Euro Area

Highlights Two big distortions in the euro area economy arose because Germany depressed its wages for a decade, and then Italy failed to fix its broken banks for a decade... ...but both distortions are now correcting. Long-term property investors in Europe should seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. Steer clear of Scandinavia, France and central London. Stay overweight a basket of German real estate stocks. Maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Feature In Germany and Italy, real house prices are at the same level today as they were in 1995 (Chart of the Week). Germany and Italy share another similarity. Through the past two decades, they have delivered their workers the same subpar real wage growth (Chart I-2). Chart of the WeekThe Mirror Image Journeys Of German ##br##And Italian House Prices Chart I-2The Mirror Image Journeys Of ##br##German And Italian Wages However, while the point-to-point growth rates for both house prices and wages look identical, the journeys that Germany and Italy have travelled have been mirror images of one another. Germany's journey has been a decline followed by rapid ascent; Italy's journey has been a rapid ascent followed by decline. These mirror image journeys encapsulate the two big distortions within the euro area economy. The Euro Area's Two Big Distortions The euro area's first distortion arose from Germany's labour market reforms at the start of the millennium. Germany's labour reforms were putatively to boost productivity. In fact, the reforms' main impact was to depress German wages for a decade. The consequent boost in competitiveness caused symmetrical distortions: a bubble in German exports, and an anti-bubble in German household incomes. Before Germany joined the euro, such a distortion would have been impossible. An appreciating deutschemark would have arbitraged away any rise in export competitiveness. But an exchange rate appreciation could no longer happen once Germany was sharing its currency with other economies that were not replicating Germany's wage depression strategy. Hence, German household incomes - and house prices - have been one of Europe's biggest losers in the single currency era. Conversely, Germany's export-oriented companies - and their shareholders - have been amongst the biggest winners (Chart I-3). Just consider, the Siemens dividend is up almost one thousand percent! The euro area's second distortion arose because Italy failed to fix its broken banks for a decade. After a financial crisis such as in 2008, the golden rule is to nurse the financial system back to health as quickly as possible. Which is precisely what all the major economies did. All the major economies, that is, apart from Italy (Chart I-4). Chart I-3Distortion 1: Germany Depressed##br## Its Wages For A Decade Chart I-4Distortion 2: Italy Failed To Fix Its ##br##Broken Banks For A Decade Italy procrastinated because its government is more indebted than other sovereigns and because its dysfunctional banks did not cause an acute domestic crisis. Nevertheless, Italy's reluctance to fix its banks is the central reason for its decade-long economic stagnation, and declining real house prices. The good news is that the euro area's two big distortions are now correcting. Germany is allowing its wages to adjust rapidly upwards. Meanwhile, in the space of just a year, Italy has raised almost €50 billion in equity capital for its banks. Italian bank solvency and loan quality have improved sharply. This raises an interesting question: do the German and Italian housing markets now offer compelling long-term investment opportunities? European Housing Markets: The Good, The Bad, And The Ugly Property investments offer income via rents. Over time, these rents should increase in real terms. Items such as a litre of milk or a London commuter train journey do not increase in quality. If anything, the London commuter train journey has decreased in quality! By contrast, accommodation does increase in quality. For example, kitchens and bathrooms, home security, and heating and cooling systems should all get better over time. In essence, the quality of accommodation benefits from productivity improvements, so real rents rise. Of course, such improvements require investment expenditure. But a property investor requires a return on this investment. Therefore, property income - even after expenses - should and does increase in real terms. What about capital values? In the long term, we would expect capital values to have some connection to rising real rents. So if real house prices have not increased over several decades, then it signals a very likely undervaluation. Conversely, if real house prices have increased an implausibly large amount over several decades, then it raises a red flag for a likely overvaluation (Chart I-5, Chart I-6, and Chart I-7). Chart I-5German Real House Prices Are No Higher Than In 1995 Chart I-6Scandinavian Real House Prices Have Trebled Since 1995 Chart I-7Italy, Portugal And Greece Offer Good Opportunities For Property Investors On this evidence, we expect the long-term returns from the housing markets in France, Netherlands, Belgium and Finland to be bad. More worrying, we expect the long-term returns from the housing markets in Sweden and Norway to be ugly. Real house prices have more than trebled since 1995. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated credit-fuelled bubbles... albeit in Sweden and Norway. Chart I-8London House Prices Have Rolled Over We are also reluctant to own London property. London house prices have rolled over, and headwinds persist (Chart I-8). Theresa May wants to drag the U.K. out of the EU single market and customs union, which cannot be a good thing for London. On the other hand, if parliament forces May to soften her Brexit stance, it could fracture a precarious truce between hard and soft Brexiters in her cabinet and topple the government. Thereby, it could pave the way for a Jeremy Corbyn led Labour government and the spectre of a high-end 'land value' tax. So where are long-term returns likely to be good? We repeat that where house prices have shown no real increase from 25 years ago, it bodes very well for the long-term investment opportunity. This describes the situation for the housing markets in Germany, Italy, Portugal and Greece. To summarise, if you are looking for a long-term investment property in Europe, steer clear of Scandinavia, France and central London. And seek out undervalued gems on the Greek islands, Portuguese Atlantic coast, Italy and German second-tier cities. What Is The Related Opportunity In Equity Markets? Real estate holding and development companies and REITS are the equity market plays on real estate. The trouble is that the stocks are too few and too small for a meaningful investment in Greece, Italy and Portugal. However, in Germany, stay overweight the basket of real estate stocks which we first introduced a few years ago. The basket has outperformed by 50%, but the outperformance isn't over. In Germany, the catch-up of house prices is closely connected to the catch-up of household incomes. As Germany continues to reduce its export-dependence and rebalance its economy towards domestic demand, the catch-up has further to run. Chart I-9German Consumer Services Will ##br##Outperform Consumer Goods It is possible to play this structural theme in the equity market via an overweight in consumer services versus consumer goods. Consumer services tend to have more domestic exposure compared to the consumer goods sector which is dominated by autos. Understandably, during the era of German export-dominance, the German consumer services sector strongly underperformed consumer goods. But in recent years, as the German economy has rebalanced, the tables have turned. German consumer services have been outperforming German consumer goods (Chart I-9). We expect this trend to persist. Our preferred expression is to maintain a long basket of German consumer services versus a short basket of exporters comprising autos, chemicals and industrials. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week's recommendation is a commodity pair-trade: short nickel / long lead. The pair trade's 65-day fractal dimension is at the lower bound which has signalled several reversals in recent years. Set a profit target of 8% with a symmetrical stop-loss. We are also pleased to report that all of the four other open trades are comfortably in profit. 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-10 * 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 Fed preview: The Fed will hike rates again this week, and may signal a faster pace of future hikes given signs that U.S. inflation is starting to accelerate. Maintain a below-benchmark duration stance and stay underweight U.S. Treasuries in global hedged bond portfolios. Oversold U.S. Treasuries: While most indicators of positioning and momentum for U.S. Treasuries show a deeply oversold market, an analysis of past such episodes shows that it can take 4-6 months before bond yields correct an oversold condition in the absence of slowing growth or inflation - with yields potentially hitting new highs in the interim. ECB Tapering: The ECB strongly believes that the "stock effect" of its asset purchases matters more for European bond yields than the "flow effect". This suggests that the odds of a European "Taper Tantrum" later this year are low, although bond yields there are still headed higher. Feature Chart of the WeekThis Time Is Different? Global bond markets have calmed down after the big surge that started the year. The 10-year U.S. Treasury yield has traded in a relatively narrow 2.80-2.95% range since the VIX spike in early February, despite a string of weaker-than-expected U.S. economic data prints that has triggered sharp downgrades to Q1/2018 U.S. GDP growth forecasts. At the same time, 10-year benchmark yields for other major government bond markets (Germany, France, U.K., Canada) have been drifting lower, but remain above levels that began the year. In the case of U.S. Treasuries, the overall level of yields is being held up by the steady climb at the short-end of the yield curve. Recent hawkish comments from new Fed Chairman Jay Powell and long-time Fed dove Lael Brainard have raised expectations for a rate hike at this week's FOMC meeting, which is now priced as a certainty. The 2-year Treasury yield has climbed to a 10-year high of 2.3%, which is helping keep a floor underneath longer-term Treasury yields despite positioning indicators showing that traders and bond managers already have significantly reduced duration exposure (Chart of the Week). The other factor that is likely holding up global bond yields is the incremental move by the European Central Bank (ECB) towards a tapering of its asset purchases. The market has already repriced both future interest rate expectations and the term premia embedded in European government bond yields, although recent comments from ECB officials suggest that they believe that there will not be a "Taper Tantrum 2.0" in Europe similar to the Treasury market sell-off in 2013. This week, we tackle those two critical issues for bond markets head-on: the implications of large short positions in the U.S. Treasury market versus the ECB taper impact on global bond yields. Our conclusion is that the impact of both is likely overestimated by investors. How To Think About A Technically Oversold Treasury Market The Fed will deliver another rate hike this week. That outcome has already been fully discounted by the market, which should not be considered surprising given the current U.S. economic backdrop: Inflation: Underlying inflation has clearly bottomed out and has begun to accelerate, with the 3-month annualized growth rate of core CPI inflation now up over 3% (Chart 2). That trend should continue in the next several months: our model for CPI Shelter inflation is calling for a pickup (2nd panel), core goods inflation is showing signs of responding to the weakening U.S. dollar (3rd panel), and the big plunge in U.S. wireless phone prices that severely dampened inflation in 2017 is about to wash out of the year-over-year CPI data and boost core services inflation (bottom panel). Growth: Despite some recent signs of softening momentum in the Q1 data, the underlying trend in U.S. growth remains upbeat. Labor demand is accelerating and our payrolls growth model suggests further gains are coming (Chart 3). Corporate profit growth remains solid and the impact of the Trump tax cuts will only boost earnings momentum and business confidence. Leading economic indicators are also accelerating and suggest that any loss of growth momentum in Q1 - which seems to be an annual occurrence despite the seasonal adjustment of data - will be short-lived (bottom panel). Chart 2U.S. Inflation Is Starting To Perk Up Chart 3No Reason For Any Dovish Fed Surprises Financial Conditions: U.S. equity prices have recovered much of the losses suffered during the February VIX-driven correction, while corporate credit spreads remain narrow from a historical perspective (Chart 4). Add in the weaker U.S. dollar - the impact of which is already boosting import prices and potentially following through into the shorter-term inflation expectations of households (bottom panel) - and overall financial conditions remain highly accommodative. Against this positive backdrop, the Fed can feel confident that its growth and inflation forecasts for 2018 will be achieved, and that inflation expectations can continue to climb back to levels consistent with the Fed's inflation target. There is even a chance that the Fed could accelerate its planned pace of rate hikes (Chart 5), particularly if there is an upgrade to the FOMC growth and inflation projections, which will be updated for this week's meeting. Chart 4U.S. Financial Conditions##BR##Remain Accommodative Chart 5All Eyes On##BR##The Dots This Week Yet for all the positive economic, bond-bearish news, one fact stands out - the U.S. Treasury market is deeply oversold from a technical perspective. This should, in theory, limit the ability for bond yields to continue rising and could set up a short-covering bond rally if there is a more meaningful and prolonged slowing of economic growth or inflation. The technical indicators that we regularly monitor for the U.S. Treasury market are all at or near the extremes of the ranges observed since 2000 (Chart 6). Chart 6U.S. Treasuries Are Very Oversold The 10-year Treasury yield is 43bps above its 200-day moving average The 26-week total return of the Bloomberg Barclays U.S. Treasury index is -4.3% The J.P. Morgan client survey of bond managers and traders showed the largest underweight duration positioning since the mid-2000s, although there has been some recent reduction of those positions The Market Vane index of sentiment for Treasuries is now at 49, near the bottom of the range since 2000 The CFTC data on positioning in 10-year Treasury futures shows a large net short of -8%, scaled by open interest Given this degree of investor negativity toward U.S. Treasuries, some pullback in yields seems inevitable. However, a look back at past episodes where Treasuries were this oversold shows that the timing of such a pullback is highly variable - anywhere from one month to seven months. The determining factor is the growth and inflation backdrop in the U.S. To show this, we did a simple study using two series from our list of Treasury technical indicators. Specifically, we looked at "oversold episodes" since 2000 where the Market Vane Treasury sentiment index dipped below 50 and where the 10-year Treasury yield was trading at least 30bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield fell back below its 200-day moving average. We then looked at the duration (in days), and change in bond yields, for each oversold episode. There were eleven such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we list them ranked by the number of days it took to complete each episode as we defined it. The longest correction of an oversold Treasury market since 2000 took place between July 2003 and February 2004, where 203 days passed before the 10-year yield dipped back below its 200-day moving average. The shortest correction was in May 2000, where only 28 days were needed. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market To determine what the U.S. economic backdrop was during each episode, we then simply asked if economic growth was rising or falling, or if inflation was stable/rising or falling, using the ISM Manufacturing index and core PCE inflation as the relevant data series. The answers to those questions are found in the final two columns of Table 1. All the positioning and economic indicators used in our historical study, shaded for the oversold episodes, are shown in Charts 7, 8 and 9. Chart 7U.S. Treasury Market##BR##Oversold Episodes 2000-2005 Chart 8U.S. Treasury Market##BR##Oversold Episodes 2006-2011 Chart 9U.S. Treasury Market##BR##Oversold Episodes 2011 To Today The simplest conclusion that we reached from our study is that the shortest corrections of an oversold Treasury market occurred, unsurprisingly, during the two episodes where both growth and inflation were slowing, with an average length of each episode of 42 days. The four episodes where growth and inflation were both rising had a more variable performance, lasting anywhere from 98 days to 203 days, averaging 156 days per episode. The five episodes where growth was slowing but inflation was stable or rising were also of varying length, averaging 140 days. In other words, it has taken around five months, on average, to correct an oversold Treasury market when inflation was stable or rising, and about 1.5 months when inflation was falling. In the current environment, where the ISM Manufacturing index is in an uptrend and core PCE inflation is rising, we should expect a longer period of time before the Treasury market corrects its oversold condition. If we mark the start of the current episode on February 20th of this year, using the definition described above, then the 10-year Treasury yield may return to its 200-day moving average of 2.4% by August (five months from now). A word of warning for traders and investors looking to play for that move by flipping to a long duration position now, though - the primary trend of the market, defined by that 200-day moving average, is currently rising. It was also rising during the two longest oversold correction episodes 2003-04 and 2013-14. The 10-year Treasury yield only declined -14bps and -17bps, respectively, over those entire episodes. During the 2013-14 episode, also a period similar to today when growth and inflation were both rising, yields actually climbed to new cyclical highs before finally peaking. In other words, betting on a reversal of an oversold bond market without any deterioration in growth and inflation dynamics may generate only modest returns over a lengthy period, and with substantial mark-to-market volatility in the meantime. In the current cycle, with leading indicators for U.S. growth and inflation accelerating and the Fed becoming more hawkish, we recommend maintaining below-benchmark duration positions in the U.S. rather than positioning now for a short-covering rally. Bottom Line: The Fed will hike rates again this week, and may signal a faster pace of future hikes given signs that U.S. inflation is starting to accelerate. While most indicators of positioning and momentum for U.S. Treasuries show a deeply oversold market, an analysis of past such episodes shows that it can take 4-6 months before bond yields correct an oversold condition in the absence of a slowing of economic growth or inflation - with yields potentially hitting new highs in the interim. Maintain a below-benchmark duration stance and stay underweight U.S. Treasuries in global hedged bond portfolios. The ECB Is Betting On A Tantrum-Free Taper Several key ECB officials have been giving speeches over the past week, spelling out a consistent message to the markets on the future of euro area monetary policy. Most notably, ECB President Mario Draghi and ECB Chief Economist Peter Praet gave speeches last week at a conference in Frankfurt. Both of them used nearly identical language to highlight how the ECB's main policy tool going forward will no longer be net asset purchases, but instead will be interest rates and forward guidance on changes to rates.1 This echoes the message sent after the ECB's policy meeting earlier this month, when the commitment to increase the pace of asset purchases was dropped from the ECB policy statement. Both Draghi and Praet repeated the ECB's official stance on the end of asset purchases, which requires a "sustained adjustment" in the path of inflation. This was described by Draghi as: Specifically, a sustained adjustment requires three conditions to be in place. [...] The first is convergence: headline inflation has to be on course to reach our aim over a meaningful definition of the medium term. The second is confidence: we need to be sure that this upward adjustment in inflation has a sufficiently high probability of being realized. The third condition is resilience: the adjustment in inflation has to be self-sustained even without additional net asset purchases. Draghi then went on to add these comments on the sequencing of rate hikes after the asset purchases are completed, with our emphasis added: [...] when progress towards a sustained adjustment in the path of inflation is judged to be sufficient, net purchases will come to an end. At that point, next to our forward guidance, appropriate financial conditions will be maintained by our reinvestment policy. [...] as regards the evolution of our policy rates beyond the end of our net purchases, we will maintain the sequencing that is currently set out in our forward guidance, namely our pledge to keep key interest rates at their current levels "well past" the end of net purchases. This time-based element of our guidance is already vital today, in particular to ensure that our policy stimulus is not weakened by premature expectations of a first rate rise, and so financial conditions remain consistent with inflation convergence. That last line can be roughly translated from policymaker-speak as "we want to avoid a Fed-style Taper Tantrum when we stop buying euro area government bonds." Chart 10An Orderly Repricing Of ECB Expectations Praet made similar comments in his speech, discussing how the first rate hike after the end of asset purchases must only take place once there is a "durable convergence" of euro area inflation with the ECB target of just below 2% on headline inflation. So far, the markets have been heeding the ECB's communication and policy guidance. The timing of the ECB's first full 25bp rate hike, taken from our "months-to-hike" indicator, shows that the market does not expect the ECB to adjust rates until November of 2019 (Chart 10). At the same time, the market is only slowly repricing the term premium on longer-dated euro area government bonds, which would be expected if the ECB were to take its time in fully tapering its asset purchases. With realized euro area inflation, and market-based inflation expectations, still well short of the ECB's target, the market appears to be "correctly" following the ECB's guidance on the timetable for future policy moves. This is keeping euro area bond yields at low levels and dampening interest rate volatility. There may be another factor at work holding down bond yields, however. In a speech given at the U.S. Monetary Policy Forum in New York last month - an event attended by numerous academic and Wall Street economists, as well as several current FOMC members - ECB Executive Board Member Benoit Coeure discussed the importance of the "stock" effect of central bank asset purchases compared to the "flow" effect.2 Or as Coeure described it: [...] the "stock effect" - that is, the persistence of the effects of the stock of bonds held by the central bank on its balance sheet under a commitment of reinvestment. If the effects of purchases dissipate quickly, a shorter purchase horizon could lead to term premia rising even as interest rate expectations remain well anchored by forward guidance. Financial conditions would then tighten. But if the effectiveness of asset purchases rises with the stock of assets already acquired - if there is some "crossover point" where the stock effect becomes more important than the continued flow of purchases - then a reduced pace of purchases would not unduly decompress the term premium. This brings up an interesting point about the ECB's policy strategy as it prepares to taper its asset purchase program. If the ECB can effectively communicate that it will continue to reinvest the maturing bonds on its balance sheet after the new asset purchases have stopped, then the market will not price in a bigger term premium on longer-dated bonds since the ECB will continue to own a huge share of the stock of euro area government debt. The stock effect will dominate the diminishing flow effect. Coeure noted in his speech that the experience of the U.S. in 2013, when Ben Bernanke surprised markets with talk that the Fed was planning on cutting back its asset purchases, is different than Europe today. The biggest reason is that the ECB owns a far bigger share of the European bond market than the Fed did at that time. That is because the ECB asset purchases since its bond buying program began in 2015 have dwarfed the net issuance of euro area government debt (Chart 11). At no point during the Fed's quantitative easing (QE) era did the central bank ever buy more U.S. Treasuries than the U.S. government was issuing. According to the logic of Benoit Coeure, the smaller Fed "footprint" in the Treasury market relative to the ECB's ownership share of euro area government bonds (Chart 12) should mean that the Treasury term premium will be more volatile than that for German bunds (and other euro area debt). That is because a greater share of Treasury issuance must be sold to private investors who are more price-sensitive than central banks. In other words, the flow effect dominates the stock effect. Chart 11ECB & BoJ Have Been Absorbing##BR##All Net Government Bond Issuance Chart 12The 'Stock Effect' Of QE##BR##Should Be Bigger In Europe & Japan In Chart 13, we try and visually prove Coeure's thesis. The chart plots the gap between central bank asset purchases and net government bond issuance (the blue solid line proxying the "flow effect", using IMF data) for the U.S., euro area and Japan versus our estimates of the term premium (the black dotted line). The correlation appears to be very strong for the euro area and Japan during the era of asset purchases for those central banks, perhaps due to the "stock effect" dominating the "flow effect". This differs from the experience seen in the U.S. during the Fed QE era, when there was no stable relationship between the term premium and the amount of Treasuries the Fed was purchasing relative to net issuance. Looking ahead, there are important implications of this "stock vs. flow" argument for the future direction of euro area (and Japanese) bond yields, both in absolute terms and relative to U.S. Treasuries. In Chart 13, we also added BCA's forecasts for net government bond issuance over the next two years relative to our projections for the pace of asset purchases from the ECB and BoJ (both new purchases and reinvestments), and the Fed's own projections for the runoff of Treasuries from its balance sheet. Our estimates show that there will still be no new government bond issuance for the private sector to absorb in the euro area and Japan in 2018 and 2019, even with the ECB expected to fully taper new buying to zero by the end of this year and the BoJ dramatically cutting back its pace of buying. This contrasts to the U.S., where the private sector will be forced to absorb an extra US$1 trillion (!) of Treasuries this year and next, thanks to the huge Trump fiscal stimulus and the diminished buying by the Fed. U.S. private investors may require a higher yield (i.e. term premium) to absorb that additional debt, especially if inflation expectations are rising and the Fed is hiking interest rates at the same time. The implication is that the spread between Treasuries and euro area debt (and Japanese bonds, for that matter) could stay stubbornly wide - at least until there is more decisive evidence that the U.S. economy is in a cyclical slowdown that would put the Fed rate hiking cycle on hold (Chart 14). Chart 13The 'Flow Effect' Of##BR##QE Does Still Matter Chart 14The 'Stock Effect' Could Keep The##BR##UST-Bund Spread Wider For Longer From the point of view of euro area debt, however, the existence of a "stock effect" means that those investors expecting a Taper Tantrum 2.0 will likely be disappointed in the size of any upward move in euro area bond yields this year. Bottom Line: The ECB strongly believes that the "stock effect" of its asset purchases (how much they already own) matters more for European bond yields than the "flow effect" (how much they are buying). This suggests that the odds of a European "Taper Tantrum" later this year are low, although bond yields there are still headed higher. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Draghi speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html, while the Praet speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_2.en.html 2 Coeure's speech can be found at https://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180223.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. 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 11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 Risk assets find themselves in a precarious equilibrium. Record high valuations are fully justified if bond yields remain at current levels or fall, but valuations become increasingly hard to justify if bond yields march much higher. If the average of the German 10-year bund yield and U.S. 10-year T-bond yield breaks through 2%, we would downgrade equities and upgrade bonds. Stay long Italian BTPs versus French OATs. The Italian election result is not an investment game changer... ...but stay underweight the Italian equity market (MIB) on a 6-9 month horizon. Our sector stance to underweight banks necessarily implies underweighting the bank-heavy MIB. Feature "Even yet we may draw back, but once cross yon little bridge, and the whole issue is with the sword." - Julius Caesar, contemplating whether to cross the Rubicon River in 49 BC World GDP amounts to $80 trillion. But the combined value of equities and correlated risk assets such as high yield and EM debt is worth double that, around $160 trillion. Real estate is worth $220 trillion. Hence, global risk assets are worth around five times world GDP. With the value of risk assets dwarfing the world economy by a factor of five, it perplexes us that many commentators insist that causality must always run from the economy to financial markets. In fact, in major downturns, the causality usually runs the other way. Rather than economic downturns causing financial instabilities, it is more common for financial instabilities to cause economic downturns. Specifically, the last three economic downturns had their geneses in the financial markets. The bursting of the dot com bubble triggered the downturn of 2001; the large-scale mispricing of U.S. mortgages caused the Great Recession of 2008; and the explosive widening of euro area sovereign credit spreads resulted in the euro area recession of 2011. This raises a crucial question: is there a major vulnerability in financial markets right now? Risk Assets Are As Expensive As In 2000... For at least five decades, the ratio of global equity market capitalization to world GDP (effectively, the price to sales ratio) has proved to be an excellent predictor of subsequent 10-year global equity returns (Chart I-2). Chart of the WeekWorld Equities As Highly-Valued As In 2000 On Price To Sales Chart I-2Price To Sales Has Been An Excellent Predictor Of World Equity Returns Today's extreme ratio of global equity market capitalization to world GDP has been seen only once before in modern history - at the peak of the dot com boom in 2000. In the subsequent decade global equities went on to return a paltry 2% a year. Using the particularly tight predictive relationship in recent decades, we can infer that global equities are now priced to generate 2% a year in the coming decade too (Chart of the Week). Still, equities are not as extremely valued relative to government bonds as they were in 2000. Today, the global 10-year bond yield stands near 2%, implying a broadly equal prospective 10-year return from equities and bonds. In 2000, the global 10-year bond yield stood at 5%, implying that equities would return 3% less than bonds, which they duly did (Chart I-3). Chart I-3Relative To Government Bonds, Equities Were More Expensive In 2000 On the other hand, high yield credit is more extremely valued relative to government bonds than it was in 2000. Today, the global high yield credit spread stands at a very tight 4%: in 2000, it stood at 8% (Chart I-4). So taking the combination of equities and high yield credit, we can say that risk assets are as highly valued today as they were in 2000. Chart I-4Relative To Government Bonds, High Yield Credit Was Less Expensive In 2000 ...But Risk Assets Should Be Very Expensive When Bond Yields Are Ultra-Low The record high valuation of risk assets is fully justified when government bond yields are ultra-low. This is because bond returns take on the same unattractive asymmetry - known as 'negative skew' - that equity and high yield credit returns possess. For a detailed explanation, please revisit our report Are Bonds A Greater Risk Than Equities? 1 But in a nutshell, as bond risk becomes 'equity-like' it diminishes the requirement for a superior return on equities and other risk-assets, lifting their valuations exponentially. Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative skew than 10-year bonds. So investors will demand a comparatively higher return from equities, let's say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative skew. So investors will demand the same return from equities as they can get from bonds, 2% a year (Chart I-5). Chart I-5Below A 2% Yield, 10-Year Bonds Are Riskier Than Equities At the lower bond yield, the bond must deliver 2% a year less for ten years, meaning its price must rise by 22%.2 But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%.3 All well and good, except if bond yields go back up to 4%. In which case, bond and equity prices must fall again - in proportion to their preceding rise. Hence, risk assets find themselves in a precarious equilibrium. Record high valuations are fully justified if bond yields remain at current levels or fall, but valuations become increasingly hard to justify if bond yields march much higher. However, a setback to $380 trillion of global risk assets means that yields can't march much higher without at least a temporary reversal. Unfortunately, the exact point at which the precarious equilibrium becomes threatened is hard to define. Still, we might define crossing the Rubicon as follows. If the average of the German 10-year bund yield and U.S. 10-year T-bond yield - now standing at 1.8% - breaks through 2%, we would downgrade equities and upgrade bonds. Italy: Banks More Important Than Politics On Sunday, Italy's electorate punished the establishment centre-left and centre-right parties - the Democratic Party and Forza Italia - whose combined vote share collapsed to just 33%. Italians gravitated to parties offering populist, anti-establishment and anti-migration bromides. Sound familiar? This is just a continuation of the pattern seen in recent elections in France, Germany and Austria - as well as the victories for Brexit and President Trump. Begging the question, does the Italian election result change anything for investors? Political change disrupts markets if it dislocates the long-term expectations embedded in economic agents and financial prices. The vote for Brexit changed expectations about the U.K.'s long-term trading relationships; the election of Trump changed expectations about fiscal stimulus, the tax structure, and protectionism; and the election of Macron exorcised the potential chaos of a Le Pen presidency. On this basis, the Italian election result is not an investment game changer. The one exception would be if M5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low. Many people - including some of the more populist Italian politicians - claim that Italy's long-standing economic underperformance is because it is shackled to the euro. But membership of the single currency cannot be the main cause of Italy's underperformance. After all, through 1999-2007, Italian real GDP per head performed more or less in line with the U.S., Canada and France, even without a private sector credit boom. Italy's underperformance really started after the 2008 financial crisis (Chart I-6). And the most plausible explanation is that its dysfunctional banking system has been left broken for close to a decade (Chart I-7). Italy procrastinated because its government is more indebted than other sovereigns and its banking problems did not cause an outright crisis. Chart I-6Italy Has Underperformed##br## Since The Great Recession... Chart I-7...Because The Banks ##br##Were Left Unfixed But now the banking system is finally recuperating. In the past year, banks have raised almost €50 billion in much needed equity capital, the share of non-performing loans (NPLs) is down sharply having peaked at the same level as in Spain in 2013 (Chart I-8), and bank solvency is much healthier (Chart I-9). Chart I-8Italy's NPLs Are Finally Declining... Chart I-9...And Bank Solvency Is Getting Better In effect, Italy is where Spain was in 2014. So could Italy in 2018-21 repeat Spain's turnaround in 2014-17? Italy has more work to do, but on balance we remain cautiously optimistic, and express this optimism through a relative trade in bonds: long Italian BTPs versus French OATs. The connection with the Italian equity market (MIB) is more tenuous. The market's outsize exposure to banks means that sustained outperformance of the MIB requires sustained outperformance of banks. On a 6-9 month horizon, our sector stance is to underweight banks. Necessarily, this means our country stance must be to underweight Italy. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities?" published on January 25, 2018 and available at eis.bcaresearch.com 2 1.02^10 3 1.06^10 Fractal Trading Model* The rally in the Chilean peso appears technically extended. Hence, this week's trade recommendation is to short the Chilean peso versus the U.S. dollar setting a profit target of 2.7% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 Policymakers & Volatility: The major developed market central banks (Fed, ECB, BoJ), facing low unemployment rates and slowly rising inflation, are less able to respond to volatility spikes with more dovish monetary policies compared to past years. Investors should get used to a structurally higher level of volatility, likely for the remainder of the current business cycle upturn. Higher Volatilty & Spread Product: The relative risk-adjusted attractiveness of global spread product looks different when using a higher level of yield volatility, particularly when hedged into U.S. dollars. Continue to favor U.S. investment grade and high yield corporate debt over euro area and emerging market equivalents, even with the more elevated volatility backdrop. Feature If there is one lesson to be learned from recent events, it is that global policymakers can no longer be trusted to always make the most market-friendly decisions. Central bankers in most countries have shifted from solely supporting growth to fighting inflation pressures. The White House is now willing to risk a disruptive trade war to try and "correct" the large U.S. trade deficit, rather than focusing on stimulating growth solely through fiscal policy. Even geopolitical headlines have become more worrisome for investors, with Russia announcing new nuclear capabilities, China appointing a "president for life", the U.K. government remaining vague on the details of its Brexit negotiating stance and Italy's elections producing a hung parliament with anti-establishment parties outperforming expectations. The idea that central bankers have been explicitly putting a floor under risk assets, by focusing so much on financial conditions as a critical input into their economic and inflation forecasts, has become very entrenched among investors. The implication is that if risky assets sell off, central banks will shift to a more dovish stance, thus causing interest rate expectations to shift lower which eventually causes risk assets to rebound and financial conditions to ease. This has been most evident in the U.S., where a belief in the "Fed Put" - the idea that the Fed has implicitly sold investors a put option on equities by responding dovishly to market selloffs - goes all the way back to the Greenspan era. In the U.S., however, there is now greater uncertainty that a "Powell Put" even exists - or at least one as valuable as the "Yellen Put" and "Bernanke Put" before it. In other words, it may now take a much larger decline in risk assets to cause the Fed to question its economic forecasts enough to change them. New Fed Chairman Jay Powell said as much in his first appearance before the U.S. Congress last week, where he noted that the recent equity market turbulence was not "weighing heavily" on the Fed's outlook. In fact, Powell talked up a very bullish view on the U.S. economy, which markets took as a sign that the Fed could hike rates four times in 2018 - more than the three hikes currently embedded in the Fed's projections. A similar dynamic is playing out in Europe and Japan, where the European Central Bank (ECB) and Bank of Japan (BoJ) have been more vocal about the potential end of their respective asset purchase programs given the underlying strength of the euro area and Japanese economies. The belief in a "Draghi Put" or "Kuroda Put" is also strong, but is starting to wane. Central Bankers As Options Traders Chart 1A Smaller Response To Higher Volatility One way to see this changing backdrop is to look at the response of monetary policy expectations to increases in market volatility. During 2017, there were a few small flare-ups of equity market volatility in the U.S., euro area and Japan. In each of those episodes, interest rate markets were quick to price in easier monetary policy through a lower projected level of the funds rate in the U.S. or by pushing out the timing of the eventual first rate hike in Europe and Japan (Chart 1). The story is much different in 2018, where volatility has soared higher but there has been little change to the expected path of interest rates. Markets now understand that inflation-fighting central banks, who strongly believe in the Phillips Curve, now have to focus more on inflation than asset prices with unemployment rates at or below full employment levels. Using the language of options markets, the "strike price" on the put options allegedly sold by central bankers is now much lower. The implication is that bouts of market turbulence cannot generate lasting decreases in government bond yields that can eventually restore calm to financial assets. In other words, policymakers are now implicitly, but not intentionally, putting a floor under volatility rather than asset prices. This has made the investment backdrop much more challenging in 2018, as both absolute market returns and, especially, risk-adjusted returns will be far lower than investors have enjoyed over the past couple of years. This is one of the key themes that we outlined in our 2018 Outlook.1 It will take signs that more volatile markets are damaging economic growth and inflation expectations for this new dynamic to change. Yet there is little sign of that happening, at least among the "Big 3" central banks. The Federal Reserve In the U.S., economic data continues to print strongly. The February ISM manufacturing Index hit a 13-year high (Chart 2, top panel), with the export index hitting the highest level since 1988! The Conference Board index of consumer confidence hit the highest level since 2000 (2nd panel), while the Board's index of leading indicators continues to accelerate (3rd panel). The ISM new orders index remains at elevated levels that suggest that the latest upturn in capital spending should continue (bottom panel). Meanwhile, U.S. inflation gauges continue to grind slowly higher. The 3-month annualized growth rate of the core PCE deflator rose to 2.1% in January - above the Fed's 2% target - while the ISM Manufacturing Prices Paid index is now at a 6-year high (Chart 3). Inflation expectations from the TIPS market have recently stalled below levels that we deem consistent with the Fed's inflation objective (between 2.3% and 2.5% on both the 10-year TIPS breakeven and the 5-year TIPS breakeven, 5-years forward), but they continue to trend in the direction of the Fed's target. If the wage numbers in this Friday's February Payrolls report build on the breakout seen in the January data, then breakevens should begin to climb higher once again and would all but ensure that another Fed rate hike will occur later this month. Chart 2Fed Chair Powell Is Right##BR##To Be Optimistic On U.S. Growth Chart 3U.S. Inflation Now Moving##BR##Towards The Fed Target The ECB Chart 4Will The ECB Pull Forward Its Projections? Turning to the euro area, economic data has begun to dip lower in recent readings for cyclical indicators like the manufacturing PMI, which complicates the story for the ECB heading into this Thursday's policy meeting. We continue to expect any decision on a tapering of the ECB's asset purchase program to not take place until the summer. However, some minor changes to its forward guidance, like removing language suggesting that asset purchases could be increased if necessary, could happen this week. The more meaningful signal will come from the new set of ECB economic forecasts. Core euro area HICP inflation is not projected to return close to the ECB's 2% target until 2020, and if that timetable is pulled forward in the new forecasts, that would give the ECB a credible reason to begin signaling a taper later this year. With full euro area unemployment hitting an 8-year low of 8.6% in January - dipping below the OECD full employment NAIRU estimate of 8.7% - the ECB could raise its projections for both wage growth and core inflation (Chart 4). With our own core HICP diffusion index showing a sharp increase in January, the risk of future upside surprises in euro area realized inflation has increased. Yet core inflation is still only 1.0% - a long way from the ECB's 2% target. This is already reflected in measures of inflation expectations like CPI swap forwards, which remain between 50-75bps below the levels that prevailed the last time euro area core inflation was around 2% (bottom two panels). This suggest further upside for euro area bond yields if core inflation does start to print higher later this year. For now, the ECB is unlikely to make any earth-shattering changes to its monetary policy this week, but should signal another small incremental step towards a full-blown taper later in 2018. The BoJ BoJ Governor Haruhiko Kuroda threw a bit of a surprise at the markets last week in his testimony before the Japanese parliament following his reappointment as the head of the central bank. In response to a question on when the BoJ could consider beginning to exit its current Yield Curve Control (YCC) program, Kuroda stated that it could happen in fiscal year 2019 if the BoJ's inflation projections are realized. The media headlines took that as a sign that the BoJ was starting to change its forward guidance about its monetary policy, but that is an overreaction, in our view. Chart 5The Yen Leads The BoJ, Not Vice Versa Realized inflation remains well below the BoJ's target, with headline CPI inflation hitting 1.3% and 0.4%, respectively, in January (Chart 5). Even given the continued strength of the Japanese economy, with the unemployment rate now sitting at a 29-year low of 2.4%, inflation will have no realistic shot of reaching the BoJ 2% target without a weaker Japanese yen. The markets understand that dynamic, as our Japan months-to-hike measure - measuring the time until the first 25bps rate hike is priced into the Overnight Index Swap curve - has recently drifted up from 38 months to 47 months alongside the current appreciation of the yen (bottom panel). The BoJ remains the one major central bank that can still talk dovishly because inflation remains so low. Yet investors are aware that the BoJ is having greater difficulty operationally executing its asset purchase program, given its huge ownership share of Japanese government bonds and equity ETFs. So, like the Fed and the ECB, the BoJ's ability to credible respond in a dovish fashion to rising market turbulence - manifested through a rising yen - is severely hamstrung. Bottom Line: The major developed market central banks (Fed, ECB, BoJ), facing low unemployment rates and slowly rising inflation, are less able to respond to volatility spikes with more dovish monetary policies compared to past years. Investors should get used to a structurally higher level of volatility, likely for the remainder of the current business cycle upturn. What A Higher Volatility Regime Means For Global Spread Product If policymakers are now unable to take actions that can restore the low volatility regime seen last year, then this has implications for the relative attractiveness of global fixed income spread product. One way to see is this is to look at the ranking of volatility-adjusted yields for various global spread sectors. We present that in Table 1, where we take the currency-hedged yields for spread sectors and rank them according to two metrics: a) the outright hedged yield and b) the hedged yield relative to its trailing yield volatility.2 The sector yields are then re-ranked using the average ranking of those two metrics. We present the table with yields hedged into the four major developed market currencies (U.S. dollar, euro, yen and British pound). The level of those yields, shown against credit ratings, are graphically presented in the Appendix on pages 11 and 12. Table 1Ranking Currency-Hedged Global Spread Product Yields We also show two versions of the yield rankings - one using trailing volatility over the past year in the denominator of the risk-adjusted yield, and the other using trailing volatility over three years in the denominator. This is important, as bond volatility over the past year has been historically depressed and is much lower than the three-year volatility measure for almost every spread sector. The conclusion is that many sectors that look most attractive using the more recent low volatility look less appealing with a more "normal" volatility level. For example, U.S. high-yield corporates are the top ranked sector in USD terms using a trailing one-year volatility, but that ranking falls to #10 using a higher three year volatility. Euro area high yield falls from #6 to #11 when applying the different volatility measures, while emerging market USD-denominated sovereign debt falls from #3 to #6. While the differences in the yield rankings are not as meaningful for higher-quality sectors, and for other base currencies besides the U.S. dollar, the main takeaway is that a higher volatility environment can alter the relative attractiveness of spread sectors given the current low level of yields. Thus, if central banks now have reduced ability to respond to volatility shocks by signaling a more dovish stance - given strong growth, tight labor markets and slowly rising inflation - then investors should judge spread product, and risk assets in general, using a higher level of volatility than seen last year. The conclusion is that we should be using the upper left column of Table 1, using the more "normal" level of yield volatility, when assessing the attractiveness of spread sectors within our recommended investment universe that uses the U.S. dollar as the base currency. With regards to corporate bonds in our model bond portfolio, that means favoring U.S. investment grade over euro area and emerging market equivalents and favoring U.S. high yield over euro area high yield. We are happy to report that we already have those recommendations implemented in our portfolio. While the absolute valuations of U.S. investment grade corporates, from a perspective of breakeven spreads, do look historically tight (Chart 6, middle panel), the same can be said for euro area investment grade corporates (Chart 7, middle panel). We are willing to take that trans-Atlantic spread risk favoring the U.S., however, given that currency hedging costs continue to favor U.S. dollar investments over euro-denominated equivalents. Chart 6Favor U.S. Corporate Bonds... Chart 7...Especially Versus Euro Area Corporates The story is cleaner for U.S. high yield over euro are high yield, as the default-adjusted spreads in the former (Chart 6, bottom panel) look far more attractive than in the latter (Chart 7, bottom panel). Bottom Line: The relative risk-adjusted attractiveness of global spread product looks different when using a higher level of yield volatility, particularly when hedged into U.S. dollars. Continue to favor U.S. investment grade and high yield corporate debt over euro area and emerging market equivalents, even with the more elevated volatility backdrop. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Appendix Appendix Chart 1Global Spread Product Yields, Hedged Into U.S. Dollars Appendix Chart 2Global Spread Product Yields, Hedged Into Euros Appendix Chart 3Global Spread Product Yields, Hedged Into British Pounds Appendix Chart 4Global Spread Product Yields, Hedged Into Japanese Yen 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2018 Key Views: BCA's Outlook & What It Means For Global Fixed Income Markets", dated December 5th 2017, available at gfis.bcareseach.com. 2 Using rolling averages of 60-day realized hedged yield volatility. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Easier fiscal policy will cause U.S. inflation to rise or force the Fed to raise rates more aggressively than the market is discounting. Either outcome is likely to lead to a real appreciation in the dollar. Policy developments are starting to work in the greenback's favor. The Fed's leadership is turning somewhat more hawkish. Trade protectionism is also on the rise. Contrary to yesterday's market reaction, this will end up being dollar-bullish. The only plausible scenario where the dollar weakens in the face of bountiful fiscal stimulus is one where U.S. rates rise a lot but foreign rate expectations rise even more. Such an outcome is not particularly likely, considering that the U.S. is going from laggard to leader in the global growth horserace and most central banks are tightening monetary policy much more gingerly than the Fed. Nevertheless, it cannot be excluded, which is why investors should consider going long 30-year U.S. Treasurys versus German bunds in currency-unhedged terms. This position would pay off if EUR/USD weakens, while also providing downside protection in the case where the greenback comes under pressure due to a narrowing in the long-term interest rate spread between Germany and the U.S. Held to maturity, investors stand to gain 40% on this position. Feature Beware Of "Arguments By Accounting Identity" One of the biggest mistakes economic commentators make is that they engage in "arguments by accounting identity." These arguments almost always fall flat. This is because there are plenty of ways for accounting identities to hold true, only a small number of which are consistent with how people actually respond to economic incentives. Consider the often-cited identity which says that the difference between what a country saves and what it invests is equal to its current account balance or, in algebraic terms, S-I=CA. The U.S. is currently operating at close to full employment. It is sometimes asserted, using this formula, that a large dollop of fiscal stimulus will drain national savings, thereby increasing America's current account deficit. A bigger current account deficit is normally associated with a weaker currency. Ergo, fiscal stimulus must be dollar-bearish. It is a plausible sounding argument, but it makes no sense because it confuses cause and effect.1 It is analogous to saying that an increase in the number of apples coming to market means that the price of apples will fall even when it is apparent that farmers are planting more apple trees because the demand for apples is rising. If the government cuts taxes and boosts outlays, aggregate spending will increase. Should the value of the dollar simultaneously fall, the composition of that spending will shift towards domestically produced goods and services. Not only will people want to spend more, but they will also want to devote a larger share of their spending on U.S.-made goods. But how exactly is the economy supposed to generate all this additional output? It is already running at full capacity! The only story that makes sense is one where the value of the dollar rises. That would allow aggregate spending to go up, while ensuring that spending on American-made goods and services remains the same. Table 1 illustrates this point using a stylized example of a hypothetical economy. Table 1A Stronger Currency Can Be A Counterweight To Fiscal Stimulus U.S. imports account for about 15% of GDP (Chart 1). Assuming no change in the exchange rate, spending on domestically produced goods and services will rise by about 85 cents in response to every $1 increase in aggregate demand. If the economy cannot produce this additional output due to a lack of available workers, one of two things will happen: Either inflation will go up or the Fed will be forced to raise rates more aggressively than it otherwise would. Chart 1U.S. Trade As A Share Of The Economy Both outcomes imply a "real appreciation" in the dollar exchange rate, which can be thought of as the value of foreign goods and services that can be acquired by selling a basket of U.S. goods and services.2 In the former case, the real dollar exchange rate will appreciate because the U.S. price level will rise relative to prices abroad. In the latter case, the real dollar exchange rate will appreciate because higher interest rates will put upward pressure on the nominal value of the currency. Two Paths To A Real Dollar Appreciation The catch is that it is impossible to know how much of the real appreciation will occur through higher inflation and how much of it will occur through a stronger nominal dollar. In theory, one could envision a scenario where the real value of the dollar rises even as the nominal value declines. This would happen if the Fed fell so far behind the curve that inflation rocketed higher. Alternatively, one could contemplate a scenario where the Fed raises rates too aggressively, driving the dollar up so much that the economy falters and inflation declines. Our baseline scenario lies somewhere between these two extremes. We expect U.S. fiscal stimulus to push up inflation, while also pushing up the nominal trade-weighted dollar. It rarely happens that real and nominal exchange rates move in opposite directions (Chart 2). Thus, if the real dollar exchange rate appreciates, the nominal exchange rate is bound to appreciate as well. Chart 2Nominal And Real Exchange Rates Tend To Move In The Same Direction Global Growth: Back To The USA So why, then, has the dollar been on the back foot over the past year? The answer is better economic prospects at home were more than matched by stronger growth abroad. Keep in mind that the discussion above does not need to be confined to fiscal stimulus. Anything that causes domestic demand to accelerate is apt to trigger a real appreciation of the currency. After a sluggish recovery following the sovereign debt crisis, euro area growth accelerated last year as credit markets thawed and pent-up demand was unleashed. Sensing better economic times ahead, investors bid up the euro. The global growth revival was assisted by a rebound in global manufacturing activity. The manufacturing sector tends to be highly procyclical; when global growth accelerates, manufacturing production usually accelerates even more. The U.S. manufacturing sector accounts for only 12% of GDP, compared to 18% in the euro area, 21% in Japan, and 30% in China (Chart 3). As such, an improving manufacturing outlook disproportionately helped the rest of the world. Meanwhile, a rebound in commodity prices aided emerging markets and other economies with large natural resource sectors. Looking out, the picture for global growth is murkier. Global manufacturing PMIs have likely peaked. Korean exports, a leading indicator for the global business cycle, have softened (Chart 4). China is decelerating, with this week's weaker-than-expected official PMI print being the latest example. This could weigh on metals prices (Chart 5). As we discussed last week, slower global growth tends to benefit the dollar.3 Meanwhile, the composition of global demand growth should shift back toward the U.S. thanks to the lagged effects from the relative easing in financial conditions that the U.S. enjoyed last year, as well as all the fiscal stimulus coming down the pike (Chart 6). Chart 3Global Manufacturing Revival ##br##Not Benefiting The U.S. Much Chart 4Global Growth Seems To Be Peaking Chart 5Chinese Slowdown Will Weigh On Metal Prices Chart 6Lagged Easing In Financial Conditions ##br##And Fiscal Stimulus Bode Well For Growth A More Dollar-Friendly Policy Backdrop Policy developments are starting to work in the dollar's favor. Jerome Powell tried not to rock the boat during his Humphrey-Hawkins testimony this week. However, he did stress that the economic outlook did improve since the Fed last met in December, seemingly opening the door to four rate hikes this year. That was enough to lift the DXY by 0.4%. Powell is not a doctrinaire hard-money type, but he is no Yellen clone either. Remember this was the guy who said back in 2012 that "We look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that is our strategy."4 Critically, there are still four vacancies on the Fed's Board of Governors. If the nomination of Martin Goodfriend - who is definitely no good friend of easy money - is part of a broader trend, the composition of the board will shift in a somewhat more hawkish direction. Meanwhile, the Trump administration has introduced tariffs on imported steel and aluminum. While we do not expect this decision to trigger an all-out trade war, it will almost certainly prompt retaliatory actions. There are three reasons why an escalation in trade protectionism would help the dollar. First, a decrease in global trade would likely reduce trade surpluses and deficits alike. This would shift demand back towards economies such as the U.S., which run trade deficits, at the expense of surplus economies such as Japan, China, and the euro area. Second, a slowdown in trade flows would curb global growth. As noted above, slower global growth tends to be dollar-bullish. Third, the specter of trade wars would exacerbate geopolitical risks. A more uncertain political landscape, even when instigated by the U.S., tends to prop up the dollar. It is true that foreign powers could retaliate against the U.S. by buying fewer Treasurys. But why would they? This would only drive down the dollar, giving U.S. exporters an even greater advantage. The smart strategic response would be to intervene in currency markets with the aim of bidding up the dollar. All this suggests that the dollar may be ripe for a rebound. Positioning has gotten fairly short the dollar (Chart 7). This raises the odds of a short-covering rally. Momentum measures have also improved over the past few weeks, an important consideration given that the dollar is one of the most momentum-driven currencies out there (Chart 8). Chart 7Speculative Positioning Has Gotten Increasingly Dollar-Bearish Chart 8Momentum Matters, And It May Be Starting To Move Back In The Dollar's Favor A Safer Way To Go Long The Dollar: Buy 30-Year Treasurys/Short 30-Year German Bunds, Currency-Unhedged The only scenario where the dollar weakens in the face of bountiful fiscal stimulus is one where U.S. rates rise a lot but foreign rate expectations rise even more. Sharply higher U.S. interest rates would offset the stimulative effects of a weaker dollar, thus preventing the economy from overheating. Such an outcome is not particularly likely, given that the U.S. is going from laggard to leader in the global growth horserace, and most central banks are tightening monetary policy much more gingerly than the Fed. Nevertheless, it cannot be excluded. As such, investors should consider going long 30-year U.S. Treasurys versus German bunds in currency-unhedged terms. This position would pay off if EUR/USD weakens, while also providing downside protection in the case where the greenback comes under pressure due to a narrowing in the long-term interest rate spread between Germany and the U.S. The trade is effectively a bet that the interest rate differential between bunds and Treasurys - which has widened sharply this year, even as the dollar has weakened - will revert to its former self (Chart 9). Over the long haul, it is hard to see how one could lose money on this trade. As we go to press, 30-year Treasurys are yielding 3.11% while 30-year bunds yield only 1.29%. The euro would have to strengthen to 2.10 against the dollar over the next 30 years to cancel out the 182 bps in additional carry that U.S. bonds are offering. Even if one assumes that the fair value for the euro climbs by 0.4% annually due to lower inflation in the common-currency bloc, this would still leave the euro 40% overvalued.5 To maintain consistency with our other trade recommendations, we are closing our short 30-year Treasury trade for a gain of 3.8% and opening a new trade going long 30-year TIPS breakevens. Chart 10 shows that long-term inflation expectations as gauged by 30-year breakevens are still 27 basis points below where they were on average between 2010 and 2013. Chart 9EUR/USD And Long-Term Spreads Will Recouple Chart 10More Upside To Long-Term TIPS Breakevens Investment Conclusions We expect the dollar to strengthen over the coming months. EUR/USD should ultimately bottom at around 1.15. EM currencies will also struggle on the back of slower Chinese growth and higher financing costs for dollar-denominated loans. Among commodity producers, we favor "oily" currencies such as the Canadian dollar and Norwegian krone over metal exporters such as the Australian dollar. Our commodity strategists expect Brent and WTI to average $74 and $70/bbl this year, above current market expectations of $66 and $62, respectively. They note that Saudi Arabia has a strong incentive to boost oil prices by curtailing production in the lead up to Aramco's initial public offering. The yen is better positioned to hold its ground, considering that it is still very cheap and positioning remains heavily short (Chart 11). My colleague, Mathieu Savary, discussed the yen's prospects two weeks ago.6 A rebound in the dollar and creeping protectionism will pose headwinds for global equities. Nevertheless, with corporate earnings continuing to surprise on the upside, this is unlikely to derail the cyclical bull market in stocks. However, investors should prepare for a lot more volatility, as we flagged in several reports earlier this year.7 At the regional level, U.S. equities have underperformed their global peers in common-currency terms since the start of 2017, but outperformed in local-currency terms (Chart 12). We could see a reversal of that pattern over the coming months as the dollar begins to firm. Chart 11The Yen Is Cheap And ##br##Positioning Is Short Chart 12A Stronger Dollar Could Reverse ##br##U.S. Equity Relative Performance Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Paul Krugman made a similar point more than 20 years ago. 2 The real exchange rate between two currencies is the product of the nominal exchange rate and the ratio of prices between the countries. A real appreciation tends to make a country less competitive, either through a nominal increase in its currency or through an increase in prices in that country relative to those of its trading partners. 3 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. 4 Please see FOMC Meeting Transcript, "Meeting of the Federal Open Market Committee on October 23-24, 2012," Federal Reserve. 5 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The inflation differential of 0.4% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.49 after 30 years. If the euro needs to strengthen to 2.10 over 30 years to cover the cost of carry, this would leave it 41% (2.10/1.49) overvalued. Our assessment would not change much if we used Germany rather than the euro area as the basis for the analysis. We estimate that the fair value exchange rate for Germany is 1.45, which is higher than the fair value exchange rate for the euro area as a whole. However, the differential in 30-year CPI swaps between Germany and the U.S. is only 16 basis points. Thus, if the fair value German exchange rate evolves in line with inflation differentials, it would rise to only 1.52. This would still leave Germany 38% (2.10/1.52) overvalued against the U.S. after 30 years. 6 Please see Foreign Exchange Strategy, "The Yen's Mighty Rise Continues...For Now," dated February 16, 2018. 7 Please see Global Investment Strategy Special Report, "The Return Of Vol," dated February 6, 2018; and Weekly Report, "Take Out Some Insurance," dated February 2, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Chart I-3...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Chart I-9Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk

Highlights The combined U.S. current account and fiscal deficits are set to rise as Trump's profligacy and higher interest rates kick in. In and of itself, this does not spell doom for the dollar. The Fed's response to the twin deficit is what will ultimately set the path for the greenback. Stimulus hitting an economy at full employment raises the likelihood that the Fed will not stand idly by. The dollar's momentum is not deteriorating anymore, global growth could hit a soft patch, and U.S. hedged yields might regain some composure versus European hedged yields. These factors are likely to precipitate a dollar rebound. The durability of this rebound remains an unknown. An opportunity to go short EUR/SEK has emerged. Feature When it comes to the U.S. dollar, the story of the day has become the twin deficits. It is now presented as the key factor that will drag the dollar lower over the course of the cycle. We do agree there are plenty of reasons to be concerned with the long-term outlook for the dollar. However, we remain unconvinced whether the twin deficits really are the much-vaunted "boogey man" that will haunt the greenback. In fact, we would argue that while they are a handicap for the dollar, the role of the Federal Reserve, global growth and hedging costs take precedence over the evil twins. The Twin Deficit Will Widen We take no offence with the assertion that the twin deficits are set to increase. According to the work of Mark McClellan, who writes The Bank Credit Analyst, the U.S. fiscal deficit is set to increase to 5.5% of GDP over the course of the next two years. U.S. President Donald Trump's tax cuts and the recent spending agreement will undeniably contribute to this.1 The current account deficit is also set to widen. Chart I-1 shows our estimate for the path of the current account. We anticipate it to move to -3.4% of GDP by late 2018 or early 2019. This is a noteworthy deterioration, but one that only brings the U.S. current account to a level last experienced in 2009. One contributor is obviously the trade balance. The Bank Credit Analyst estimates that the impact of the combined fiscal measures announced will reach 0.3% of GDP in 2018. The biggest source of deterioration will not come from trade: it will come from a fall in the net primary income balance of the U.S., which currently stands at 1.1% of GDP. Essentially, higher interest rates in the U.S. means that foreigners will receive greater income from the U.S. Based on the current level of the median long-term interest rate forecasts by the FOMC's participants, my colleague Ryan Swift estimates that a move in 10-year Treasury yields to 3.5% is likely by year end.2 Based on our estimate, this will push down the primary income balance to 0.4% of GDP. It is important to acknowledge that this forecast for the current account is likely to prove to be a worst-case scenario. To begin with, the trade balance could continue to be buffeted by the fact that U.S. energy production keeps expanding, which is slowly but surely moving the U.S. toward a positive energy trade balance (Chart I-2). Moreover, periods of weakness in the USD have been followed by improvements in the U.S. primary income balance. This is because while payments made by the U.S. to foreigners are mostly in the form of interest, 55% of U.S. income receipts are earnings on FDIs. If we add dividends received on foreign equity holdings, this share rises to 80% of U.S. gross primary income. Thus, if the dollar weakens, U.S. receipts benefit from a translation effect as corporations convert their foreign earnings back into U.S. dollars at more beneficial exchange rates. Chart I-1Higher U.S. Rates ##br##Will Hurt The Current Account Chart I-2U.S. Shale Oil Production Will Prevent Too Great A Deterioration In The Trade Balance But do twin deficits even matter? We would argue, it depends. Bottom Line: The U.S. twin deficits are set to increase. The U.S. fiscal deficit will move to 5.5% of GDP and the current account to -3.4% of GDP as interest owed to foreigners is set to increase. Twin Deficit, So What? It is one thing to anticipate a widening of the twin deficits, but does history suggest that twin deficits have an impact on the dollar? Here, the empirical evidence is rather mixed. As Chart I-3 illustrates, there has been no obvious link between twin deficits and the dollar. In fact, Arthur Budaghyan highlighted in BCA's Emerging Market Strategy service the following phases:3 1970s: no discernable relationship; First half of the 1980s: Substantial widening of twin deficits, but a massive dollar bull market materialized; 1985 to 1993: no reliable relationship between twin deficits and the dollar; 1994 to 2001: The dollar did rally as twin deficits narrowed on the back of the fiscal balance moving from roughly -4% of GDP to 2% of GDP; 2001 to 2011: dollar weakened as twin deficits grew deeper; 2011 to 2016: When twin deficits narrowed considerably, the dollar was stable, but when they stopped improving, the dollar rallied 25%. Chart I-3In My Time Of Dying? Let us focus on the growing twin deficits episodes. As it turns out, the missing link between twin deficits and the dollar is Fed policy. A widening in twin deficits is normally associated with a strong economy. Profligate government spending can boost domestic demand, and because imports have a high elasticity to domestic demand, a widening current account also tends to come alongside robust growth. The Volcker Fed played a high-wire act from 1979 to 1982, plunging the U.S. into a vicious double-dip recession in order to bring realized and expected inflation back to earth after the 1970s. Volcker was not about to let former President Ronald Reagan's stimulus boost growth to the point of lifting inflation expectations again, undoing all the Fed's previous good work. He elected to increase real rates sharply, which was the key factor behind the dollar's strength. The 2001 to 2011 experience needs to be broken down in parts. From 2001 to 2003, the twin deficits were expanding thanks to former President George Bush's wars and tax cuts. Yet the Fed did not play the same counterweight as it did in the mid-1980s. Instead, it kept cutting rates all the way until 2003 as then-Chairman Alan Greenspan was worried about deflation. U.S. real rates did not experience the necessary lift required to fight the negative impact of the twin deficits on the dollar. From 2003 to 2007, the twin deficits were in fact narrowing, real rates were trendless and the dollar was experiencing mild depreciation. During that time frame, global growth was extremely robust, China was growing at a double-digit pace and EM economies were booming. Money was flowing toward these destinations. From 2007 to mid-2008, while the twin deficits continued to narrow, the dollar plunged. The sharp fall in real rates as the Fed engaged in aggressive rate cutting explains this apparent inconsistency. From the second half of 2008 to 2009, the dollar surged, despite a further widening of the twin deficits. Real rates rebounded as inflation expectations melted, and risk aversion prompted investors to seek the safety of the global reserve asset and the global reserve currency - Treasurys and the greenback, respectively. From 2009 to the middle of 2011, the twin deficits stabilized, real rates stabilized, and the dollar stabilized as well, but nonetheless experienced wild gyrations as the global economy kept experiencing aftershocks from the great financial crisis. Neither the twin deficits nor real rates were offering a clear path forward, thus the dollar was also mixed. Bottom Line: A close look at various episodes of twin deficits in the U.S. pushes us toward one conclusion: if twin deficits are expanding but the Fed is trying to tighten policy and real rates are rising, the dollar ignores the twin deficits and, in fact, manages to rise. If, however, the twin deficits expand, and real rates do not experience enough upside to counterbalance this development, the dollar weakens. This means one thing for the coming years: Forecasting twin deficits is not sufficient to predict a dollar bear market. Instead, we also need a view on the Fed and the outlook for real rates. So Where Will The Dollar Go In 2018? We expect there could be some upward pressure on the Fed's dots as the year progresses. The reason is rather straightforward. The U.S. economy will receive a very large shot in the arm this year and next. Mark's calculations show that the fiscal thrust in 2018 and 2019 will morph from -0.4% of GDP to 0.8% of GDP, and from 0.3% of GDP to 1.3% of GDP, respectively (Chart I-4). While currently the fiscal thrust is expected to become a large negative in 2020, that year is an election year. There is a non-trivial probability that the fiscal cliff anticipated that year may in fact be postponed: it is not in the interest of the Republicans or Democrats to be blamed for a slowing economy in a year where Americans are hitting the voting booths! This stimulus is not happening in a vacuum either: it is materializing in an environment where the labor market seems to be at full employment, where capacity utilization is tight, and where financial conditions remain easy (Chart I-5). Stimulating when the economy is at full capacity is likely to lift prices more than it will boost real economic activity. The Fed is fully aware of this risk. Chart I-4Much Stimulus ##br##In The Pipeline Chart I-5Could Fiscal Stimulus Be Inflationary With This Backdrop?##br## We Think So However, it remains possible that the Fed will err on the side of caution and wait until the impact of the stimulus measures on the economy become more evident before sending a more hawkish message to the markets. Chart I-6Twin Deficits Narratives ##br##Look Like Ex-Post Explanations If the Fed elects to be proactive and adjusts its message regarding the future path of policy before the impact of the stimulus becomes evident, the dollar could rise as it would put upward pressure on U.S. real rates. If, however, the Fed elects to be reactive and wait until the economy responds to the stimulus package with higher wage growth and inflation, then the dollar could weaken as real rates experience little upside and the twin deficits exact their toll. BCA is currently conducting research to assess which path is more likely. In the meanwhile, there other factors to consider. First, as we highlighted three weeks ago, since 2011, spikes in the number of mentions of the twin deficits in media have historically been associated with temporary rebounds in the dollar following periods of USD weakness (Chart I-6).4 The twin deficits seem to come to the forefront of investors' minds as an ex-post explanation for previous weak-dollar periods. Second, our dollar capitulation index is not only at oversold levels, but the indicator has formed a positive divergence with the trade-weighted dollar's exchange rate (Chart I-7). Technically, this increases the probability of a meaningful rebound in the USD. Chart I-7A Positive Technical Development For The Greenback Third, global growth is showing signs of weakening. We have already highlighted that rollovers in the performance of EM carry trades such as the one we have been experiencing for a few months now have been very reliable leading indicators of activity slowdowns over the past 20 years.5 Korea exports are also ebbing. As Chart I-8 illustrates, when Korean exports weaken, this tends to be associated with weakness in highly pro-cyclical financial variables like EM equities, EM bonds, AUD/USD or AUD/JPY. When a slowdown in global growth materializes, especially when it does so as the U.S. economy is set to accelerate, it tends to be associated with a stronger dollar. Fourth, the super-charged strength in the euro versus the USD since the second quarter of 2017 happened as European hedged yields overtook U.S. hedged yields. Chart I-9 takes the example of a Japan-based investor. We pick Japan as an illustration because Japan is the largest creditor nation in the world, and extra-low domestic yields, Japanese investors continue to exhibit heightened yield-seeking behaviors. When the gap between European bond yields hedged into yen and U.S. bond yields hedged into yen became more negative, the euro was depreciating. Once this gap started to narrow, the euro stabilized. Once European bond yields hedged into yen became greater than U.S. bond yields hedged into yen, the euro took off. Chart I-8Growth Sensitive Assets May Be At Risk Chart I-9Are Hedged Yields The Culprit Behind The Dollar's Weakness? We expect these gaps in hedged yields to move back in the U.S.'s favor. The U.S. yield curve has some scope to begin to steepen a bit, especially as U.S. growth accelerates. Additionally, a big component of the underperformance of U.S. hedged yields has been associated with a widening of the LIBOR spread and the cross-currency basis swap spreads (Chart I-10). As we anticipated, the introduction of tax rules favoring repatriations of foreign earnings by U.S. corporations is having this effect.6 U.S. firms hold their offshore earnings in high-quality securities like bank papers or Treasurys. These securities are a vital supply of dollars in the Eurodollar market - the offshore USD market - as they are high-quality collateral that can be used to secure many transactions. As the market in December began to discount the impact of the tax changes, FRA-OIS spreads and basis swap spreads began to widen. This increased the cost of hedging U.S. bonds. Chart I-10Will The Increase In Treasurys Issuance ##br##Pull Back Down The Cost Of Hedging U.S. Assets? But here's one overlooked but potentially friendly outcome of the twin deficits. By increasing its current account deficit, the U.S. economy will begin to supply more USDs to Eurodollar markets, providing a relief valve to the collateral-starved offshore USD-funding markets. Moreover, because the fiscal deficit is set to mushroom, and because after many debt-ceiling debacles the Treasury's cash reserves are low, the Treasury is likely to start issuing a lot more T-Notes and T-Bills, which will also provide a source of high-quality collaterals in the system, especially as the Fed is not buying those bonds anymore. The stress in the funding market may begin to recede and hedged U.S. yields may begin to rise relative to the rest of the world. Bottom Line: While the twin deficit could become a negative for the USD, it is not yet clear that this will indeed be the case. Instead, we need to keep in mind that the U.S. government is injecting a large amount of stimulus in an economy running at full capacity. This could be inflationary. The Fed's response will dictate the USD's path. If the Fed is proactive, the USD will experience an upswing. If the Fed is reactive and waits to guide real rates higher, the dollar could remain weak. In the meanwhile, other forces are pointing toward a rebound in the dollar. The greenback is oversold and unloved; momentum indicators are forming positive divergences, raising the odds of a rebound; global growth is set to slow; and U.S. hedged yields are likely to move back in favor of the dollar. Will EUR/SEK Break Above 10? The recent inflation miss in Sweden has raised some concerns, with EUR/SEK hovering around the critical 10 level, and NOK/SEK breaking above the 1.03 handle. Headline consumer prices rose only 1.6% annually in January, while contracting by 0.8% in monthly terms. The official inflation measure tracked by the Riksbank - the CPIF - fell to 1.7% per annum. This move away from the inflation target has market participants questioning the Riksbank's willingness and ability to normalize policy this year. However, the underlying picture is not that negative. The most recent inflation figure was greatly impacted by the seasonality of Swedish CPI. As Chart I-11 shows, January tends to be a very weak number for Swedish inflation. The February data is likely to rebound significantly. Additionally, our model further highlights that based on both international and domestic factors, Swedish inflation should rise in the coming months, putting CPI much closer to the Riksbank's objective (Chart I-12). Chart I-11Seasonal Pattern In Swedish CPI Chart I-12Swedish Inflation Is Set To Rebound Reassuringly, Swedish inflation expectations have not subsided, suggesting market participants are fading the latest weak reading. As the bottom panel of Chart I-13 illustrates, CPI swap rates are still holding steady. On the macro front, consumers continue to be a source of durable strength. Real consumption is growing at a 3% annual rate, and Swedish consumer confidence is still elevated (Chart I-14). Chart I-13Swedish Inflation Expectations Are Stable Chart I-14The Swedish Consumer Is Still Spending Essentially, the Riksbank's extremely easy monetary policy may not have yet generated inflation in the prices of consumer goods and services, but it has generated huge debt and asset price inflation. The clearest symptom of this is Sweden's non-financial private debt, which now stands at a stunning 240% of GDP, only surpassed by Switzerland and Norway among the G10 economies. These developments imply that the positive Swedish output gap will expand further, and that inflationary pressures will only become more entrenched. Thus, we continue to anticipate a rate hike by the Riksbank this year. This is very much a consensus call. However, where we diverge from consensus is that while futures are pricing in approximately 85 basis points of interest rate hikes by March 2020, we think the scope to lift rates is greater. We also see a higher probability of hikes over that time frame than the Riksbank's own forecast. In other words, we anticipate that the Riksbank's rate forecasts will be revised to the upside. This is because inflationary pressures are growing greater and the economy is very strong. Thus, the Swedish central bank is falling behind the curve and will have to play catch up as soon as inflation moves back closer to target. This will most likely happen over the coming 12 months. As a result, selling EUR/SEK at current levels seems an interesting trade with an attractive entry point. As Chart I-15 illustrates, EUR/SEK only traded above this level during the great financial crisis. It did not manage to punch above this level during the Nordic financial crises of the early 1990s, nor did it during the 1997-'98 crisis - or directly after the September 11 attacks. Chart I-15The Line In The Sand Moreover, EUR/SEK currently trades 7.5% above its purchasing power parity equilibrium. The gap between Sweden's and the euro area's basic balance of payments is very large. While Sweden's stands at 5.1% of GDP, the euro area's is near zero. This reinforces the message that the EUR/SEK is very expensive: when the cross appreciates too much, Swedish assets become much more attractive to foreigners relative to European assets. These long-term flows end up boosting the relative basis balance in favor of Sweden. This is exactly what is happening today (Chart I-16). Chart I-16Expensive EUR/SEK Makes Swedish Assets Attractive From a tactical perspective, EUR/SEK also looks vulnerable. Various short-term momentum measures such as the 14-day RSI or the 13-week rate of change are diverging from actual prices. Additionally, EUR/SEK risk reversals - i.e. the implied volatility of calls versus the implied volatility of puts on this cross - have spiked up. This is true even after controlling for the rise in implied volatility that has affected the option market. It seems to suggest that investors that would have been buying EUR/SEK have already placed their bets. The marginal player is likely to now bet in the other direction. This trade is not without risks. First, a move above 10.1 could be mechanically followed by a sharp rally as stops are hit and momentum traders force the cross higher. Second, Swedish PMIs have been rolling over for six months, but so have the preliminary releases of Europe PMIs this week. What is more concerning is the weakness in Asian manufacturing production that is behind the sharp slowdown in Korean exports. This is worrisome because historically, the Swedish economy has been very sensitive to EM shocks. However, only 2008 was able to push EUR/SEK above 10. Even if EM slows, we are not anticipating a shock as large as what occurred in 2015, let alone in 2008. Moreover, while we anticipate Swedish inflation to surprise to the upside, we equally expect euro area inflation to exhibit much more limited gains. Bottom Line: Sweden's inflation report came in well below expectations, which prompted a sharp rally in EUR/SEK to near 10. However, this level has been an important resistance since the early 1990s, only breached during the great financial crisis. We are betting on it not being breached this time around. The Swedish economy is strong, and inflation is set to pick up again. As a result, we think the Riksbank will be forced to lift its interest rate forecast as time passes. Moreover, EUR/SEK is expensive, and flows are currently very much in favor of Sweden. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant HaarisA@bcaresearch.com 1 Please see The Bank Credit Analyst Monthly Report, dated February 29, 2018, available at bca.bcaresearch.com. 2 Please see U.S. Bond Strategy Weekly Report, "On the MOVE", dated February 13, 2018, available at usbs.bcaresearch.com. 3 Please see Emerging Markets Strategy Weekly Report, "EM Local Bonds and U.S. Twin Deficits", dated February 21, 2018, available at ems.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot", dated February 2, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Weekly Reports, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, and "Canaries In the Coal Mine Alert 2: More on EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Special Report, "It's Not My Cross To Bear", dated October 27, 2017, available at fes.bcaresearch.com. Currencies U.S. Dollar U.S. data was mixed: Markit PMIs beat expectations ; Existing home sales, however, grew by less than expected at 5.38 million, a 3.2% contraction form the previous month; Continuing jobless claims outperformed expectations, coming in at 1.875 million; Initial jobless claims also outperformed with 222,000. In the meeting's minutes, FOMC members were quite positive on growth and their rhetoric suggest they intend to follow up on the current set of dot plots. Subsequently, equities sold off, the 10-year yield climbed to 2.954%, bringing them close to BCA's fair value estimate. Due to these developments, the dollar's descent seems to be taking a breather for now, and it may even experience a rebound in the coming weeks. Chart II-1USD Technicals 1 Chart II-2 Report Links: Who Hikes Again? - February 9, 2018 A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Euro The tone of European data has been deteriorating: German PMIs underperformed expectations, with services coming in at 55.3, and manufacturing, at 60.3; European PMIs also underperformed anticipations with manufacturing coming in at 58.5 and services at 56.7; The Current Situation section of the ZEW Survey was also weaker than expected; German IFO underperformed expectations, with the Business Climate measure coming in at 115.4, and the Expectations measure also dropping to 105.4. The euro weakened substantially this week on poor data and a hawkish Fed, even if it managed to eke out a rebound on Thursday. We have recently published on the risks to global growth, and the weak European PMIs seem like a consequence of these developments. We expect the euro's bull market to pause until global growth picks back up. Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Recent data in Japan has been mixed: Imports yearly growth underperformed expectations, coming in at 7.9%. It also declined significantly from the previous 14.9% pace . Moreover, Nikkei Manufacturing PMI underperformed expectations, coming in at 54. It also declined from 54.8 in the previous month, However, exports yearly growth outperformed expectations, coming in at 12.2%. It also increased from its 9.3% pace the previous month. USD/JPY has rallied by roughly 1.5% since last week. Overall, we expect that the current volatile environment will provide strength to the yen to the point that a level of 100 for USD/JPY is plausible. However, on a long term basis the yen is likely to be weak against the U.S. dollar, as the BoJ will fight tooth and nail to prevent a strengthening yen from hampering inflation. Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Recent data in the U.K. has been mixed: The ILO Unemployment rate surprised negatively, coming in at 4.4%. It also increased form 4.3% the previous month. Moreover, retail sales and retail sales ex-fuel annual growth also underperformed, coming in at 1.6% and 1.5% respectively. However, average hourly earnings yearly growth excluding bonus outperformed expectations, coming in at 2.5% GBP/USD has depreciated by nearly 1.6% this week. There are currently 45 basis points of hikes by the BoE priced into the next 12-months. We believe that there is not much more upside beyond this, given that the end of the pound's collapse will weigh on inflation. Moreover, recent data has shown that although inflation is high, the economy rests on a shaky foundation. We continue to expect the pound to fall on a trade-weighted basis as well. Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Australian Dollar Data out of Australia was mixed: The Westpac Leading Index stayed steady at -0.2%; Wage growth beat expectations, growing at a 0.6% quarterly rate, and 2.1% annual rate; Construction work done slowed down severely, contacting by -19.4%, greatly surpassing the expected 10% contraction. It should also be noted that much of the wage growth was driven by the growth in public sector wages, which grew by 2.4% as opposed to the 1.9% growth experienced by the private sector. RBA members highlighted the risks created by lower than expected wage growth: weaker household consumption as a below-target inflation. The RBA is therefore likely to stay put this year, and the AUD will underperform its G10 peers. Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar The kiwi has fallen by roughly 1% this week, in part due to dollar rebound in the greenback. Nevertheless, AUD/NZD has declined by 0.6%, and is now down almost 3% during the year, thanks to dairy prices surging by more than 13% in 2018. Overall, we expect that the NZD will outperform the AUD, given that the consumer sector in China should outperform the industrial sector, as the Chinese authorities are cracking on overcapacity. With this being said, NZD/JPY will probably see downside, as the current volatility in markets will weigh on this cross. Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Canadian data was weak: Wholesale sales contracted by 0.5% at a monthly pace; Retail sales contracted by 0.8%, underperforming expectations; Core retail sales, excluding autos, contracted by 1.8%. The CAD weakened against all currencies this week. However, even if it may not increase much against the U.S. dollar, the case for a stronger CAD against other major currencies is still firm as the BoC is likely to hike interest rates more than most central banks year. Additionally, stronger U.S. growth should support the health of the Canadian export sector. Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Recent data in Switzerland has been mixed: The trade balance underperformed expectation on January, coming in at CHF1.324 billion. It also declined from last month's value of CHF3.374 billion. However, industrial production yearly growth increased from last month, coming in at a stunning 19.6% pace. EUR/CHF has been relatively flat this week. Overall we believe that the franc can only rally against the euro on episodes of rising global volatility, given that the SNB will fight against any appreciation of the franc that could hurt the little progress that has been made in achieving their inflation target. Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Norwegian Krone USD/NOK has rallied by roughly 1.3% on the back of a stronger dollar. Overall, we believe that the krone should be the best performer amongst the commodity currencies, as the economic situation has improved substantially, with the Labour Survey improving last month. This will help the Norges Bank to tighten monetary policy more than the market currently expects. Investors who want to take advantage of these developments should short CAD/NOK as an oil-neutral bet. More audacious traders could short AUD/NOK or NZD/NOK as well. Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Swedish inflation dropped by more than expected: in monthly terms, inflation contracted by 0.8%, while in annual terms it grew by only 1.6%, less than the expected 1.8%. However, this monthly contraction was in line with the seasonal pattern historically witnessed in Swedish inflation, which also tells us that inflation is likely to pick up again in the following months. EUR/SEK hit 10, an historically very strong overhead resistance, indicating that markets may be unnerved by the Riksbank's unwillingness or inability to tighten policy. While the OIS curve is pricing in 80 bps of hikes in the next two years, we believe that the Riksbank will hike more than that, as inflation will come back to Sweden with a vengeance. Not only is the economy firing on all fronts, but the currency is also very cheap. The SEK is likely to strengthen this year. Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. ­­ Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. 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-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields 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 Economy: The Italian economy is enjoying a solid, if unspectacular, cyclical upturn led by exports, but inflation pressures remain subdued. Banks: The health of Italian banks has improved drastically over the last year, with liquidity, solvency, and systemic risks fading for the time being. Politics: Euroskepticism will not be the major issue in the election given an expanding economy, but none of the likely outcomes will lead to a prudent fiscal policy. ECB: The inevitable tapering of ECB asset purchases later in 2018 will not have a meaningful impact on Italian government bond valuations - as long as the ECB does not begin to raise rates soon after. Upgrade Italian government bonds to neutral until signs of an economic slowdown in Italy emerge. Feature Italy's financial markets have been on quite a roll over the past year. Italian equities are up 13% since the beginning of 2017 in local currency terms, well above the 8% increase in overall Euro Area stocks (Chart 1). Italian government bonds returned 1.8% over that same period (also in local currency terms), massively outperforming core European equivalents that have suffered significant losses as global bond yields have risen substantially. Investors have been focusing on the upbeat news of a cyclical economic expansion and the improving health of Italian banks, which has helped reduce the risk premia on Italian financial assets (Chart 2). At the same time, markets are not pricing in any political risk in the run-up to next month's Italian parliamentary elections that could end up with, at best, yet another unstable coalition government. Chart 1Italy Has Been##BR##A Star Performer Chart 2Investors Are Focusing On Italian Growth,##BR##Not Politics Most importantly, the growing pressure on the European Central Bank (ECB) to begin shifting away from the era of extreme monetary policy accommodation threatens to remove a major buyer of Italian debt. This is a large problem down the road, as the easy money policies of the ECB have helped paper over a lot of structural cracks that still exist in Italy. In this Special Report, jointly prepared by BCA's Global Fixed Income Strategy and Geopolitical Strategy teams, we examine the outlook for Italian financial assets, both in the short run heading into the March 4th election and also over a medium-term perspective. Specifically, we look at the ultimate measure of Italian risk - the Italy-Germany government bond yield spread. Our conclusion is that Italy's economy and financial markets may be better placed to survive the more volatile global investment backdrop in 2018 than is commonly believed. Beyond this time horizon, however, Italian politics remains a risk. The Economy: Looking Better, But Highly Levered To Global Growth Italy's economy is enjoying a relatively strong economic expansion, judged by its own modest standards. Real GDP grew 1.5% last year, delivering the fourth consecutive year of growth following the recession in 2012-13. That was slower than the 2.5% pace witnessed across the entire Euro Area. The cyclical trend in Italy, however, remains highly correlated to that of its common currency neighbors, as all have benefitted from the easy financial conditions created by ECB policy (Chart 3). Consumer spending has been a modest contributor to the current economic upturn. Consumer confidence is steadily climbing and approaching its 2015 highs, yet retail sales volumes are only growing at a 1% pace. Sluggish incomes are the reason. Real wage growth has struggled to stay positive in the years since the last recession and now sits at a mere 0.25% (Chart 4). Against this backdrop, Italian consumers have been reluctant to significantly run down savings or ramp up debt to support a faster pace of consumption. The household debt/GDP ratio is only 42%, well below the Euro Area median. The decline in Italian interest rates, however, has helped free up income available for spending; the household debt service ratio is now sitting at 4.5%, one full percentage point below the 2012 peak (bottom panel). Chart 3Italian Growth Is Out Of The Doldrums Chart 4A Modest Pick-Up In Consumer Spending A bigger boost to Italian growth has come from the corporate sector. Business confidence has been steadily improving in response to the cyclical upturn in global economic growth. Exports, which now represent about one-third of Italian GDP, are growing just over 5% in real terms. This has helped boost industrial production and capacity utilization, with the latter reaching the highest level since 2007 (Chart 5). Companies have responded by ramping up capital spending, which grew 4.6% (year-over-year) in Q3 2017. Structurally, problems of poor labor productivity continues to plague Italian companies, however, and it remains to be seen if the rise in the euro over the past year will begin to have an impact on sales and profits. For now, the cyclical industrial upturn will likely continue as long as global growth, and specifically export demand, remain buoyant. Another underappreciated driver of the current Italian expansion has been mildly stimulative fiscal policy. Italy benefited from four consecutive years of positive "fiscal thrust", i.e., the change in the cyclically-adjusted primary budget balance (Chart 6). This was a welcome relief given the austerity that was imposed on Italy after the European Debt Crisis, which drained 3% from the Italian economy from 2011 to 2013. The IMF is projecting that Italian fiscal policy will turn restrictive this year and in 2019 but, as we discuss later in this report, the upcoming Italian election is likely to deliver a government that will go for more fiscal stimulus, not less. Chart 5An Expansion##BR##Fueled By Exports Chart 6Fiscal Tightening Will Not Happen,##BR##Post-Election The labor market recovery from the 2012 recession has been slow. Italy's unemployment rate is 10.8%, down from a peak level of 13% in 2014 but still well above the OECD's estimate of full employment (NAIRU). For Italy, the youth unemployment rate remains a major problem - at 33%, it is easily the highest among European countries and continues to fuel support for the anti-establishment Five Star Movement. More generally, Italy's relatively high unemployment rate is not necessarily a sign of underlying economic malaise. Italy's labor force participation rate has risen from a low of 60.4% in August 2010 to 64.5% at the end of 2017 (Chart 7). The steadily improving economy is drawing discouraged workers back into the labor force, as we predicted it would in 2012,1 with the extra labor supply ensuring that Italian wage growth will stay sluggish for some time. On a related note, Italy's inflation remains well below the ECB's 2% target rate. Headline HICP and core HICP inflation are 1% and 0.6%, respectively. These levels are also well below the Euro Area aggregate levels, which are 1.35% and 1.2% for headline and core HICP, respectively. Although consumer spending has improved in Italy, it has not been strong enough to put upward pressure on consumer prices, and weaker wage growth will not force businesses to raise prices to protect profitability. In addition, the IMF projects that Italy's output gap will not close until 2022, or three years after the overall Euro Area gap will be eliminated (Chart 8). Chart 7Plenty Of Labor Market Slack In Italy Chart 8No Sign Of Inflation Pressures Bottom Line: The Italian economy is enjoying a solid, if unspectacular, cyclical upturn. This is being led by exports and flowing through into domestic production and investment. Inflation pressures remain subdued, however, given ample slack in labor markets. The Banks: Drastic Improvement, But Risks Remain The Italian banking system has a well-earned reputation of being dysfunctional, undercapitalized and plagued by non-performing loans (NPLs). However, last summer, the ECB declared that two Italian banks were "failing or likely to fail," prompting state intervention. The Italian government followed that with a E5.4 billion bailout for Monte dei Paschi di Siena, Italy's fourth largest bank. Given the tight correlation between Italy's relative financial asset performance and its banking sector, these actions were met with loud cheers from investors as both Italian equities and bonds rallied. Standard & Poor's credit rating agency then raised Italy's sovereign debt rating to BBB, citing "subsiding risks" in the banking sector. As a result, investors' fears have eased, as evidenced by recent successful capital raisings and the collapse in bank credit default spreads (CDS) for the major banks, which have now fallen to nearly the same levels as their European counterparts (Chart 9). The health of the Italian banking system has improved drastically over the past year given the improving economy. Italy still sits on a large absolute amount of non-performing loans at E274 billion, but this is a risk has receded quickly from its peak of E328 billion in Q1 2017. The continued economic recovery and sales of bad loans have pushed the NPL ratio down to approximately 15%, well below its peak of over 19% (Chart 10). The Bank of Italy's recent Financial Stability Review projects that the one-year forward default probability from a sample of nearly 300,000 indebted companies has fallen to 1% in mid-2017 from 2.5% in 2013. Fewer new loans are becoming impaired, which is encouraging given the ongoing pressures on the banks from the ECB and the Italian government to improve asset quality. Chart 9Italian Bank Risk##BR##Has Declined Chart 10Banks Better Capitalized,##BR##But NPLs Remain A Problem The rise in capital ratios over the last year is also a very positive development. For the major banks, liquidity coverage ratios are nearly 200%, the ratio of tangible equity to tangible assets has skyrocketed to nearly 7%, and the Tier 1 capital ratio has increased to 14.8%. Even with the introduction of the IFRS 9 accounting rules in January, which is estimated to reduce the Tier 1 ratio by 38bps, capital levels are high and will allow for banks to operate more normally. Bank earnings rebounded in Q4 2017 on the back of aggressive cost cutting, falling loan impairments and solid net interest income. Margins remain stubbornly weak, even though the yield curve has been steepening since early 2015. Going forward, earnings expectations do not seem overly optimistic, particularly in relation to long-term averages. The continued acceleration in economic growth will provide a considerable tailwind. Lending volumes should rise, albeit at a relatively slow pace, due to improving business confidence. Asset quality is set to strengthen as NPLs decline further, reducing the cost of capital and loss provisions. Bank expenses will also decline due to additional layoffs and a reduction in branch locations. However, despite the substantial improvement in their balance sheets, the Italian banking system is far from invulnerable. Apart from the obvious downturn in economic growth, banks are heavily exposed to Italian government bonds. Holdings of government debt securities as a percentage of total assets have declined considerably to 9% from nearly 11% a year ago, but still remain much higher than levels seen during the euro debt crisis (Chart 11). This suggests that fears of the so-called "doom loop" - where the credit quality of the government and the banks are intertwined through bond holdings – may arise once again in the future if Italy suffers another sovereign debt crisis. Another potential source of risk to the banking sector is the housing market. Unlike its EU counterparts, where house prices have been in an uptrend since 2013, house prices in Italy have been collapsing in both nominal and real terms since 2008, falling -20% and -28% respectively (Chart 12). The Italian real estate market is facing multiple headwinds: poor demographics, a lack of property investors dampening transaction volumes, banks aggressively selling repossessed homes at large discounts, and a large stock of unsold properties. Further declines could damage asset quality and impair bank balance sheets. Nevertheless, prices in nominal terms appear to be stabilizing. As real GDP growth continues to recover, the real estate market should eventually start to catch up. Chart 11Can The 'Doom Loop' Be Broken? Chart 12No Recovery In Italian House Prices Bottom Line: The health of Italian banks has improved drastically over the last year. Cost cutting has been aggressive, capital levels have risen, and non-performing loans are slowly declining in a growing economy. Recently added macro-prudential measures will provide additional buffers. As such, liquidity, solvency and systemic risks have faded for the time being. The Political Outlook: Acute Pain Is Gone, But Chronic Risks Linger Italian equity and bond markets have priced out political risk in the country's asset markets over the past 12 months, and for good reasons: New election rules: The October 2017 electoral rule changes have made it highly likely that the next government in Italy will be a coalition government, reducing the probability of a runaway electoral performance by an anti-establishment party.2 Anti-establishment becomes the establishment: Italy's populists have dulled their edge by moving to the middle on the key question of Euro Area membership. The anti-establishment Five Star Movement (M5S) announced in early January that "it is no longer the right moment for Italy to leave the euro." The party's leader, Luigi Di Maio, pledged to remain "comfortably below the antiquated and stupid three percent level" EU deficit limit. The party followed this announcement by slaughtering its final sacred cow and renouncing its promise never to form a coalition with traditional, centrist parties. Migration crisis has ended: While continental Europe has gotten relief from the migration wave since early 2016, Italy continued to be impacted throughout 2017. Nonetheless, the EU's intervention in Libyan security and politics has successfully, and dramatically, altered the trajectory of migrants arriving in Italy and Europe as a whole (Chart 13). Current polls show that no single party is close to the 40% threshold needed to win the election outright, although the ostensibly center-right coalition of Forza Italia, Lega Nord, and Fratelli d'Italia is the closest (Chart 14). Predicting the outcome of the election is therefore impossible, other than to guarantee that the next Italian government will be a coalition. Chart 13Italians (And Europeans) Reject Immigration Chart 14Italy: No Party Will Rule Alone New electoral rules - which favor coalition building - and poor turnout in a recent regional election will encourage parties to make extravagant promises, particularly on the spending side of the ledger. Italian politicians understand that, in a coalition government, the partner can always be blamed for why election promises fell by the wayside. This has produced a deluge of unrealistic promises.3 What should investors know about the upcoming election? First, the center-right is not the center-right. When investors hear that the "center right is likely to win," they are likely to bid up assets in expectation of structural reforms and prudent fiscal policy. If the recent polling performance of Forza Italia and Lega Nord has in any way contributed to the appreciation of Italian assets, we would caution investors to fade the rally. Former PM Silvio Berlusconi, leader of Forza Italia, has promised to reverse crucial (and bitterly fought) employment law reforms. Meanwhile, his coalition partner Matteo Salvini, leader of Lega Nord, has promised to scrap pension cuts altogether. The proper characterization for the Forza-Lega alliance is therefore "conservative populism," not pro-market center-right. In fact, the two parties are the most vociferously anti-EU and anti-euro of the four major parties, with Lega still pushing for the abolishment of the euro and even for an EU exit. For a summary of the most market-relevant electoral promises, please refer to Box 1. Box 1: Italian Electoral Promises Of Major Parties Presented in the order of current polling Five Star Movement (M5S) Italy's anti-establishment party wants to abolish 400 laws, including a web of regulation that makes it difficult for businesses to invest. The promise is unusually "supply-side" oriented for an anti-establishment party, but Italy's establishment has made the business environment difficult. In addition, the party wants to invest in technology and clean energy. What is truly anti-establishment is that M5S has promised to provide a monthly universal income of E780, but also to introduce means-testing for public services so that the well-off pensioners do not receive them. It also seeks broad justice system reforms, including a crackdown on corruption and the mafia, building new prisons, and hiring more police. Its immigration plans are centrist, if not right-leaning, with plans to repatriate migrants back to their original countries. Democratic Party (PD) Led by former PM Matteo Renzi, the Democratic Party (PD) is contesting elections on the basis of its past achievements, which includes passing the 2015 "Jobs Act," mitigating the country's banking crisis, and keeping up the pulse of the otherwise sclerotic economy. Current caretaker PM Paolo Gentiloni remains popular, in part because of his no-nonsense, humble approach to governance. Other than minor proposals - scrapping the TV license fee that finances the national Rai network and raising the minimum wage - the party is largely standing pat in terms of promises. The PD-led government has clashed with the EU, including over its 2018 budget proposal, which the Commission criticized as a "significant deviation" from the bloc's fiscal target. However, aside from its disagreements with the Commission over fiscal policy, PD is broadly pro-Europe and pro-euro. Forza Italia Populist Forza is proposing a flat tax of 23%, which would abolish the current staggered income tax rate. It would also abolish taxes on real estate, inheritance, and transportation, and expand reprieves to tax payers with financial problems. The party would double minimum pension payments and scrap the 2015 "Jobs Act." That said, leader Silvio Berlusconi has said that his proposals would respect the EU's 3% of GDP budget deficit target - in fact that his government would eliminate the deficit completely by 2023 - and that it would rein in the debt-to-GDP ratio to 100%. However, it is unclear how the math would actually work. At the same time, a collision course with the EU is likely as the party wants not only to end budget austerity but also to revise EU treaties, including the fiscal compact, and to pay less into the EU's annual budget. Lega Nord The other populist party looks to out-do the more establishment Forza by proposing an even lower flat tax rate of 15%. The revenue shortfall would be made up by aggressive enforcement against tax cheats. The party is the most Euroskeptic of the major Italian parties, arguing that a Euro-exit is in the country's national interest and should be contemplated unless fiscal rules set out by the Maastricht Treaty are scrapped. Leader Matteo Salvini recently suggested that he had changed his position on the euro, but the chief economist of the party - Claudio Borghi - has since reversed that position, stating that "one second after the League is in government it will begin all possible preparations to arrive at our monetary sovereignty." This last statement is more in keeping with the Lega's recent history of euroskepticism. Second, the electoral platforms of all four major parties are profligate. The flat tax proposal by Forza and Lega is likely the most egregious. Generally speaking, Berlusconi's previous governments can be associated with a rise in expenditure, deficits, and debt levels, with no real track record of fiscal prudence. Even during the boom years (2001-2006), Berlusconi failed to reduce the budget deficit. By contrast, the center-left has been marginally more fiscally prudent (Chart 15), with a considerable improvement in the country's budget balance under each Democratic Party-led government (Chart 16). Chart 15Italy's Debt Dynamics Are Contained Chart 16Democratic Party Is Relatively Prudent Given the mildly Euroskeptic positioning of the conservative populist coalition and their likely bias toward profligacy, we would rank the currently most likely electoral coalition as the least pro-market. Below are the three potential outcomes and their likely impact on the markets: Scenario 1 - Populist Coalition Probability of winning: 35% - Polls currently put the Forza-Lega coalition in a clear lead and only several percentage points away from the likely 40% threshold needed to secure a majority. Fiscal impact: We would assign a 100% probability that the Forza-Lega coalition would negatively impact the country's budget balance, with debt levels most likely rising. Reform impact: There is a 0% probability of pro-growth, structural reforms being passed by the conservative populist coalition. As such, investors should stop referring to the Forza-Lega alliance as a center-right alliance. European integration: We would assign a high probability, around 50%, that a Forza-Lega government would threaten to exit the Euro Area at some point during its mandate. This is based on a two-fold assumption that there will be a recession at some point during its reign and that its electoral platform reveals the potential for a serious Euroskeptic turn not only by Lega Nord but also by the formerly staunchly pro-EU Forza Italia. Scenario 2 - Grand Coalition Probability of winning: 35% - If the Forza-Lega coalition fails to win enough votes, the second-most likely outcome would be a grand coalition between Forza Italia and the center-right Democratic Party (PD), perhaps with both M5S and Lega joining in. Fiscal impact: Given that all four major parties are essentially looking to spend more money and collect less revenue, we would expect that the country's budget balance would be negatively impacted in this scenario. However, both PD and M5S have less profligate electoral platforms. As such, the impact would likely be a lot less dramatic than if Forza-Lega coalition won. Reform impact: With Forza-Lega potentially in a grand coalition, we would expect the probability of pro-growth reforms to be just 25%. European integration: We would assign a very low probability, essentially 0%, that a grand coalition contemplates Euro-exit during its mandate. However, a global recession that impacts Italy would almost certainly force such a government to fall as Euroskeptic parties withdrew their support, thus shortening the electoral mandate. This means that a grand coalition is the least viable and least stable outcome. It would allow the Euroskeptic Forza-Lega to campaign from a populist, Euroskeptic, position. Scenario 3 - Center-Left Coalition Probability of winning: 30% - A PD-M5S coalition is less likely despite being mathematically the most likely. This is because M5S has not said that it would ever join a coalition with the PD; only that it would join a grand coalition with all parties. Nonetheless, such a coalition makes the most sense ideologically now that M5S has abandoned its Euroskepticism. Fiscal impact: Both parties are looking to expand the minimum wage, with M5S arguing for a universal basic income. It is very likely that the impact on the budget balance would be negative, although we would not expect extreme profligacy. Reform impact: Given the electoral platform of M5S and the reform record of PD, we assign a healthy 75% probability for pro-growth structural reforms. Despite the view that M5S is an anti-establishment party, it is actually quite pro-reform, with several of its proposals in the past being characterized as impacting the supply-side. Investors should remember that being anti-establishment does not mean being anti-reform, especially in Italy where the establishment has an atrocious record of being pro-reform! European integration: We do not think that the M5S move to the middle on European integration is false. Forcing it to be in government, particularly once a recession hits over the course of its mandate, will only lock in its establishment position on European integration. As we have expected for some time, the M5S has followed the path of other Mediterranean, left-leaning, anti-establishment parties on the euro, with both Podemos (Spain) and SYRIZA (Greece) now being fully pro-Europe. As such, the probability that a PD-M5S government considers Euro-exit during its mandate is 0%. Counterintuitively, a PD-M5S coalition is therefore the most pro-market option for Italy. It would be relatively fiscally prudent and would surprise to the upside on structural reforms. In addition, it would give Italy a five-year window during which no challenge to its membership in European institutions is possible (provided that the coalition does not rely on small parties whose exit threatens the stability of government). This outcome could extend the current rally in Italian assets, although that rally is already long-in-the-tooth. On the other hand, a Forza-Lega coalition is the least stable. First, we believe that such a coalition has a 50% probability of challenging Italy's membership in European institutions at the first sign of a domestic recession. Lega is outwardly Euroskeptic, even at the top of the global economic cycle and with a healthy Italian recovery underway. Meanwhile, Silvio Berlusconi has consciously evolved his Forza Italia towards a more Euroskeptic position. In addition, we believe that this populist alliance would be fiscally profligate and would not attempt any structural reforms. This political outcome is therefore an occasion to underweight Italian sovereign bonds. Finally, a grand coalition would have a neutral market impact. However, due to structural political risks, we would expect such a government to collapse at the first sign of economic hardship.4 This would open up the risk of a Euroskeptic electoral challenge and a potential market riot as the likelihood of brinkmanship with Brussels and Berlin rises.5 We encourage our clients to revisit our "Divine Comedy" series on Italy, where we have set out the argument for why Euroskepticism continues to have appeal in Italy. We would briefly remind our readers that: Italians remain Euroskeptic despite a European-wide recovery in support for the common currency (Chart 17); Italians are increasingly confident in a future outside of Europe (Chart 18), whereas such a trend is not identifiable in wider Europe (Chart 19); Chart 17Italy Lags In Support For Euro Chart 18Italians Optimists About Future Outside EU While Europeans are increasingly comfortable with dual-identities (national and continental), Italians are increasingly identifying as strictly Italian (Chart 20); Chart 19Europeans Pessimists About Future Outside EU Chart 20We Are Italian (Not European)! Italians do not see the EU as a geopolitical project, leaving them more likely to focus on the transactional and economic nature of their relationship with Europe (Chart 21); Chart 21Italians View The EU In Transactional Terms On net, Italians are the most anti-immigrant people in core Europe (Chart 22), which suggests that the migration crisis hit them quite hard. Any restart of that crisis could push the country towards anti-EU politicians; Chart 22Italians Are Staunchly Anti-Immigration Finally, we would remind investors that many Italians continue to see FX devaluation as a panacea that can save the economy. Our view is that Italy has, by far, the highest baseline level of Euroskepticism among Euro Area members. The March 4 election is important because the next government will likely have to face a recession and a global downturn during its mandate. A grand coalition or a populist coalition would both leave Italy more vulnerable to Euroskeptic alternatives. This is because a grand coalition would most likely collapse at the first sign of a recession whereas a populist government would itself turn to Euroskepticism. If the election produces either of these outcomes, we would assign a very high probability - near 50% - that Italy produces a global risk off event sometime within the next five years. Bottom Line: The upcoming Italian parliamentary election is difficult to call, but one thing seems certain - the winning coalition will seek to ease fiscal policy. Euroskepticism will not be the major issue in the election given the expanding economy; yet, in two of the scenarios discussed above, it will come back with a vengeance after the next Italian recession. The ECB: Don't Fear The QE Unwind If there is one consensus view on Italy among investors (at least among the BCA clients that ask questions on Italy!), it is that Italian government bonds will suffer significant losses when the ECB begins to unwind its easy money policies. For many people, 10-year bonds trading with less than a 2% yield, with a government debt/GDP ratio near 130%, in a country with a structural low growth problem and perpetually unstable politics, just screams "bubble" - one that will end badly when the ECB is eventually forced to stop buying government bonds. With the broader Euro Area economy now operating at full employment, an announcement of a tapering of asset purchases by the ECB is inevitable. Our base case remains that the ECB will announce during the summer that the bond buying program will be wound down by year-end. After that, maturing bonds will be reinvested, with the first interest rate hike not taking place until the latter half of 2019. How the ECB communicates that message to the markets will be critical in avoiding a "Taper Tantrum 2.0." Already, the ECB is sending a bit of a mixed message with its current asset purchases. Officially, the central bank has been aiming to distribute its monthly pace of asset purchases along the lines of the ECB's Capital Key, which is roughly correlated to the size of each Euro Area country. This rule was put in place by the ECB to avoid any accusations that the central bank would politically favor the more indebted countries when executing its bond buying. Yet a look at the ECB's actual data on its monthly purchases shows that the Capital Key limits have often been breached, and for what appears to be reasons rooted in politics (Chart 23). The ECB exceeded the Capital Key limit on French bonds in the run-up to last year's French presidential election. The limit on Italian bonds was also consistently breached for much of last year, as investors were beginning to grow more concerned about potential ECB tapering and anti-euro factions winning the next election in Italy. We shared those concerns, which led us to downgrade Italian government bonds to underweight in Global Fixed Income Strategy in late 2016, both in absolute terms and versus Spanish debt. That call has obviously not worked out as we hoped. In fact, a counterintuitive result occurred where Italian bonds outperformed German debt in 2017, even as the ECB was already beginning to slow the pace of its bond buying. That can be seen in Chart 24, which shows the annual growth rate of the ECB's monetary base (which proxies the flow of bonds purchased by the ECB) versus both the Italy-Germany 10-year government bond spread (top panel) and the annual excess return of Italian government bonds relative to German debt (bottom panel).6 There has been no reliable correlation between the pace of ECB buying and the Italy-Germany spread, but there has been a very strong correlation with relative returns. When the ECB was buying more bonds in 2015 and 2016, Germany was outperforming Italy. The opposite occurred last year when the ECB started to dial back the pace of its purchases. Why? Most likely, it was because the Italian economy was starting to gain momentum, which helps alleviate (but not eliminate) the debt sustainability fears about Italy's massive debt stock. The ECB's other extraordinary policy tool, low interest rates, has been an even bigger support for Italian debt sustainability. The government of Italy has been able to consistently issue bonds with coupons below 1% in the years after the ECB went to its zero interest rate policy (ZIRP) in 2014, according to the Bank of Italy (Chart 25). This has lowered the average interest rate on all outstanding Italian government bonds from 4% to 3% over that same period. This also reduced the ratio of Italian government interest payments to GDP by nearly one full percentage point over the past three years (bottom panel). Chart 23The Capital Key Is Only##BR##A 'Guideline' For ECB QE Chart 24Less ECB Bond Buying =##BR##Italian Bond Outperformance! Chart 25ZIRP/NIRP More Helpful##BR##For Italy Than QE Italy still has a significant long-run fiscal problem, however. The gross government debt/GDP ratio of 126% is only dwarfed by Japan and Greece within the developed markets (Chart 26). Even when looked at on a net basis (i.e. excluding the debt owned by Italian government entities like state pension funds) and, more importantly, after removing the bonds owned by the ECB, Italy still has a stock of debt equal to 100% of GDP (Chart 27). This is the highest in the Euro Area for countries eligible for the ECB's asset purchase program. Chart 26Italy's Debt Problems Have Not Gone Away Chart 27Still A Big Stock Of Italian Debt, Net Of ECB Purchases Importantly for market perceptions of Italy's debt sustainability, the ECB absorbing 15% of the stock of Italian government bonds has provided some wiggle room for an expansion of fiscal deficits without materially affecting long-term interest rates. That is no small matter, given how it is highly likely that the winner of the March 4th Italian election will step on the fiscal accelerator. Bottom Line: The inevitable tapering of ECB asset purchases later in 2018 will not have a meaningful impact on Italian government bond valuations - as long as the ECB is not planning on quickly raising interest rates soon after tapering. Upgrade Italian government bonds to neutral until signs of an economic slowdown in Italy emerge. Investment Conclusions After assessing the four main drivers of Italian bond risk premia - economic growth, the health of the banks, domestic politics and ECB monetary policy - it is clear that the state of the economy is the most important factor. If Italian growth is strong enough, investors will feel more comfortable about chasing the higher yields on Italy's government bonds and be a lot more relaxed about its Euroskeptic leanings. Given Italy's heavy reliance on exports as the driver of the current cyclical upturn, this means Italian financial assets are a levered play on global growth. The next most important factor is the ECB's monetary policy, but specifically, its interest rate policy and not its asset purchase program. Chart 28Upgrade Italian Debt To##BR##Neutral Until Growth Rolls Over This week, we are upgrading our recommended allocation to Italian government bonds to neutral from underweight in Global Fixed Income Strategy. At current yield levels and spreads to core European debt, a move all the way to an overweight recommendation is not ideal. Yet the case for Italian bond underperformance on the back of political uncertainty and eventual ECB tapering is even less ideal. Moving to neutral is a sensible compromise between a positive cyclical backdrop with poor valuation. Going forward through 2018, we will monitor the Italy Leading Economic Indicator (LEI) as a signal for when to consider downgrading Italian debt. If the LEI begins to hook down, that would be a bearish sign for the relative performance of both Italian government bonds and Italian equities (Chart 28). In addition, any indication that the ECB is considering not only tapering its bond buying, but also raising interest rates, could pose a problem for Italian assets. Although given the low starting point for any shift higher in policy rates, it would likely take several interest rate increases before Italian economic growth would start to be negatively impacted. Over a longer-term time horizon, investment implications are difficult to gauge. Structurally, both from an economic and political perspective, Italy is the least stable pillar of European economy. As such, it still has a potential to be a source of global risk-off if an economic downturn negatively impacts the current political stability. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Demographics And Geopolitics, Part I: A Silver Lining?", dated October 10, 2012, available at gps.bcaresearch.com. 2 The new Italian Electoral law - also known as Rosatellum - is particularly negative for Five Start Movement (M5S). First, it assigns over a third (37%) of the seats using a first-past-the-post system. This will hurt M5S, which lacks a geographical base where it can guarantee easy electoral district wins. Second, the vote eliminates a seat bonus for the party that wins a plurality of votes, forcing the winning coalition to gain at least around 40% of the vote to govern. Eliminating the bonus hurts M5S as it has led other parties in the polls. That said, a coalition government almost guarantees that fiscal spending will increase over the course of the next administration, given that budget outlays will be used to grease-the-wheels of any coalition deal. 3 The Italian public, known for its knack for satire, has parodied the electoral platforms with a Twitter hashtag #AboliamoQualcosa ("let's abolish something"). Twitter and Facebook have suggested that everything from French carbonara to vegan Bolognese should be abolished (BCA's Geopolitical Strategy heartily agrees with both suggestions!). 4 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 6 It is important to note that the relative returns shown in the bottom panel Chart 24 are calculated using the Bloomberg Barclays benchmark Treasury indices for Italy and Germany. These indices include debt across all maturities for both countries, not just the benchmark 10-year Italy-Germany spread shown in the top panel.