Euro Area

Highlights Global credit markets have endured a surprising bit of turbulence over the past month. Credit spreads in a variety of markets, from U.S. High-Yield (HY) to Euro Area Investment Grade (IG) to Emerging Markets (EM) corporate debt, have widened for the first time since August. Outflows from dedicated corporate bond funds helped fuel the sell-off, with a reported $6.8 billion pulled from U.S. high-yield mutual funds and ETFs over the past week according to Reuters.1 Feature This volatility in credit markets spooked other asset classes last week, triggering a few days of equity market weakness. That is no surprise given the reliable and well-known leading relationship between corporate bond spreads and equity values. For markets that are priced for perfection, with tight credit spreads and elevated equity market valuations at a time when global central banks are inching towards a less accommodative policy stance, it may not take much to prompt some nervous selling by investors. Was this risk-off move justified by any renewed deterioration in credit fundamentals? Or was it just a correction in a market that was very overdue for one? To try and answer this, we think this is an ideal time to present an update of our Corporate Health Monitor (CHM) Chartbook. Chart 1Credit Markets Priced For Perfection Our CHMs are composite indicators of balance sheet and income statement ratios designed to assess the financial well-being of the overall non-financial corporate sectors in the U.S., Europe and Emerging Markets (EM). We have developed both top-down (based on profit data from national income/GDP accounts) and bottom-up (based on actual reported financial data of individual companies) versions of the CHM. While there are differences in methodology between the two measures due to data availability and coverage (see Appendix 1 on Page 13 for details), we have found that both are useful in providing a more complete and comprehensive assessment of the state of corporate finances. The broad conclusion from the latest readings on our Developed Markets CHMs paint a mixed picture (Chart 1): Medium-term credit quality in the U.S. continues to deteriorate, especially for high-yield borrowers, although there has been some cyclical improvement on the back of the solid cyclical performance of U.S. profit growth. Euro Area corporate health remains in good shape, supported in no small part by the hyper-accommodative policy stance of the European Central Bank (ECB) that includes corporate bond purchases. Although returns on capital remain poor and leverage has increased in the Peripheral economies. U.K. corporates are enjoying very strong liquidity positions that are boosting overall credit quality despite mediocre underlying earnings performance. With the global economy enjoying a coordinated cyclical upturn that is supporting solid earnings growth, combined with global monetary policy settings that still accommodative, corporate health is not the primary driver of credit market returns at the moment. Yet if the BCA view on global growth, inflation and interest rates plays out in 2018 - all moving higher, especially in the U.S. - then the story is likely to change. Investors who have been piling into credit because of low risk-free interest rates (and spillovers from global central bank asset purchases) will begin to worry more about credit fundamentals than simply chasing higher yields, to the detriment of credit market performance. U.S. Corporate Health Monitors: Still Deteriorating Our top-down CHM for the U.S. has now been in the "deteriorating health" region for thirteen consecutive quarters dating back to the middle of 2014 (Chart 2). The current U.S. economic expansion has boosted corporate earnings growth on a cyclical basis. This has only acted to slow the modest decline in top-down profit margins, and much larger fall in return on capital, since the peak in both ratios three years ago. The reading on the latter from the 2nd quarter of 2017 (the last data available) is only 6%, not far from the lows seen during the past two recessions. The low return on capital during the current cycle is a disturbing development, as it suggests that there has is a surplus of capital on U.S. balance sheets that is largely unproductive and not boosting profits (the numerator in the ratio). This can also be seen in the run-up in corporate borrowing in recent years that has been used strictly to do share buy-backs. If the best investment idea that a company can have is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the internal rate of return on that investment (i.e. the return on capital) must indeed be quite low, which is a longer-term problem for corporate health. Short-term liquidity remains in good shape for U.S. companies, but interest coverage remains near the low end of the historical range of this ratio. This combination suggests that U.S. companies are not facing an imminent cash crunch that could raise downgrade/default risk, but there is less room for error than in years when interest coverage was at higher levels. This can also be seen in the bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Interest coverage is at historically depressed levels for the U.S. HY names in our indicator, and has fallen back to just slightly above the levels seen prior to the 2009 recession. Leverage levels are much higher in HY - around 180% debt/equity (at book value) compared to around 100% for IG - with profit margins that are ½ as wide as those of the IG names in our CHM universe. Thus, it is no surprise to see a far worse interest coverage ratio within our HY CHM where most components are near historically "bad" levels for credit quality. Chart 2Top-Down U.S. CHM:##BR##Still Deteriorating Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Still Deteriorating What is rather worrying is the fact that U.S. IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This suggests that the stock of debt has now grown so much after the rapid run-up in leverage (i.e. record bond issuance) that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is robust. This will raise downgrade risk if corporate borrowing rates were to rise significantly or the U.S. experiences a major economic downturn, as interest costs would rise while earnings deteriorate. Given our views on the likelihood of additional Fed rate hikes and higher Treasury yields in 2018, with even a possibility of a Fed-induced recession in 2019 if policy is tightened too aggressively to combat rising inflation, the risks to U.S. corporate debt performance (both IG and HY) will grow over the course of next year. For now, we are still recommending playing the growth phase of the business cycle by staying overweight U.S. corporate debt within global fixed income portfolios (Chart 5). The time to scale back positions will come after there is more decisive evidence that rising realized inflation is boosting inflation expectations, which will give the Fed confidence to tighten policy more aggressively. This will dampen future corporate profit expectations and likely raise risk premiums on U.S. corporate bonds. Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Modest Cyclical Improvement, From Very Bad Levels Chart 5Credit Rally##BR##Losing Momentum? One final point on the U.S. CHMs - in this version of the CHM Chartbook, we are adding some additional charts showing the bottom-up CHMs for some selected corporate bond sectors. These can be found in Appendix 2 on Page 13. We are only showing the charts this time, but we do plan on doing deeper dives on some individual sectors in future Weekly Reports and CHM Chartbooks. Euro Area CHMs: Still O.K., But With Some Mixed Signals Our top-down Euro Area CHM remains in "improving health" territory as it has for the entire period since the Global Financial Crisis. The direction is turning a bit more worrisome, though, as the indicator is now the closest it's been to the zero line since 2013 (Chart 6). By construction, the CHM shows deviations of the indicator from recent trends, in order to more quickly capture turning points in credit quality. Looked in that light, the steady worsening of the top-down CHM is a function of recent declines in profit margins, return on capital and debt coverage. This is offsetting the high and rising levels of short-term liquidity levels and interest coverage. The latter two points are directly related to the easy money policies of the ECB. The combination of zero (and even negative) short-term interest rates, specific liquidity programs aimed to prompt low-cost bank lending, and outright ECB asset purchases of Euro Area corporate debt have all helped drive borrowing rates to record low levels. Perhaps surprisingly, the low return on capital in the Euro Area, around 8%, is still above the return on capital from the U.S. top-down CHM of 6%. This is also confirmed by the bottom-up versions of the Euro Area CHMs for IG corporates (Chart 7) and HY corporates (Chart 8). Return on capital for Euro Area IG issuers (both domestic issuers and foreign issuers in the European bond market) is between 8-10%, a healthy number by any measure and similar to the level in the bottom-up U.S. IG CHM. Even Euro Area HY shows a return on capital of 4-6%, similar to that of U.S. HY. Chart 6Top-Down Euro Area CHM:##BR##Trending In A Bad Direction Chart 7Bottom-Up Euro Area##BR##Investment Grade CHMs: Improving Within the countries of the Euro Area, our bottom-up CHMs show that the credit metrics look better for the Core versus the Periphery (Chart 9). The biggest difference comes from a cyclical improvement in profit margins and interest coverage in the Core that is not being matched in the Periphery. Chart 8Bottom-Up Euro Area##BR##High-Yield CHMs: Looking Much Better Chart 9Bottom-Up Euro Area##BR##IG CHMs: Core Vs. Periphery More broadly, European corporate health seems to be improving when looking at our bottom-up CHMs. This goes against the trend we are seeing in the top-down CHM, although the latter is still in the "improving health" zone. Declining leverage, especially among the HY issuers in our bottom-up universe, appears to be the biggest source of the HY CHM improvement - again, a bit of a surprising result given how low the cost of debt finance currently is in Europe. Looking ahead, the outlook for Euro Area corporate credit looks positive in the near term, but murkier after that. The current powerful cyclical upturn in the European economy is likely to continue in 2018, as is the ECB's highly accommodative monetary policy. But at some point in the middle of next year, the ECB will be having the same discussion with the markets that was conducted over the past few months, regarding the future of the central bank's asset purchase program. This time, we think the growth and inflation data will give the ECB no choice but to announce a full tapering of its bond-buying program by the end of 2018. Interest rate hikes will come after that, but with a lag of at least one full year. European government bond yields will rise as the ECB eventually stops its asset purchases and the market pulls forward the timing of the next ECB rate hiking cycle. This also applies to corporate debt, where the ECB has become a massive buyer over the past three years. As the pace of ECB buying diminishes, Euro Area corporate bond yields should begin to rise and credit spreads will widen (Chart 10). The underlying improvements in our bottom-up Euro Area CHMs suggests that the repricing of European credit post-ECB tapering may be relatively contained. We still prefer to own U.S. corporate credit over Euro Area equivalents at this time, though. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs. Europe (Chart 11). That CHM gap continues to favor U.S. credit, although of late only U.S. IG corporates have outperformed Euro Area corporates. European HY has been outperforming in 2018 (in excess return terms), which may be a sign that investors are seeing the better European credit health that our bottom-up CHM is showing. Chart 10European Credit##BR##Looks Fully Valued Chart 11Relative Top-Down CHMs##BR##Still Favor The U.S. Over Europe U.K. Corporate Health Monitor: No Major Causes For Concern The top-down U.K. CHM has been in the "improving health" zone for the past two years, led by cyclical improvements in profit margins and interest coverage, combined with very strong short-term liquidity (Chart 12). Return on capital is low relative to its history, which is consistent with the trends seen in the U.S. and Euro Area and likely reflects the global low productivity backdrop (although at levels not far off those seen in the U.S. and Europe). U.K. credit has enjoyed the same global liquidity tailwind that other corporate bond markets have enjoyed. This is doubly so because of the specific easy monetary policies of the Bank of England (BoE) after the 2016 Brexit vote. The BoE has already reversed the post-Brexit interest rate cut, although additional hikes are highly unlikely given muddled growth momentum and the lingering uncertainties over the Brexit negotiations. The post-Brexit weakness in the British pound has stabilized, with the trade-weighted exchange rate now in positive territory on a year-over-year basis. This will result in slower inflation rates in the coming months and a BoE that is likely to sit on its hands for a while. An environment of mushy domestic growth and a stand-pat central bank would typically be good for risk assets like corporate credit. Yet at current low yield and spread levels, it is difficult to paint a scenario of additional outperformance of U.K. credit without a catalyst like accelerating growth or monetary easing. The combination of accommodative monetary policy and a solid credit backdrop, as indicated by our U.K. CHM, leads us to maintain our current neutral allocation to U.K. corporate debt, even though valuations do not look particularly cheap (Chart 13). Chart 12U.K. Corporate Health Monitor:##BR##Credit Quality Still Improving Chart 13U.K. Credit Rally Starting##BR##To Lose Steam Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.reuters.com/article/us-markets-flows-baml/investors-yank-6-8-billion-from-high-yield-bonds-third-largest-outflows-baml-idUSKBN1DH1G8 Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., Euro Area and U.K. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.2 The financial data of a broad set of individual U.S. and Euro Area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. An EM version of the bottom-up CHM was introduced by the BCA Emerging Markets Strategy team in September 2016, which extends the CHM analysis to EM hard-currency corporate debt.3 2 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Special Report, "EM Corporate Health Is Flashing Red" dated September 14 2016, available at ems.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

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

Highlights The euro doesn't have the key attributes of a funding or a risk-off currency. This means its behavior is not fixed. While in the past it has behaved as a risk-off currency, this year it has traded as a risk-on one, correlating with key risky assets. The current episode of market volatility will not help the euro. CAD/SEK will benefit if asset-market volatility continues. A global growth deceleration helps the CAD outperform the SEK, especially as this cross trades at a discount to rate differentials. Feature As markets have begun selling off, the euro has once again become well bid. Does this reaction makes sense, or is it a move that should be faded? We are inclined to look the other way, as it is highly unlikely that the euro will benefit from market weakness this time around. The Chameleon Currency Is the euro a risk-off or risk-on currency? We believe it is neither, and that its behavior evolves over time. The reason for this is that the euro is not underpinned by one of the key attributes that offer currencies like the Swiss franc or the yen their strong defensive characteristic: a large positive net international position (NIIP). While Switzerland or Japan have NIIPs in excess of 130% of GDP and 62% of GDP, respectively, the euro area owes the equivalent of 3% of GDP more to the rest of the world than the rest of world owes the Eurozone. This means the euro does not benefit from its investors repatriating funds at home when market turbulences emerge. In other words, unlike Japan or Switzerland, local investors' home bias does not come to the euro's rescue when markets vacillate. Moreover, unlike the USD, the euro is not the key reserve currency global investors seek when turmoil grips the market. The euro represents 20% of allocated global reserves, while the USD still garners 64% of these reserves. Rightly or wrongly, investors do not yet feel that the euro area has the permanence of the U.S., nor that it possesses the military might and the same capacity to control global sea lanes that the U.S. currently enjoys. Lacking these attributes, the euro is a bit of a chameleon. When investors are negative on the outlook for the European economy, the euro is used as a funding currency for carry trades. However, sometimes it is used as the vehicle to bet on a weaker dollar or an improving global economy. These two last bets are often one and the same, as the greenback remains a countercyclical currency, enjoying strength when the global economy weakens (Chart I-1). This is because the U.S. is low-beta economy as it is much less exposed to the vagaries of EM growth - a key source of variation in the global economy and the global industrial cycle - than the euro area is (Chart I-2). This is the case as the manufacturing sector is a much lower contributor to U.S. growth than to the euro area. Chart 1The Dollar Is Countercyclical Chart I-2The U.S. Is A Low-Beta Economy This time around, the euro seems to have been used to bet on stronger global growth and a weaker dollar. This makes sense. There is no doubt that the European economic upswing is based on domestic dynamics, but foreign factors have supercharged the European recovery this year. As Chart I-3 illustrates, French exports to Germany and China have tracked the Chinese Keqiang index - a key measure of Chinese industrial activity. More interestingly, French exports to Germany and China have been correlated with Chinese monetary conditions, suggesting China's economic rebound has filtered through a wide swath of the euro area. The action of the euro only agrees with the macroeconomic observations made above. The euro and copper - a key beneficiary of Chinese reflation - have both been moving together through most of 2017 (Chart I-4). The same holds true for EM stocks. As Chart I-5 shows, the euro has tracked the performance of EM equities relative to U.S. ones since August 2015. Both these observations make sense. A stronger China should benefit EM economies more than it benefits the U.S. A stronger China should help copper as it consumes three times as much of the red metal as the U.S., the euro area, and Japan combined. And stronger EM help Europe more than they help the U.S. Chart I-3The Positive Influence Of China Chart I-4EUR/USD Moves With Copper Chart I-5EUR/USD And EM Relative Performance Yet, as we highlighted last week, cracks are emerging in the global economy that should prove particularly painful for EM economies and EM assets.1 Behind some of these weaknesses lies China itself. After having eased fiscal and monetary conditions through most of 2015 and all of 2016, Chinese authorities are using elevated core CPI and producer price readings to reverse course. Aggregate fiscal spending is slowing massively - pointing to a negative fiscal impulse - and broad money supply is growing at its slowest pace ever (Chart I-6). The tightening in monetary conditions is bearing fruit. Chinese industrial production and retail sales disappointed this month, and the Chinese surprise index has now dipped into negative territory (Chart I-7). The boost to global growth, and EM growth especially, that was caused by Chinese imports lifted by domestic investment is now receding. Chart I-6China: Aggregate Fiscal Spending Growth##br## Is Also Weak China: Broad Money Growth Is At ##br##Record Low Chinese Policy Tightening Chart I-7Chinese Surprises Have ##br## Turned Negative EM assets are not ready for this, as they are priced for perfection. EM assets, which have traded in line with U.S. high-yield bond prices since 2008, are now very expensive relative to this already expensive asset (Chart I-8). A slowdown in Chinese and EM growth is likely to represent a substantially negative shock for EM equities, especially as the slowdown in EM M1 to 9.3% already portends a contraction in EM profit growth. The breakdown in U.S. and EM high-yield bond prices could easily catalyze these risks. Copper, too, is vulnerable. With an almost insatiable love for the red metal, investors are not positioned for a reversal of its bull market (Chart I-9). However, China already has near record-high inventories of copper; slowing public spending and money growth suggest that the construction industry is likely to decelerate, limiting China's intake over the next few quarters. A negative surprise is likely to come. Chart I-8EM Stocks Offer No Protection##br## Against A Slowdown Chart I-9Too Much Love For Copper Equals ##br##High Risk Of Disappointment Falling copper prices and underperforming EM equity prices will thus drive the euro lower, as they will be key symptoms of the waning of a crucial euro support. Moreover, the euro is now overbought, and as we have highlighted before, over-owned (Chart I-10). This picture alone should support the notion that the euro is unlikely to benefit from a short squeeze as global risk aversion rises. How could it? After all, investors did not sell the euro to fund carry trades when global growth was rising and global volatility was falling. They were buying it along with carry trades. Maybe the euro was buoyed by strong GDP prints out of Europe this week, with Germany growing at a 3.2% pace on an annualized basis in the third quarter, faster than the U.S. If this response of the euro were to be durable, it should be associated with a commensurate move in interest rate differentials. Neither the gap in 5-year risk-free rates or 1-year forward, 1-year risk free rates between Europe and the U.S. have moved in favor of the euro in the wake of the release (Chart I-11). However, in the face of the existing gap between the euro and interest rate differentials, to stay stable, the euro will need an increase in the pace of positive surprises relative to the U.S. over the coming months - something that is unlikely to materialize as European financial conditions have greatly tightened relative to the U.S. Chart I-10The Euro Has Not Been Used##br## To Fund Carry Trades Chart I-11If Growth Was The Current Driver, The Euro And ##br##Rate Differentials Would Be Moving Together Instead, we believe that worries regarding the U.S. tax plan may be playing a role in the euro's strength. Investors are worried of a repeat about the Obamacare repeal debacle. Now that Senators Cruz, Rand and Cotton want to add a provision to the tax bill that would eliminate Obamacare's individual mandates, investors worry that Senators McCain, Murkowski and Collins will down the bill. This is a valid concern, but we should not forget that this is only U.S. legal process, and that reconciliation of the House version and the Senate version of the bill will need to take place before it is finalized, suggesting the final bill proposed could be very different from the version currently being discussed. Bottom Line: The euro is unlikely to benefit from a risk-off environment if the current selloff in EM and high-yield bonds continues. The euro area's net international investment position is too small to suggest that fund repatriation by local investors will result in the euro being bid. In fact, the euro has rallied on a similar impulse that pushed EM assets and copper higher: Stronger global growth and Chinese stimulus. Thus, now that the euro is over-owned and overbought, any tightening in EM financial conditions is likely to hurt it as well. Long CAD/SEK: The Rationale Last week, we opened a long CAD/SEK trade. The rationale for this position is rather straightforward. To start, the SEK is a more pro-cyclical currency than the CAD. Our Global Growth Indicator has rolled over and, if history is any guide, when this global growth gauge weakens, this leads to a period of depreciation for the stokkie relative to the loonie (Chart I-12). Stefan Ingves's renewed leadership of the Riksbank makes this risk even more salient. Throughout his tenure, Governor Ingves has emphasized that the Swedish central bank would fight imported deflation. Weakening global growth should result in some deflationary forces in Sweden, even if the domestic economy is experiencing growing resource utilization pressures. Ingves will counterbalance these dynamics by keeping the SEK down. Also, over the past 10 years, when U.S. two-year rates have been rising relative to euro area short rates, CAD/SEK has appreciated (Chart I-13). This is simply because the Canadian economy is tied to the U.S., while Sweden's is tied to the euro area. Thus when U.S. rates rise, this tends to let the Bank of Canada hike as well without putting undue pressure on CAD/USD. The same relationship is true between Swedish and European rates. As such, the current upward bias in U.S. relative to euro area rates is creating an upward drift on Canadian relative to Swedish rates. Chart I-12Growth Rolling Over Leads ##br##To A Stronger CAD/SEK Chart I-13When The Fed Tightens Versus ##br##The ECB, CAD/SEK Rises Some key domestic factors are also favoring the CAD over the SEK. Canadian real retail sales have spiked, growing a record three percentage points faster than Sweden's. Moreover, this development has occurred despite a surge in the Swedish credit impulse relative to that of Canada. The relative credit impulse is now slowly moving in favor of the Canadian economy. If this continues, since the Canadian consumer is already roaring, it will support Canadian aggregate demand relative to Sweden's. With Canadian wages set to pick up as labor shortages intensify, this could stoke additional wage and inflationary pressures (Chart I-14). The BoC is thus likely to continue to hike even if Ingves is hampered by the ECB and EM. Finally, CAD/SEK is trading at a 5% discount to our relative intermediate-term timing model (Chart I-15). This kind of a discount has historically been associated with tradeable rebounds in the loonie relative to the stokkie. We believe that a risk-off period in global capital markets is the likely catalyst required to realize the good value currently present in this cross. Chart I-14Canada Will Experience Rising Wages Chart I-15CAD/SEK Trading At A Discount to Rates This trade is obviously not devoid of risks. The most salient one remains the renegotiation of NAFTA. As Marko Papic, our Chief Geopolitical strategist argues in a Special Report, large swaths of the U.S. population are not in favor of free trade, and feel they have not gained much from globalization. Low social mobility, high income inequality, stagnant middle-class wages and growing difficulty to access debt have fueled this sentiment.2 Since U.S. President Donald Trump and not Congress is ultimately in charge of trade relations between the U.S. and the rest of the world, Trump has much leeway to please his electorate. He can therefore repudiate NAFTA. Such a development would hurt Canada. Exports to the U.S. represent 20% of Canada's GDP. A large share of these exports, especially in the auto sector, could fall under a new trade regime. This means that net exports might become a drag on Canadian growth, but it also means that a lot of capex that should have materialized in Canada will instead be realized in the U.S. This would boost USD/CAD. However, as excess investment in the U.S. is a positive for U.S. rates, it would also lift the USD against the EUR. Considering EUR/USD has a negative 67.3% correlation with CAD/SEK, this would limit the damage to our long CAD/SEK trade created by NAFTA renegotiations. Bottom Line: CAD/SEK should benefit as global growth and global risk assets hit a snag in the coming months. Moreover, the Canadian economy continues to experience growing inflationary pressures, while the Riksbank is likely to prove ultra-sensitive to any weakness in EM. With CAD/SEK trading on the cheap side, such a development is likely to result in a tactical upswing in this cross. The biggest risk to this position is related to an adverse ending to NAFTA renegotiations. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Temporary Short-Term Risks", dated November 10, 2017, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Special Report, titled "NAFTA - Populism Vs. Pluto-Populism", dated November 10, 2017, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was generally positive: PPI measures beat expectations, with the headline measure coming in at 2.8% and the core at 2.4%; Core CPI beat expectations, coming in at 1.8%, while headline inflation remained steady at 2%; Continuing jobless claims decreased to 1.86 million, however initial jobless claims increased to 249,000; Net long-term TIC flows increased to USD 80.9 bn, while total net TIC flows are negative at USD -51.3 bn; NFIB Business Optimum Index and the Philadelphia Fed Manufacturing Survey underperformed expectations, coming in at 103.8 and 22.7, respectively; There was, however, a generally bearish rhetoric for the USD this week due to perceived inability of President Trump's administration to push through tax reform. Nevertheless, stronger inflation should lift the dollar in the coming months. Report Links: It's Not My Cross To Bear - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data was generally positive: German GDP accelerated greatly, hitting an annual rate of 2.3%, although this was in line with expectations. However, the quarterly measure of 0.8% beat expectations of 0.6%; European GDP grew in line with expectations of 2.5% on an annual basis; Industrial production increased by 3.3%, beating expectations of 3.2%; CPI across the euro area stayed steady and in line with expectations, with core inflation slowing to 0.9%. Importantly, the euro area core CPI diffusion index is decelerating sharply; As expected, French unemployment increased to 9.7% from 9.5%. The euro experienced a strong week following the release of these data points. However, as we have iterated in the past, the appreciation in the euro has tightened financial conditions, which means that inflation is unlikely to increase much from current levels. Report Links: Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data has surprised to the upside in Japan: Industrial production monthly growth was not as weak as expected, only weakening -1%. Meanwhile, yearly growth came in at 2.6%, an acceleration relative to last month. Gross domestic product annual growth also outperformed expectations, coming in at 1.4%. However it is worth to point out that growth slowed from a 2.6% reading last quarter. The yen has appreciated slightly this week, with USD/JPY rising by about 0.4%. Overall we continue to bearish on the yen against the dollar, given that interest rate differentials will continue to be the main determinants of this cross. On the other hand we are more bullish on the yen against commodity currencies like the NZD, given that we expect a temporary growth downshift is likely to cause commodity and EM plays to experience some downside. Report Links: Temporary Short-Term Rates - November 10, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Consumer price inflation underperformed expectations, coming at 3%. Core inflation also surprised to the downside, coming in at 2.7%. However average hourly earnings surprised to the upside, coming in at 2.2%. It is important to note however, that this is a slowdown from last month's number of 2.3%. Moreover, retail sales growth outperformed expectations coming in at -0.3%. Nevertheless, this measure drop sharply from last month's reading of 1.3%. Overall, the GBP/USD has stayed relatively flat this week, while it has depreciated by about 1% against the euro. We believe that the upside for the pound against the dollar from here on is limited, as the BoE has very little incentive to hike any more than what is priced into the SONIA curve given that inflation seems to be stabilizing. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has suffered this week following a slew of mixed data: NAB Business Conditions improved to 21 from 14, but Business Confidence remained steady at 8; Westpac Consumer Confidence was negative at -1.7%; Wage growth remains depressed at 2% annually and 0.5% quarterly, underperforming the expected 2.2% and 0.7%, respectively; Melbourne Institute's Consumer Inflation Expectations declined to 3.7% from 4.3% in November; The participation rate dropped 10 bps to 65.1% and employment grew by only 3,700, below the expected 17,500. However, this was because the decline in part-time employment of 20,700 was offset by the increase in full-time employment of 24,300. While there were some positive developments in the labor market, wages remain depressed, pointing to ongoing underemployment within the economy. This is likely to leave the RBA to stay cautious. Report Links: Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The New Zealand dollar has depreciated by almost 2% this week, as commodities and junk bonds have plunged. We continue to be bearish on this currency against both the dollar and then yen, as we expect a further deterioration in EM financial conditions. This is mainly due to 2 factors: First, monetary tightening in China should cause a worsening in financial conditions, which will weigh on growth and commodity producers. Moreover, market-based expectations of U.S. interest rates could experience some upside as U.S. inflation is slated to pick up. This will put upward pressure on the U.S. dollar, and thus, weigh on commodity prices. Nevertheless, we continue to be bullish on the NZD relatively to the AUD, as the Australian economy is much more sensitive to the dynamics described above. Report Links: Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data has been positive: Manufacturing shipments increased by 0.5% on a monthly basis, beating expectations of -0.3% but they were weaker than the previous release of 1.6%; Foreign portfolio investment in Canadian securities increased to CAD 16.81 bn, above the expected CAD 10.68 bn and also beating the previous figure of CAD 9.77 bn. However, oil weaknesses weighed on the CAD this week. Furthermore, a lack of Canadian data meant that USD/CAD traded mostly off positive U.S. data, which further handicapped the CAD. Report Links: Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 The Swiss franc has continued to depreciate, with EUR/CHF surging by almost 1% this week. This cross is now roughly 2.5% away from the level at which it was when the Swiss National Bank took off its floor in early 2015. Overall we see very little indication that the SNB will let off their ultra-dovish monetary policy and currency intervention. Speaking with the government on Wednesday, the SNB's president Thomas Jordan said that the Franc is still "highly valued". Although there has been a slight improvement in price inflation and in economic activity, it still too tepid for central bankers to change policy significantly. Thus, the franc will continue to suffer downward pressure, due to FX market intervention. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Gross domestic product growth outperformed expectations, coming in at 0.7%. Moreover core inflation also surprised to the upside, coming in at 1.1%, and increasing from last month's reading of 1%. However headline inflation underperformed substantially, coming in at 1.2% and decreasing from last month's reading of 1.6%. The krone has depreciated slightly against the dollar, as USD/NOK has risen by almost 0.6% this week. In spite of our positive view on oil, we continue to be bullish on USD/NOK, given that this cross is more sensitive to interest rate differentials than it is to oil prices. The Norwegian economy is still plagued with plenty of slack, thus the spread between U.S. and Norwegian rates will continue to widen. Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 10 Charts For A Late-August Day - August 25, 2017 Balance Of Payments Across The G10 - August 4, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK had a dismal week due to downbeat data: Inflation slowed greatly to 1.7% from 2.1%, even underperforming the expected slowdown of 1.8%. In monthly terms, it contracted by 0.1%; Capacity Utilization fell in Q3 to 0.2% from 0.5%, indicating slack in the economy; The unemployment rate also rose to 6.3%; EUR/SEK traded near 10.0000, appreciating to levels reached last October. These data points will certainly be taken into account by the Riksbank, and a dovish tilt has most likely been priced in by the market. Close EUR/SEK trade Report Links: Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Who Hikes Next? - June 30, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six 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 I-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 Question 1: Why is U.S. inflation still so low? Question 2: How important is the upcoming change in Fed leadership? Question 3: What are the implications of the U.S. tax cuts? Question 4: What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? Question 5: Are markets underestimating the potential impact from slower growth of central bank balance sheets? Question 6: How much longer can this powerful rally in Emerging Markets continue? Question 7: What are other investors worried about? Feature I have just returned from an extended two-week trip visiting clients in the Asia-Pacific region. The meetings were all very well attended, with even many non-dedicated fixed income investors turning up to ask tough questions about global bond markets. My impression was that given the powerful returns earned in virtually all risk assets this year (equities, credit, Emerging Markets), our clients are growing more concerned about the potential risks from tighter global monetary policy and rising interest rates than they have been for some time. Oddly enough, this is despite not fearing either a serious rise in inflation or a major growth slowdown next year. If such a thing as "nervous complacency" can exist, it seemed widely evident in most of my meetings. This week, I am taking a more personal tone than in a typical Global Fixed Income Strategy Weekly Report to summarize the key client questions from ten days of meetings, spread across six cities in five countries on two continents. Why is U.S. inflation still so low? Chart 1Tightest Global Labor Market##BR##Since The Mid-2000s Almost all of the meetings began with a discussion of the current situation in the U.S., particularly the lack of inflation. The current BCA view that U.S. inflation will accelerate in 2018 was met with some skepticism, particularly when framed in the context of the uncertain unemployment/inflation trade-off. In one meeting, outright laughter actually broke out when the term "Phillips Curve" was mentioned! Clearly, the burden of proof is on the inflation data itself. On that note, I presented several of the best BCA charts from recent months that show how the backdrop is ripe for a turnaround in global inflation. Clients were impressed when shown that nearly ¾ of the countries in the OECD had unemployment rates below the full-employment NAIRU, a level not seen since the period of strong coordinated global growth and rising inflation in the mid-2000s (Chart 1). Yet when I then presented a chart showing the actual inflation/unemployment data in the U.S. over the past 20 years, with a clear "kinked" Phillips Curve and the latest data point well on the steeper portion of that curve (Chart 2), the majority of clients were less convinced. The most cited reason was that the U.S. inflation data simply did not accelerate in 2017 when it was supposed to given the steady fall in unemployment over the preceding few years. Perhaps most surprising was that, rather than believe that the NAIRU rate may simply be lower now than in past business cycles, so many people that I met were willing to discard the entire Phillips Curve concept as a useful framework to forecast inflation. When presented with charts showing non-Phillips Curve reasons to expect higher inflation, however, there was far less skepticism. Perhaps the most compelling chart showed the typical 18-month lag between U.S. economic growth and the "momentum" of U.S. inflation (Chart 3). Upon seeing this, clients were more convinced that inflation would pick up next year in response to the current U.S. growth upturn. Chart 2U.S. Economy Has Moved Into##BR##The "Steep" Part Of The Phillips Curve Chart 3Inflation Typically Follows Economic Growth With A Long Lag I was also able to break down some of the skepticism on the U.S. inflation outlook even more after discussing the bullish oil forecast from our colleagues at Commodity & Energy Strategy. Admittedly, their view that the benchmark Brent oil price will average $65/bbl in 2018 sounds far less dramatic given that the current spot price has risen to nearly that level in the aftermath of the recent political turmoil in Saudi Arabia. Yet clients did appreciate that our bullish oil call was driven more by a view of improving global oil demand and continued production discipline by oil producers (especially for the so-called "OPEC 2.0" nations of Russia and Saudi Arabia). When shown our chart describing how oil prices persistently in the mid-$60s next would put some upward pressure on the inflation expectations component of global bond yields (Chart 4), there was virtually no disagreement from any clients that I met. There was a bit more pushback on the view that, if the BCA forecast of higher U.S. inflation and rising oil prices in 2018 comes to fruition, there is room for a substantial rise in U.S. Treasury yields from current levels. When presented a chart showing that market-based inflation expectations (both using TIPS breakevens and CPI swaps) could rise by 50-60bps just to get back to levels consistent with the Fed's inflation target (Chart 5), most clients politely nodded and basically said "show me the actual inflation first." Although there was widespread agreement with our view that it would take that kind of move in inflation expectations to prompt the Fed to fully deliver on the 100bps of rate hikes it is currently projecting to occur over the next year. Chart 4A Boost To Inflation Expectations##BR##From Higher Oil In 2018 Chart 5The Normalization Of U.S. Inflation##BR##Expectations Will Continue How important is the upcoming change in Fed leadership? The vast majority of clients that I met asked about the BCA view on the nomination of Jerome Powell as the new Fed Chair, replacing Janet Yellen. My impression was that there was not a lot of concern over the potential for serious alterations to the future path of U.S. monetary policy under new leadership. Yet it was still potentially a big enough change to ask questions about it. Most clients agreed with the BCA view that a Fed Chair Powell will not act much differently than Yellen. His voting history has aligned with hers and, by his own admission, he is a very data dependent central banker given that he is not a formally-trained economist. Only by knowing the ins and outs of the data has he been able to debate successfully with the Ph.D economists on the FOMC. Powell will likely be a data-driven Fed Chair that would not look to hike rates without higher inflation (and vice versa). Chart 6A Communications Problem##BR##For Jerome Powell? One point that I raised in all the meetings was that the Fed's communication strategy on future rate increases is the more worrisome issue for financial markets at the moment. The U.S. money market curve is still priced for only 50bps of rate increases over the next year, while the Fed "dots" are signaling 100bps of hikes. We think the Fed will deliver on its projections, which is one of the reasons we are recommending a below-benchmark duration stance in the U.S. (the upside in inflation expectations is the other reason). More importantly, the Fed's so-called "terminal rate" projection is at 2.75%, while our proxy for the market pricing of that rate - the 5-year U.S. Overnight Index Swap rate, 5-years forward - is hovering just above 2% (Chart 6). The persistent disagreement between the market and the Fed over the appropriate level of the terminal rate will become a problem later in 2018 if the Fed does indeed raise the funds rate to over 2% and continues to signal that more rate hikes will come to get the funds rate up to "neutral" (the terminal rate). If the Fed is not able to change the market's mind about the appropriate neutral level of the funds rate, then a move to the Fed's estimated terminal rate of 2.75% would push U.S. monetary policy into what will would be perceived a restrictive stance. This would have implications for the shape of the U.S. Treasury curve (a lot flatter) and for future growth expectations (a lot slower) heading into 2019. My impression from my meetings was that this possibility - that the Fed could engineer what would look to the markets like a policy mistake simply by sticking to its forecasts - was not at the forefront of clients' thinking at the moment. Yet there was no disagreement with the logic of how that could play out. The new Fed leadership under Jerome Powell may have its hands full clearly explaining their policy decisions in 2018, which could create some turbulence in global financial markets later in the year. What are the implications of the U.S. tax cuts? The details of the tax plans from the U.S. House of Representatives and the U.S. Senate were a very hot topic in all of my client meetings. Considering all the ideas being proposed, from cuts in corporate tax rates to changes in the tax treatment of debt interest costs to removing the disincentive to repatriate profits earned abroad, it is no surprise that both equity and fixed income clients had a lot of questions on future U.S. tax policy. It is difficult right now to judge the net impact of the tax changes, as not all of the proposals in the two Congressional tax plans will likely be implemented. There will be plenty of horse trading between the Republicans and Democrats (and between the Republicans themselves) before the final tax deal is done. Yet there was a lot of concern among clients in my meetings over the likelihood that the tax cuts will be implemented at all. After seeing President Trump lose the battle on health care reform earlier this year, many clients were worried that a repeat could happen for the Trump tax cut agenda. This would have negative implications for U.S. equity markets, the U.S. dollar and future Fed policy moves. I explained the views from our colleagues at Geopolitical Strategy, who strongly believe that a tax cut will eventually pass (likely in early 2018) given the need for Congressional Republicans to have something positive to present to voters heading into the 2018 U.S. midterm elections. The tax cuts will have a moderate stimulative effect on the U.S. economy that the markets were not yet fully discounting. I also presented the chart from Global Fixed Income Strategy showing that wider U.S. budget deficits usually coincide with a steeper U.S. Treasury curve, almost always because the U.S. economy is slowing down, prompting looser fiscal policy and also Fed rate cuts (Chart 7). This time is different, however, since the Trump tax cuts will be stimulating an economy currently at full employment (middle panel). This has the potential to trigger more inflation through faster economic growth and even tighter labor markets which could prompt the Fed to move more aggressively on interest rate increases next year and eventually flatten the UST curve (bottom panel). Chart 7A Full-Employment Fiscal Stimulus Will Bear-Steepen The UST Curve The idea of a "steeper, then flatter" Treasury yield curve in response to U.S. fiscal policy stimulus generated a lot of discussion in my meetings. Some even noted that the recent flattening of the curve was a sign that the markets were discounting a lower probability of a tax deal being reached in D.C. I described the flat curve as a consequence of inflation expectations remaining too low, as the Treasury curve was much flatter than implied by the low level of the real fed funds rate, which is one of the most reliable relationships in the bond markets (higher real rates = a flatter curve, and vice versa). My conclusion from these meetings (and from the current market pricing) is that clients are a bit skeptical that a tax deal will be reached. This suggests there is room for bond yields to rise, and the Treasury curve to bear-steepen, if our political strategists are right and the tax cuts will happen. What is the outlook for the ECB next year, and how will this impact the U.S. dollar versus the euro? While most of the questions in my meetings focused on the U.S. outlook, several clients asked about the next move from the European Central Bank (ECB). This was both from a fixed income perspective and, perhaps even more importantly, with an eye on the future direction of the euro versus the U.S. dollar. I made the straightforward argument that with Euro Area economic growth showing strong momentum that is unlikely to slow much in 2018, and with headline Euro Area inflation likely to surprise to the upside based on our bullish oil call (Chart 8), the ECB would likely be forced to signal a tapering of its asset purchase program to zero by the end of next year. The oil view was especially important, as the ECB is expecting a slowing of headline Euro Area inflation to 1% in early 2018 based on the base effects from comparisons to the rise in oil prices seen in early 2017. If our house view on oil prices plays out, then there is potential for inflation to catch the ECB by surprise in 2018. The key will be how core inflation plays out as oil prices rise further. Core Euro Area inflation has dipped lower in recent months, even as wage growth has accelerated (bottom panel). Given tightening Euro Area labor markets, and robust domestic demand, the recent dip in core inflation is likely to bottom out sometime in the first few months of 2018. But until that happens, there is more potential for higher U.S. bond yields through faster increases in inflation expectations and Fed rate hikes (Chart 9). This will support a higher U.S. dollar versus the euro through wider interest rate differentials (bottom panel). Chart 8ECB Will Fully Taper##BR##By The End Of 2018 Chart 9UST-Bund Spread Will Widen Next Year,##BR##Supporting The USD Clients were generally in agreement with that view on relative interest rates, but the views on the direction of EUR/USD were far more mixed. My impression is that if the Fed delivers the rate hikes that we expect in 2018, EUR/USD has room to move lower as investors were not prepared for this. Are markets underestimating the potential impact from slower growth of central bank balance sheets? I received many questions on the potential impact of central banks either shrinking balance sheets (the Fed) or slowing their expansion (the ECB and Bank of Japan). The chart showing how the growth in central bank money printing since 2015 (when the ECB began buying bonds) has correlated strongly with the bull markets in virtually all global risk assets garnered a lot of attention (Chart 10). This was especially true when I showed the chart that converted the level of the major central bank balance sheets to a growth rate and plotted that versus the returns on global equities and credit markets (Chart 11). The implication - expect lower returns on global equity markets, and MUCH lower returns from corporate bond markets next year. Chart 10CB Liquidity Has Supported Risk Assets... Chart 11...But That Tailwind Will Fade Next Year On this point, there was almost no disagreement from clients. There is widespread awareness that this era of puny interest rates, spurred on by central banks buying up huge quantities of government bonds and other financial assets, was forcing investors to take on far more risk in their portfolios to achieve acceptable returns. The key is when this will all turn around. Clients were generally in agreement with my view that the final leg of this liquidity-driven global bull market in risk assets will best be played through equity markets over corporate credit. These stable, earnings-driven rallies seen in global equity markets have not yet reached a "blowoff" phase that would suggest a larger correction is imminent. Perhaps it will take a final asset allocation decision to move more money out of bonds into equities to trigger that final run-up in equity prices before tighter monetary policies and slower growth expectations begin to damage returns later in 2018 into 2019. How much longer can this powerful rally in Emerging Markets continue? This is a topic that generated a healthy amount of debate in my meetings, particularly given the bearish views on Emerging Market (EM) assets from my colleagues at Emerging Markets Strategy. Here again, clients were generally looking at EM as a way to achieve acceptable returns in their portfolios while also participating in the global economic upturn through growth-sensitive assets. The previous chart showing the impact of diminished central bank liquidity on EM credit markets got some clients a bit nervous about the outlook for EM markets. What also spooked them were the charts from our EM strategists showing accelerating Chinese inflation (Chart 12) and slowing Chinese money growth. There is obviously a connection between the two, as China's policymakers are being forced to tighten monetary policy, and clamp down on excess credit creation, in response to accelerating inflation and very high debt levels. The chart showing how our "China M3 Impulse" had turned negative this year and was pointing to slower growth in industrial metals prices and China capital goods imports (Chart 13) was particularly unnerving for even the most bullish of EM clients. Chart 12This Is Why China Is Tightening Monetary Policy Chart 13Prepare For Slower Chinese Growth In 2018 My impression is that the clients I met were fully loaded up on EM assets but were comfortable holding those positions based on expectations of solid Chinese economic growth and continued inflows into EM assets from yield-starved global investors. If BCA's view that Chinese growth will slow next year comes to fruition, combined with rising U.S. interest rates and a stronger U.S. dollar as the Fed tightens more than currently discounted by the markets, then there is potential for outflows from EM markets to accelerate, to the detriment of EM returns. What are other investors worried about? This is a question that comes up a lot at BCA meetings, as clients are always curious as to what we are hearing from other investors. Perhaps this can be chalked up to a version of "confirmation bias", where investors like to hear that their own views are shared by others in the markets. In my meetings over the past two weeks, however, I got the sense that clients are heavily exposed to risk assets, which have performed beyond their expectations, and are growing more worried about how things can go wrong. Like an end to the current low volatility regime, for example. Given the BCA views on the likelihood of global inflation increasing next year, triggering a more hawkish response from policymakers, I noted that I did not believe that clients were prepared for that outcome. This suggests that the beginning of the end of the current low volatility regime, which is seen across all asset classes (Chart 14), will occur through a pickup in bond volatility. This will take place from a rise in inflation expectations first, and a rise in policy rate expectations later. My advice to clients was that if realized bond volatility picks up, this is the signal to reduce exposure to credit and equity markets. We anticipate making such a recommendation sometime during 2018. Chart 14The Low Market Volatility Backdrop Will End When Bond Volatility Rises Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked The Equity Risk Premium Chart I-7Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders Chart II-6Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe Chart II-8Immigration Is Straining Generous ##br##European Welfare States All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind Chart II-10Worries About Immigrant Assimilation Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart Chart II-13The Erosion Of Trust In Media It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? Chart II-15People Versus Companies The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? Table II-2Crime Rates Are Creeping Higher In Europe Chart II-17Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Depressed bond yields do justify exponentially higher equity valuations provided bond yields stay well below 3%. But when bond yields are at ultra-low levels, the much higher equity valuations necessarily mean that both bond and equity markets go on to generate feeble 10-year returns. The mainstream investments that could produce impressive 10-year returns are now most likely to come from the currency and real estate asset classes. The glaring pricing anomaly right now is the interest rate expected in the euro area relative to that in the U.S. five years out. The record high spread between euro area and U.S. long-term interest rates is nothing more than a QE 'timing distortion'. Chart Of The WeekEuro Area Employment To Population Is Now At An All-Time High Feature As the ECB prepares to 'recalibrate' its bond purchases, the 9-year global QE story is approaching its denouement. This makes now the perfect moment to put this big story into its full context. The $10 trillion of bonds that the 'big four'1 central banks have bought is not far short of the size of the euro area economy (Chart I-2). Hence, it would be natural to believe that this massive buying in itself is behind the structural rally across the whole global fixed income complex. However, this belief would be wrong. The global bond market exceeds $100 trillion. Long-term bank loans amount to another $100 trillion. In the context of this $217 trillion2 global fixed income market, $10 trillion of QE is small change. For the $217 trillion global bond and bank loan complex, the much more significant driver of yields is the expected path of short-term interest rates. The important thing about QE is not the $10 trillion of central bank purchases per se, but what these purchases have signalled for the path of interest rate policy.3 QE Is The Action That Speaks Louder Than Words We will let ECB Chief Economist, Peter Praet explain:4 "There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. The credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these purchases are a concrete demonstration of a desire to provide additional stimulus." Or to put it more bluntly, actions speak louder than words. QE is nothing more than actions that make credible the words that promise ultra-low interest rates for an extended period. It follows that as QE ends, the market impact depends almost entirely on what the end of QE implies for the path of interest rates (Chart I-3). Chart I-2The 9-Year Global QE Story ##br##Is Approaching Its Denouement Chart I-3The Expected Path of Interest ##br##Rates Determines Bond Yields Interestingly, the Federal Reserve has now explicitly broken the link between QE (unwinding) and its interest rate policy. In essence, the Fed is communicating that asset sales have no direct bearing on the path of interest rates. So they do not imply monetary tightening. But in the case of the ECB, its asset purchases and the path of interest rates are still closely entwined. So a reduced rate of asset purchases does imply a higher path of interest rates further out along the expectations curve. The question is: how much higher and how much further out? The Glaring Pricing Anomaly We expect a very tentative ECB to leave interest rate policy broadly unchanged for the next couple of years, perhaps to the end of Draghi's term as President in October 2019. But to us, the glaring pricing anomaly is the interest rate expected in the euro area relative to that in the U.S. five years out (or equivalently, the 10-year bond yield spread.) Absent the distortion from QE, the interest rate expected five years out is a reflection of structural fundamentals. For years, or even decades, the interest rates expected five years out in the euro area and the U.S. rarely separated because the structural fundamentals of the world's two largest economies looked very similar. But in 2013, a very sharp divergence started (Chart I-4 and Chart I-5). What happened in 2013? Did the euro area's structural fundamentals suddenly deteriorate vis-à-vis the U.S.? No, on the contrary, the euro area started a strong rebound from its debt crisis. Chart I-4The Expected Path Of Interest Rates Diverged In 2013... Chart I-5...Bond Yields Also Diverged In 2013. Why? The simple answer is that in May 2013 the Federal Reserve announced that it would exit its QE experiment by tapering its asset purchases. Meanwhile, the market was aware that the ECB's own QE experiment was still to come - and Mario Draghi duly announced it in the summer of 2014. Effectively, in the U.S. the interest rate expected five years out broke free from Fed QE's heavy anchor while in the euro area it got weighed down by ECB QE's heavy anchor. Fast forward to today. Absent the distortion from QE, is the record high spread between interest rates expected five years in the euro area and the U.S. still justified? Looking at the structural fundamentals, the answer is a very emphatic no. The euro area employment to population ratio is at an all-time high - meaning both a structural high and a cyclical high (Chart of the Week); real growth per head in the euro area has been exactly in line with that in the U.S. through the 19-year life of the euro (Chart I-6); and inflation rates in the two economies are near-identical (Chart I-7). Chart I-6Long-Term Productivity Growth Is The Same... Chart I-7...Inflation Is Near-Identical... Sceptics might counter that the euro area's impressive statistics have depended on ECB QE, but the evidence contradicts this. The trends were in place years before ECB QE. So objectively, there is little to separate the structural fundamentals of the euro area and the U.S. We conclude that the record high spread between interest rates expected five years out (or equivalently, the 10-year bond yield spread) is nothing more than a QE 'timing distortion' (Chart I-8). And the spread must compress in the coming years, which constitutes an excellent structural position. Chart I-8...Yet The Bond Yield Spread Is Near A Record Wide Bond investors should structurally underweight German bunds versus U.S. T-bonds. Investment Reductionism5 then implies that equity investors should structurally overweight euro area Financials versus U.S. Financials. QE: The Bittersweet Legacy QE has depressed bond yields by signalling an extended period of ultra-low interest rates. However, as we explained last week in The Mystery Of The Risk Premium... Finally Solved,6 when yields drop to ultra-low levels, bonds become much riskier investments. This is because the prospects for capital appreciation rapidly disappear, while the prospects for large-scale capital losses suddenly increase. But if bonds become riskier investments, it reduces the justification for demanding a 'risk premium' (an excess return) on equities. Thereby, when bond yields drop to ultra-low levels, the boost to bond valuations is linear, but the boost to equity valuations is exponential. Consider what happens to a bond price and an equity price when a 10-year bond yield declines by 2%. To generate the lower yield, today's bond price must rise by 2% compounded over ten years - about 20%. And the same applies to the equity price. Now consider what happens when the bond yield declines by 2% to an ultra-low level. Today's bond price must again rise by about 20%, but the equity price gets a double boost. If its annual risk premium also compresses by, say, 2% then the equity price must rise by 4% compounded over ten years - about 50%. So the boost to the equity valuation is non-linear. At a bond yield of 5%, a 2% decline boosts the equity valuation by 20%. But at a bond yield of 3%, a 2% decline boosts the equity valuation by 50%! This means that QE leaves a bittersweet legacy. The sweet part is that depressed bond yields do justify exponentially higher equity valuations provided bond yields stay well below 3%. The bitter part is that once bond yields reach ultra-low levels, the much higher equity valuations necessarily mean that both bond and equity markets go on to generate feeble 10-year returns. This has been the precise experience of both Japan and Switzerland, where bond yields reached ultra-low levels almost two decades ago (Chart I-9). Chart I-9When Bond Yields Reach Ultra-Low Levels, ##br##Equities Become Highly Valued And Generate 10-Year Excess Feeble Returns So what should long-term investors do? We will save the details for future reports, but we believe that the mainstream investments that could produce impressive 10-year returns are now most likely to come from the currency and real estate asset classes. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Federal Reserve, ECB, Bank of Japan and Bank of England. 2 Source: The Institute of International Finance (IIF) https://www.iif.com/publication/global-debt-monitor/global-debt-monitor-june-2017. 3 For example, if the market feared bond purchases would cause inflation and thereby imply a higher path of interest rates, QE would push up bond yields! 4 From a speech by Peter Praet on October 11 2017: Maintaining price stability with unconventional monetary policy measures. 5 Please see the European Investment Strategy Weekly Report, "The Law Of the Vital Few," published on September 14, 2017 and available at eis.bcaresearch.com. 6 Published on October 19 2017 and available at eis.bcaresearch.com. Fractal Trading Model* This week, our model suggests that the short-term relationship between copper and tin has become overstretched. The recommended trade is short copper/long tin with a profit target/stop loss set at 5%. 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 Fractal Trading Model* 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. 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 - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations