Fixed Income

Fiscal Stimulus To Prolong The Expansion The market swoon in early February should not induce investors to lower risk. The stock market correction (the first for almost two years) was triggered by a couple of inflation and wage readings that came in slightly above expectations, and was exacerbated by some technical factors such as automated trading by volatility-target funds. But, significantly, it was not accompanied by the usual signals of rising risk aversion: for example, credit spreads barely widened and the gold price was stable (Chart 1). Volatility is likely to remain high but, as our U.S. Investment Strategy service recently found, the VIX has not been a useful indicator of recessions and bear markets: many times over the past 30 years it has spiked higher without risk assets producing negative returns over the subsequent 12 months (Chart 2).1 Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1Sell-Off Didn't Trigger Risk Signals Sell-Off Didn't Trigger Risk Signals Sell-Off Didn't Trigger Risk Signals Chart 2Spike In Vix Is Not A Sell Signal Spike In Vix Is Not A Sell Signal Spike In Vix Is Not A Sell Signal Fiscal policy moves in the U.S. make us believe, rather, that the current economic expansion will last longer than we previously forecast. A combination of tax cuts plus recent spending proposals (including $165 billion on the military and $45 billion on disaster relief) will boost GDP by about 0.8% of GDP this year and 1.3% next, compared to the IMF's earlier forecast of a fiscal contraction this year (Chart 3).2 Add to that the boost from the 8% trade-weighted depreciation of the U.S. dollar over the past 12 months (which should add 0.3% to growth over two years), and it is difficult to imagine U.S. GDP growth turning down any time soon. Accordingly, BCA has shifted its recession call from the second half of 2019 to sometime in 2020. Of course, this is not all good news. The U.S. budget deficit is likely to increase to 5½% of GDP in 2019, which will put upward pressure on interest rates. The fiscal impulse will hit an economy already at full capacity, and so will be inflationary. The scenario we envisage is boom-and-bust, leading to a nastier recession than we had previously expected. Nonetheless, the boost to growth should be positive for risk assets over the next 12 months. Our model of earnings growth now suggests that U.S. EPS should continue to grow at close to a 20% rate for the rest of this year (Chart 4). Chart 3Fiscal Boost To U.S. Growth Monthly Portfolio Update Monthly Portfolio Update Chart 4Earnings Growth Gets A Boost Too Earnings Growth Gets A Boost Too Earnings Growth Gets A Boost Too How quickly will the Fed push back against the potentially inflationary implications of this higher growth? We have found a remarkable turnaround in investors' perceptions of inflation over the past few weeks. Whereas last year most argued that structural forces (online shopping, the gig economy etc.) meant that inflation would stay depressed, now many worry that it will quickly shoot above 2% and force the Fed to tighten policy aggressively. This has caused them to over-react, for example, to the (rather obvious) statement from the last FOMC minutes that "participants noted that a stronger outlook for economic growth raised the likelihood that further gradual policy firming would be appropriate." Our view remains that core PCE inflation - the Fed's favorite measure - is likely to move back gradually to 2% (from 1.5% currently), but not accelerate dramatically. Unit labor costs remain subdued (Chart 5), the continued rise in the participation rate means there is more slack in the labor market than implied by headline unemployment (Chart 6), and inflation expectations remain low. This should allow new Fed chair Jerome Powell to continue to withdraw accommodation at a measured pace. The market has already priced in that the Fed will tighten this year at least in line with its dots (Chart 7). We expect four, rather than the Fed's projected three, hikes this year, but this should not be too hard for the market to absorb. Chart 5Unit Labor Costs Don't Point To Jump In Inflation Unit Labor Costs Don't Point To Jump In Inflation Unit Labor Costs Don't Point To Jump In Inflation Chart 6 Still Some Slack In Labor Market Still Some Slack In Labor Market Still Some Slack In Labor Market Chart 7Market Has Caught Up To The Fed Market Has Caught Up To The Fed Market Has Caught Up To The Fed We have for some months now advised long-term, more risk-averse investors to consider dialing back risk, and the volatility in February was a good example of why. We would expect further such bouts of volatility. However, with a recession still probably two years away, and a combination of stronger-than-expected growth and a Fed reluctant to accelerate tightening, the next 12 months should remain positive for equities and other risk assets. Fixed Income: We now expect the 10-year U.S. Treasury bond yield to rise to 3.3-3.5%. This will come from a further 40 BP increase in inflation expectations (taking them back to a level compatible with the Fed achieving its inflation target) plus a rise in the real yield, as markets start to price in the end of secular stagnation (Chart 8). The rise in global yields will be exacerbated by increasing net supply, as fiscal deficits rise and central banks wind down QE (Chart 9). We are, accordingly, underweight duration, and prefer inflation-linked bonds to nominal ones. We will likely reduce our exposure to credit before we turn defensive on equities. But, for now, strong economic growth and higher oil prices mean spread product is likely to outperform government bonds. Chart 8Inflation Expectations And Real Yields To Rise Inflation Expectations And Real Yields To Rise Inflation Expectations And Real Yields To Rise Chart 9Net Government Bond Supply To Increase Net Government Bond Supply To Increase Net Government Bond Supply To Increase Currencies: Rising interest rate differentials have failed to cause the dollar to rally (Chart 10). FX markets are trading, rather, on valuations (the euro and yen are, indeed, undervalued), on current account positions (the euro zone and Japan have large surpluses), and on the narrative that U.S. twin deficits historically caused the dollar to weaken. Our FX strategists find this is true only when, as in 2001-3, U.S. real rates were falling; after the Reagan tax cuts in 1981, real rates rose, pushing up the dollar (Chart 11). The key, therefore, is how quickly the Fed reacts this time. The dollar currently has strong downward momentum (especially against the yen) and this could continue. But as global growth slows relative to the U.S., relative interest rates are likely to reassert themselves as a factor, causing the dollar to strengthen again. Chart 10Rising Rate Differentials Fails To Boost Dollar Rising Rate Differentials Fails To Boost Dollar Rising Rate Differentials Fails To Boost Dollar Chart 11Do Twin Deficits Matter For Dollar? Do Twin Deficits Matter For Dollar? Do Twin Deficits Matter For Dollar? Equities: Given the macro environment, we continue to recommend pro-cyclical equity tilts, with overweights in higher beta markets such as the euro zone and Japan, and cyclical sectors such as financials, energy, and industrials. Our underweight on EM equities is based on the risk of a slowdown in China (where tighter financial conditions point to a slowing of the industrial sector, Chart 12), the possibility of a U.S. dollar rebound, and the vulnerability of highly leveraged foreign-currency EM borrowers to a rise in U.S. interest rates. Commodities: Our energy team has further revised up their oil price forecast, on expectations that the OPEC agreement will be extended, which will cause a greater draw-down in oil inventories (Chart 13).3 They see Brent crude averaging $74 a barrel this year, with spikes above $80. However, the response of the U.S. shale industry will begin to kick in, pushing the price down to below $60 by end-2019. We are neutral on industrial commodities, which will benefit from stronger global growth but are at risk in the event of dollar appreciation and slowdown in China. Chart 12Tighter Monetary Conditions In China Tighter Monetary Conditions in China Tighter Monetary Conditions in China Chart 13Oil Inventories To Draw Down Further Oil Inventories To Draw Down Further Oil Inventories To Draw Down Further Please note that, due to the Easter holidays in some countries, the GAA Quarterly Portfolio will be published one day later than usual, on April 3. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report, "Late Innings," dated 26 February 2018, available at usis.bcaresearch.com 2 For details, please see The Bank Credit Analyst, "March 2018," available at bca.bcaresearch.com 3 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0: Getting Comfortable With Higher Prices," dated 22 February 2018, available at ces.bcaresearch.com GAA Asset Allocation

Highlights The political path of least resistance leads to fiscal profligacy - in the U.S. and beyond. The response to populism is underway. The U.S. midterm election is market-relevant. Gridlock between the White House and Congress does, in fact, weigh on equity returns, after controlling for macro variables. The Democratic Party's chances of taking over Congress have fallen, but remain 50% in the House of Representatives. A divided House and Senate is the worst combination for equities, but macro factors matter most. China is clearly rebooting its "reform" agenda as Xi Jinping becomes an irresistible force. We remain long H-shares relative to EM, for now. Emerging markets - including an improved South Africa - will suffer as politics become a tailwind for U.S. growth and a headwind for Chinese growth. Feature The bond market has been shocked into action this month by the twin realizations that the Republican-held Congress is not as incompetent as believed and that the Republican Party is not as fiscally conservative as professed. When combined with steady U.S. wage growth and rising inflation expectations (Chart 1), our core 2018 theme - that U.S. politics would act as an accelerant to growth - has been priced in by the bond market with impressive urgency.1 The tax cuts alone were not enough to wake the bond market. First, the realization that a tax cut would pass Congress struck markets in late October, when it became increasingly clear that the $1.5 trillion Tax Cuts And Jobs Act would indeed pass the Senate. Second, the bill's passage along strict party lines - including the slimmest of margins in the Senate thanks to reconciliation rules - convinced investors that there would be no further compromises down the pipeline. The real game changer was the realization that the political path of least resistance leads towards profligacy. This happened with the signing into law of the February 9 two-year budget compromise (the Bipartisan Budget Act of 2018) that will see fiscal spending raised by around $380 billion.2 The deal failed to gain the support of a majority of Republicans in the House, despite House Speaker Paul Ryan's support, but 73 Democrats crossed the aisle to ensure its passage. They did so despite a lack of formal assurances that the House would consider an immigration bill. The three-day shutdown in late January has forced Democrats, who largely took the blame, to assess whether they care more about preserving their liberal credentials on fiscal policy or immigration policy. The two-year budget agreement is a testament to their concern for the former. The deal will see the budget deficit most likely rise to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). Chart 1Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Rising U.S. Inflation Expectations Chart 2Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Fiscal Policy Gets Expansive Adding to the newly authorized fiscal spending could be a congressional rule-change that reintroduces earmarks - leading to a potential $20 billion additional spending per year. There is also a 10-year infrastructure plan that could see spending increase by another ~$200 billion over the next decade. The new budget compromise, combined with last year's tax cuts, will massively increase U.S. fiscal thrust beyond the IMF's baseline (Chart 3). The IMF's forecast, done before the tax cuts were passed, suggested that fiscal thrust would contract by about 0.5% of GDP this year, and would only slightly expand in 2019. Now we estimate that fiscal thrust will be a positive 0.8% of GDP in 2018 and 1.3% in 2019. These figures are tentative because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. Our colleague Mark McClellan, author of BCA's flagship The Bank Credit Analyst, has stressed that the impact on GDP growth will be less than these figures suggest because the economic multipliers related to tax cuts are less than those for spending.3 Our theme that the political path of least resistance will lead to profligacy is not exclusive to the U.S. After all, populism is not exclusive to the U.S, with non-centrist parties consistently capturing around 16% of the electoral vote in Europe (Chart 4). Chart 3The Budget Deal And Tax Cuts##br## Will Expand U.S. Fiscal Thrust Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 4Populism Will Fuel Fiscal##br##Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Populism Will Fuel Fiscal Spending Beyond The U.S. Policymakers are not price-setters in the political marketplace, but price-takers. The price-setter is the median voter, who we believe has swung to the left when it comes to economic policy in developed markets after a multi-year, low-growth, economic recovery.4 Broadly speaking, investors should prepare for higher fiscal spending globally on the back of this dynamic. Aside from the U.S., the populist dynamic is evident in the world's third (Japan), fourth (Germany), and sixth (the U.K.) largest economies. Japan may have started it all, as a political paradigm shift in 2011-12 spurred a historic reflationary effort.5 Geopolitical pressure from China and domestic political pressures on the back of an extraordinary rise in income inequality, and natural and national disasters, combined to create the political context that made Abenomics possible. While the fiscal arrow has somewhat disappointed - particularly when PM Shinzo Abe authorized the 2014 increase in the consumption tax - Japan has still surprised to the upside on fiscal thrust (Chart 5). On average, the IMF has underestimated Japan's fiscal impulse by 0.84% since the beginning of 2012. Investors often understate the ability of centrist, establishment policymakers to rebrand anti-establishment policies - whether on fiscal spending or immigration - as their own. In January 2015, we asked whether "Abenomics Is The Future?"6 We concluded that rising populism in Europe would require a policy response not unlike the policy mix favored by Tokyo. Today, the details of the latest German coalition deal between the formally fiscally conservative Christian Democratic Union (CDU) and the center-left Social Democratic Party (SDP) means that even Germany has now succumbed to the political pressure to reflate. The CDU has agreed to fork over the influential ministry of finance to the profligate SPD and apparently spend an additional 46 billion euros, over the duration of the Grand Coalition, on public investment and tax cuts. Finally, in the U.K., the end of austerity came quickly on the heels of the Brexit referendum, the ultimate populist shot-across-the-bow. The new Chancellor of the Exchequer, Philip Hammond, announced a shift away from austerity almost immediately, scrapping targets for balancing the budget by the end of the decade. The change in rhetoric has carried over to the new government, especially after the Labour Party pummeled the Tories on austerity in the lead up to the June 2017 election. The bond market action over the past several weeks suggests that investors have not fully appreciated the political shifts underway over the past several years. Bond yields had to "catch up" to the political reality essentially over the course of February. However, the structural upward trajectory is now in place. The end of stimulative monetary policy will accelerate the rise in bond yields. Quantitative easing programs have soaked up more than the net government issuance of the major economies. Chart 6 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative from 2015-2017. This flow will now swing to the positive side as fiscal spending necessitates greater issuance and as central banks withdraw demand. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private-sector issuance for available savings. Chart 5Japan's Abenomics Leads The Way To More Spending Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Chart 6Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Lots Of Bonds Hitting The Private Market Bottom Line: The U.S. electorate chose the populist, anti-establishment Donald Trump as president with unemployment at a multi-decade low of 4.6%. The message from the U.S. election, and the rise of anti-establishment parties in Europe, is that the electorate is restless, even with the post-Great Financial Crisis recovery now in its ninth year. Policymakers have heard the message, loud and clear, and are adjusting fiscal policy accordingly. Over the course of the next quarter, BCA's Global Investment Strategy expects the rapid rise in bond yields to peter out, but investors should use any bond rallies as an opportunity to reduce duration risk. BCA's House View calls for the 10-year Treasury yield to finish the year at about 3.25%.7 Our U.S. bond strategists expect the end-of-cycle level of the nominal 10-year Treasury yield to be between 3.3% and 3.5%.8 Does The U.S. Midterm Election Matter? The three-day government shutdown that ended on January 22 has hurt the chances of the Democratic Party in the upcoming midterm election. The Democrats' lead in the generic congressional ballot has gone from a high of 13% at the end of 2017 to just 9% today (Chart 7). As Chart 8 illustrates, this generic ballot has some predictive quality. However, it also suggests that for Democrats, the lead needs to be considerably larger than for Republicans to generate the type of seat-swing needed to win a majority in the House of Representatives in 2018. Chart 7Democrats Have Lost Some Steam Democrats Have Lost Some Steam Democrats Have Lost Some Steam Chart 8Democrats Need Big Polling Lead To Win Majority Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China There are three reasons for this built-in advantage for the Republican Party in recent midterm elections. First, the Republicans dominate the rural vote, which tends to be overrepresented in any electoral system that draws electoral districts geographically. Second, redistricting - or gerrymandering - has tended to favor the Republican Party in the past several elections. While the Supreme Court has recently struck down some of the most egregiously drawn electoral districts, the overall impact of gerrymandering since 2010 overwhelmingly favors the GOP. Third, midterm elections tend to have a lot lower voter turnout than general elections, which hurts the Democrats who rely on the youth and minority vote. Both constituencies tend to shy away from participation in the midterm election. Does the market care who wins the House and Senate? On the margin, yes. If the current GOP control of the White House, House of Representatives, and Senate were to be broken, markets might react negatively. It is often stated that gridlock has a positive effect on stock prices, as it reduces the probability of harmful government involvement in the economy and financial markets. However, research by our colleague Jonathan LaBerge, which we have recently updated, suggests otherwise. After controlling for the macro environment, gridlock between the White House and Congress is actually associated with modestly lower equity market returns.9 This conclusion is based on the past century of data. For most of that period, polarization has steadily risen to today's record-setting levels (Chart 9). As such, the negative impact of gridlock could be higher today. Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of executive/legislative disunity and reduced uncertainty in the 12-months following presidential and midterm elections.10 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 9U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years U.S. Polarization Has Risen For 60 Years Table 1Divided Government Is, In Fact, Bad For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of timeframe. The takeaway for equity investors is that, contrary to popular belief, political gridlock is not positive for stock prices after controlling for important macro factors. Absolute results are similarly negative, with the average monthly S&P 500 returns considerably larger during periods of unified executive and legislative branches (Chart 10). Intriguingly, the less negative constellation of forces is when the president faces a unified Congress ruled by the opposing party. We would reason that such periods force the president to compromise with the legislature, which constitutionally has a lot of authority over domestic policy. The worst outcome for equity markets, by far, is when the president faces a split legislature. In these cases, we suspect that uncertainty rises as neither party has to take responsibility for negative policy outcomes, making them more likely. Chart 10A Unified Congress Is A Boon For Stocks Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In the current context, gridlock could lead to greater political volatility. For example, a Democratic House of Representatives would begin several investigations into the Trump White House and could potentially initiate impeachment proceedings against the president. But as we pointed out last year, impeachment alone is no reason to sell stocks.11 The Democrats would not have the ability to alter President Trump's deregulatory trajectory - which remains under the purview of the executive - nor would they be likely to gain enough seats to repeal the tax cut legislation. Yet given President Trump's populist bias, center-left Democrats could find much in common with the president on spending. This would only reinforce our adage that the political path of least resistance will tend towards profligacy. The only thing that President Trump and the Democrats in Congress will find in common, in other words, will be to blow out the U.S. budget deficit. Bottom Line: The chances of a Democratic takeover following the midterm elections have fallen, but remain at 50% for the House of Representatives. A gridlocked Congress is mildly negative for equity markets, taking into consideration that macro variables still dominate. Nonetheless, investors should ignore the likely higher political volatility and focus on the fact that President Trump and the Democrats are not that far apart when it comes to spending. China: The Reform Reboot Is Here And It Is Still Winter He told us not to believe the people who say it's spring in China again. It's still winter. - Anonymous Chinese government official referring to Liu He, the top economic adviser.12 The one risk to the BCA House View of a structural bond bear market - at least in the near term - is a peaking of global growth and a slowdown in emerging markets. The EM economies, which normally magnify booms in advanced economies, particularly in latter stages of the economic cycle, are currently experiencing a relative contraction in their PMIs (Chart 11). BCA Foreign Exchange Strategy's "carry canary" indicator - which shows that EM/JPY carry trades tend to lead global industrial activity - is similarly flashing warning signs (Chart 12).13 Chart 11EM Economies Underperforming EM Economies Underperforming EM Economies Underperforming Chart 12Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress Yen Carry Trades Signal Distress At the heart of the divergence in growth between EM and DM is China. Beijing has been tightening monetary conditions as part of overall structural reform efforts, causing a sharp deceleration in the Li Keqiang index (Chart 13). In addition, the orders-to-inventories ratio has begun to contract, import volumes are weak, and export price growth is slowing sharply (Chart 14). Chart 13Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Li Keqiang Index Surprises Downward Chart 14China's Economy Weakens... China's Economy Weakens... China's Economy Weakens... The Chinese slowdown is fundamentally driven by politics. Last April we introduced a checklist for determining whether Chinese President Xi Jinping would "reboot" his reform agenda during his second term in office. We define "reform" as policies that accelerate the transition of China's growth model away from investment-driven, resource-intensive growth. Since then, political and economic events have supported our thesis. Most recently, interbank lending rates have spiked due to China's new macro-prudential regulations and monetary policy (Chart 15), and January's total credit growth clocked in at an uninspiring 11.2% (Chart 16). Tight credit control in the first calendar month typically implies that credit expansion will be limited for the rest of the year (Chart 17). A strong grip on money and credit growth is entirely in keeping with the three-year "battle" that Xi Jinping has declared against systemic financial risk.14 Chart 15...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates ...While Policy Drives Up Interbank Rates Chart 16January Credit Growth Disappoints... January Credit Growth Disappoints... January Credit Growth Disappoints... Chart 17... And January Credit Is The Biggest Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China In short, we have just crossed the 50% threshold on our checklist, confirming that China is indeed rebooting its reform agenda (Table 2). Going forward, what matters is the intensity and duration of the reform push. Three events at the start of the Chinese New Year suggest that the market will be surprised by both. Table 2How Do We Know China Is Reforming? Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China First, the National People's Congress (NPC), which convenes March 5, is reportedly planning to remove term limits for the president and vice-president, thus enabling Xi Jinping to remain as president well beyond March 2023. Xi was already set up to be the most powerful man in China's politics through the 2020s,15 so we do not consider this a material change in circumstances: the material change occurred last October when "Xi Thought" received the status of "Mao Zedong Thought" in the Communist Party's constitution and reshaped the Politburo to his liking. The point is that Xi's position is irresistible which means that his policies will have greater, not lesser, effectiveness as party and state bureaucrats scramble to enact them faithfully.16 Chart 18Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Crackdown On Shadow Lending Has Teeth Second, the Communist Party is reportedly convening its "Third Plenum" half a year early this year - that is, in late February and early March, just before the annual legislative meeting that begins March 5. This is a symbolic move. The third plenum is known as the "reform plenum," and this year is the fortieth anniversary of the 1978 third plenum that launched China's market reform and opening up to the global economy under Deng Xiaoping. However, the last time China convened a third plenum - in 2013 when Xi first announced his agenda - the excitement fizzled as implementation proved to be slow.17 As we have repeatedly warned clients, China's political environment has changed dramatically since 2013: the constraints to painful structural reforms have fallen.18 If the third plenum is indeed held early, some key decisions on reform initiatives will be made as we go to press, and any that require legislative approval will receive it instantly when the National People's Congress convenes on March 5.19 This will be a "double punch" that will supercharge the reform agenda this year. It is precisely the kind of ambition that we have been expecting. Third, one of the most important administrative vehicles of this new reform push, the Financial Stability and Development Commission (FSDC), has just made its first serious move.20 On February 23, China's top insurance regulator announced that it is taking control of Anbang Insurance Group for one year, possibly two, in order to restructure it amid insolvency and systemic risks. Anbang's troubles are idiosyncratic and have received ample media attention since June 2017.21 Nevertheless, China's government has just seized a company with assets over $300bn. Clearly the crackdown on the shadow financial sector has teeth (Chart 18). Anbang's case will reverberate beyond the handful of private companies involved in shadow banking and highly leveraged foreign acquisitions abroad. Beijing's focus is systemic risk, not merely innovative insurance products. The central government is scrutinizing state-owned enterprises (SOEs) and local governments as well as a range of financial companies and products. We provide a list of reform initiatives in Table 3. Table 3China Is Rebooting Economic Reforms Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China What is the cumulative effect of these three developments? Basically, they raise the stakes for Xi's policies dramatically this year. If Xi makes himself president for life, and yet this year's third plenum is as over-hyped and under-delivered as in 2013, then we would expect China's economic future to darken rapidly. China will lose any pretext of reform just as the United States goes on the offensive against Beijing's mercantilism. It would be time to short China on a long-term time line. However, it would also spell doom for our positive U.S. dollar outlook and bearish EM view. If, on the other hand, Xi Jinping couples his power grab with renewed efforts to restructure China's economy and improve market access for foreigners, then he has a chance of deleveraging, improving China's productivity, and managing tensions with the U.S. This is the best outcome for investors, although it would still be negative for Chinese growth and imports, and hence EM assets, this year. The next political indicator to watch is the March 5 NPC session. This legislative meeting will be critical in determining what precise reforms the Xi administration will prioritize this year. The NPC occurs annually but is more important this year than usual because it installs a new government for the 2018-23 period and will kick off the new agenda. In terms of personnel, there is much speculation (Table 4).22 Investors should stay focused on the big picture: four months ago, the news media focused on Xi Jinping's Maoist thirst for power and declared that all reform efforts were dead in the water. Now the press is filled with speculation about which key reformer will get which key economic/financial position. The big picture is that Xi is using his Mao-like authority in the Communist Party to rein in the country's economic and financial imbalances. His new economic team will have to establish their credibility this year by remaining firm when the market and vested interests push back, which means more policy-induced volatility should be expected. Table 4China's New Government Takes Shape At National People's Congress Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China The risk is that Beijing overcorrects, not that reforms languish like they did in 2015-16. Our subjective probability of a policy mistake remains at 30%, but we expect that the market will start to price in this higher probability of risk as the March political events unfold. As Liu He declared at Davos, China's reforms this year will "exceed the international community's expectations."23 The anti-corruption campaign is another important factor to monitor. In addition to any major economic legislation, the most important law that the NPC may pass is one that would create a new nationwide National Supervisory Commission, which will expand the Communist Party's anti-corruption campaign into every level of the state bureaucracy. In other words, an anti-corruption component is sharpening the policy effectiveness of the economic and financial agenda. In the aforementioned Anbang case, for instance, corporate chief Wu Xiaohui was stung by a corruption probe in June 2017 and is being tried for "economic crimes" - now his company and its counterparty risks are being restructured. The combination of anti-corruption campaign and regulatory crackdown has the potential to cause significant risk aversion among financial institutions, SOEs, and local governments. Add in the ongoing pollution curbs, and any significant SOE restructuring, and Chinese policy becomes a clear source of volatility and economic policy uncertainty this year that the market is not, as yet, pricing (Chart 19). On cue, perhaps in anticipation of rising domestic volatility, China has stopped updating its home-grown version of the VIX (Chart 20). Chart 19Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Market Expects No Political Volatility Yet Chart 20Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? Has China Halted Its Version Of The VIX? We would not expect anything more than a whiff, at best, of policy easing at the NPC this March. For instance, poverty alleviation efforts will require some fiscal spending. But even then, the point of fiscal spending will be to offset credit tightness, not to stimulate the economy in any remarkable way. Monetary policy may not get much tighter from here, as inflation is rolling over amid the slowdown (Chart 21),24 but anything suggesting a substantial shift back to easy policy would be contrary to our view. More accommodative policy at this point in time would suggest that Xi has no real intention of fighting systemic risk and - further - that global growth faces no significant impediment from China this year. In such a scenario, the dollar could fall further and EM would outperform. We expect the contrary. We are long DXY and short EUR/JPY. We remain overweight Chinese H-shares within emerging markets, but we will close this trade if we suspect either that reform is a fig leaf or that authorities have moved into overcorrection territory. Otherwise, reform is a good thing for Chinese firms relative to EM counterparts that have come to rely on China's longstanding commodity- and capital-intensive growth model (Chart 22). Chart 21Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Monetary Policy May Not Tighten From Here Chart 22Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Tighter-Fisted China Will Hit EM Bottom Line: Xi Jinping has rebooted China's economic reforms. The new government being assembled is likely to intensify the crackdown on systemic financial risk. Reforms will surprise to the upside, which means that Chinese growth is likely to surprise to the downside amidst the current slowdown, thus weighing on global growth at a time when populism provides a tailwind to U.S. growth. What It All Means For South Africa And Emerging Markets We spent a full week in South Africa last June and came back with these thoughts about the country's economy and the markets:25 The main driving force behind EM risk assets, year-to-date, has been U.S. TIPS yields and the greenback (Chart 23). Weak inflation data and policy disappointments as the pro-growth, populist, economic policy of the Trump Administration stalled have supported the ongoing EM carry trade. The actual emerging market growth fundamentals and politics are therefore unimportant. Chart 23Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Weak Inflation And Dollar Drove EM Assets Chart 24Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma Market Likes Ramaphosa, Unlike Zuma In the near term, South African politics obviously do matter. Markets have cheered the election of Cyril Ramaphosa to the presidency of the African National Congress (ANC), a stark contrast to the market reaction following his predecessor's ascendancy to the same position (Chart 24). However, the now President Ramaphosa's defeat of ex-President Jacob Zuma's former cabinet minister and ex-wife, Nkosazana Dlamini-Zuma was narrow and has split the ANC down the middle. On one side is Ramaphosa's pragmatic wing, on the other is Dlamini-Zuma's side, focused on racial inequality and social justice. Chart 25Chronic Youth Unemployment Chronic Youth Unemployment Chronic Youth Unemployment Chart 26Few Gains In Middle Class Population Few Gains In Middle Class Population Few Gains In Middle Class Population For now, the ANC bureaucracy has served as an important circuit-breaker that will limit electoral choices in the 2019 election to the pro-market Ramaphosa, centrist Democratic Alliance, and radical Economic Freedom Fighters. From investors' perspective, this is a good thing. After all, it is clear that if the South African median voter had her way, she would probably not vote for Ramaphosa, given that the country is facing chronic unemployment (Chart 25), endemic corruption, poor healthcare infrastructure, and a desire for aggressive, and targeted, redistributive economic policies. South Africa stands alone amongst its EM peers when it comes to its tepid rise in the middle class as a percent of the population (Chart 26) and persistently high income inequality (Chart 27). We see no evidence that the electorate will welcome pro-market structural reforms. Chart 27Inequality Remains Very High Politics Are Stimulative, Everywhere But China Politics Are Stimulative, Everywhere But China Nonetheless, Ramaphosa's presidency is a positive given the recent deterioration of South Africa's governance, which should improve as the new regime focuses on fighting corruption and restructuring SOEs. Whether Ramaphosa will similarly have the maneuvering room to correct the country's endemically low productivity (Chart 28) and still large twin deficits (Chart 29) is another question altogether. Chart 28A Distant Laggard In Productivity A Distant Laggard In Productivity A Distant Laggard In Productivity Chart 29Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Twin Deficits A Structural Weakness Will investors have time to find out the answer to those latter questions? Not if our core thesis for this year - that politics is a tailwind to U.S. growth and a headwind to Chinese growth - is right. In an environment where the U.S. 10-year Treasury yield is rising, DXY stabilizes, and Chinese economy slows down, commodities and thus South African assets will come under pressure. As our colleague Arthur Budaghyan, BCA's chief EM strategist, recently put it: positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. Bottom Line: Markets are cheering Ramaphosa's ascendancy to the South African presidency. We agree that the development is, all other things being equal, bullish for South Africa's economy and assets. However, the structural challenges are vast and we do not see enough political unity in the ANC to resolve them. Furthermore, we are not sure that the global macro environment will remain sanguine for long enough to give policymakers the time for preemptive structural reforms. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our recommendation to bet on yield curve steepening in South Africa, which has been flat since initiation on June 28, 2017. However, we will maintain our recommendation to buy South African 5-year CDS protection and sell Russian, even though it has returned a loss of 17.08 bps thus far. We expect that Russia will prove to be a low-beta EM play in the next downturn, whereas South Africa will not be so lucky. On a different note, we are booking gains of 2525bps on our short Venezeulan vs. EM 10-yr sovereign bonds, as our commodity team upgrades its oil-price forecast for this year. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 2 Please see the Congressional Budget Office, "Bipartisan Budget Act of 2018," February 8, 2018, available at www.cbo.gov. 3 Please see BCA The Bank Credit Analyst Monthly Report, "March 2018," dated February 22, 2018, available at bca.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Monthly Report, "Is Abenomics The Future?" dated February 11, 2015, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. 8 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds," dated February 20, 2018, available at usbs.bcaresearch.com. 9 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 10 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 11 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 12 Please see Tom Mitchell, "Xi's China: The Rise Of Party Politics," Financial Times, July 25, 2016, available at ft.com. See also BCA Geopolitical Strategy and China Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at www.bcaresearch.com. 13 "Carry Canary" indicator tracks the performance of EM/JPY carry trades. These trades short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian real, Russian ruble, or South African rand), and as such they are highly geared to a positive global growth back-drop. Please see BCA Foreign Exchange Strategy Weekly Report, "The Yen's Mighty Rise Continues ... For Now," dated February 16, 2018, available at fes.bcaresearch.com. 14 The other two battles are against pollution and poverty. 15 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 19 Consider that the standard political calendar would have called for Xi to make personnel adjustments at the second plenum (which was held in January), then to formalize those personnel changes at the legislature in March, and then to announce reform initiatives at the third plenum in the fall, leaving implementation until late in the year or even March 2019. Instead, all of this will be done by March of this year, leaving the rest of the year for implementation. 20 The Financial Stability and Development Commission was created last July at an important financial gathering that occurs once every five years. We dubbed it a "Preemptive Dodd Frank" at the time because of China's avowed intention to use it to tackle systemic financial risk. Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. The FSDC's purpose is to coordinate the People's Bank of China with the chief financial regulators - the banking, insurance, and securities regulatory commissions (CBRC, CIRC, and CSRC) and the State Administration of Foreign Exchange (SAFE). There is even a possibility under discussion (we think very low probability of happening) that the FSDC will preside above the central bank - though the precise organizational structure will remain unclear until it is formalized, probably during the March legislative session. 21 Anbang is part of a group of companies, including Foresea, Fosun, HNA, Ping An, and Dalian Wanda, that have been targeted over the past year for shady financial doings, corruption, excessive debt, and capital flight. In particular, Anbang was integral to the development of universal life products, which have been highly restricted since last year. These were not standard insurance products but risky short-term, high-yield shadow investment products. Investors could redeem them easily so there was a risk that purchasers could swamp insurance companies with demands for paybacks if investment returns fell short. This would leave insurance companies squeezed for cash, which in turn could shake other financial institutions. The systemic risk not only threatened legitimate insurance customers but also threatened to leave insurance companies unable to make debt payments on huge leveraged buyouts that they had done abroad. Anbang and others had used these and other shadow products to lever up and then go on a global acquisition spree, buying assets like insurance subsidiaries, hotels, and media/entertainment companies. The targeted firms are also in trouble with the central government for trying to divest themselves of China's currency at the height of the RMB depreciation and capital flight of 2015. They were using China's shadow leverage to springboard into Western assets that would be safe from RMB devaluation and Chinese political risk. The government wants outward investment to go into China's strategic goals (such as the Belt and Road Initiative) instead of into high-profile, marquee Western assets and brands. 22 Particularly over whether Xi Jinping's right-hand man, Liu He, will be appointed as the new central bank governor, to replace long-serving Governor Zhou Xiaochuan, and/or whether he will replace Vice Premier Ma Kai as chairman of the FSDC. It is important whether Liu He takes the place of central banker or chief reformer because those roles are so different. Making him PBoC chief would keep a reformer at the helm of a key institution at an important point in its evolution, but will raise questions about who, if anyone, will take charge of structural reform. Giving him the broader and more ad hoc role of Reformer-in-Chief would be reminiscent of Zhu Rongji at the historic NPC session in March 1998, i.e. very optimistic for reforms. Of course, Liu He is not the only person to watch. It is also important to see what role former anti-corruption czar Wang Qishan gets (for instance, leading U.S. negotiations) and whether rising stars like bank regulator Guo Shuqing are given more authority (he is a hawkish reformer). 23 Please see Xie Yu and Frank Tang, "Xi picks team of problem solvers to head China's economic portfolios," South China Morning Post, dated February 21, 2018, available at www.scmp.com. 24 Please see BCA China Investment Strategy Weekly Report, "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "South Africa: Crisis Of Expectations," dated June 28, 2017, available at gps.bcaresearch.com.

Highlights Federal Reserve: Is the U.S. neutral rate now higher? ECB: How much has the euro rally damaged European growth? Bank of Japan: Will a stronger yen tip Japan back into deflation? Bank of England: Will higher real wages offset Brexit uncertainties? Bank of Canada & Reserve Bank Of Australia: How much spare capacity truly exists? Feature We have not published a regular Weekly Report in Global Fixed Income Strategy since February 6th. We instead published necessary Special Reports on two countries of immediate relevance: Japan, because of the recent surprising strength in the yen, and Italy, because of the upcoming election. The pause in our regular commentary on the state of the markets, however, was useful. It has given us more time to reflect on the potential for a continuation of the global bond bear market after the volatility spike earlier in the month. What we find interesting is that, despite the common narrative that the back-up in global bond yields seen in 2018 has been about rising inflation fears, market pricing suggests the big shift has instead been in real bond yields and central bank policy expectations. In Table 1, we present the year-to-date change in the 10-year government bond yield for the major developed markets. We also show the changes in various other interest rate measures, including: Table 12018 Year-To-Date Changes In Government Bond Yield Components The Biggest Question Facing Each Central Bank The Biggest Question Facing Each Central Bank Our 12-month Policy Rate Discounters, which show the change in short-term interest rates priced into money market curves Our proxy measure of the market pricing of the real neutral ("terminal") interest rate - the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward Our estimate of the term premium on the 10-year government bond yield. What stands out in the table is that markets have moved to price in both a higher amount of expected rate hikes over the next year (Chart 1) and a higher neutral real interest rate, even with very little change in expected inflation. This can also been seen by looking at recent declines in the correlations between inflation expectations and nominal bond yields in the major economies, which are off from the peaks seen late in 2017 (Chart 2). Chart 1Rising Rate Expectations Have##BR##Been Pushing Yields Higher Of Late... Rising Rate Expectations Have Been Pushing Yields Higher Of Late... Rising Rate Expectations Have Been Pushing Yields Higher Of Late... Chart 2...Rather Than Higher##BR##Inflation Expectations ...Rather Than Higher Inflation Expectations ...Rather Than Higher Inflation Expectations The obvious conclusion is that the bulk of the rise in global bond yields seen year-to-date has been driven by increases in the real yield component, which itself has been heavily influenced by expected changes to central bank policy rates. Keeping that in mind, in this Weekly Report, we take a look at the most important question faced by each major central bank, and what that means for future decisions on policy interest rates - and by extension, for government bond yields. The Federal Reserve: "Is The U.S. Neutral Rate Now Higher?" With the 10-year U.S. Treasury yield having taken several runs at the critical 3% level in recent weeks, the debate has raged among investors as to whether that should be considered a breakout point or a buying opportunity. Comparing the U.S. economy now to what it looked like the last time the 10-year yield was at 3% at the end of 2013 suggests that yields could have more upside: Real GDP growth: 1.7% then, 2.3% now1 The unemployment rate: 6.7% then, 4.1% now Headline CPI inflation: 1.4% then, 2.1% now Core CPI inflation: 1.7% then, 1.8% now Average Hourly Earnings growth: 1.9% then, 2.9% now Growth is faster, there is less spare capacity, and inflation is higher now than it was just over four years ago. Yet when looking at the decomposition of the 10-year U.S. Treasury yield into its real and inflation expectations component (Chart 3, 2nd panel), we find that the mix is only slightly more skewed to real yields today: Chart 3Treasury Yields Still Have More Upside,##BR##Based On 2013 Comparisons Treasury Yields Still Have More Upside, Based On 2013 Comparisons Treasury Yields Still Have More Upside, Based On 2013 Comparisons Nominal 10-year Treasury yield: 3.03% then (December 31st, 2013), 2.87% now (February 26th, 2018) Inflation expectations (10-year CPI swap): 2.54% then, 2.30% now Real yields (nominal 10-year yield minus 10-year CPI swap): 0.49% then, 0.57% now In other words, the real yield today is 20% of the total nominal 10-year yield compared to 16% back at the end of 2013. Not a major difference. Yet there are much bigger discrepancies between the elements that go into our real neutral rate proxy for the U.S. (bottom two panels): 5-year OIS rate, 5-years forward: 4.1% then, 2.6% now 5-year CPI swap rate, 5-years forward: 2.9% then, 2.3% now Real neutral rate proxy: 1.2% then, 0.3% now The market is now pricing in a real neutral funds rate that is nearly one full percentage point below the level that prevailed the last time the 10-year Treasury yield reached 3% prior to 2018. Even though the U.S. economy is now growing faster, with far less spare capacity and higher inflation, than it did at the end of 2013. This does suggest that the level of the neutral real fed funds rate has likely gone up, which the 43bps increase in our market-implied real neutral rate proxy so far in 2018 is likely reflecting. But does the Fed actually believe that the neutral funds rate should be higher? The minutes from the January FOMC meeting, released last week, noted that there was discussion on the neutral funds rate, but one that was different than during previous FOMC meetings in 2017 - the actual appropriate level of the neutral funds rate was a topic of debate: "Some participants also commented on the likely evolution of the neutral federal funds rate. [...] the outlook for the neutral rate was uncertain and would depend on the interplay of a number of forces. For example, the neutral rate, which appeared to have fallen sharply during the Global Financial Crisis when financial headwinds had restrained demand, might move up more than anticipated as the global economy strengthened. Alternatively, the longer-run level of the neutral rate might remain low in the absence of fundamental shifts in trends in productivity, demographics, or the demand for safe assets."2 Any change in the Fed's estimation of the long-run neutral funds rate is critical for the future path of Treasury yields, given where market pricing is at the moment. The U.S. OIS curve has now fully converged to the FOMC interest rate projections (the "dots") for this year and next year. More importantly, the market-implied terminal rate (the nominal 5-year OIS rate, 5-years forward) has now caught up to the FOMC terminal rate dot (Chart 4). The implication is that any further meaningful increase in Treasury yields can only come from higher inflation expectations - unless the Fed signals that a higher neutral rate is required. Our colleagues at our sister publication, U.S. Bond Strategy, recently noted that the Fed has historically been much more reluctant to raise its terminal rate projection in response to rising inflation than it was in cutting the projection when inflation falls.3 The conclusion is that inflation expectations will likely need to return to levels consistent with the Fed's inflation target - 2.3-2.5% on both the 10-year TIPS breakeven rate and the 5-year breakeven rate, 5-years forward - before the Fed would make any significant upward revisions to its terminal rate projection. In the meantime, Treasury yields are more likely to see a near-term consolidation, as U.S. data surprises have rolled over, market positioning has become very short, momentum is oversold and market pricing has fully converged with Fed expectations (Chart 5). In terms of data, the release of the next U.S. Employment report on March 9th is critical for the Treasury market in the near term, given that the January uptick in wage growth was the trigger for the spike in bond yields, and subsequent equity market correction, at the beginning of February (bottom panel). Chart 4Could The Fed Move##BR##The Interest Rate 'Goalposts'? Could The Fed Move The Interest Rate 'Goalposts'? Could The Fed Move The Interest Rate 'Goalposts'? Chart 5Treasury Selloff May Be##BR##Due For A Pause Treasury Selloff May Be Due For A Pause Treasury Selloff May Be Due For A Pause The ECB: "How Much Has The Euro Rally Damaged European Growth?" The European Central Bank (ECB) has been slowly preparing markets for an eventual withdrawal of its extraordinary monetary policy stimulus since last summer. Specifically, the ECB has begun a discussion of what it would take to end its bond buying program. Already, the central bank cut the monthly pace of its asset purchases in half at the beginning of 2018, and the topic of "tapering" has come up in many speeches from ECB officials. The ECB has been trying to not present an overly hawkish message when discussing an eventual end to its hyper-easy monetary stance. The overall level of government bond yields - both in the core and Periphery of the Euro Area - has been drifting higher, but by less than the increases seen in the U.S. Inflation expectations have been rising since the middle of 2017, although most of the 23bps increase in the benchmark 10-year German Bund yield seen so far in 2018 can be attributed to rising real yields (Chart 6). The market-implied real neutral rate has also been increasing, but still remains below zero (-0.2%). Yet despite only the modest increase in European interest rate expectations, there has been a substantially larger move in the euro. The trade-weighted euro has bond up by 8% over the past year, bringing the currency back to levels last seen in 2014 (Chart 7, top panel). The appreciating euro has become a subject of focus by the ECB, although it is not yet a cause for worry according to the minutes of the January ECB meeting released last week: Chart 6Only A Modest Rise In European Yields, So Far Only A Modest Rise In European Yields, So Far Only A Modest Rise In European Yields, So Far Chart 7A Potential ECB Dilemma A Potential ECB Dilemma A Potential ECB Dilemma "[...] although the past appreciation of the euro had so far had no significant impact on euro area external demand, volatility in foreign exchange markets represented a further increase that need monitoring."4 Chart 8No Damage Yet To European##BR##Exports From The Euro Rally No Damage Yet To European Exports From The Euro Rally No Damage Yet To European Exports From The Euro Rally The ECB is correct that the rising euro has not yet impacted Euro Area exports, the growth rate of which remains solid at 8% (bottom panel). This contrasts sharply with the performance the last time the trade-weighted euro was at current levels in 2014, when exports were barely growing at all. The difference is a much stronger global economy that is demanding far more European goods and services now compared to four years ago. For now, the ECB can look to the stability of export demand as a sign that the euro has not become a drag on the economy, but some warning signals may be flashing. Euro Area economic data surprises have plunged sharply, and the manufacturing PMI data has been softer in the past couple of months (Chart 8). While the absolute levels of the PMIs suggest an economy that is still growing at an above-trend pace, a continuation of the recent drops could pose a problem for the ECB as it tries to communicate its next policy move to the markets. The surging euro has done very little to drag down overall Euro Area headline inflation, given the strength in global oil prices over the past year (3rd panel). Core inflation has struggled to stay much above 1% over the past year or so, but our core inflation diffusion index - which measures the number of core Euro Area HICP sectors with rising inflation rates versus those with falling inflation rates - has surged in the past couple of months, which typically leads to a faster rate of core inflation (bottom panel). As long as the Euro Area export growth data holds up, the ECB is likely to focus more on rising core inflation than a stronger euro and should begin signaling an end to the asset purchase program by year-end. The Bank Of England: "Will Faster Wage Growth Offset Brexit Uncertainty?" The Bank of England (BoE) has surprised markets with its more hawkish commentary of late, particularly given the reason for the change - faster wage growth. The BoE had previously been cautious on its outlook for the U.K. economy, which was suffering from two powerful drags. First, the uncertainty over the Brexit negotiations was dampening business confidence and restraining capital spending. Second, the surge in realized inflation following the post-Brexit collapse of the British Pound triggered a period of contracting real wages that would be a drag on consumer spending. Until these were resolved, the BoE would be cautious with its future policy moves. Next month's European Union (EU) summit can provide some news on Brexit, as the U.K. government will be seeking a transition agreement that would give U.K. businesses a firm timeline for the separation of the U.K. from the EU. The U.K. government is reported to be seeking a two-year period for the agreement, but it may take longer than that to hammer out all the deals involved with the contentious issues of trade, immigration, etc. The longer the Brexit transition period, the more likely that U.K. firms will hold back on long-term investment spending because of uncertainty. As for the wage side of the story, the annual growth rate of Average Weekly Earnings has increased from 1.7% to 2.6% since the April 2017 low, but this is still below the headline CPI inflation rate of 3% (Chart 9, bottom panel). With the U.K. unemployment rate at a cyclical low of 4.4% - far below the OECD's estimate of the full employment NAIRU rate of 5.1% - additional increases in wage growth are possible if hiring demand does not begin to slow. Yet with U.K. data surprises rolling over (top panel), and with the OECD's U.K. leading economic indicator decelerating (middle panel), there is a growing risk that economic growth will slow in the coming quarters, to the detriment of hiring activity and wages. The current market pricing shows that there remains a wide gap between U.K. inflation expectations and nominal Gilt yields (Chart 10). The real 10-year Gilt yield is -1.84% (deflated by CPI swaps), while the market-implied neutral real interest rate is -1.94%. While such a deeply negative interest rate is unlikely to be a permanent state of affairs in the U.K., such an accommodative policy setting is required to prevent the economy from falling into a deep slump. Chart 9Is The BoE More Worried About##BR##Wage Pressures Than Growth? Is The BoE More Worried About Wage Pressures Than Growth? Is The BoE More Worried About Wage Pressures Than Growth? Chart 10Real Gilt Yields Rising,##BR##But Still Very Low Real Gilt Yields Rising, But Still Very Low Real Gilt Yields Rising, But Still Very Low As we noted back in January, we do not see the BoE being able to raise rates much at all this year given the likelihood of prolonged sluggishness of the U.K. economy and some reversal of the currency-fueled surge in inflation seen in 2017.5 The BoE choosing to tackle rising wage inflation while growth was decelerating would be a huge policy error that would eventually benefit the performance of U.K. Gilts. The Bank Of Japan: "Will A Stronger Yen Tip Japan Back Into Deflation?" The extraordinary monetary policy accommodation provided by the Bank of Japan (BoJ) makes an analysis of Japanese Government Bond (JGB) yields far less interesting. After all, when the central bank is actively intervening in large quantities to hold the level of the 10-year JGB around 0%, do the signals sent from money market and bond yield curves have any meaning vis-à-vis the actual Japanese economy? Right now, the pricing of the real 10-year JGB yield (deflated by CPI swaps) is just below 0%, as is the real terminal rate proxy from the Japanese OIS curve (Chart 11). Keeping JGB yields at such low levels is part of the BoJ's attempt to raise Japanese inflation back towards the central bank's 2% yield target. The mechanism by which that should happen is through a weaker Japanese yen. Yet the yen has been showing surprising strength in recent weeks, most notably the USD/JPY exchange rate that has been falling in the face of rising U.S.-Japan interest rate differentials (Chart 12, top panel). Chart 11Negative Real Rates Still Necessary In Japan Negative Real Rates Still Necessary In Japan Negative Real Rates Still Necessary In Japan Chart 12An Unwelcome Rise In The Yen An Unwelcome Rise In The Yen An Unwelcome Rise In The Yen The risk going forward is that the strengthening yen will create a drag on headline Japanese inflation that has recently accelerated back to 1% (middle panel). Given that both core CPI and nominal wages barely growing at all (bottom panel), the odds are increasing that Japanese inflation could begin to move lower without getting anywhere close to the BoJ's 2% target. As we discussed in our recent Special Report, a much weaker yen (i.e. USD/JPY between 115 and 120) is the first necessary precondition before the BoJ would consider raising its yield target on the 10-year JGB.6 We had placed odds of no more than 20% that the BoJ would raise its yield target in 2018, but if the yen continues to hold firm or even strengthen further from current levels, those odds fall to zero. Bank Of Canada & Reserve Bank Of Australia: "How Much Spare Capacity Truly Exists?" We are lumping the Bank of Canada (BoC) and Reserve Bank of Australia (RBA) together in this report, as both are facing the same critical question. The BoC has already raised its policy rate three times since last summer, in response to accelerating growth and diminished spare capacity in Canada. Canadian bond yields have risen in response through higher inflation expectations, rising real yields and greater expected rate increases from the BoC (Chart 13). The real 10-year Canadian yield has risen back to the highs last seen in late 2013, while inflation expectations are not quite back to those levels - a similar story to that seen in the U.S. The BoC's own estimate of the Canadian output gap flipped into positive territory at the end of 2017, signifying that there was no longer any spare capacity in the Canadian economy (Chart 14, top panel). The signal from the Canadian labor market is similar, with the unemployment rate now at 5.9% - well below the OECD NAIRU estimate of 6.5% (middle panel). Yet Canadian inflation rates, both for headline and core CPI, are only at 1.7% and 1.5%, respectively - both not even at the midpoint of the BoC's 1-3% target band (bottom panel). At the same time, wages have been accelerating, with the annual growth rate of Average Hourly Earnings now up to a two-year high of 3.3%. Chart 13All Bond Yield Components Rising In Canada All Bond Yield Components Rising In Canada All Bond Yield Components Rising In Canada Chart 14Where's The Inflation? Where's The Inflation? Where's The Inflation? Such a wide gap between price inflation and wage growth does throw into the question if the BoC's own output gap estimate is correct. We expect Canadian price inflation to eventually begin to close the gap with wage inflation, which will keep the BoC on its current expected rate hiking path in 2018 as long as the economy does not begin to slow meaningfully. The CPI inflation reports will be the most important data to watch in Canada over the next few months to determine if our view will pan out. In Australia, the market pricing is nowhere near as hawkish as in Canada, with inflation expectations (10-year CPI swaps) having been stuck in a range between 2.2-2.4% for the past two years (Chart 15, 2nd panel). The market-implied neutral real interest rate is stuck at 0% and has not been sustainably above that level since 2014 (bottom panel). Yet, like Canada, there are questions about the true degree of slack in the economy. The Australian unemployment rate is currently at 5.5%, well below NAIRU (Chart 16, top panel). The last time that the Australian economy ran for so long beyond full employment was in 2010-11, when headline inflation breached the upper limit of the RBA's 1-3% target band (bottom panel). Yet the so-called "underemployment rate" - essentially, those working part-time that would like to work full-time - has been much higher in recent years and now sits at 8.3%. This also fits with the IMF's estimate of the Australian output gap, which is still a very large -1.8%. Chart 15Australian Yields Are Stuck In A Range Australian Yields Are Stuck In A Range Australian Yields Are Stuck In A Range Chart 16Very Different Than 2011-12 Very Different Than 2011-12 Very Different Than 2011-12 Given these signs of excess capacity in both the labor market and the overall economy, it is no surprise that Australian inflation has struggled to surpass even the 2% midpoint of the RBA target band. The implication is that the Australian NAIRU is much lower than the official OECD estimate, and that the RBA is under no pressure to contemplate any interest rate increases for at least the rest of 2018. Net-net, while both the BoC and RBA are facing questions over the true amount of spare capacity in their economies, the situation is much more bullish for Australian government bonds than Canadian equivalents given the greater slack Down Under. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 These are average quarterly growth rates of U.S. real GDP for the full calendar year of 2013 and 2017, respectively. 2 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20180131.pdf 3 Please see BCA U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20th, 2018, available at usbs.bcaresearch.com. 4 https://www.ecb.europa.eu/press/accounts/2018/html/ecb.mg180222.en.html 5 Please see BCA Global Fixed Income Strategy Weekly Report, "A Melt Up In Equities AND Bond Yields?", dated January 23rd, 2018, available at gfis.bcaresearch.com. 6 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Biggest Question Facing Each Central Bank The Biggest Question Facing Each Central Bank Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Fed: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Inflation: The headwinds working against inflation are set to fade this year. The core goods and medical care sectors will lead the way, but there are even tentative signs that the deceleration in shelter inflation might start to ease. Spread Product: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Feature One byproduct of this year's increase in Treasury yields is that market expectations for the near-term path of Fed rate hikes have converged with the Fed's most recent median projection (Chart 1). At present, the overnight index swap curve is priced for a fed funds rate of 2.19% by the end of this year and 2.54% by the end of 2019. The Fed's most recent median projection calls for a fed funds rate between 2% and 2.25% by the end of 2018, and of 2.75% by the end of 2019.1 Chart 1Market Expectations Have Converged With The Fed Dots Market Expectations Have Converged With The Fed Dots Market Expectations Have Converged With The Fed Dots This convergence makes the next few Fed meetings particularly interesting. Will the Fed revise up its rate projections, giving the market permission to push short-dated yields even higher? Or will the Fed continue to signal three hikes this year and 2-3 more in 2019, restraining the bear market in short-dated bonds? Fortunately, last week we received a lot of information to help us answer these questions. Several FOMC members made noteworthy public remarks and the Fed released the minutes from the January FOMC meeting. What To Expect From The March FOMC Meeting The Fed's Rosy Growth Outlook The minutes from the January FOMC meeting showed a great deal of optimism about the U.S. recovery, from both the Fed staff and FOMC participants. Chart 2Substantial Stimulus In The Pipeline Monetary Restraints Monetary Restraints The minutes noted that the Fed staff submitted stronger economic projections at the January meeting than at previous meeting, noting that: [T]he forecast for real GDP growth was revised up, reflecting a reassessment of the recently enacted tax cuts, along with higher projected paths for equity prices and foreign economic growth and a lower assumed path for the foreign exchange value of the dollar. It's important to note that while these projections include the impact of recent changes to the tax code, they do not include the potential impact from the newly proposed two-year appropriations bill that is poised to pass through Congress in the next few weeks. This bill is significant with large outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. Chart 2 demonstrates how much this spending bill and the recent tax cuts have altered the growth outlook. It shows two estimates of fiscal thrust, the initial economic impulse of changes in government tax and spending policies.2 One estimate is the IMF's baseline forecast that was made before the tax legislation was passed. That estimate showed that fiscal policy would have been contractionary this year, trimming about 0.5% from GDP, and only slightly expansionary in 2019. The second estimate, which incorporates both the tax legislation and the proposed spending bill, shows that the fiscal impulse will be +0.8% this year and +1.3% next year. A major turnaround, and the most stimulative fiscal policy since the immediate aftermath of the financial crisis. Staying The Course On Inflation At the January FOMC meeting the Fed saw a presentation on the performance of different inflation models, an exercise that is particularly important given that the Fed's traditional expectations-augmented Phillips curve model was not able to explain why prices decelerated last year. The staff concluded that while the prediction errors from Phillips curve-style models have been larger in recent years than during the 2001-07 period, they were not completely out of line with history. This synchs up with our own analysis. We re-created the Fed's expectations-augmented Phillips curve model using details from a speech given by Janet Yellen in 2015 (Chart 3).3 That model certainly shows a large prediction error in 2017, but one that is not inconsistent with past errors. The message is that 2017 was not an outlier in terms of the Fed's ability to forecast inflation, but rather that inflation is quite often difficult to forecast. The Fed staff did provide a couple reasons for why inflation lagged the model's predictions last year: [S]tructural changes in the price setting for some items, such as medical care, and the effects of idiosyncratic price shocks, such as the unusual drop in prices of wireless telephone services. And also forecast that inflation would reverse course in 2018: [C]ore PCE prices were forecast to rise notably faster in 2018, importantly reflecting both the expected waning of transitory factors that held down 12-month inflation measures in 2017 as well as the projected further tightening in resource utilization. We agree with this assessment. In fact, both CPI and PCE inflation measures have formed tentative troughs in the past few months and should see further near-term upside from both the core goods and medical care components (Chart 4). Core goods inflation has still not caught up with accelerating import prices (Chart 4, panel 2) and the PPI data show a recent large jump in health-care prices (Chart 4, panel 3). Chart 3The Fed's Inflation Model The Fed's Inflation Model The Fed's Inflation Model Chart 4Inflation Headwinds Will Fade Inflation Headwinds Will Fade Inflation Headwinds Will Fade On medical care, research from the San Francisco Fed has shown that a major reason for lower inflation in recent years has been the slower growth of Medicare payments to physicians and hospitals as mandated by the Affordable Care Act. But these payments are also forecast to grow 2% this year, much higher than the 0.6% growth seen last year and the 0.9% growth seen in 2016.4 It is even possible that the deceleration in shelter inflation could moderate in the months ahead, given the renewed decline in the rental vacancy rate (Chart 4, panel 4). Meanwhile, we continue to expect that stronger wage growth will eventually pressure core services inflation (excluding shelter and medical care) higher (Chart 4, bottom panel). But What Are They Saying? Even though the minutes conveyed a decidedly optimistic tone with regards to both growth and inflation, Fed speakers were much more cautious last week. Philadelphia Fed President Patrick Harker said that "based on the relatively strong economy, but the continued stubbornness of inflation, I've penciled in two hikes for 2018." Atlanta Fed President Raphael Bostic said he is "comfortable continuing with a slow removal of policy accommodation" but also that "that doesn't necessarily mean as many as three or four moves per year." St. Louis Fed President James Bullard also said that 100 basis points of rate hikes in 2018 "seems like a lot." At the very least it appears that upward revisions to GDP growth forecasts are not sufficient for these three members to revise their rate projections higher. But these three members also already projected shallower paths for rate hikes than the median FOMC member (Table 1). Table 1Composition Of The FOMC Monetary Restraints Monetary Restraints More important is whether FOMC members whose projections are consistent with the median - those with a "neutral" policy bias in Table 1 - are inclined to get more hawkish. One of those members is San Francisco Fed President John Williams who said last week that "it makes sense to think about three or four rate increases in 2018." Chart 5Still Not Back To Target Still Not Back To Target Still Not Back To Target At the moment, the median Fed projection calls for three rate hikes in 2018, and that median will only move higher in March if four out of the six members who currently forecast three hikes this year decide to increase their dots. Given the cautious tone struck by most Fed speakers last week, we think the odds of an upward revision to the Fed's 2018 rate hike forecasts at the March meeting are low. Bottom Line: The Fed is getting more optimistic on growth and continues to forecast a rebound in inflation. Nevertheless, the March FOMC meeting is probably too soon to expect an upward revision to the Fed's rate hike expectations. Our own assessment is that the headwinds working against inflation are set to fade this year and that 3-4 Fed rate hikes are likely. In either case, bond yields are still biased higher given that they are still not priced for an eventual return of inflation to the Fed's target (Chart 5). Maintain a below-benchmark duration stance. Searching For Late-Cycle Value In Spread Product As we have noted repeatedly in recent reports, we anticipate that we will start to de-risk the spread product side of our U.S. bond portfolio sometime in 2018, possibly quite soon depending on the future path of inflation.5 So this week we perform a survey of investment grade spread product sectors, with an eye towards identifying sectors that look attractively valued and also present a low risk of spread widening. Our primary tool for identifying value is the 12-month breakeven spread. The 12-month breakeven spread is the basis point spread widening required on a 12-month horizon for a sector to earn zero excess returns versus a duration-equivalent position in Treasury yields.6 Table 2 shows the 12-month breakeven spread for each sector split by credit rating. Table 212-Month Breakeven Spreads By Credit Rating Monetary Restraints Monetary Restraints The first thing we notice is the attractive spreads offered by municipal bonds after adjusting for the tax advantage. In fact, for investors exposed to the top marginal tax rate, the 12-month breakeven spread on a Aaa-rated municipal bond exceeds the spread offered by a Baa-rated corporate bond. We have previously noted that when the tax-adjusted spread on a 10-year Aaa-rated municipal bond exceeds the spread offered by the duration-matched investment grade corporate bond index, it has historically been a signal that the credit cycle is very late. We are not seeing this signal yet, but it is getting very close (Chart 6). The second observation that jumps out is that USD-denominated Sovereign debt is not attractive compared to U.S. corporate debt. This is true across the entire investment grade credit spectrum. Further, Chart 7 shows that Sovereign bonds typically exhibit greater excess return volatility than U.S. corporate bonds. Chart 6Positive Muni/Corporate Spreads##br## Are A Late-Cycle Indicator Positive Muni/Corporate Spreads Are A Late-Cycle Indicator Positive Muni/Corporate Spreads Are A Late-Cycle Indicator Chart 712-Month Breakeven Spread Versus ##br##Excess Return Volatility Monetary Restraints Monetary Restraints We anticipate getting an opportunity to shift out of corporate bonds and into Sovereign debt at some point during the next 12 months, but expect some poor performance from Sovereign bonds first. A quicker expected pace of Fed rate hikes has historically coincided with Sovereign bond underperformance (Chart 8), and if that plays out while growth outside the U.S. starts to moderate - a risk that has been flagged by both our leading indicators for the Chinese economy and the performance of EM/JPY currency carry trades - then this would further exacerbate the underperformance of Sovereign bonds by putting upward pressure on the U.S. dollar.7 A third observation from Table 2 is that Foreign Agency bonds look very attractive, and Chart 7 also shows that the sector has historically exhibited quite low volatility. Foreign state-owned energy companies make up a large portion of the Foreign Agency index, and this sector's performance closely tracks the price of oil (Chart 9). With our commodity strategists now calling for average 2018 crude oil prices of $74/bbl and $70/bbl for Brent and WTI respectively, the Foreign Agency sector should stay well supported.8 Local Authority bonds are also attractively valued, though to a lesser extent than Foreign Agencies, and also tend to exhibit relatively low excess return volatility. We continue to recommend an overweight position in this sector that is comprised principally of taxable municipal debt and USD-denominated Canadian provincial bonds. Chart 8Underweight Sovereigns Underweight Sovereigns Underweight Sovereigns Chart 9Overweight Foreign Agencies Overweight Foreign Agencies Overweight Foreign Agencies Finally, we notice that credit card and auto loan backed Consumer ABS offer very attractive spreads and relatively low volatility. While we retain a neutral allocation to Consumer ABS, we note that credit trends are starting to shift against the sector. Bank are now tightening lending standards on both credit cards and auto loans, and the delinquency rate has made a cyclical bottom (Chart 10). Aaa-rated non-Agency CMBS also offer an attractive breakeven spread, though this sector has historically been much more volatile. Here too we see that banks are tightening lending standards, but the tightening has moderated in recent quarters. If this continues then delinquencies could start to roll over and property prices could start to accelerate (Chart 11). We remain underweight non-agency CMBS for now, but note the tentative improvement in credit quality. Chart 10Neutral Consumer ABS Neutral Consumer ABS Neutral Consumer ABS Chart 11A Nascent Improvement In Credit Quality A Nascent Improvement In Credit Quality A Nascent Improvement In Credit Quality Bottom Line: A survey of investment grade bond sectors shows that municipal bonds, Foreign Agency bonds and Local Authority bonds are all attractively valued relative to corporates. In contrast, USD-denominated Sovereign bonds are expensive. At the upper-end of the credit spectrum, Consumer ABS offer good value but deteriorating credit fundamentals. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We exclude the forecast provided by the St. Louis Fed President as an outlier and calculate the median from the remaining forecasts. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percentage of GDP. 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.frbsf.org/economic-research/publications/economic-letter/2017/november/contribution-to-low-pce-inflation-from-healthcare/ 5 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 6 We calculate the 12-month breakeven spread as the average index option-adjusted spread divided by the average index duration. We ignore the impact of convexity. 7 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 8 Please see Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22, 2018, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights BCA has shifted its view on how fiscal policy will impact the U.S. economy, the path of S&P 500 earnings growth and the 10-year Treasury yield. While we remain positive on risk assets, the U.S. is in the late innings of the expansion and markets have entered a new, more volatile phase. The FOMC will continue to monitor financial stability under Powell and raise rates four times in 2018. Feature The S&P 500 and other risk assets continued their recovery last week after an early February swoon. Equity volatility ebbed, but remains well above levels seen at the start of the year. The dollar rose while the 10-year Treasury yield stabilized near 2.90%. WTI oil prices climbed above $63/bbl, but remain below BCA Commodity & Energy Strategy's revised $70 target for 2018.1 It was a quiet week for economic data and news. The U.S. data that was released (initial claims, existing home sales, leading economic indicators) continue to suggest that the U.S. economy will grow well above its long term potential in the next few quarters. The data calendar is full this week, and investors will focus on Fed Chair Jay Powell's Monetary Policy testimony to Congress on Tuesday, February 27. Changes BCA has shifted its view on how fiscal policy will impact the U.S. economy, the path of S&P 500 earnings growth and the 10-year Treasury yield. Notably, minutes from the FOMC's January meeting suggest that the Fed's forecast for above-trend growth and higher inflation solidified after the Tax Cut and Jobs Act of 2017 passed late last year. The influence of the tax bill, coupled with the Senate deal on spending, has turned the fiscal impulse positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger at 1.3% (Chart 1). Our expectation in early January was that the direct effect of the tax cuts would likely boost U.S. real GDP growth in 2018 by only 0.2 to 0.3 percentage points. The U.S. budget deficit will likely jump to about 5.5% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast (Chart 2). This increase reflects the tax cuts, but also outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to the deficit. The additional fiscal stimulus will lift nominal GDP growth as well. Stronger nominal growth and a patient Fed will be a positive combination for risk assets, such as corporate bonds and equities. Chart 3 provides an update of our top-down forecast for the S&P 500 operating profits, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, compared with our previous forecast, the projected peak will occur later in the year and at a higher level, and the entire profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart 1Substantial Stimulus In The Pipeline Late Innings Late Innings Chart 2U.S. Budget Deficit To Reach 5 1/2 % In 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 Chart 3The Profile For S&P 500 EPS Growth Shifts Up The Profile For S&P 500 EPS Growth Shifts Up The Profile For S&P 500 EPS Growth Shifts Up BCA's U.S. Bond Strategy service raised its year-end target for the 10-year Treasury yield from around 3% to 3.3-3.5%, partly reflecting the U.S. fiscal shock.2 Nonetheless, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Bottom Line: Fiscal stimulus will extend the expansion to 2020, but faster growth in the coming quarters will deepen the next recession. BCA's stance remains that the next economic downturn will be triggered by the Fed's overtightening. BCA's recommended asset allocation remains unchanged: overweight risk assets and below-benchmark on duration. In fixed-income portfolios, we will probably trim corporate bond exposure to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The End Of The Low-Vol Period While we remain positive on risk assets, the U.S. is in the late innings of the expansion and markets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart 4). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in the February Bank Credit Analyst.3 Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart 5). Industrial production in the advanced economies is in hyperdrive as global capital spending growth accelerates (Chart 6). Chart 4February's Volatility Reset February's Volatility Reset February's Volatility Reset Chart 5Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Chart 6... Partly Due to Capex Acceleration ... Partly Due to Capex Acceleration ... Partly Due to Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality.4 Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed. Then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Vol Spike The spike in equity volatility in early 2018 was extreme. Table 1 shows 10 episodes when the VIX climbed by more than 10% in a 13-week period when the economy was not in recession. The equity price index fell by an average of 7% during those episodes, with a range of -3.6 to -18.1%. Our November 13, 2017 report discussed volatility and its relationship with the business cycle, monetary policy and economic volatility.5 In that report, we noted that "any meaningful pickup in inflation would upset the 'low vol' applecart." Table 1Episodes When VIX Spiked Late Innings Late Innings Table 1 and Chart 7 show that a spike in volatility does not signal the end of the business cycle. However, 6 of the 10 of the upheavals outside of recessions occurred during the late stages of the business cycle. The step-up in volatility in 2010, 2011 and 2015 arose mid-cycle, while only one (2002) was in the early stages of an expansion. On average, the economic expansion lasted for an additional 41 months after the spikes noted in Table 1. Investors should be aware that the recent surge in volatility is another signal that the economy is in the final stages of the expansion. Chart 7Spikes In Vol Typically Occur Late In The Economic Cycle Spikes In Vol Typically Occur Late In The Economic Cycle Spikes In Vol Typically Occur Late In The Economic Cycle Volatility is not a leading indicator of equity prices. While U.S. equity prices declined during each of the episodes in Table 1, none marked the start of a bear market. U.S. stock prices were higher a year after a spike in vol in 8 of 9 episodes. The average interval between the spikes and the end of the bull market was 45 months. While there are many examples of shifts in correlation around elevated equity volatility, there is no consistent relationship between the two. Chart 8 examines the relationship between spikes in equity volatility and correlations among several key U.S. asset classes. For example, the relationship between the S&P 500 and the 10-year Treasury yield (panel 1) changed direction in about half of the 10 periods of higher vol. The correlation between the 10-year Treasury and the U.S. dollar changed in 7 of the 10 occasions (panel 2). Panel 6 shows that shifts in correlation between real Treasury yields and the S&P 500 tend to coincide with periods of higher equity volatility. On balance, however, it is not clear that a spike in equity volatility leads to widespread changes in the relationships between asset classes. Chart 8Spike In Vol Vs Stock,Bond Dollar, Oil Correlations Spike In Vol Vs Stock,Bond Dollar, Oil Correlations Spike In Vol Vs Stock,Bond Dollar, Oil Correlations Chart 9A shows that the correlation between S&P 500 and HY spreads do tend to flip near peaks in equity vol. Shifts in correlation between U.S. equity prices and most commodities change course more often than not around a surge in equity vol. Chart 9B shows a clear relationship between spikes in equity vol and changes in intra-S&P 500 correlations. Chart 9ASpikes In Vol Vs S&P 500 Correlation To HY And Commodities Spikes In Vol Vs S&P 500 Correlation To HY And Commodities Spikes In Vol Vs S&P 500 Correlation To HY And Commodities Chart 9BSpikes In Vol Vs Intra-S&P 500 Correlations Spikes In Vol Vs Intra-S&P 500 Correlations Spikes In Vol Vs Intra-S&P 500 Correlations The Fed's Third Mandate Revisited Chart 10FOMC Closely Monitoring Financial Stability FOMC Closely Monitoring Financial Stability FOMC Closely Monitoring Financial Stability BCA views financial stability as a third mandate6 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the January meeting by both Fed staff and voting FOMC members (Chart 10). However, the meeting ended prior to early February's turmoil in the stock market. Former Fed Chair Janet Yellen elevated financial stability during her tenure, leading discussions or staff briefings in 26 of the 32 meetings. New Fed Chair Jay Powell is expected to continue Yellen's lead and will likely face questions on financial stability this week from Congress, as he delivers testimony related to the Fed's semiannual Monetary Policy Report. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment (also moderate) was only in January 2016. Since then, the FOMC stepped up its discussions of financial stability. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated financial stability at all but 1 of its 8 meetings in 2017, and in 13 of the 15 since April 2016. At the January meeting, Fed staff noted that valuations in financial assets were high, but that vulnerabilities due to leverage in the nonfinancial sector appeared to remain moderate. Fed staff downplayed risks in the financial sector associated with leverage and from maturity and liquidity transformation. Fed economists recently updated their quantitative assessments of the FOMC's minutes.7 The note provides a guide (Table 1 in the Fed paper and Table 2 below) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the committee's latest views on financial stability, inflation and the impact of fiscal policy. FOMC meeting participants seemed less concerned with financial stability at the January meeting. That may change at the next meeting given the recent upheaval in financial markets. A couple of FOMC participants raised concerns that "a step-up in the pace of economic growth could tighten labor market conditions even more than they currently anticipated, posing risks to inflation and financial stability associated with substantially overshooting full employment". According to the FOMC minutes, for the second consecutive meeting, there was no assessment of overseas financial stability. However, at the October 2017 meeting, Fed staff had assessed overall vulnerabilities to foreign financial stability as moderate. Moreover, the staff highlighted specific vulnerabilities in some foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sectors, rising property prices, overhangs of sovereign debt and susceptibility to political developments. Table 2FOMC Minutes Rubric Late Innings Late Innings Some FOMC participants raised the prospect that inflation would continue to fall short of the Committee's objectives, adding they observed no significant wage or inflationary pressures. However, they counselled patience before deciding whether to increase the target range for the federal funds rate. Notably, however, almost all participants continued to anticipate that inflation would move up to the Committee's 2 percent objective over the medium term as economic growth remained above trend and the labor market stayed strong. There were extensive comments from both Fed staff and FOMC participants about the impact of fiscal policy on views of the economy and inflation. Fed staff continued to assume that the tax cuts would boost real GDP growth moderately in the medium term. Moreover, they noted that the unemployment rate was projected to decline further in the next few years and would continue to run well below the staff's estimate of the longer-run natural rate of unemployment in that timeframe. FOMC participants, on the other hand, noted that there was still some uncertainty about how the tax bill would affect companies' investment or compensation plans. A number of participants bumped up their forecasts for economic growth in the near term, due in part to the bill's positive impact. Bottom Line: We maintain our base case scenario: the FOMC will continue to monitor financial stability under Powell and raise rates four times in 2018. The FOMC has revised up growth, but is reluctant to signal a faster pace of rate hikes until it sees how the fiscal impulse affects growth and inflation. This means they will be "behind the curve" as inflation lifts. However, once realized inflation climbs and inflation expectations approach 2.3%, the FOMC will have to get more aggressive. At that point, because the Fed would be targeting slower growth to curb inflation, another 'vol shock' is likely. This would be a negative signal for risk assets. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Getting Comfortable With Higher Prices", February 22,2018. Available at ces.bcaresearch.com. 2 Please see BCA Research U.S. Bond Strategy Weekly Report "Two Stage Bear Market In Bonds," February 13, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, March 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Patience Required", published November 13, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate", published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm

We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends March 2018 March 2018 As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. Chart II-2Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. Chart II-3Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs March 2018 March 2018 The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM BOTTOM-UP IG CHM BOTTOM-UP IG CHM Chart II-5Bottom-Up HY CHM BOTTOM-UP HY CHM BOTTOM-UP HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging March 2018 March 2018 Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta March 2018 March 2018 Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta March 2018 March 2018 Chart II-8Interest Coverage Ratio Vs. Earnings Beta March 2018 March 2018 Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Char II-9Debt Maturing In Next ##br##Three Years (% Of Total) March 2018 March 2018 Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Interest Coverage Ratio Headed To New Lows Interest Coverage Ratio Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com.

Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline March 2018 March 2018 Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots U.S. Inflation Green Shoots U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset February's Volatility Reset February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration ... Partly Due to Capex Acceleration ... Partly Due to Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating Government Bond Supply is Accelerating Government Bond Supply is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment U.S. Net International Investment U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing Oil Inventory Correction Continuing Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends March 2018 March 2018 Chart II-2Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 Chart II-3Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs March 2018 March 2018 The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM BOTTOM-UP IG CHM BOTTOM-UP IG CHM Chart II-5Bottom-Up HY CHM BOTTOM-UP HY CHM BOTTOM-UP HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging March 2018 March 2018 Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta March 2018 March 2018 Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta March 2018 March 2018 Chart II-8Interest Coverage Ratio Vs. Earnings Beta March 2018 March 2018 Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) March 2018 March 2018 Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Interest Coverage Ratio Headed To New Lows Interest Coverage Ratio Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI 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 bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The euro is cheap. To cease being cheap, EUR/USD needs to approach 1.35. Euro area bonds are expensive. To cease being expensive, the yield spread between the euro area and U.S. long bond needs to compress from -135 bps to -40 bps. Never pick mainstream stock markets on the basis of seeming cheapness. Sector effects, step changes in sector valuations and currency effects make relative valuations very difficult to interpret. Always pick mainstream stock markets on the basis of the sector and currency biases you wish to express. Overweight Denmark's OMX and Ireland's ISEQ on a 6-9 month horizon. Feature A very common question we get asked is: are European investments attractively priced compared to those elsewhere in the world? To which the current answers are: yes for the euro currency; no for euro area government bonds; and highly unlikely for the aggregate European stock market. That said, we can still identify individual European stock markets that are well placed to outperform major equity indexes, including the S&P500, over the coming 6-9 months. Chart of the WeekWhen Healthcare Outperforms, Denmark's OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 When Healthcare Outperforms, Denmark"s OMX Outperforms The S&P 500 The Euro Is Cheap... Says The ECB We can confidently claim that the euro is cheap because the ECB's own indicators say so.1 According to the ECB, the euro needs to appreciate at least 7% to cancel the euro area's over-competitiveness versus its top 19 trading partners. In terms of EUR/USD this translates to 1.32. Admittedly, 1.32 encapsulates a spectrum of fair values for the individual euro area economies: 1.45 for Germany; around 1.30 for France, Spain and Netherlands; and around 1.20 for Italy (Chart I-2). Chart I-2The Euro Needs To Appreciate 7% To Cancel The Euro Area's Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The Euro Needs To Appreciate 7% To Cancel The Euro Area"s Over-Competitiveness The ECB indicators also assume that the euro began its life close to fair value. This seems plausible. Twenty years ago, the euro area's constituent economies were broadly in internal balance and had a lot in common. Remarkably, Germany and Italy scored identically on total debt as a share of GDP as well as on exports as a share of GDP. Furthermore, euro area trade was in external balance, and the bloc's real competitiveness versus its major trading partners was exactly in line with its long-term average. After its birth, the euro first became extremely undervalued in the dot com bubble, then extremely overvalued in the global credit boom, and most recently, extremely undervalued again. Seen in this bigger picture, the euro's current ascent is just a recovery from an extreme undervaluation, an argument that even Mario Draghi made at the last ECB press conference: "Movements in the exchange rate, to the extent that it is justified by the strengthening of the economy, is part of nature." At what level would EUR/USD cease to be cheap? Based on the average of the ECB's three competitiveness indicators, EUR/USD needs to approach 1.35. Euro Area Bonds Are Expensive The yield spread between the euro area and U.S. long bond stands at an extreme -135 bps.2 This compares with an average -40 bps through the twenty year life of the euro - indicating that euro area government bonds are very expensive relative to U.S. T-bonds. Over the completion of this cycle, this yield spread is highly likely to compress to its long-term average of -40 bps, given that the yield spread just tracks relative real GDP per head - which is itself mean-reverting (Chart I-3). Interestingly, the euro area versus U.S. annual inflation differential has also averaged -40 bps (Chart I-4), so the real interest rate differential has averaged zero. This means that the so-called 'neutral' (or mid-cycle) real interest rates in the euro area and the U.S. have been identical through the past twenty years. Growth in real GDP per head has also been identical (Chart I-5). Chart I-3Euro Area-U.S.: Average Interest ##br##Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Euro Area-U.S.: Average Interest Rate Differential = -40bps Chart I-4Euro Area-U.S.: Average Inflation ##br##Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Euro Area-U.S.: Average Inflation Differential = -40bps Chart I-5The Euro Area And U.S. Have Generated##br## Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The Euro Area And U.S. Have Generated Identical Growth Per Head The past twenty years provide a good template for what the future holds, at least in relative terms if not in absolute terms. This is because 1999-2018 captures multiple manias and crises, some centred in Europe, some in the U.S. With no difference in neutral real rates over the past two decades, is there any reason to expect the future neutral rate to be meaningfully lower in the euro area compared to the U.S.? Our starting assumption has to be no. This assumption would be at risk if the existential threat to the euro resurfaced. Looking at the political calendar, the immediate concern might be the Italian election on March 4. Specifically, the anti-establishment Five Star Movement and Northern League could poll well enough to hold some sway in the next government and ruffle the markets. However, while both the Five Star Movement and Northern League have agendas that are unashamedly disruptive, anti-establishment and anti-austerity, neither party is standing on an anti-euro platform. Unless there is a major change in emphasis, the Italian election should not pose an existential threat to the euro. Our central expectation is that the euro area versus U.S. yield spread has the scope to compress substantially from its current -135 bps. In other words, euro area government bonds are very expensive relative to U.S. T-bonds. Never Pick Stock Markets On The Basis Of Seeming Cheapness Compared with currencies and bonds, stock markets are much less connected with their domestic economies. Mainstream stock markets are eclectic collections of multinational companies, with each stock market possessing its own unique fingerprint of sector and industry skews. Therefore, a head-to-head comparison of European stock market valuations either with each other or with non-European stock markets is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, Financials and Personal Products (Chart I-6) - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the cheaper sector. By extension, a stock market with a lower valuation because of its sector fingerprint is not necessarily a cheaper stock market. Chart I-6Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Two Sectors With Vastly Different Growth Prospects Will Trade On Vastly Different Valuations Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem with this standard deviation approach is that it assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations can and do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is like comparing an apple with an orange. Another issue for stock markets that contain multinational companies is the so-called 'currency translation effect'. A multinational company will intentionally diversify its sales and profits across multiple major currencies - say, euros, dollars and yen - but of course its primary stock market listing will be in just one currency - say, euros. So when the other currencies weaken versus the euro, the company's profit growth (quoted in its home currency of euros) will necessarily weaken too. If investors anticipate this effect - because they see that the euro is structurally cheap today - they might downgrade the stock market's profit growth expectations. Thereby, they will also downgrade the stock market's valuation. Pulling together these complexities of sector effects, step changes in sector valuations and currency effects, we offer some very strong advice: picking stock markets on the basis of relative valuation is a wrong and very dangerous way to invest. The correct and safe way to invest is to pick stock markets on the basis of the sector and currency biases you wish to express (Chart I-7). This brings us to one of the major advantages of investing in Europe. The plethora of stock markets - each with their own unique fingerprint of sector and industry skews - means that there are always European bourses worth overweighting, whatever your economic outlook. Right now, two of our sector recommendations are to overweight Healthcare and to underweight Energy. Please review our report Beware The Great Moderation 2.0 for the underlying thesis, which we will not repeat here.3 If these sector recommendations pan out as we expect, Denmark's OMX is highly likely to outperform the S&P500 given the OMX's substantial overweighting to Healthcare (Chart of the Week). Likewise, Ireland's ISEQ is highly likely to outperform the S&P500 given the ISEQ's substantial underweighting to Energy via its large exposure to budget airline Ryanair (Chart I-8). Chart I-7Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs.##br## 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Eurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Chart I-8When Energy Underperforms, Ireland's ##br##ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 When Energy Underperforms Ireland"s ISEQ Outperforms The S&P 500 Overweight Denmark's OMX And Ireland's ISEQ. A final salutary observation illustrates the importance of the sector approach to picking stock markets. As a result of favourable sector biases - overweight Healthcare, underweight Energy - a 50:50 combination of Denmark and Ireland has kept pace with the S&P500 over the past 20 years, while the Eurostoxx50 has been left a very long way behind (Chart I-9). Chart I-9Sector Biases Helped Denmark's OMX And Ireland's ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Sector Biases Helped Denmark"s OMX And Ireland"s ISEQ, But Hindered The Eurostoxx 50 Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Available at https://www.ecb.europa.eu/stats. The ECB calculates three Harmonised Competitiveness Indicators for the euro area versus its top 19 trading partners based on unit labour costs (ULCs), GDP deflators, and consumer price indices (CPIs), with the latest readings referring to Q3 2017 for ULCs and GDP deflators and January 2018 for CPIs. Updating these for the euro's move to February 20 2018, the three indicators suggest that the trade-weighted euro is still undervalued by 7%, 12% and 7% respectively. 2 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. 3 Please see the European Investment Strategy Weekly Report 'Beware The Great Moderation 2.0' published on February 1, 2018 and available at eis.bcaresearch.com. ­­ Fractal Trading Model* This week our fractal model has produced a very interesting finding. The 130-day fractal dimension for the U.S. 10-year T-bond is approaching a level which has consistently signalled a technical inflection point. This suggests that the recent sell-off in bonds might be close to running its course. We are not putting on a countertrend position yet, but expect to do so within the next few weeks. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long U.S. 10-Year Gov. Bond Long U.S. 10-Year Gov. Bond 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The call on EM local bonds boils down to the outlook for EM exchange rates. Forthcoming EM currency depreciation will halt the rally in local bonds. EM currencies positively correlate with commodities prices but not with domestic real interest rates. Widening U.S. twin deficits are not a reason to be long EM currencies. There has historically been no consistent relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. For investors who have to be invested in EM domestic bonds, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Feature The stampede into EM local currency bonds has persisted even amid recent jitters in global equity markets. Notably, surging U.S./DM bond yields have failed to cause a spike in EM local yields, despite past positive correlations (Chart I-1). Chart I-1Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? Will EM Domestic Bond Yields Continue Defying Rising U.S. Treasury Yields? The main reason is the resilience of EM currencies. The latter have not sold off even during the recent correction in global share prices. In high-yielding EM domestic bond markets, total returns are substantially affected by exchange rates. Not only do U.S. dollar total returns on local bonds suffer when EM currencies depreciate, but also weaker EM exchange rates cause spikes in domestic bond yields (Chart I-2). Consequently, the call on EM local bonds, especially in high-yielding markets, boils down to the outlook for EM exchange rates. Chart I-2EM Currencies Drive EM Local Yields EM Currencies Drive EM Local Yields EM Currencies Drive EM Local Yields We are negative on EM currencies versus the U.S. dollar and the euro. The basis for our view is two-fold: Strong growth in the U.S. and higher U.S. bond yields should be supportive of the greenback vis-à-vis EM currencies; the same applies to euro area growth and the euro against EM exchange rates; Weaker growth in China should weigh on commodities prices and, in turn, on EM currencies. So far, this view has not played out. In fact, negative sentiment on the U.S. dollar has recently been amplified by concerns about America's widening fiscal and current account deficits. In fact, one might argue that EM local bonds stand to benefit from the potential widening in U.S. twin deficits and the flight out of the U.S. dollar. We address the issue of U.S. twin deficits first. Twin Deficits And The U.S. Dollar... The recent narrative that the dollar typically depreciates during periods of widening twin deficits is not supported by historical evidence. We are not suggesting that twin deficits lead to currency appreciation. Our argument is that twin deficits have historically coincided with both appreciation and depreciation of the U.S. dollar. Chart I-3 exhibits the relationship between the U.S. dollar and the fiscal and current account balances. It appears that there is no consistent relationship between the fiscal and current account balances and the exchange rate. Chart I-3No Stable Relationship Between U.S. Twin Deficits And Dollar No Stable Relationship Between U.S. Twin Deficits And Dollar No Stable Relationship Between U.S. Twin Deficits And Dollar To produce a quantitative measure of the twin deficits, we sum up both the fiscal and current account balances. Chart I-4 demonstrates the relationship between the latter measure and the trade-weighted U.S. dollar. This analysis encompasses the entire history of the floating U.S. dollar since 1971. Chart I-4Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar Combination Of U.S. Twin Deficits And Real Bond Yields Better Explain Dollar The vertical lines denote the tax cuts under former U.S. President Ronald Reagan in 1981 and 1986, and under former U.S. President George W. Bush in 2001 and 2003. As can be seen from Chart I-4, there is no stable relationship between the twin deficits and the greenback. In the 1970s, there was no consistent relationship at all; In the first half of the 1980s, the twin deficits widened substantially, but the dollar rallied dramatically. The tailwind behind the rally was tightening monetary policy and rising/high real U.S. interest rates; From 1985 through 1993, there was no consistent relationship between America's twin deficits and the currency; From 1994 until 2001, the greenback appreciated as the twin deficits narrowed, particularly the fiscal deficit; From 2001 through 2011, the dollar was in a bear market as the twin deficits expanded; From 2011 until 2016, the shrinking-to-stable twin deficits were accompanied by a U.S. dollar rally. Bottom Line: We infer from these charts that there has historically been no stable relationship between the U.S. exchange rate and America's twin deficits in general, or its fiscal balance, in particular. ... And A Missing Variable: Interest Rates Twin deficits are often associated with rising inflation. In fact, a widening current account deficit can mask hidden price pressures. In particular, an economy that over-consumes - consumes more than it produces - can satisfy its demand via imports without exerting pressure on the economy's domestic productive capacity. Booming imports will lead to a widening trade deficit rather than higher consumer price inflation. Hence, in an open economy, over-consumption can lead to a widening current account deficit, rather than rising inflation. A currency is likely to plunge amid widening twin deficits if the central bank is behind the inflation curve. In such a case, the low real interest rates would undermine the value of the exchange rate. If the central bank, however, embarks on monetary tightening that is adequate, the currency can in fact strengthen amid growing twin deficits. In this scenario, rising real interest rates would support the currency. With respect to the U.S. dollar today, its future trajectory depends on the Fed, and the market's perception of its policy stance. If the market discerns that the Fed is behind the curve, the greenback will plummet. By contrast, if the market reckons that the Fed policy response is appropriate, and U.S. real interest rates are sufficiently high/rising, the dollar could in fact appreciate amid widening twin deficits. Specifically, the U.S. dollar was in a major bull market in the early 1980s, with Reagan's tax cuts in 1981 and the ensuing widening of the country's twin deficits doing little to thwart the dollar bull market (Chart I-4). In turn, the Bush tax cuts in 2001 and 2003 were followed by a major dollar bear market. The main culprit between these two and other episodes was probably real interest rates. U.S. real interest rates/bond yields rose between 1981 and 1985, generating an enormous dollar rally. In the decade of the 2000s, by contrast, U.S. real interest rates fell and that coincided with a major bear market in the greenback (Chart I-4). Overall, the combination of U.S. twin deficits and real bond yields together, help better explain U.S. dollar dynamics than twin deficits alone. We agree that America's twin deficits will widen materially. That said, odds are that the Fed commits to further rate hikes and that U.S. bond yields continue to rise. In fact, not only are U.S. inflation breakeven yields climbing, but TIPS (real) yields have also spiked significantly. Rising real yields, which in our opinion have more upside, should support the U.S. dollar. As a final point, if the Fed falls behind the curve and the dollar continues to tumble, the markets could begin to fear a material rise in U.S. inflationary pressures. That scenario would actually resemble market dynamics that prevailed before the 1987 stock market crash. Although this is a negative scenario for the U.S. currency and is, by default, bullish for EM exchange rates and their local bonds, this is not ultimately an optimistic scenario for global risk assets. Bottom Line: Twin deficits are not solely sufficient to produce a currency bear market. Twin deficits accompanied by a central bank that is behind the inflation curve - i.e., combined with low/falling real interest rates - are what generate sufficient conditions for currency depreciation. EM Currencies And Commodities Many EM exchange rates - such as those in Latin America, as well as South African, Russian, Malaysian and Indonesian currencies - are primarily driven by commodities prices. Not surprisingly, the underlying currency index of the EM local bond benchmark index (the JPM GBI index) - which excludes China, India, Korea and Taiwan - positively correlates with commodities prices (Chart I-5). Hence, getting commodities prices right is of paramount importance to the majority of high-yielding EM local bonds. We have the following observations: First, investors' net long positions in both oil and copper are extremely elevated (Chart I-6). The last datapoint is as of February 16. Any rebound in the U.S. dollar or mounting concerns about China's growth could produce a meaningful drop in commodities prices as investors rush to close their long positions. Second, we maintain that China's intake of commodities is bound to decelerate, as decelerating credit growth and local governments' budget constraints lead to curtailment of infrastructure and property investment (Chart I-7). Chart I-5EM Currencies Positively Correlate ##br##With Commodities Prices EM Currencies Positively Correlate With Commodities Prices EM Currencies Positively Correlate With Commodities Prices Chart I-6Investors Are Very Long##br## Copper And Oil Investors Are Very Long Copper And Oil Investors Are Very Long Copper And Oil Chart I-7Slowdown In ##br##China's Capex Slowdown In China's Capex Slowdown In China's Capex Strong growth in the U.S. and EU will not offset the decline in China's intake of raw materials (excluding oil). China accounts for 50% of global demand for industrial metals. America's consumption of industrial metals is about 6-7 times smaller. For crude oil, China's share of global consumption is 14% compared with 20% and 15% for the U.S. and EU, respectively. We do not expect outright contraction in China's crude imports or consumption. The point is that when financial markets begin to price in weaker mainland growth or the U.S. dollar rebounds, oil prices will retreat as investors reduce their record high net long positions. Finally, even though EM twin deficits have ameliorated in recent years, they remain wide (Chart I-8). In turn, the majority of these countries have been financing their deficits by volatile foreign portfolio flows, as FDIs into EM remain largely depressed. If commodities prices relapse and EM currencies depreciate, there will be a period of reversal in foreign portfolio inflows into EM. While EM real local bonds yields are reasonably high, they are unlikely to prevent outflows if the U.S. dollar rallies. In the past, neither high absolute EM real yields nor their wide spreads over U.S. TIPS prevented EM currency depreciation (Chart I-9). Chart I-8AEM Twin Deficits Have Ameliorated ##br##But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide Chart I-8BEM Twin Deficits Have Ameliorated ##br##But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide EM Twin Deficits Have Ameliorated But Are Still Wide Chart I-9EM Local Real Yields Do Not ##br##Drive Their Currencies EM Local Real Yields Do Not Drive Their Currencies EM Local Real Yields Do Not Drive Their Currencies EM Local Bonds: Country Allocation Strategy Chart I-10 attempts to identify pockets of value in EM domestic bonds. It exhibits the sum of current account and fiscal balances on the X axis, and domestic bond yields deflated by headline inflation on the Y axis. Chart I-10Identifying Pockets Of Value In EM Domestic Bonds EM Local Bonds And U.S. Twin Deficits EM Local Bonds And U.S. Twin Deficits Markets in the upper-right corner should be favored as they offer high real yields and maintain healthy fiscal and current account balances. Bond markets in the lower-left corner should be underweighted. They have low inflation-adjusted yields and large current account and fiscal deficits. Based on these metrics as well as fundamental analysis, our recommended country allocation for EM domestic bond portfolios has been and remains: Overweights: Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. Neutral: Brazil, Mexico, Indonesia, Hungary, Chile and Colombia. Underweights: Turkey, South Africa and Malaysia. The below elaborates on Brazil, Russia and South Africa. Russia Fiscal and monetary policies are extremely tight. While they are curtailing the economic recovery, they are very friendly for creditors. Interest rates deflated by both headline and core consumer price inflation are at their highest on record, government spending is lackluster, and the new fiscal rule has replenished the country's foreign currency reserves (Chart I-11). Besides, the government's budget assumption for oil prices is very conservative - in the low-$40s per barrel for this year and 2019. Commercial banks have been increasing provisions, even though the NPL ratio is falling. In fact, Russia is well advanced in terms of both corporate and household deleveraging as well as banking system adjustment. On the whole, having experienced two large recessions in the past 10 years and having pursued extremely orthodox fiscal and monetary policies, Russian markets have become much more insulated from negative external shocks than many of their peers. In brief, Russian financial markets have become low-beta markets,1 and they will outperform their EM peers in a selloff even if oil prices slide. Brazil Brazilian local bonds offer the highest inflation-adjusted yields. However, unlike Russia, Brazil has untenable public debt dynamics, and its politics remain a wild card. The public debt-to-GDP ratio is 16% in Russia and 80% in Brazil. The fiscal deficit in Brazil stands at a whopping 8% of GDP, and interest payments on public debt are equal to 6% of GDP. Without major fiscal reforms, Brazil's public debt will continue to surge and will likely reach almost 100% of GDP by the end of 2020. High real interest rates are not only holding back the recovery but are also making public debt dynamics unsustainable. Chart I-12 illustrates that nominal GDP growth is well below local government bond yields. Chart I-11Continue Favoring ##br##Russian Local Bonds Continue Favoring Russian Local Bonds Continue Favoring Russian Local Bonds Chart I-12Brazil: Borrowing Costs Are Dreadful ##br##For Public Debt Dynamics Brazil: Borrowing Costs Are Dreadful For Public Debt Dynamics Brazil: Borrowing Costs Are Dreadful For Public Debt Dynamics Brazil needs either much higher nominal growth or major fiscal tightening to stem the surge in the public debt-to-GDP ratio. The necessary fiscal reforms - social security restructuring or primary budget surpluses - are not politically feasible right now. Meanwhile, materially higher nominal growth can be achieved only if interest rates are brought down quickly and drastically and the currency is devalued meaningfully. Hence, the primary risk to Brazilian local bonds is the exchange rate. The currency is at risk from potentially lower commodities prices on the external side, and continuous public debt deterioration, debt monetization or drastic interest rate cuts on the domestic side. Remarkably, Chart I-13 demonstrates that historically real interest rates in Brazil do not explain fluctuations in the real. The currency, rather, positively correlates with commodities prices (Chart I-14). Chart I-13Brazil: No Relationship Between##br## Real Yields And Currency Brazil: No Relationship Between Real Yields And Currency Brazil: No Relationship Between Real Yields And Currency Chart I-14The Brazilian Real And ##br##Commodities Prices The Brazilian Real And Commodities Prices The Brazilian Real And Commodities Prices It is possible that policymakers find an optimal balance between these adjustment paths, and financial markets continue to rally. However, with the current government lacking any political capital and great uncertainty surrounding the October presidential elections; the outlook is very risky, We recommend a neutral allocation to Brazilian local bonds for EM domestic bond portfolios. South Africa The South African rand and fixed-income markets have surged in the wake of Cyril Ramaphosa's win of the ANC leadership elections and his taking over of the presidency from Jacob Zuma. This has been devastating to our short rand and underweight local bonds positions. Chart I-15The South African Rand And Metals Prices The South African Rand And Metals Prices The South African Rand And Metals Prices There is no doubt that President Ramaphosa will adopt some market-friendly policies. This will constitute a major change from Zuma's handling of the economy in the past nine years. Yet the outlook for the rand is also contingent on global markets. If commodities prices do not relapse and EM risk assets generally perform well, the rand will continue strengthening, and local bond yields will decline further. However, if metals prices begin to drop and EM currencies sell off, it will be hard for the South African currency to rally further (Chart I-15). While we acknowledge the potential for positive political announcements and actions from the new political leadership, the main drivers of the rand, in our opinion, remain the trends in the U.S. dollar and commodities prices. Some investors might be tempted to compare South Africa to Brazil in terms of political headwinds turning into tailwinds. From a political vantage point, it is a fair comparison. Nevertheless, investors should put Brazil's rally into perspective. If commodities prices did not rise in 2016-2017, the Brazilian real would not have rallied. In brief, external tailwinds are as - if not more - important for EM high-yielding currencies than domestic political developments. Positive political developments are magnified amid a benign external backdrop. Conversely, in a negative external environment, positive political transformations can have limited impact on the direction of financial markets. To reflect the potential for a positive political change and forthcoming orthodox macro policies, we are closing our bet on yield curve steepening in South Africa. This position was stipulated by unorthodox macro policies of the previous government. This trade has been flat since its initiation on June 28, 2017. Weighing pros and cons, we are reluctant to upgrade the South African rand and its fixed-income market at the moment because of our negative view on metals prices and EM currencies versus the U.S. dollar. Investment Conclusions The broad trade-weighted U.S. dollar is at record oversold levels (Chart I-16). Given the forthcoming U.S. fiscal stimulus, the Fed will likely lift its dots and the greenback will rebound. This is bearish for EM currencies, especially if China's growth slows and commodities prices roll over, as we expect. EM exchange rate depreciation will halt the rally in local bonds, especially in high-yielding markets. Foreign holdings of EM local bonds are elevated (Table I-1). Hence, risks of unwinding of some positions are not trivial. Chart I-16The U.S. Dollar Is Due For A Rally The U.S. Dollar Is Due For A Rally The U.S. Dollar Is Due For A Rally Table I-1Foreign Ownership Of EM Local Bonds Is High EM Local Bonds And U.S. Twin Deficits EM Local Bonds And U.S. Twin Deficits Nevertheless, as we have argued in the past, EM local bonds offer great diversification benefits to all type of portfolios, as their correlations with many asset classes are low. For domestic bond investors who have to be invested, our recommended overweights are Russia, Argentina, Poland, the Czech Republic, Korea, India and Thailand. As to the sovereign and corporate credit markets, asset allocators should compare these with U.S. corporate credit. Consistent with our negative view on EM currencies and equities vis-à-vis their U.S. counterparts, we recommend favoring U.S. corporates versus EM sovereign and corporate credit. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, titled "Russia: Entering A Lower-Beta Paradigm," dated March 8, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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