI inflation will continue to drift lower. Disinflation in PPI is less positive for the economy, but is not outright negative, unless PPI deflates. Odds are low that PPI will deflate anytime soon. Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. Feature China's GDP figures to be released next week will likely show that the economy continued to accelerate in the second quarter, as indicated by recent high-frequency macro indicators (Chart 1). Looking forward, the near-term outlook remains promising, but the strong tailwinds behind China's recovery since early 2016 are likely to wane in the coming months, which could lead to softer growth down the road. However, the Chinese economy has regained some self-sustaining momentum, which will allow it to glide at cruising speed without major growth difficulties. For investors, H-shares and onshore corporate bonds should continue to advance, aided by the profit cycle upturn and a largely accommodative policy setting over the next six to nine months. Chart 1Chinese GDP Likely Accelerated In Q2 Chart 2Exports And Monetary Conditions ##br##Drive Chinese Industrial Activity Tailwinds Are Waning... China's seemingly static GDP growth figures disguise much greater volatility in the underlying economy, especially in the industrial sector. The famed Keqiang index, named after China's incumbent premier which incorporates electricity consumption, railway transportation and bank lending, has shown dramatic swings in the past two decades (Chart 2). The index has roared back from rock bottom in late 2015 to currently a one sigma overshoot above its long-term trend, underscoring a sharp recovery in industrial activity. Some have attributed this to a massive dose of fiscal and monetary stimuli - we disagree. In our view, the swings in China's industrial sector performance can be fully explained by the performance of exporters and the country's Monetary Conditions Index (MCI). Our "Reflation Indicator," a combination of export growth and MCI, shows a very tight correlation with the Keqiang Index in the past several cycles. In other words, the rapid recovery in industrial activity since early 2016 was boosted by tailwinds from both accelerating export growth and easing monetary conditions. Currently, the tailwinds are likely passing maximum strength and will wane on both fronts going forward: Global demand appears to be in a synchronized upturn, which bodes well for Chinese exports. The manufacturing PMI new export orders component has been in expansionary territory for eight consecutive months and made a new recovery high in June, pointing to upside surprises in export growth in the near term. Looking further out, our model predicts export growth will likely peak out before the end of the year (Chart 3). After all, it is unrealistic to expect Chinese exports to always grow at double-digit rates - particularly with global trade having downshifted structurally post-global financial crisis. On monetary conditions, the depreciation of the trade-weighted RMB, a major reflationary force for the Chinese economy since late 2015, has stalled in recent weeks. Broad dollar weakness of late has failed to further push down the trade-weighted RMB - either because of the People's Bank of China's intervention, or because bearish bets on the RMB by investors are now off the table (Chart 4). Regardless, a stable RMB exchange rate decreases investors' anxiety on China's macro situation, but also reduces a reflationary source for the overall economy. Overall, recent changes in China's macro environment suggest growth tailwinds are diminishing, but have not yet become headwinds. This on margin is bad news for the economy, but should not lead to a significant growth slowdown. Chart 3Exports: Upside Is Limited Chart 4The RMB Is No Longer Falling ...But Growth Drivers Remain Largely In Place We expect Chinese business activity to remain reasonably buoyant going into the second half of the year. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks to the economy will stay low. Some major growth drivers in the economy remain largely in place. Looking at the consumer sector, the growth recovery and labor market improvement have significantly lifted consumer confidence, which historically is positive for retail sales (Chart 5). Chinese households are under-levered and over-saved, and improving confidence should on margin reduce savings and further boost consumption. Retail sales have already bottomed out and will likely accelerate. The corporate sector's inventory restocking cycle is likely still at an early stage, as the inventory component of the manufacturing Purchasing Managers' Index (PMI) surveys has never moved above 50 since 2012, underscoring increasingly lean stock of finished goods. Industrial firms' inventory levels relative to sales are still standing at close to record low levels (Chart 6). Going forward, inventory re-stocking may supercharge production, should new orders remain elevated. At a minimum, very lean inventory levels limit the downside in industrial production - even if the improvement in new orders stalls. Chart 5Consumer Spending Should Remain Strong Chart 6Inventory Restocking Has Further To Go Furthermore, China's capital spending cycle has likely bottomed out, especially among private enterprises and in the resource sectors. The corporate profit cycle recovery has continued to unfold, and business confidence has improved sharply - both of which are conducive for private sector expansion (Chart 7). There has been dramatic improvement in resource sector profits, which at a minimum will put a floor under the relentless contraction in capex these industries have experienced in recent years. Overall, it is premature to expect a major boom, but the case for a modest upturn in private capital spending continues to strengthen. Finally, the risk of a significant housing growth slowdown due to the government's tightening measures, a major concern among investors earlier this year, has abated. Home sales have cooled off due to local government restrictive policies, but developers' inventories have declined substantially following booming sales in previous years. Therefore, housing starts have continued to improve, which should lift real estate investment going forward (Chart 8). Anecdotal evidence suggests land purchases by developers have been buoyant. Meanwhile, developers' stocks have been outperforming the benchmark, which historically has led housing transactions. All of this means a sharp reduction in real estate investment is highly unlikely, at least from a cyclical point of view. Chart 7Private Sector Capex ##br##Will Likely Accelerate Chart 8Real Estate: Near Term Outlook Improving ##br##The Chain Reactions In Housing In short, we see limited downside risks in the Chinese economy in the near term. Diminishing reflationary forces will not immediately lead to a growth relapse, as the domestic economy has developed some self-feeding momentum. Will PPI Deflate Again? Chinese producer prices have quickly rolled over in the past several months, falling from a peak of 7.8% in February to 5.5% in June. Rising PPI last year was regarded as a key signpost of China's reflationary trend; in this vein, the latest deterioration in PPI indeed raises a red flag. Our model predicts that PPI inflation will likely drift even lower, reaching 3% before year end (Chart 9). We rely on our models to understand the trend rather than to make number forecasts. It now appears a sure bet that Chinese PPI will continue to surprise to the downside in the coming months. How investors will react to likely increasingly disappointing PPI numbers remains to be seen. Our sense is that disinflation in PPI is less positive, but is not outright negative, unless PPI deflates. For now, we see low odds that PPI will deflate anytime soon. Chart 9PPI Will Continue To Moderate Chart 10Industrial Goods Prices Are Fairly Robust A key reason for the rapid decline in PPI inflation is an increasingly unfavorable "base effect," where the year-over-year growth rate naturally tapers off after a period of rapid acceleration. In terms of levels, overall PPI should remain largely stable, according to our model. The recent softness in Chinese PPI largely reflects weakness in crude oil prices, while prices of most basic industrials prices have been fairly robust, including some products that are widely perceived as suffering chronic overcapacity (Chart 10). This suggests the weakness in PPI is fairly concentrated, and likely reflects the unique supply demand dynamics of the oil market, rather than a demand slowdown in the broader economy. More importantly, China's PPI deflation that lasted between February and June was to a large extent due to policy tightening by the Chinese authorities, which, together with weak global demand amplified strong deflationary pressures in the Chinese economy. This time around, the PBoC is highly unlikely to repeat the policy mistakes of draconian credit and monetary tightening. Even if the central bank intends to tighten policy, it will be a lot more cautious and data-dependent. We will follow up on this issue in the coming weeks. The bottom line is that falling PPI inflation should be closely monitored. For now, we expect continued disinflation rather than outright PPI deflation. Profits And Markets Without a major growth relapse and PPI deflation, the upturn in the Chinese profit cycle should have further to run, which bodes well for asset prices - particularly for investable Chinese shares and corporate bonds. For stocks, net earnings revisions of Chinese companies have been rising, confirming the profit cycle upturn (Chart 11). Even if profit growth rolls over along with other macro numbers, a profit contraction is unlikely. Meanwhile, Chinese stocks are among the cheapest of the major bourses (Chart 12), particularly H shares. Overall, Chinese stocks should continue to do well from a cyclical perspective, and will outperform global and EM peers. For bonds, we went long onshore corporate bonds after the sharp selloff earlier this year - namely because the selloff was entirely triggered by the authorities' liquidity tightening rather than corporate fundamentals. The upturn in the profit cycle should also improve the corporate sector's balance sheet, which should be good news for corporate bonds. This trade has been profitable so far, but we expect further narrowing in corporate bond spreads, as they are still elevated both compared with their global counterparts and their historical norms (Chart 13). Investors should hold. Chart 11Earnings Outlook ##br##Will Continue To Improve Chart 12Chinese Stocks Multiples ##br##Are Among The Lowest Globally Chart 13Chinese Corporate Bond Spreads Set ##br##To Narrow Further Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights EM growth is set to falter due to budding weakness in Asia's trade, a decline in commodities prices, and the frailty of EM banking systems. U.S./DM bond yields are heading higher for now and China's money/credit growth is set to decelerate. Together, these will trigger a selloff in EM risk assets. The EM equity outperformance versus DM has been extremely narrow and, hence, it is unsustainable. The EM tech sector is unlikely to support the equity rally much further because these stocks are overbought, and the Asian semiconductor cycle is entering a soft patch. Take profits on the yield curve flattening trade in Mexico. Stay long MXN on crosses versus BRL and ZAR and continue overweighting Mexican bonds. Feature Higher bond yields within the advanced economies and policy tightening in China remain the key threats to EM risk assets in the near term (the next three months). In the medium-term (the next three to 12 months or so), the principle risk is weaker growth in EM/China, and hence contracting corporate profits in EM. While this rally has lasted longer and has gone further than we had anticipated, we find the risk-reward for EM risk assets extremely unattractive. In fact, the huge amount of money that has flown into EM equity and debt markets in the past year amid poor fundamentals suggests to us that the next move will not be a simple correction but rather a major bear market. EM Recovery To Falter Although on the surface global growth appears to be on solid footing, there are early signs of a slowdown in Asian exports. Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes by a few months, as shown in Chart I-1. The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and shipped worldwide. This is why Taiwan's overall shipments to China lead global trade cycles. On top of this, Korea's overall manufacturing and semiconductor shipments-to-inventory ratios have relapsed. Historically, these ratios have correlated with the KOSPI (Chart I-2). Chart I-1Signs Of Slowdown ##br##In Asian Trade Chart I-2Korea's Manufacturing ##br##Growth Has Peaked Outside the manufacturing-based Asian economies, most other EMs are basically commodities plays, except for India and Turkey. The latter two countries are not only relatively small, but Indian stocks are also expensive and overbought while Turkey is sufferings from its own malaise. In short, if the Asian tech cycle rolls over, China slows down and commodities prices relapse, EM growth will falter. That is why the focus of our analysis has been and remains on China's growth, commodities prices and the Asian trade cycle. Meanwhile, many banking systems in the developing world remain frail following the credit excesses of the preceding years. BCA's Emerging Markets Strategy service remains bearish on commodities, and believes the breakdown in the correlation between commodities prices and EM risk assets since the beginning of this year is temporary and unsustainable. As for the increased importance of the technology sector in the EM equity benchmark, we offer further analysis on page 10. Our negative view on EM growth is not contingent on a relapse in U.S. and euro area growth. In fact, our current baseline scenario is that DM growth will remain solid, and government bond yields in these markets will rise further. Although growth in both the U.S. and euro area is robust, their importance for EM has become small. For example, exports to the U.S. and EU altogether account for 35% of total exports in China, 22% in Korea and 20% in Taiwan. All in all, if commodities prices continue to downshift and Asian trade slows, as we expect, EM growth will decelerate. Bottom Line: EM growth is set to falter notably, despite solid demand growth in DM. Liquidity Backdrop To Deteriorate Investors and market commentators often use the term "liquidity" loosely, and denote numerous things by it. We use the term 'liquidity' to signify the level and/or direction of interest rates as well as the level and/or direction of money/credit growth. Below we review some different perspectives of liquidity: EM narrow money (M1) growth points to both lower share prices and a relapse in EPS growth in the months ahead (Chart I-3). Chart I-3EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices This is an equity market cap-weighted aggregate of narrow money growth. M1 growth in China - the largest market cap in the EM equity benchmark - has been essential in driving aggregate EM M1 cycles in recent years. More importantly, China has been tightening liquidity, yet the majority of investors remain complacent about its impact on growth. In this regard, investors should remind themselves that monetary policy works with time lags, and the considerable rise in China's interbank rates and corporate bond yields will produce a growth slowdown in the real economy later this year. Chart I-4 demonstrates that China's broad money growth (M2) - which has in effect dropped to an all-time low - leads bank and non-bank credit origination. This suggests the odds of a slowdown in bank and non-bank credit flows are considerable. There has been no stable correlation between the size of DM central banks' balance sheets and EM stock prices, bond yields and currencies since 2011. Therefore, the Fed's move to reduce its balance sheet by itself should not matter for EM risk assets from a fundamental perspective. Nevertheless, EM risk assets have been negatively correlated with U.S. TIPS yields (Chart I-5), and the potential further rise in U.S./DM real and nominal yields will hurt EM sentiment, with flows to EM drying up. Chart I-4China: M2 Heralds ##br##Slowdown In Credit Growth Chart I-5EM Currencies To Depreciate ##br##As U.S. Real Yields Drift Higher Importantly, traders' bets on U.S. yield curve flattening have risen, as evidenced by large short positions in 2-year U.S. notes and considerable long positions in 10- and 30-year bonds. The unwinding of these positions will drive bond yields higher. Chart I-6Precious Metals Signal ##br##Higher Real Yields Ahead Notably, precious metal prices have failed to break out amid a weak U.S. dollar and have lately relapsed (Chart I-6). Precious metals prices could be sensing a further rise in U.S. real yields and/or an upleg in the U.S. dollar. Both the rise in U.S. yields and a stronger dollar will be negative for EM. Bottom Line: We maintain that U.S./DM bond yields are heading higher in the months ahead and China's money/credit growth is set to decelerate. Altogether these will trigger a selloff in EM risk assets. Underwhelming EM Technicals It is a well-known fact that flows into EM debt funds have been enormous, making EM fixed-income markets vulnerable to a reversal of these flows at the hands of tightening liquidity and EM growth disappointments, as argued above. This section focuses on a number of bearish technical signals for EM share prices. In particular: The EM equity implied volatility curve - 12-month VOL minus 1-month VOL - is at a record steep level, based on available history (Chart I-7). Periods of VOL curve flattening have historically coincided with a selloff in EM share prices, as evidenced by Chart I-7. Given that the VOL curve is record steep, the odds of flattening are substantial. Consistently, the probability of an EM selloff is considerable. Chart I-7A Sign Of Top In EM Share Prices? In absolute terms, EM equity implied 1-month VOL is at an all-time low and reflects enormous complacency about EM. EM equity breadth has also been poor. The MSCI EM equally weighted stock index (where each stock commands an equal weight) has considerably underperformed the EM market cap-weighted index since May 2016 (Chart I-8). This suggests the EM rally has been very narrowly driven. The same measure for DM stocks has done relatively better (Chart I-8). Remarkably, EM has underperformed DM based on equal-weighted equity indexes since July 2016 (Chart I-9). This confirms that EM outperformance against DM since early this year has been largely driven by a few stocks, namely the five companies accounting for the bulk of the EM tech index. Furthermore, EM ex-tech stocks have also failed to establish a bull market, in that the index remains below its prior low (Chart I-10). Chart I-8EM Equity Breadth ##br##Has Been Poor Chart I-9EM Versus DM: Relative ##br##Equity Performance Chart I-10EM Ex-Technology Stocks: ##br##Rebound But No Bull Market Finally, the magnitude of the EM rally this year is somewhat misleading. Only three out of 11 sectors - technology, real estate and consumer discretionary (mainly, autos) - have outperformed the EM benchmark this year. Table I-1 illustrates that these three sectors have been responsible for about 50% of the EM rally year-to-date while their market cap is only 36% of total. Table I-1EM Rally In 2017: Return Decomposition Bottom Line: The EM equity outperformance versus DM has been extremely narrow: it has been due to five tech companies that are currently very overbought (see Chart I-8 on page 7). Valuations EM equity valuations are not cheap, as most of the rally since the early 2016 bottom has been driven by a multiple expansion rather than a rise in corporate earnings (Chart I-11). We are not suggesting EM stocks are expensive, but they do not offer good value either. In fact, good companies/countries/sectors are expensive, while those, that appear "cheap", command low multiples for a reason. As for currencies, they are not cheap either. The real effective exchange rate of EM ex-China is rather elevated after the rally of the past year or so (Chart I-12). Finally, not only are EM sovereign and corporate spreads close to record lows, but also local government bond yield spreads over U.S. Treasurys are at multi-year lows (Chart I-13). Chart I-11Decomposing EM Equity ##br##Return Into P/E And EPS Chart I-12EM Ex-China Currencies ##br##Are Not Cheap And Vulnerable Chart I-13EM Local Bond Yields Spreads ##br##Over U.S. Treasurys Is Low Bottom Line: Adjusted for fundamentals, EM equity, currency and credit market valuations are rather expensive. The odds are that the reality will underwhelm expectations, and that EM risk assets will sell off. A Word On EM Tech: Is This Time Different? During our recent trip to Europe, many clients argued that the increased weight of technology in the EM equity benchmark will cause EM share prices to decouple from the traditional variables they have historically been correlated with, like commodities prices, commodities stocks and others. In brief, the argument is that EM has entered a new paradigm, and past correlations will not work. The last time we at BCA heard similar arguments was back in early 2000 at the peak of the global tech bubble. At the time, the argument was that this time was truly different - that tech stocks could drive the market higher regardless of the old indicators and the performance of other sectors. Chart I-14 portrays that in 2000 the EM equity index, for several months, decoupled from global mining and energy stocks when tech and telecom stocks went ballistic. Chart I-14EM And Commodities Stocks: Can The Recent Decoupling Persist? Back in 2000, the bubble was in tech and telecom stocks. These two sectors together comprised 33% of the EM benchmark as of January 2000 (Chart I-15). This compares with a 27% weighting of technology stocks alone in the EM benchmark now. The combined weight of energy and materials is currently 14% versus 19% in January 2000, as can been seen in Chart I-15. Chart I-15EM Equities Sector Composition Now And In Late 1990s To be sure, we are not suggesting that tech stocks are in a bubble as they were in 2000, and that a bust in share prices is imminent. However, several observations are noteworthy: Chart I-16EM Equities Sector ##br##Composition Now And In Late 1990s Just because EM tech stocks have skyrocketed in the past six months does not mean they will continue to do so. In fact, EM tech is already extremely overbought and likely over-owned (Chart I-16). As global bond yields rise, high-multiples stocks, especially social media/internet companies, could selloff. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. However, we can shed some light on the business cycle in the semiconductor sector that influences performance of heavyweight companies like TSMC and Samsung. As Chart I-1 and I-2 on pages 1 and 3 demonstrate, there are signs that the semi/electronics cycle in Asia has peaked. We do not mean that this sector is headed toward recession. But this is a very cyclical sector, and some slowdown is to be expected following the growth outburst of the past 18 months. This will be enough to cause a correction in semi stocks from extremely overbought levels. The tight correlation between EM share prices and energy and mining stocks has persisted for the past 20 years (Chart I-14 on page 10), and we believe it will re-establish as technology stocks' shine diminishes. Finally, we have been recommending an overweight position in Taiwanese, Korean, and Chinese stocks primarily because of their large tech exposure. For now we maintain this strategy. Bottom Line: While the technology sector could make a difference for EM economies and equity markets in the long run, it is unlikely to support the current rally and outperformance much further. Indeed, tech stocks are heavily overbought, and the Asian semiconductor cycle is entering a soft patch. In brief, the overall EM equity benchmark is at a major risk of relapse and underperformance versus the DM bourses. Stay underweight. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Take Profits On Yield Curve Flattener And Stay Long MXN On Crosses Mexico's 10/1-year swap curve has inverted for the first time in history and we are taking a 160 basis points profit on our yield curve flattening trade recommended on June 8, 2016 (Chart II-1). Will the central bank begin cutting interest rates soon? Is it time to get bullish on stocks? We do not think so: Inflation is well above the central bank's target and is broad based (Chart II-2). Notably, wage growth is elevated (Chart II-3). Chart II-1Mexico's Yield Cruve Has Inverted: Take Profits Chart II-2Mexico: Inflation Is Above The Target Chart II-3Mexico: Wage Inflation Is High Provided productivity growth is meager in Mexico, unit labor costs - which are calculated as wage per hour divided by productivity (output per hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will in turn prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart II-4). This will weigh on corporate profits and share prices. Fiscal policy is not going to support growth either because policymakers will opt to consolidate the recent improvement in the fiscal deficit. This is especially true given the latest selloff in oil prices. Notably, oil accounts for about 20% of government revenues. Even though non-oil exports and manufacturing output are accelerating (Chart II-5), non-oil exports - that make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. Chart II-4Mexico: Domestic Demand To Buckle Chart II-5Mexico: Exports Are Robust Investment Conclusions The outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Meanwhile, inflation is still elevated to justify rate cuts by the central bank. Within an EM equity portfolio, we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. The Mexican peso is still cheap (Chart II-6). Therefore, we continue to recommend long positions in MXN versus ZAR and BRL. If EM currencies depreciate and oil prices drop further as we expect, it will be hard for the peso to appreciate versus the U.S. dollar. However, the peso will outperform many other EM currencies. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. (Chart II-7). Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Chart II-6Mexico: Peso Is Cheap Chart II-7Continue Overweighting Mexican Bonds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Chart 9Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* LegendCorporate Sector Abbreviations Chart 12Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The long-term interests of both Chinese policymakers and foreign investors are aligned regarding the Chinese onshore bonds. There is a strong case for higher demand for Chinese bonds going forward. The Bond Connect program may not immediately lead to a massive influx of foreign capital into the Chinese onshore bond market, but it holds the promise of improving the efficiency of China's financial system over the long run, making the economy less dependent on the banking sector for financial intermediation. Chinese domestic bonds will become increasingly more "investable" to foreigners, and investors' interest in Chinese bonds will only grow. This week we review some basics of this asset class. Feature The Bond Connect program, which launched early this week, has established another channel for foreign investors to tap into China's massive onshore bond markets. Like Chinese A shares' inclusion in the MSCI indices announced last month, the Bond Connect scheme offers little near term impact but marks yet another milestone in China's financial market liberalization. Together with some existing channels, the new program opens up China's vast fixed-income assets to world financial markets, which have yet to be explored by global investors. There is a clear case for rising interest among global investors in Chinese onshore bonds going forward. This also holds the promise of improving the efficiency of China's financial system over the long run. It Takes Two To Tango For Chinese regulators, the benefits of opening up the bond market to foreigners are straightforward. First, it helps develop a deep and more efficient bond market, which is instrumental in allowing market forces to set interest rates for the overall economy.1 Although already one of the largest in the world, the Chinese bond market is primarily for the government and government-related entities. Corporate issuers also tend to be state-owned enterprises, which overwhelmingly carry investment-grade ratings from local rating agencies - i.e. little differentiation in credit quality (Chart 1). The primitive state of the corporate bond market (and financial markets in general) is a key reason why China's financial resources are predominantly channeled by the banking sector. A key target of China's financial sector reforms is to improve the efficiency of financial markets and reduce the reliance on the banking sector. Along with the Bond Connect initiative, Chinese regulators also granted access to overseas rating agencies to its domestic bond market, which should also help Chinese investors properly price credit risks. Chart 1Outstanding Corporate Bonds##br## By Credit Ratings Second, it also facilitates further internalization of the RMB, as it offers a vast asset class for foreign investors to park their RMB exposure. A major consideration for the Chinese authorities to internationalize the RMB has been to reduce exchange rate risk for domestic entities both for trade and financing. Governments and companies in the developed world mostly issue bonds in their respective local currencies, while developing countries typically issue bonds in foreign "hard currencies" such as the dollar and the euro, which makes them vulnerable to exchange rate volatility. By joining the IMF Special Drawing Right (SDR) basket, the Chinese authorities aim to foster the RMB to be an international "hard currency." This, together with a sufficiently deep and efficient RMB bond market, allows Chinese corporate borrowers to issue local currency bonds that are immune to exchange rate fluctuations. Finally, there is clearly a short-term intention to support the RMB exchange rate. The newly established Connect program only allows for "northbound" flows, meaning foreigners are only able to purchase onshore bonds through Hong Kong. This is designed to offset domestic capital outflows and mitigate any downward pressure on the RMB exchange rate. A reciprocal "southbound" channel that allows domestic investors to purchase foreign bonds will inevitably be established. However, the timing will be contingent on conditions of cross-border capital flows and exchange rate performance. For foreign investors, the Connect program and onshore RMB bonds will also prove attractive. Unlike existing programs facilitating foreign bond purchases such as Qualified Foreign Institutional Investors (QFII), RMB QFII (RQFII) and foreign eligible institutions' direct participation in the onshore interbank bond market, the Bond Connect program bypasses China's often lengthy and complicated regulatory procedures, making it easier and more flexible for foreign investors to directly hold Chinese onshore bonds. Holding RMB fixed income assets offers diversification benefits. Foreigners' exposure to Chinese bonds is practically nonexistent, which will inevitably increase. It is worth noting that foreign holdings in most emerging countries' bonds have been rising over time, despite exchange rate fluctuations (Chart 2). The volatility of the RMB exchange rate against the dollar is the smallest among SDR currencies, and Chinese onshore bonds offer the highest yields - both of which will prove attractive for foreign bond investors over the long run (Chart 3). China's structurally higher economic growth should also deliver higher returns for investors over the long run. Chart 4 shows that total returns of Chinese stocks and bonds have been almost identical since 2004 (when Chinese bond data became available) - both of which significantly outperformed global benchmarks. However, the volatility of Chinese stocks has been much greater than bonds. In other words, Chinese bonds offer an attractive risk-return trade off for investors to capitalize on China's growth outlook. Chart 2Foreign Holdings Of Chinese Bonds ##br##Are Set To Grow Chart 3China's Yield Advantage Chart 4Chinese Bonds: A Long Term Play ##br##To Capitalize On Chinese Growth All in all, the Bond Connect program may not immediately lead to a massive influx of foreign capital into the Chinese onshore bond market. However, it is clear that the long-term interests of both Chinese policymakers and foreign investors are aligned, which builds a strong case for higher demand for Chinese bonds going forward. A Synopsis Of The Chinese Onshore Bond Market Regardless of any near-term considerations, Chinese domestic bonds, and onshore assets in general, will become increasingly more "investable" to foreigners, and investors' interest in Chinese bonds will only grow. It is useful to review some basics of this asset class. At the onset, China's total outstanding bonds currently stand at RMB 69 trillion, or US$10.2 trillion, the majority of which are issued by government and related entities (Table 1). Treasurys and bonds issued by policy banks are backed by the central government. Municipal bonds issued by local governments are not explicitly backed by Beijing, but in reality the odds of a local government defaulting on its bonds are very low. Bonds issued by the corporate sector account for about 20% of the market, but corporate issuers also tend to be state-owned enterprises. Bonds and Certificates of Deposits (CDs) issued by banks are also state-owned. The Bond Connect program allows foreigners to tap into Chinese onshore bonds traded in the interbank market (CIBM), where the majority of Chinese bond transactions take place. CIBM hosts about 70% of total Chinese onshore bonds, while the rest are listed on securities exchanges and over-the-counter (OTC) markets (Chart 5). Chinese bonds are primarily held by commercial banks (and credit co-ops), accounting for about 65% of total outstanding bonds. In recent years, investment funds have become increasingly active, currently holding 15% of the market, compared with 10% three years ago. This, together with increasing foreign participation, will over time help improve the efficiency of the onshore bond market. Table 1Chinese Bond Market Breakdown Chart 5Where Are The Bonds Traded? Bond issuance increased sharply in previous years, mostly boosted by municipal bonds and more recently by banks' CDs (Chart 6). The Chinese authorities' regulatory tightening to rein in financial excesses has led to a notable slowdown in overall bond issuance, which is likely to be temporary.2 Overall, the country's financial reforms will continue to encourage bond issuance and reduce the economy's overreliance on the banking sector for financial intermediation. Chart 6The Growing Importance Of Bond Market The importance of bond issuance for the corporate sector to raise capital has been increasing in recent years, but is still marginal. Currently, corporate bond issuance accounts for over 10% of total social financing (TSF), up from practically zero in the early 2000s (Chart 7). As stated earlier, corporate bonds are primarily issued by state-owned enterprises or listed firms, while small and private enterprises' access to bond issuance is still very restrictive. Maturities of the majority of Chinese corporate bonds are less than five years, while long-dated corporate bonds are rare. Corporate bonds with over 10-year maturities account for about 1% of total outstanding bonds (Chart 8). Chart 7The Growing Importance Of Corporate Bonds Chart 8Maturity Profile China's bond market liberalization measures have allowed some ETFs to be established to track the onshore bond market - a trend that is set to accelerate going forward with the latest Bond Connect scheme (Table 2). Onshore bonds will likely follow A shares to progressively enter major international bond indexes over time, which will further stoke global investors' interest. Table 2ETFs For Chinese Onshore Bonds An Update On The Chinese Economy Chart 9The Economy Will Remain Resilient Recent growth numbers from China confirm that the economy has remained resilient amid the regulatory crackdown by Chinese regulators. Both official and privately sourced manufacturing PMI numbers have improved, and both have moved above the 50 threshold. The regained momentum is also reflected in the rebound in raw materials prices in the global market (Chart 9, top panel). The regained strength in the Chinese economy, in our view, is probably due to easing in monetary conditions, primarily through the exchange rate. Although the RMB has stopped depreciating against the dollar of late, it has relapsed in trade-weighted terms, thanks to weakness in the greenback. This has led to a period of easing in monetary conditions, which in turn has helped the economy reflate (Chart 9, bottom panel). Looking forward, we maintain the view that China's business activity will remain reasonably buoyant. It is not realistic to expect growth figures, measured by year-over-year growth rates, to accelerate in perpetuity, but downside risks in the economy will remain low. China's growth improvement since early last year was primarily due to easing in monetary conditions rather than a massive dose of fiscal and monetary stimuli,3 and it is highly unlikely that the authorities will tighten their overall policy stance significantly, causing major growth problems. As such, we remain positive on both the economy and Chinese H shares. Overall, China's growth performance has been largely in line with our expectations outlined in our 2017 outlook report published in January.4 We will offer a mid-year revisit on the cyclical trends of the economy and financial markets next week. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Chinese Financial Tightening: Passing The Phase Of Maximum Strength," dated June 22, 2017 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, “A Chinese Slowdown: How Much Downside?” dated June 08, 2017 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The euro area's structural growth prospects (adjusted for demographics) are no different to any other developed economy such as the U.K., U.S. or Japan. Liberated from the headwinds of its own policy errors, the euro area's relative growth is now transitioning from a down-cycle to a multi-year up-cycle, and this brings three multi-year investment implications: Underweight German bunds and French OATs, both in a European bond portfolio and in a global bond portfolio. Overweight the euro, specifically euro/dollar and euro/yuan. Overweight euro area retailers versus U.S. retailers. Feature Over the past 20 years or so, every major European country has at one time or another been given the dubious title 'the sick man of Europe'. Chart of the Week AAfter 2008, Everybody Recapitalised Their Banks... Chart of the Week B...Except Italy Remarkable as it sounds today, in the early 2000s the sick man was Germany - whose economy suffered recurring stalls; in 2007 it was Portugal; then in the aftermath of the Great Recession the sick man title went at different points in 2009 to the U.K. and to Spain, as both economies struggled to bounce back from the downturn. Thereafter, the title has variously gone to Ireland, Finland, France, and Italy. In most cases, the sick man title mistakes a cyclical problem for a structural problem. So when the cyclical weakness ends, the country shakes off the dubious title. Another common mistake is rushing to judgement on the wrong analysis. The best example of this is Japan. You may be familiar with Japan's so-called 'lost decades' or the term 'Japanification' used as a pejorative. The trouble is that the perception of such lost decades is outright wrong! The truth is that over the past two decades Japan's growth in real GDP per head, at 34%, is the best among major developed economies, easily outperforming Germany, the U.K. and the U.S. (Chart I-2). Chart I-2What Lost Decades? Japan Has Outperformed Everybody Else The point is that to level the playing field for countries' different demographic profiles, it is important to compare growth on a per head basis. Real growth per head is what determines improvement in wellbeing and living standards and the best resolution of indebtedness for society as a whole. High nominal growth via inflation may sound appealing to a highly indebted society, but it is over-simplistic. One person's debt is another person's asset, so inflation reduces the burden on half of society - the debtors - by robbing the other half - the creditors. Which isn't necessarily good for society as a whole. Can Italy Recover? This brings us to Europe's current 'sick man', Italy. Some people claim that Italy has underperformed through the full 18 years of the euro. Not true. Based on the all-important real GDP per head metric, Italy was performing more or less in line with the other major developed economies until the Great Recession (Chart I-3). Still, an underperformance that started at the Great Recession means it has lasted almost nine years. So can Italy really be a cyclical 'sick man' - or in this case, is something structural at work? In The Euro's 18th Birthday: Why Isn't Italy Partying?1 we suggested that the root cause of Italy's nine year problem is its still undercapitalised and dysfunctional banking system. This has paralysed an economy heavily dependent on small and medium sized enterprises (SMEs), and their access to bank financing. We can say this with conviction for two reasons. Can it really be just coincidence that Italy is the only major economy that has not recapitalised its banks after the 2008 crisis, and that its underperformance began at exactly the same moment (Chart of the Week)? And can it really be just coincidence that as soon as Spain substantially recapitalised its banks in 2013, the Spanish economy made a remarkable transformation from sick man to strapping health2 (Chart I-4)? To us, these are not coincidences. They pinpoint the root of Italy's problem and solution. Chart I-3Italy Did Not Underperform ##br##Until The Great Recession Chart I-4Spain Recovered Strongly As##br## Soon As Its Banks Were Recapitalised The good news is that Italy is progressing to a solution, albeit slowly. Last week's relatively trouble-free winding down of the failing Banca Popolare di Vicenza and Veneto Bank showed that the ECB, Brussels and the Italian government are on the same page. A pragmatic solution let institutional investors suffer losses while protecting 'widows and orphans' retail investors with public money. In Italy, with many retail investors owning banks' senior bonds, this is the politically acceptable way to go. And at the current rate of resolution, we estimate that the further €50-75 billion of recapitalisation required can be finished within a year. If Italy can get through its next general election without a shock, it will be on the road to a long-term recovery. Euro Area: Don't Mistake A Cyclical Problem For A Structural Problem To reiterate, one of the biggest mistakes in economics and investment is to mistake a cyclical problem for a structural problem. This is especially true when two cyclical downturns come in quick succession. The resulting extended period of poor performance inevitably feels like something structural rather than something cyclical. Many commentators regard the poor performance of the euro area economy since 2008 as evidence of a structural malaise. But the bigger picture does not support this thesis. Through the 18 year lifetime of the monetary union, the euro area and the U.S. have generated identical growth in real GDP per head (Chart I-5). Chart I-5Since The Euro's Birth, The Euro Area And##br## U.S. Have Produced Identical Growth Within this bigger picture, the euro area has underperformed through multi-year periods encompassing around half of the 18 years. And it has outperformed through the multi-year periods encompassing the other half. Seen in this light, the post-2008 phase of poor performance is really the impact of back to back recessions separated by an unusually short gap - with the second of the two recessions the direct result of policy errors specific to the euro area. First, the ECB resisted taking on its critical role as lender of last resort to solvent but illiquid sovereign borrowers, thereby enflaming a containable liquidity crisis into an almost uncontainable and catastrophic solvency crisis. Then, when the ECB ultimately relented, a protracted stress test of European banks forced lenders to shrink their assets, effectively paralysing an economy heavily dependent on bank finance. Still, the euro area does not have a monopoly when it comes to damaging policy errors and misanalysis. We tend to have short memories, but let's not forget former U.K. Finance Minister and Prime Minister Gordon Brown's claim that the boom-bust cycle had been abolished, justifying a much lighter touch regulation of the financial system through the early 2000s. Or Ben Bernanke's now infamous misanalysis of the U.S. housing market in 2005: "Well, I guess I don't buy the premise that U.S. house prices will come down substantially. It's a pretty unlikely possibility..." These observations are not meant to criticise, but just to illustrate that policymakers are not omniscient. They understand the economy and financial markets little more than we do. Furthermore, political constraints often limit their room for manoeuvre, forcing the policy errors. Policy Error Now More Likely Outside The Euro Area Looking ahead to the next few years, our sense is that the risk of policy error is now greater outside the euro area than inside. Specifically, the still uncertain trajectories of Brexit and of the Trump administration are likely to have their greatest disruptive impacts in the U.K. and U.S. respectively. Our broad thesis is that the euro area's structural growth prospects (adjusted for demographics) are no different to any other developed economy such as the U.K., U.S. or Japan. And liberated from the headwinds of its own policy errors, the euro area's relative growth is now transitioning from a down-cycle to a multi-year up-cycle. Which brings three multi-year investment implications: Underweight euro area government bonds, specifically German bunds and French OATs, both in a European bond portfolio and in a global bond portfolio (Chart I-6 and Chart I-7). Overweight the euro, specifically euro/dollar and euro/yuan. For equities, the translation to the headline euro area index, the Eurostoxx50 is somewhat complicated by its dominant sector skew (overweight banks, underweight technology) which tends to drive relative performance. Instead, we find that in recent years the relative performance of the more domestic-focussed retailers has closely tracked relative economic performance (Chart I-8). Hence, overweight euro area retailers versus U.S. retailers. Chart I-6Relative Bond ##br##Yields... Chart I-7...Must Follow Relative##br## Economic Performance Chart I-8Retailers Relative Performance Tracks##br## Relative Economic Performance Please note there will be no report next week. Our next report will come out on July 20. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on June 1, 2017 and available at eis.bcaresearch.com 2 Spain's real GDP per head has grown by over 12% since its trough in 2013. Fractal Trading Model* Long nickel / short palladium has achieved its 10% profit target, and is now closed, leaving four open positions. There are no new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Global Growth: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. Global Inflation: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Feature Have bond investors now become too pessimistic on global growth and inflation prospects? This is a question worth asking after the sharp decline in longer-dated government bond yields witnessed since the peak in mid-March. The benchmark 10-year yield has fallen during that period by -43bps in the U.S., -21bps in Germany, -24bps in the U.K., -45bps in Canada and -54bps in Australia. Granted, there has been a bit of softer news on both growth and, more importantly, inflation readings in several economies in the past couple of months. Those pullbacks, however, have been relatively modest compared to the severe bull-flattening bond rally seen in most developed economies (Chart of the Week). Chart of the WeekAn Overreaction From Bond Investors Global leading economic indicators are still pointing to faster growth over the latter half of the year, led by easing financial conditions given booming equity and credit markets. With most major economies either at full employment (U.S., U.K., Japan, Australia) or approaching full employment (Euro Area, Canada), accelerating growth will ensure that the recent downtick in global inflation will not persist for long - especially if oil prices begin to move higher again as our commodity strategists expect. This week brings several major central bank meetings with an opportunity to change the bullish tone in the bond markets. The Federal Reserve, the Bank of England (BoE) and the Bank of Japan (BoJ) all meet, although only the Fed is expected to deliver another rate hike that is now heavily discounted in the markets. The BoE's hands are now effectively tied, even with high U.K. inflation, after last week's election outcome where the ruling Conservatives lost their majority government, thus ensuring even more uncertainty over the contours of the Brexit process. The BoJ is also stuck in a bind, with surprisingly strong Japanese economic growth but shockingly weak inflation. This is also the situation that the European Central Bank (ECB), Bank of Canada and Reserve Bank of Australia are facing, to a lesser extent: solid domestic growth but without enough inflation to force any immediate tightening of monetary policy. These sorts of mixed messages and conflicting signals also exist in the bond markets in the developed world, as we discuss in this Weekly Report. Our conclusion is that yields have now priced in too much pessimism and the balance of risks points to yields rising again in the months ahead, led by U.S. Treasuries. A Big Move In Yields For Such A Small Change In Growth... Looking at the change in government bond yields within the major developed markets since the peak on March 13th (Table 1) shows a few important facts: Table 1A Bull Flattening Of Global Yield Curves Since March The largest yield declines were in the U.S., Canada & Australia; The smallest declines were in the U.K., the Euro Area and Japan - unsurprisingly, the countries where central banks are engaged in large bond purchase programs; Lower market-based inflation expectations have played a role in the bond rally, coinciding with softer energy prices and declines in realized inflation outcomes; Real yields (i.e. nominal yields minus inflation expectations) have fallen sharply in the U.S., Canada & Australia; Yield curves have bull-flattened everywhere; Breaking the curve moves into real yield and inflation expectations components shows that both contributed to the flatter yield curves. The U.S. Treasury action stands out compared to the others. There has also been a 103bp flattening in the 2-year/10-year TIPS real yield curve, while the TIPS breakeven curve has steepened by 64bps. This is the result of the -89bp drop in 2yr breakevens, which now sit at 1.38% - well below the current U.S. headline CPI inflation rate of 2.2%. Even allowing for any potential liquidity issues that can distort the precise interpretation of shorter-dated TIPS breakevens, the market appears to be expecting a bigger drop in inflation in the next couple of years than both the Fed and the Bloomberg consensus of economic forecasters (Table 2).1 This U.S. move stands out relative to the other countries, where there has been very little change in 2-year inflation expectations (using CPI swaps instead of breakeven rates from inflation-linked bonds). With the headline U.S. unemployment rate now at a cyclical low of 4.3%, and with the broader U-6 measure, now down to a decade low of 8.4%, we anticipate a recovery in realized inflation, and TIPS breakevens, in the next few months. The source for the broader downturn in global inflation expectations is a bit of a mystery. While some cyclical global growth indicators like manufacturing PMIs have fallen a bit in some countries, most notably the U.S. and China, they are still at strong levels above 50 that point to faster economic growth (Chart 2). Leading economic indicators (LEIs) are also still pointing to some acceleration in the latter half of 2017 although, admittedly, the list of countries with rising LEIs has been diminishing in recent months. We see that as a potential sign of slower growth next year, but not for the rest of 2017. Table 2Consensus Growth & Inflation Forecasts Chart 2Global Economic Upturn Still Intact Bottom Line: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. ...And Inflation Of course, some of the decline in inflation expectations can be attributed to softer readings on realized inflation over the past few months. Yet the markets seem to have overreacted a bit to that move, as well. The run of stronger-than-expected inflation outcomes has taken a breather in both the developed and emerging world, as evidenced by the rolling over of the Citigroup inflation surprise indices (Chart 3). Yet those indices remain at high levels and are not pointing to a meaningful, extended pullback in realized inflation. Chart 3Global Inflation Data Has Cooled A Bit The pullback in global energy prices since March has played a role in softer headline inflation in most countries. That decline has been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our colleagues at BCA Commodity & Energy Strategy have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end.2 A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and help stabilize goods CPI inflation in the developed economies in the latter half of 2017 (Chart 4). This should help boost global inflation expectations, and eventually bond yields, as the downturn in energy prices has shown very little pass-through into non-energy inflation in the developed world (Chart 5). Chart 4Disinflationary Impulse##BR##From Energy Will Soon Fade... Chart 5...Although The Impact On##BR##Inflation Has Been Modest Yet that stability of non-energy inflation visible in the charts masks many of the cross-currents seen across countries and within countries. Services CPI inflation remains strong in the U.S. at 3%, and has accelerated to 2% in both the U.K. and the Euro Area (Chart 6). Yet at the same time, both services and core inflation are falling rapidly towards 0% in Japan, despite a solid economic upturn and tight labor market. The situation is even more confusing in Canada, where wage inflation has fallen to below 1% but services inflation has picked up to 3%. Australia is in a similar boat, with services inflation above 3% but wages growing at only 2%. The divergence between the inflation outcomes across the countries can also be seen in our headline CPI diffusion indices, which measure the number of CPI sectors that are witnessing accelerating rates of inflation. The diffusion indices in the U.S., Japan and Canada are all at low levels, with the majority of CPI components seeing slowing rates of inflation, yet overall inflation seems to be holding up well despite the breadth of the "downturn", at least based on past correlations (Chart 7). The opposite is true in the Euro Area and Australia, where a majority of inflation components are growing faster, yet overall inflation is only moving slowly higher. Only in the U.K. is there a clear robust rise in the breadth of inflation (90% of CPI components accelerating) and overall inflation (headline CPI expanding at around 3%). Chart 6Underlying Inflation Has Not##BR##Slowed Much (Except In Japan) Chart 7Mixed Signals From The##BR##Global CPI Diffusion Indices Given all these diverging signals within the national inflation data, we are surprised that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main cause of the lower expectations, rather than a more pernicious drop caused by expectations of slowing economic growth and cooling domestic inflation pressures. Given the BCA view that oil prices have likely reached bottom and will begin to move higher, the decline in global inflation expectations is likely to also end soon. Bottom Line: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy For The Second Half Of 2017 The outlook for government bond yields in the remaining months of the year will be driven by decent global growth and rising inflation expectations. Our Central Bank Monitors continue to point to the need for tighter monetary policy in every major developed market excluding Japan (Chart 8), leaving bond yield exposed to any unexpected moves from central bankers. This is especially problematic in the U.S., where fed funds futures now discount only a 25-30% probability of a Fed rate hike in September and December after the expected hike at this week's FOMC meeting (Chart 9). With the U.S. OIS curve pricing in only 48bps of hikes over the next 12 months, the Treasury market is exposed to a Fed moving more aggressively in meetings later in 2017. Chart 8Our Central Bank Monitors Still##BR##Calling For Tighter Policy (Ex Japan) Chart 9Markets Will Be Surprised##BR##By The Fed Later This Year In Europe, the ECB talked up a more positive economic growth story at last week's policy meeting, eliminating the language suggesting that rate cuts would be necessary because the growth recovery was still fragile. No signal was given about slowing the pace of ECB asset purchases, which was not a surprise given the still-low readings on core inflation in the Euro Area. The ECB did slightly downgrade its inflation projections for the next two years, with core inflation now expected to rise to 1.8% by 2019. Our Months-to-Hike measure for the Euro Area now out to 29 months, indicating that the first ECB rate hike is now expected in November of 2019 (Chart 10). Our view remains that the ECB will look to taper asset purchases before contemplating any rate hikes, and will likely signal a move to slow the pace of bond buying at the September policy meeting. While we agree that a rate hike is unlikely until 2019, the current market pricing does leave European bond markets exposed to any upside surprises in inflation over the next year. For now, we continue to recommend a neutral allocation to core European government bonds, with a curve steepening bias, while focusing Peripheral exposure on Spain relative to Italy. We envision moving to underweight Europe over the summer if the growth and inflation data continue to point to an eventual ECB taper, especially given the strong comparisons between Europe now and the pre-Taper Tantrum period in the U.S. in 2012-13 (Chart 11). Chart 10No ECB Hikes##BR##Expected Until 2019 Chart 11Bunds Still Following The U.S.##BR##Post-QE Experience In Japan, we expect the BoJ to continue to target a 0% 10yr JGB yield for some time, in order to ensure that there is enough currency weakness to keep headline inflation from decelerating (Chart 12). This will especially be true if our call for higher U.S. interest rates comes to fruition and USD/JPY begins moving higher again. We continue to recommend an overweight position on Japan with government bond portfolios, given the low yield beta of JGBs to the other bond markets (Chart 13). Chart 12The BoJ Will Do "Whatever It Takes"##BR##To Keep The Yen Soft Chart 13Stay Overweight##BR##Low-Beta JGBs Finally, we continue to recommend long CPI swaps positions in both the Euro Zone and Japan, and an overweight in U.S. TIPS versus nominal Treasuries, as a way to play for the rebound in global inflation expectations that we are expecting over the balance of 2017. However, given the disturbing downturn in core inflation readings in Japan, we are implementing a tight stop-loss level at 0.4% on our long 10yr Japan CPI swaps position (Chart 14). Chart 14Stay Long CPI Swaps##BR##In Europe & Japan (With A Stop) Bottom Line: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The FOMC projections for growth in the headline Personal Consumption Expenditure (PCE) deflator from the latest set of forecasts released in March called for inflation of 1.9% in 2017 and 2.0% in 2018. The gap between the headline measures of CPI inflation and PCE deflator inflation has averaged about 50bps in recent years, so that implies that the Fed is expecting CPI inflation to be much higher than the 1.38% 2-year TIPS breakeven. 2 Please see BCA Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8 2017, available at ces.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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. 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 Chart I-2Global 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 Chart I-4A Look At Purely Domestic##br## 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 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 Chart I-7Where 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 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 Chart I-10EUR/USD Is Overbought But...(1) Chart I-11EUR/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 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 Chart II-2USD 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 Chart II-4EUR 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 Chart II-6JPY 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 Chart II-8GBP 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 Chart II-10AUD 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 Chart II-12NZD 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 Chart II-14CAD 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 Chart II-16CHF 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 Chart II-18NOK 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 Chart II-20SEK 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... Chart 2...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 Chart 4Wage Growth Is In An Uptrend Chart 5Wage 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 Chart 7Rising Real Unit Labor Costs: ##br##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. 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 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 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 12U.K. Is Lagging Its Peers EM Outlook Chart 13Positive 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 Chart 15Higher Producer Prices Boosting Profits Chart 16A 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 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' Chart 3Credit: '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 Chart 5Inventory 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' 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 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... Chart 2B...But It's Not Large Enough To Offset##BR##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 Chart 4Service Sector Export Orders##BR##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 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 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. Table 2GDP Growth In 2H Has Met Or Exceeded 1H Growth In 5 Of Past 7 Years 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 Chart 8Upside Potential For Oil##BR##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 Chart 10Odds 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.