Global

Highlights There are many things that central bankers know they don't know. "Known unknowns" include the outlook for growth (both actual and potential), NAIRU, the neutral rate of interest, and the true shape of the Phillips curve. "Unknown unknowns" are, by definition, unknowable, but are often at the heart of economic downturns. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around, most likely in 2020. Keep a close eye on credit spreads. Stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Feature Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones. - Donald Rumsfeld, former Secretary of Defense under George W. Bush Uncertainty Galore Central bankers know many things. They know that growth is currently strong across most of the world, unemployment is falling and inflation, while still low, has been slowly trending higher. Unfortunately, there are also many things they don't know. These include things they know they don't know, as well as things that are not even on their radar screens - the "unknown unknowns" that Donald Rumsfeld famously warned about. Known Unknowns Let's start with five "known unknowns." 1. Will Growth Stay Strong? Global growth has likely peaked, but should remain comfortably above-trend over the remainder of this year (Chart 1). The OECD's Global Leading Economic Indicator (LEI) has leveled off, while the diffusion index, which tabulates the share of countries with rising LEIs, has dropped below 50 percent. A fall in the diffusion index has often foreshadowed outright declines in the composite LEI. Consistent with this prognosis, the Citi global Economic Surprise Index has swooned, the Chinese Keqiang index has decelerated, and Korean export growth - a leading indicator for global trade - has slowed. Global manufacturing PMIs have also edged off their highs (Chart 2). The one exception is the U.S., where the ISM index continues to power higher. Despite the occasional blip such as this week's retail sales report - which was probably depressed by tax refund delays - recent U.S. economic data have been reasonably upbeat. Goldman Sachs' Current Activity Indicator remains near cycle highs, implying strong momentum going into the second quarter. Chart 1Global Growth Has Peaked ##br##But Will Remain Above Trend Global Growth Has Peaked But Will Remain Above Trend Global Growth Has Peaked But Will Remain Above Trend Chart 2Global Manufacturing PMIs ##br##Are Off Their Highs Global Manufacturing PMIs Are Off Their Highs Global Manufacturing PMIs Are Off Their Highs Changes in financial conditions tend to lead growth by about six-to-nine months. U.S. financial conditions have eased a lot more since the start of 2017 than elsewhere (Chart 3). In addition, U.S. fiscal policy is likely to be much more expansionary over the next two years than in the rest of the world (Chart 4). All this suggests that the composition of global growth will shift in favor of the U.S. over the coming months. Chart 3Composition Of Global ##br##Growth Will Shift To The U.S. ... Composition Of Global Growth Will Shift To The U.S. ... Composition Of Global Growth Will Shift To The U.S. ... Chart 4U.S. Fiscal Policy Will Become More ##br##Expansionary Than In R.O.W. What Central Bankers Don't Know: A Rumsfeldian Taxonomy What Central Bankers Don't Know: A Rumsfeldian Taxonomy 2. Will Potential Growth Accelerate? The U.S. unemployment rate has declined from a high of 10% in 2009 to 4.1% in February 2018, even though real GDP growth has averaged a meager 2.2% over this period. Extremely weak productivity growth explains why the output gap has managed to contract in the face of subdued GDP growth. Sluggish capital spending has exacerbated the productivity downturn, but probably did not cause it. Chart 5 shows that productivity growth began to decelerate well before the financial crisis erupted. The slowdown has been pervasive across countries and sectors. Economists have a poor track record of predicting productivity trends. Not only did they fail to predict the productivity revival in the late 1990s, but because of data lags and subsequent revisions, they did not even know it had happened until the early 2000s. It is too early to say whether robotics and AI will yield the same sort of productivity windfall that the Internet did. My colleagues, Mark McClellan and Brian Piccioni, have cast a skeptical eye on some of the alleged revolutionary breakthroughs in both fields.1 If it turns out that the late 1990s was the exception rather than the rule, and that we are going back to the lackluster productivity performance of the 1970s, this will make life more challenging for central bankers. 3. What Is The True Level Of NAIRU? Spare capacity has diminished in most countries, but questions linger over how much slack remains. No one truly knows where NAIRU - the so-called Non-Accelerating Inflation Rate of Unemployment - really stands. The Fed and the Congressional Budget Office believe that NAIRU has fallen from over 6% in the late 1970s to around 4.5%-to-4.7% today (Chart 6). Chart 5Productivity Growth Slowdown ##br##Has Been Pervasive Productivity Growth Slowdown Has Been Pervasive Productivity Growth Slowdown Has Been Pervasive Chart 6NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards NAIRU Is Low By Historic Standards An aging workforce has reduced frictional unemployment because older workers are less likely to switch jobs than younger ones. The internet has also made it easier for employers to find suitably qualified workers. On the flipside, globalization, automation, and the opioid crisis have likely made it difficult for a growing list of workers to hold down a job for long. Our best guess is that the U.S. economy is operating at close to full employment. This is confirmed by various employer surveys, which show that companies are struggling to find qualified workers (Chart 7). The fact that the share of people outside the labor force who want a job has fallen to pre-recession levels also suggests that labor slack is running thin (Chart 8). Chart 7U.S. Economy: Operating At ##br##Close To Full Employment U.S. Economy: Operating At Close To Full Employment U.S. Economy: Operating At Close To Full Employment Chart 8Few People Left Who Are Eager ##br##To Rejoin The Labor Force Few People Left Who Are Eager To Rejoin The Labor Force Few People Left Who Are Eager To Rejoin The Labor Force There is more slack outside the United States. Labor underutilization is still 2.5 percentage points higher in the euro area than it was in 2008. Taking Germany out of the picture, labor underutilization is nearly six points higher (Chart 9). A number of major emerging markets, most notably Brazil and Russia, also have a lot of excess cyclical unemployment. The Japanese labor market has tightened significantly in recent years, but there is probably a fair amount of hidden underemployment left, particularly in the service sector (factoid of the week: there are more police officers in Tokyo than in New York City).2 4. Where Is The Neutral Rate Of Interest? One of the most vexing questions facing central banks is how high interest rates can go before they move into restrictive territory. There are a variety of reasons for thinking that the neutral real rate of interest - the rate consistent with full employment and stable inflation - is lower today than it was in the past. Trend real GDP growth has fallen. This has reduced the need for firms to expand capacity. The shift to a capital-lite economy - where value-added increasingly takes the form of bits and bytes rather than factory output - has further reduced the need for fresh investment. Meanwhile, a reluctance to take on new debt has restrained spending. Rising inequality has shifted more wealth into the hands of people who tend to save a lot. Globally, savings must equal investment. If desired savings go up and desired investment goes down, interest rates must fall to push down the former and push up the latter (Chart 10). Chart 9Euro Area: There Is Still Labor ##br##Market Slack Outside Of Germany Euro Area: There Is Still Labor Market Slack Outside Of Germany Euro Area: There Is Still Labor Market Slack Outside Of Germany Chart 10Interest Rates Must Fall If Desired Savings ##br##Increase And Desired Investment Declines What Central Bankers Don't Know: A Rumsfeldian Taxonomy What Central Bankers Don't Know: A Rumsfeldian Taxonomy None of these forces are immutable, however. Investment demand appears to be picking up, as judged by capex intention surveys (Chart 11). Consumer credit is rising anew. The U.S. personal saving rate is back near an all-time low (Chart 12). A tighter labor market is likely to cause labor's share of income to rise, just like it did in the late 1990s (Chart 13). This should boost aggregate demand. An unprecedented increase in the U.S. budget deficit should help absorb much of the savings from cash-rich corporations (Chart 14). Meanwhile, savings are likely to decline over the long haul as well-paid baby boomers retire en masse. All this is causing the neutral rate to move higher. Chart 11Upswing In Global Capex Is Underway Upswing In Global Capex Is Underway Upswing In Global Capex Is Underway Chart 12U.S. Consumer Credit Revival U.S. Consumer Credit Revival U.S. Consumer Credit Revival Chart 13Tight Labor Market And Rising Labor ##br##Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Tight Labor Market And Rising Labor Share Of Income: A Replay Of The 1990s? Chart 14Now Is The Time For Fiscal Consolidation, Not Profligacy Now Is The Time For Fiscal Consolidation, Not Profligacy Now Is The Time For Fiscal Consolidation, Not Profligacy 5. What Is The Shape Of The Phillips Curve? Central bankers assume that dwindling spare capacity will lead to higher inflation, a relationship immortalized by the so-called Phillips curve. The fact that inflation has barely risen over the past few years is an obvious challenge to this theory. It may simply be that the Phillips curve is "kinked" at very low levels - it only steepens when the economy has gone beyond full employment. The fact that it has taken this long to reach the kink could explain why inflation has not taken off sooner. The success that central banks have enjoyed in anchoring long-term inflation expectations is another reason why the Phillips curve has become flatter. Chart 15An Overheated Economy Led To ##br##Rising Inflation In The 1960s An Overheated Economy Led To Rising Inflation In The 1960s An Overheated Economy Led To Rising Inflation In The 1960s The problem is that there is no God-given reason why inflation expectations should stay well anchored. Core inflation was remarkably low and stable in the first half of the 1960s. However, the combination of low real interest rates and increased fiscal spending associated with Lyndon Johnson's Great Society programs and the Vietnam War led to a surge in inflation starting in 1966 (Chart 15). Inflation kept climbing thereafter, rising to 6% in 1970. This was three years before the first oil shock occurred, suggesting that an overheated economy, rather than OPEC, was the main inflationary culprit. Unknown Unknowns Then there are the things central bankers are not even thinking about, or even worse, the things they think are true but aren't.3 In the lead-up to the Great Recession, U.S. policymakers blithely assumed that house prices could not fall at the nationwide level. This caused them to turn a blind eye to soaring home prices and the deterioration of underwriting standards in the mortgage market. Warren Buffet once said, "Only when the tide goes out do you discover who's been swimming naked." Our guess is that rising rates will expose a lot of things one would rather not see in the corporate debt market. In the latest issue of the Bank Credit Analyst, my colleague Mark McClellan estimated that the interest coverage ratio for U.S. companies would drop from 4 to 2.5 if rates increased by 100 basis points across the corporate curve. Such a move would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 16A and Chart 16B).4 Consumer staples, tech, and health care would be the most adversely affected. Chart 16AU.S. Interest Coverage Ratio ##br##Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) Chart 16BU.S. Interest Coverage Ratio ##br##Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) Political shocks are also very difficult for policymakers to foresee. President Trump's decision to impose steel and aluminum tariffs spooked the markets. NAFTA negotiations remain stalled and the odds are high that the U.S. will pursue trade sanctions against China for alleged intellectual property theft. That said, as we noted last week, an all-out trade war would cause equities to crater.5 Trump remains focused on the value of the stock market as a gauge of the success of his presidency. This will curb his hawkishness. Unemployment is also very low these days, which limits the attractiveness of protectionist policies. The specter of trade wars will escalate if a recession causes stocks to tumble and unemployment to rise in key midwestern swing states. Other "unknown unknowns" include another flare-up in sovereign debt markets in Europe, a hard landing in China, and a supply-induced spike in oil prices. Investment Conclusions It may be tempting to think that central banks can calibrate monetary policy as events unfold in order to keep economies on an even keel. If only it were so easy. Monetary policy affects the economy with a lag of 12-to-24 months. By the time it is clear that either more or less monetary stimulus is needed, it is often too late to act. Central bankers have to work with incomplete or inaccurate data. One of the reasons that inflation spiraled out of control in the 1970s was because the Federal Reserve systematically overstated the size of the output gap (Chart 17). This led the Fed to falsely conclude that slower growth was the result of inadequate demand rather than a deceleration in the economy's supply-side potential. It is impossible to know what mistakes central banks will make in the future, but it is almost certain that something will go awry. Central bankers, like military leaders, tend to fight the last war. They have tirelessly waged a battle against deflation over the past decade, so it is logical to conclude that they will err on the side of keeping monetary policy too loose rather than too tight. This will prolong the recovery, but it also means that economic and financial imbalances will be greater by the time the next downturn rolls around. As we discussed several weeks ago, the next recession is most likely to arrive in 2020.6 Investors should stay overweight risk assets for now, but look to move to neutral later this year and outright underweight in the first half of 2019. Bond yields will fall as the next recession approaches, but they will do so from higher levels than today. Similar to the 1970s, investors should expect inflation and bond yields to make a series of "higher highs" and "higher lows" with every boom/bust episode (Chart 18). Chart 17The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Chart 18A Template For The Next Decade? A Template For The Next Decade? A Template For The Next Decade? Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "The Coming Robotics Revolution," dated May 16, 2017; The Bank Credit Analyst, "Did Amazon Kill The Phillips Curve?" dated August 31, 2017; and The Bank Credit Analyst, "The Impact Of Robots On Inflation," dated January 25, 2018. 2 "As crime dries up, Japan's police hunt for things to do," The Economist, May 18, 2017. 3 Mark Twain is often credited for saying that "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so." It's a great quote, but there's only one problem: There is no evidence that he ever said it. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. 5 Please see Global Investment Strategy Weekly Report, "Trump's Tariffs: A Q&A," dated March 9, 2018. 6 Please see Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," dated February 23, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Data based on Bloomberg/Barclays global treasury/aggregate indexes from December 1990 to January 2018 supports the argument that foreign government bonds are not worthy of investing in when unhedged, due to extremely high volatility. On a hedged basis, however, foreign bonds are a good source of risk reduction for bond portfolios. Hedging not only reduces volatility of a foreign government bond portfolio, it reduces it so much that on a risk adjusted-return basis, foreign government bonds outperform both domestic government bonds and domestic credit for investors in Australia, New Zealand, the U.K., the U.S. and Canada. Aussie and kiwi fixed income investors stand out as the biggest beneficiaries of investing overseas, because hedged foreign government bonds not only provide lower volatility compared to domestic bonds, but also higher returns. This empirical evidence does not support the strong home bias of Aussie and kiwi investors. Investors in the euro area also benefit from the risk reduction of hedged foreign exposure. However, they also suffer significant return reduction - such that the improvement in risk-adjusted returns is not significant. Investors in Japan do enjoy higher returns from foreign government bonds, hedged and unhedged, yet at the cost of much higher volatility, with risk-adjusted returns also not justifying investing overseas. This empirical finding does not lend support to the "search for yield" strategy that has been very popular among Japanese investors. Feature Practitioners and academics do not often agree with one another on investment management issues, but when it comes to whether to hedge foreign government bonds, both accept that foreign government bonds should be fully hedged because currency volatility overwhelms bond volatility. Yet hedged total returns from foreign government bonds are very similar to those from domestic bonds for investors in the U.S., U.K. and Canada, while worse in the euro area. Only in Japan, Australia and New Zealand do investors enjoy higher hedged returns from investing in foreign bonds, as shown in Chart 1 based on Bloomberg/Barclays Global Treasury Indexes hedged to their respective home currencies. So why do investors in the U.S., U.K. and euro area, whose own government bond markets currently account for about 60% of the global treasury index universe (Chart 2), even bother to invest in foreign government bonds? Even for those who may achieve higher returns overseas, would they not be better off just buying domestic corporate bonds (for the potentially higher returns from taking domestic credit risk) rather than venturing into foreign countries and taking the trouble to hedge currency risk? Indeed, home bias among bond investors globally is a lot higher than among equity investors. Chart 1Domestic Vs. Foreign Bonds Domestic Vs. Foreign Bonds Domestic Vs. Foreign Bonds Chart 2Country Weights In Global Treasury Index Country Weights In Global Treasury Index Country Weights In Global Treasury Index In this report, we present empirical evidence based on Bloomberg/Barclays domestic treasury indexes and aggregate bond indexes, hedged and unhedged global treasury indexes in seven different currencies (USD, EUR, JPY, GBP, CAD, AUD and NZD), in the context of strategic asset allocation. In a future report, we will attempt to identify the driving forces underpinning the decisions between investing in domestic bonds versus foreign bonds in the context of tactical asset allocation. Hedged Foreign Government Bonds Are a Good Source Of Diversification When a foreign bond is hedged back to the domestic currency, its total return correlation with domestic bonds is quite high. As shown in Chart 3, domestic bonds and their respective hedged foreign bonds have an average correlation of around 70% for all currencies, with the exception of the JPY. For Japanese investors, hedged foreign bonds have a much lower correlation with JGBs, averaging around 30%. Intuitively, there should not be a high incentive for USD, GBP, CAD, EUR, AUD and NZD based investors to invest in foreign bonds, while JPY based investors should benefit from the diversification of hedged foreign bonds. In reality, the very high home bias among fixed income investors in general and the popularity of search-for-yield carry trades among Japanese individual investors seems to support this. Is there empirical evidence that shows the same thing? Table 1 presents statistics from Bloomberg/Barclays domestic treasury indexes and their respective market cap-weighted foreign treasury indexes, hedged and unhedged, in USD, JPY, GBP, EUR, CAD, AUD and NZD. Please see Appendix 1 for the hedged return calculation. Chart 3High Correlations High Correlations High Correlations Table 1Domestic And Foreign Government Bond Profile (Dec 1999 - Jan 2018) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? On an unhedged basis, foreign bonds have much higher volatility compared to domestic bonds for all investors. In terms of return, only Japanese investors enjoy higher yields overseas. On a risk-adjusted return basis, all investors are worse off in investing in unhedged foreign bonds. This is in line with the "conventional wisdom" acknowledged by both academics and practitioners. Hedging not only reduces the corresponding foreign bond portfolio's volatility, it reduces it so much, for all currencies other than the JPY, that the foreign bond portfolio has lower volatility than domestic bonds. As such, in terms of risk-adjusted return, hedged foreign bonds outperform domestic government bonds in all countries except Japan. This implies that on a risk-adjusted return basis, Japanese investors should not invest in hedged foreign bonds at all, while other investors should. Even more shockingly, Table 1 shows that AUD and NZD investors would have achieved both higher returns and lower volatility by investing in hedged foreign bonds. These implications appear to fly in the face of common sense for AUD and NZD investors, because their domestic bonds have much higher returns than others, while in reality Japanese retail investors are keen on "carry trades" as a way to enhance yields. What has caused such significant discrepancies? Could it be simply due to the time period chosen? Chart 4 and Chart 5 present the results of the same analysis performed over different periods: the whole period from 1990, when the majority of the Bloomberg/Barclays indexes first became available; pre-euro (1990-2000); after the euro and before the global financial crisis (GFC); and after the GFC (the extremely low-yield period). Surprisingly, the relative performance of hedged foreign bonds versus domestic bonds for each currency has been quite consistent across all the time periods in terms of risk-adjusted returns, even though absolute performance varied in different periods. Chart 4Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time (1) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Chart 5Domestic Vs. Foreign Treasury Bonds: Consistent Performance Across Time (2) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? So when it comes to investing in hedged foreign government bonds, investors with different home currencies should bear the following observations in mind: For Japanese investors, the slightly higher yield enhancement from hedged foreign bonds comes with sharply higher volatility compared to JGBs. The risk-adjusted return does not justify investing in foreign bonds.1 This is mostly because Japanese bonds have below-average volatility, while hedged foreign bonds have above-average volatility. For euro area investors, the lower volatility from foreign bonds is at the expense of lower returns. The improvement in risk-adjusted returns is not significant enough to justify the extra work in hedging. U.K. gilts have the highest volatility. As such, U.K. investors have benefited the most in risk reduction from buying hedged foreign bonds, to the slight detriment of returns. Consequently, they are better off investing in hedged foreign government bonds if improving risk-adjusted return is the objective. The Aussie and kiwi government bond markets are very small in terms of market cap (Chart 2). Fortunately, hedged foreign bonds not only have lower volatility than domestic bonds, they also provide much higher returns. Indeed, Aussie and kiwi investors are the most suitable candidates for going global. For U.S. and Canadian investors, hedged foreign portfolios and domestic indexes share similar returns, but foreign portfolios have much lower volatility, hence better risk-adjusted returns. Hedging currencies is not an easy task. Would investors not be better off taking domestic credit risks than investing in hedged foreign government bonds? Domestic Credit Or Hedged Foreign Government Bonds? The Bloomberg/Barclays domestic aggregate bond indexes are comprised of treasuries, government-related, corporate, and securitized bonds. Chart 6 shows the total returns of the aggregate bond indexes and the corresponding treasury weights in each country index. It is clear that Japan's credit portion is very small, while the U.S. and Canadian credit markets dominate their corresponding treasury markets. In the euro area and Australia, credit accounts for about half of the aggregate index, while it is only about 30% in the U.K. Since some aggregate indexes have a short history (Chart 6), we use the corresponding treasury index to fill in the missing links. In the case of New Zealand, an aggregate index does not exist at all, local treasury bonds are used instead in our analysis below. Table 2 presents the risk/return profiles of the Bloomberg/Barclays domestic aggregate bond indexes, and the same market cap-weighted global treasury index hedged and unhedged in USD JPY, GBP, EUR, CAD, AUD and NZD. Chart 6Aggregate Bond Index Composition Aggregate Bond Index Composition Aggregate Bond Index Composition Table 2Domestic Aggregate Bond Index Vs. Hedged Global Treasury Index (Dec 1999 - Jan 2018) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Domestic credits also improve the risk-adjusted returns for all the investors, and for investors in the U.S., Canada and Australia, credits also add returns while reducing volatility compared to their respective treasury indexes. However, the hedged global treasury index has much lower volatility than the domestic aggregate index such that on a risk-adjusted-return basis, the hedged global treasury index still outperforms the local aggregate index for all investors except those in Japan and the euro area. Similar to the findings in the previous section, this observation also holds true across all the time periods as shown in Charts 7 and 8. Aussie and kiwi investors stand out again as the best beneficiaries of going global because the hedged global treasury indexes not only have lower volatility than the domestic aggregate bond indexes, they also provide higher returns. Chart 7Domestic Aggregate Vs. Global Treasury: Consistent Performance Across Time (3) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? Chart 8Domestic Aggregate Vs. Global Treasury: Consistent Performance Across Time (4) Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? This raises an interesting question for asset allocators: which bond index should one use to measure the performances of global bond managers? It is common for some pension funds and mutual funds to use a domestic aggregate bond index as a benchmark to measure their bond managers' performance. In such a case, what are you really paying for if your managers have the discretion to buy hedged foreign government bonds? Another interesting observation is that the hedged global treasury index has almost the same volatility around 2.85% in different currencies. This essentially levels out the playing-field for bond managers globally in terms of volatility, a very important criteria for bond investors. Is High Home Bias Justifiable? There are many well-known reasons that explain why home bias in bond portfolios is typically high. But are investors giving up too much for the comfort of "staying home"? Chart 9 shows the effects of adding hedged foreign government bonds into a portfolio of domestic aggregate bonds for each investor based on two timeframes - from 1990 and from 1999 to the present. The messages are clear: If investors are comfortable with the volatility in their domestic aggregate bond index, which is already a lot lower than equities, then investors in the U.S., the U.K., Canada and the euro area are better off staying home for higher returns without dealing with currency hedging operations. For Aussie, kiwi and Japanese investors, however, going abroad enhances returns. Chart 9Is High Home Bias Justifiable? Why Invest In Foreign Government Bonds? Why Invest In Foreign Government Bonds? If investors focus on lower volatility, then all investors should invest a large portion of their portfolios overseas, with the exception of Japanese investors. If investors focus on risk-adjusted returns, then investors in Australia, New Zealand, the U.S., the U.K., the euro area and Canada are better off investing a large portion overseas. In short, while there may be some justification for most fixed-income investors to maintain a home bias, empirical evidence does not lend strong support to Aussie and kiwi investors having a home bias at all. Chart 9 shows that Australian and New Zealand investors should consider investing 70-90% of their fixed income portfolio in hedged foreign government bonds for higher returns and lower volatility. Implications For Asset Allocators Chart 10What Drives The Dynamics Between ##br## Foreign And Domestic Bonds? What Drives The Dynamics Between Foreign And Domestic Bonds? What Drives The Dynamics Between Foreign And Domestic Bonds? The analysis presented in this report is by nature based on historical data. The findings may not apply to the future, especially because the periods for which we have data cover only the great bull market in government bonds. However, this exercise does provide some interesting aspects for consideration: Should hedged foreign government bonds have a presence in strategic asset allocation? If your fixed income managers have the discretion to invest in foreign government bonds, then is it appropriate for you to use a domestic aggregate bond index to measure their performance? In the context of strategic asset allocation, the answer to the first question is yes and to the second is no, as implied by the analysis in this report. In the context of tactical asset allocation, however, the answer may well be different. In a later report, we will attempt to identify the factors that drive the dynamics between domestic and hedged foreign bonds because the most obvious factor, interest rate differentials, cannot fully explain it as shown in Chart 10. Stay tuned. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com 1 Granted, Japanese retail investors do not pay attention to risk adjusted returns as much as institutional investors do. Therefore their buying unhedged foreign bonds is consistent with their yield enhancement objective, albeit at much higher volatility. Appendix 1: Bond Hedged Return Calculation We use the same methodology as Bloomberg/Barclays1 to calculate hedged return using one-month forward contracts and re-balancing on a monthly basis. This is unlike equity hedging, where the gain or loss of the underlying index during the month is not hedged.2 A bond index can be reasonably assumed to grow at the nominal yield (yield to worst is used). Only the gain/loss that is different from the stated yield during the month is not hedged, but converted back to the home currency at the month-end spot rate. Hedged return using forward contract: 1+Rd,t+1= (Pt+1 * St+1 ) / (Pt * St ) + Ht*(Ft - St+1)/ St..............................................(1) Where: Pt and Pt+1 are the foreign bond total return index levels at time t and t+1 in corresponding foreign currencies; St and St+1 are the foreign currency exchange rates versus the domestic currency at time t and t+1, quoted as one unit of foreign currency equal to how many units of domestic currency; Ht = (1 + Yt/2)(1/6) is the hedged notional; Yt is the yield to worst; Ft is the foreign currency's one-month forward rate at time t for delivery at time t+1; Rd,t+1 is the hedged total return in domestic currency of the foreign hedge index between time t and t+1. 1 https://www.bbhub.io/indices/sites/2/2017/03/Index-Methodology-2017-03-17-FINAL-FINAL.pdf 2 Please see Global Asset Allocation Special Report, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors," dated September 29, 2017, available at gaa.bcaresearch.com

Highlights BCA's view is that while a major trade war is unlikely, trade tensions will persist. The Fed, not protectionism, will end the cycle. There have been five episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policy were all aligned to boost the U.S. economy. The March Beige Book keeps the Fed on track to hike four times this year. Feature The Trump Administration's announcement last week to slap hefty tariffs on steel and aluminum runs the risk of provoking a "tit-for-tat" trade war. This proposed levy follows a similar move earlier this year to impose tariffs on washers and solar panels. The EU has retaliated with a threat to introduce tariffs on Harley Davidson motorcycles and Levi's jeans. Even if a trade war develops, our Global Investment Strategy team notes1 that the U.S. would suffer less in a trade war than other nations, and that higher tariffs may lead to more domestic demand, a more aggressive Fed and a stronger dollar. Certainly, the tariff issue does not signal the end of the U.S. economic expansion or equity bull market. BCA's view is that while a major trade war is unlikely, trade tensions will persist. Our Geopolitical Strategy service states2 that investors should closely monitor bellwether factors for trade policies, including Trump's position on NAFTA, exemptions granted on the steel and aluminum tariffs to countries (such as Mexico and Canada) and most importantly, the treatment of intellectual property trade with China. Bottom Line: The end of the equity bull market will probably be due to an overheated U.S. economy and rising financial imbalances, and not escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Policy Panacea The backdrop for U.S. economic growth remains solid. Consensus global GDP projections for 2018 and 2019 have perked up, in contrast with prior years when forecasters issued relentless lower GDP estimates (Chart 1). Moreover, global exports growth is in a persistent uptrend since the earlier part of 2016 (Chart 2). Chart 1U.S. & Global Growth Expectations Are Still Accelerating U.S. & Global Growth Expectations Are Still Accelerating U.S. & Global Growth Expectations Are Still Accelerating The surge in global growth occurs even as China's economy is poised to slow. Among the components of BCA's Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang), all six series are in a downtrend, and five fell in January (the growth in M2 was the exception).3 Although China's economy is decelerating, BCA's view is that a repeat of the late 2015/early 2016 shock is unlikely (Chart 3). Chart 2Global Exports##BR##Are Booming... Global Exports Are Booming... Global Exports Are Booming... Chart 3Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth In China bca.usis_wr_2018_03_12_c3 bca.usis_wr_2018_03_12_c3 The U.S. economy and financial markets will benefit from the uptick in global growth, a large dose of fiscal policy, still accommodative monetary policy, and a decline in regulation. Table 1 and Chart 4 show that there have been four other junctures in the past 35 years when these factors all pulled in the same direction to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. All four previous periods occurred closer to the start and not the end of a business cycle; BCA's stance is that the U.S. economy is in the late stages of an economic expansion that began in 2009. These phases lasted, on average, for just under two years. The current phase is entering its third year. The longest was in the early 2000s (2002-2004), while the shortest was a 14-month interval in the first year of the 1991-2001 economic expansion. Three of the prior four periods ended as fiscal policy turned restrictive. In the early 1980s' chapter, a reversal in global IP signaled the end of the growth sweet spot. Performance Of U.S. Financial Assets, Gold, Oil And Earnings When Global Growth Is Increasing Alongside Stimulative Monetary, Fiscal And Regulatory Policy .... Policy Line Up Policy Line Up Chart 4Global Growth, Fiscal, Monetary And Regulatory Policy##BR##All Pulling In The Same Direction Global Growth, Fiscal, Monetary And Regulatory Policy All Pulling In The Same Direction Global Growth, Fiscal, Monetary And Regulatory Policy All Pulling In The Same Direction Not surprisingly, risk assets perform well during these "tailwind" points (Table 1 again and Chart 5). The S&P 500 rose in the previous four periods and again in the current one. However, BCA's stock-to-bond ratio fell in the early 1990s and early 2000s. Credit tends to outperform Treasuries when monetary, fiscal and regulatory policy are synchronized, and small caps outperform large. This is the case in the current episode that began in January 2016. Gold and oil also perform well when global growth is surging, fiscal and monetary policy is stimulative and regulations are on the wane. However, on average, the dollar falls during these intervals as demonstrated in the early 2000s and early 2010s. S&P 500 earnings growth is solid and well above average during these phases. Chart 5U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push U.S. Risk Assets In Periods Of Strong Global Growth And Synchronized Policy Push Table 2 shows that U.S. risk assets tend to struggle in the year after these legs end, but the economy keeps flourishing. Stocks underperformed bonds a year after the end of two of the four periods, but none of those periods coincided with a recession. Investment-grade and high-yield credit underperforms Treasuries in the ensuing 12 months, while small caps struggle to keep up with large. Gold performs well in three of the four periods, but oil posts a mixed performance. The dollar rises and S&P 500 earnings per share increase in the year after stretches of synchronous policy, but at a much slower pace than when the stimulative fiscal policy, deregulation and easy monetary policy are all in place. Table 2... What Happens In The 12 Months After These Episodes End... Policy Line Up Policy Line Up Tighter Fed policy will end the current era of pro-growth policies. BCA's stance is that the Fed will raise rates four times this year and another three or four times next year, pushing monetary policy into restrictive territory. U.S. fiscal policy will likely add to growth into the next year, thanks to tax cuts and the lifting of spending caps, and Trump will continue to look for deregulation opportunities. Bottom Line: Fed tightening will end the latest era of deregulation, easy monetary policy and stimulative fiscal policy, but not until early next year. Until then, a favorable backdrop will persist for stocks over bonds, credit, S&P 500 earnings and oil. Stay long stocks and credit, and underweight duration. This forecast assumes that the trade spat does not degenerate into a trade war. If that occurs, we would recommend reducing our overweight to risk assets sooner than early next year. Beige Book: More Tailwinds Fed Chair Powell's February 27 testimony to Congress noted that "some of the headwinds the U.S. economy faced in previous years have turned into tailwinds."4 The Beige Book released on March 7 highlights many of those tailwinds, keeps the Fed on track to boost rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach5 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market. Furthermore, the disconnect between the Beige Book's view of inflation and the market's stance has eased. Moreover, references to a stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and Trump's assault on regulation. The latest Beige Book ran from mid-January to February 26 and, therefore, did not capture the business community's reaction to the tariff announcement in early March. Chart 6, panel 1 shows that at 67% in March, BCA's Beige Book Monitor stayed near its cycle highs, which reconfirms that the underlying economy was upbeat in early 2018. The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 15 mentions of the tax bill in the March Beige Book, up from 12 in January and only 3 in November 2017 (not shown). The tax bill was cast in a positive light in 87% of the remarks in March versus 75% in January. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Chart 6Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation And Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Based on the minimal references to a robust dollar in the past six Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018. This sharply contrasts with 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6, panel 4). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. Business uncertainty over government policy (fiscal, regulatory and health) multiplied in the past few Beige Books as Congress debated the tax bill. However, in general, these comments have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 6, panel 5). However, the controversy associated with the tariffs on steel and aluminum will add to business unease in the coming months unless Trump reverses his position. The disagreement between the Fed and the market on inflation narrowed in the March edition of the Beige Book (Chart 6, panel 3). The number of inflation words in the Beige Book rose to an 8 month high in March, reflecting the abrupt change in sentiment on inflation in early 2018 both in the business community and the market. In the past year, inflation words in the Beige Book climbed as the readings on CPI and PCE rolled over. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The March Beige Book supports BCA's view that the U.S. economy is poised to expand above its long-term potential in the first half of 2018. Moreover, the elevated soundings on inflation in the Beige Book in recent years have again proved prescience, as price measures are poised to turn higher. While the first few Beige Books in 2018 showed that the business and financial communities welcomed tax cut legislation, the next edition will likely reflect elevated concern over the nation's trade policies. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Trump's Tariffs: A Q&A", published March 9, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Client Note "Market Reprices Odds Of A Global Trade War", published March 6, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation", published March 7, 2018. Available at cis.bcaresearch.com. 4 https://www.federalreserve.gov/newsevents/testimony/powell20180226a.htm 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," published April 17, 2017. Available at usis.bcaresearch.com.

Dear Client, Following up on last week's report, my colleagues Caroline Miller, Mathieu Savary, and I held a webcast on Wednesday to discuss the outlook for the dollar along with recent events. If you haven't already, I hope you find the time to listen in. Best regards, Peter Berezin, Chief Global Strategist Highlights Protectionism is popular with the American public in general, and Trump's base specifically. The sabre-rattling will persist, but an all-out trade war is unlikely. Trump is focused on the stock market, and equities would suffer mightily if a trade war broke out. The Pentagon has also warned of the dangers of across-the-board tariffs that penalize America's military allies. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. That's not the case today. The equity bull market will eventually end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Feature Q: What prompted Trump's announcement? A: Last week began with President Trump proclaiming that he would seek re-election in 2020. Then came a slew of negative news, including the resignation of Hope Hicks, Trump's White House communications director, and the downgrading of Jared Kushner's security clearance. All this happened against the backdrop of the ever-widening Mueller probe. Trump needed to change the subject. Fast. However, it would be a mistake to think that the tariff announcement was simply a distractionary tactic. Turmoil in the White House might have been the immediate trigger, but events had been building towards this outcome for some time. The Trump administration had imposed tariffs on washing machines and solar panels in January. Hiking tariffs on steel and aluminum - two industries that had suffered heavy job losses over the past two decades - was a logical next step. In fact, the 25% tariff on steel and 10% tariff on aluminum were similar to the 24% and 7.7% tariff rates, respectively, that the Commerce Department proposed as one of three options on February 16th.1 Protectionism is popular with the American public. This is especially true for Trump's base (Chart 1). Indeed, it is safe to say that Trump's unorthodox views on trade are what handed him the Republican nomination and what allowed him to win key swing (and manufacturing) states such as Ohio, Michigan, and Pennsylvania. Trump made a promise to his voters. He is trying to keep it. Q: Wouldn't raising trade barriers hurt the U.S. economy, thereby harming the same workers Trump is trying to help? A: That's the line coming from the financial press and most of the political establishment, but it's not as clear cut as it may seem. An all-out trade war would undoubtedly hurt the U.S., but a minor skirmish probably would not. The U.S. does run a large trade deficit. Economists Katharine Abraham and Melissa Kearney recently estimated that increased competition from Chinese imports cost the U.S. economy 2.65 million jobs between 1999 and 2016, almost double the 1.4 million jobs lost to automation.2 This accords with other studies, such as the one by David Autor and his colleagues, which found that increased trade with China has led to large job losses in the U.S. manufacturing sector (Chart 2).3 Chart 1Trump Is Catering ##br##To His Protectionist Base Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Chart 2China's Ascent Has Reduced##br## U.S. Manufacturing Employment China's Ascent Has Reduced U.S. Manufacturing Employment China's Ascent Has Reduced U.S. Manufacturing Employment Granted, China does not even make it into the top ten list of countries that export steel to the United States. But that is somewhat beside the point. As with most commodities, there is a fairly well-integrated global market for steel. Due to its proximity to Asian markets, China exports most of its steel to the rest of the region (Chart 3). That does not stop Chinese overcapacity from dragging down prices around the world. Chart 3Most Of China's Steel Exports Don't Travel That Far Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Q: Wouldn't steel and aluminum tariffs simply raise prices for American consumers, thereby reducing real wages? A: That depends. If Trump's gambit reduces the U.S. trade deficit, this will increase domestic spending, putting more upward pressure on wages. As far as prices are concerned, the U.S. imported $39 billion of iron and steel in 2017, and an additional $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. And even that would be a one-off hit to the price level, rather than a permanent increase in the inflation rate. In practice, it is doubtful that prices would rise by the full amount of the tariff (if they did, what would be the purpose of retaliatory measures?). Most econometric studies suggest that producers will absorb about half of the tariff in the form of lower profit margins. To the extent that this reduces the pre-tariff price of imported goods, it would shift the terms of trade in America's favor. Chart 4Does Trade Retaliation Make Sense ##br## When Most Trade Is In Intermediate Goods? Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A There is an old economic theory, first elucidated by Robert Torrens in the 19th century, which says that the optimal tariff is always positive for countries such as the U.S. that are price-makers rather than price-takers in international markets. Put more formally, Torrens showed that an increase in tariffs from very low levels was likely to raise government revenue and producer surplus by more than the loss in consumer surplus. So, in theory, the U.S. could actually benefit at the expense of the rest of the world by imposing higher tariffs.4 Q: This assumes that there is no trade retaliation. How realistic is that? A: That's the key. As noted above, a breakdown of the global trading system would hurt the U.S., but a trade spat could help it. Trump was trying to scare the opposition by tweeting "trade wars are good, and easy to win." In a game of chicken, it helps to convince your opponent that you are reckless and nuts. Trump's detractors would say he is both, so that works in his favor. Trump has another thing working for him. Most trade these days is in intermediate goods (Chart 4). It does not pay for Mexico to slap tariffs on imported U.S. intermediate goods when those very same goods are assembled into final goods in Mexico - creating jobs for Mexican workers in the process - and re-exported to the U.S. or the rest of the world. The same is true for China and many other countries. This does not preclude the imposition of targeted retaliatory tariffs. The EU has threatened to raise tariffs on Levi's jeans and Harley Davidson motorcycles (whose headquarters, not coincidently, is located in Paul Ryan's Wisconsin district). We would not be surprised if high-end foreign-owned golf courses were also subject to additional scrutiny! But if this is all that happens, markets won't care. The fact that the United States imports much more than it exports also gives Trump a lot of leverage. Take the case of China. Chinese imports of goods and services are 2.65% of U.S. GDP, but exports to China are only 0.96% of GDP. And nearly half of U.S. goods exports to China are agricultural products and raw materials (Chart 5). Taxing them would be difficult without raising Chinese consumer prices. Simply put, the U.S. stands to lose less from a trade war than most other countries. Chart 5China Stands To Lose More From A Trade War With The U.S. Trump's Tariffs: A Q&A Trump's Tariffs: A Q&A Q: Couldn't China and other countries punish the U.S. by dumping Treasurys? A: They could, but why would they? Such an action would only drive down the value of the dollar, giving U.S. exporters an even greater advantage. The smart, strategic response would be to intervene in currency markets with the aim of bidding up the dollar. Chart 6Slowing Global Growth Is Bullish##br## For The Dollar Slowing Global Growth Is Bullish For The Dollar Slowing Global Growth Is Bullish For The Dollar Q: So the dollar could strengthen as a result of rising protectionism? A: Yes, it could. This is a point that even Mario Draghi made at yesterday's ECB press conference. If higher tariffs lead to a smaller trade deficit, this will increase U.S. aggregate demand. The boost to demand would be amplified if more companies decide to relocate production back to the U.S. for fear of being shut out of the lucrative U.S. market. The U.S. economy is now operating close to full employment. Anything that adds to demand is likely to prompt the Fed to raise rates more aggressively than it otherwise would. That could lead to a stronger greenback. Considering that the U.S. is a fairly closed economy which runs a trade deficit, it would suffer less than other economies in the event of a trade war. A scenario where global growth slows because of rising trade tensions, while the composition of that growth shifts towards the U.S., would be bullish for the dollar (Chart 6). Q: What are the implications for stocks and bonds? A: Wall Street will dictate what happens to stocks, but Main Street will dictate what happens to bonds. The stock market hates protectionism, so it is no surprise that equities sold off last week. It is this fact that ultimately got Trump to soften his position. Trump is used to taking credit for a rising stock market. If stocks flounder, this could make him think twice about pushing for higher trade barriers. As far as bonds are concerned, they will react to whatever happens to growth and inflation. As noted above, a trade skirmish could actually boost growth and inflation. Given that the economy is near full capacity, the latter is likely to rise more than the former. This, too, could cause Trump to cool his heels. After all, if higher inflation pushes up bond yields, this will hurt highly-levered sectors such as, you guessed it, real estate. Q: In conclusion, where do you see things going from here? A: Trade frictions will continue. As my colleague Marko Papic highlighted in a report published earlier this week, NAFTA negotiations are likely to remain on the ropes for some time.5 The Trump administration is also investigating allegations of Chinese IP theft. The U.S. is a major exporter of intellectual property, but these exports would be much larger if U.S. companies were properly compensated for their ingenuity. Chinese imports of U.S. intellectual property were less than 0.1% of Chinese GDP in 2017, an implausibly small number (Chart 7). If China is found to have acted unfairly, this could lead the U.S. to impose across-the-board tariffs on Chinese goods and restrictions on inbound foreign direct investment. Nevertheless, as noted above, worries about a plunging stock market will constrain Trump from acting too aggressively. The rationale for protectionism made a lot more sense when there were masses of unemployed workers. Today, firms are struggling to find qualified staff (Chart 8). This suggest that Trump will stick to doing what he does best, which is taking credit for everything good that happens under the sun. Chart 7China Is Importing More IP From The U.S., ##br##But The "True" Number Is Probably Higher China Is Importing More IP From The U.S., But The "True" Number Is Probably Higher China Is Importing More IP From The U.S., But The "True" Number Is Probably Higher Chart 8Protectionism Makes Less Sense ##br##When The Labor Market Is Strong Protectionism Makes Less Sense When The Labor Market Is Strong Protectionism Makes Less Sense When The Labor Market Is Strong Ironically, the latest trade skirmish is occurring at a time when the Chinese government is taking concerted steps to reduce excess capacity in the steel sector, and the profits of U.S. steel producers are rebounding smartly (Chart 9). In fact, the latest Fed Beige Book released earlier this week highlighted that "steel producers reported raising selling prices because of a decline in market share for foreign steel ..."6 Chart 9Chinese Steel Exports Falling, U.S. Steel Profits Rising Chinese Steel Exports Falling, U.S. Steel Profits Rising Chinese Steel Exports Falling, U.S. Steel Profits Rising Meanwile, German automakers already produce nearly 900,000 vehicles in the U.S., 62% of which are exported. In fact, European automakers have a smaller share of the U.S. market than U.S. automakers have of the European one.7 A lot of what Trump wants he already has. The Pentagon has also warned that trade barriers imposed against Canada and other U.S. military allies could undermine America's standing abroad. This is an important point, considering that Trump invoked the rarely used Section 232 of the Trade Expansion Act of 1962, which gives the President broad control over trade policy in matters of national security, to justify raising tariffs. Trump tends to listen to his generals, if not his other advisors. He probably was not expecting their reaction. All this suggests that a major trade war is unlikely to occur. As we go to press, it appears that the White House will temporarily exclude Canada and Mexico from the list of countries subject to tariffs. We suspect that the EU, Australia, South Korea, and a number of other economies will get some relief as well. White House National Trade Council Director Peter Navarro has also said that some "exemptions" may be granted for specific categories of steel and aluminum products that are deemed necessary to U.S. businesses. That is a potentially very broad basket. The bottom line is that the equity bull market will end, but chances are that this will happen due to an overheated U.S. economy and rising financial imbalances met with restrictive monetary policy, not because of escalating trade protectionism. Investors should remain overweight global equities for now, but look to pare back exposure later this year. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see "Secretary Ross Releases Steel and Aluminum 232 Reports in Coordination with White House," U.S. Department of Commerce, February 16, 2018. 2 Katharine G. Abraham, and Kearney, Melissa S., "Explaining the Decline in the U.S. Employment-to-Population Ratio: A Review of the Evidence," NBER Working Paper No. 24333, (February 2018). 3 David H. Autor, Dorn, David and Hanson, Gordon H., "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Reviews of Economics, dated August 8, 2016, available at annualreviews.org. 4 A graphical illustration of this point is provided here. 5 Please see BCA Geopolitical Strategy, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018. 6 Please see "The Beige Book: Summary of Commentary on Current Economic Conditions By Federal Reserve District,"Federal Reserve, dated March 7, 2018. 7 Please see Erik F. Nielsen, "Chief Economist's Comment: Sunday Wrap," UniCredit Research, dated March 4, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The direct impact of recently proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. In isolation, this development is not very relevant for investment strategy. However, the lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Feature The looming threat of U.S. protectionism came into full force over the past week, as President Trump stated that sweeping tariffs on all U.S. imports of steel and aluminum would soon be formalized. The tariff situation continues to evolve as we go to press, but the facts as they currently stand are the following: The proposed tariffs would be 25% on steel, and 10% on aluminum imports No exceptions are planned for any country, although statements from U.S. leadership on Monday suggested that Canada and Mexico may be exempt if NAFTA is renegotiated in the U.S.' favor Key European Union leaders threatened to retaliate against the U.S.' proposed tariffs, and the U.S. threatened to counter-retaliate China has taken a more cautious stance on the issue of retaliation, and is strongly seeking to negotiate with the Trump administration Minimal Direct Impact The developments over the past week raise two questions about China's economy that matter for investment strategy: What is the direct impact of the tariffs on China's exports likely to be? What is the implication for global growth? On the first question, the answer is fairly clear that the direct impact is likely to be small. The proposed tariffs do not disproportionately target China, and Chinese exports of steel and aluminum to the U.S. account for less than 0.2% of total exports (Chart 1). Exports of these products to all countries as a share of total exports is still quite small (panel 2). The second question is much more difficult to answer, and it has wide implications for both the Chinese economy and for investment strategy. When approaching the question, it is first important to note that the threat to the global economy from the imposition of the proposed tariffs comes from the potential for a series of retaliations from major trading partners, not the tariffs themselves. U.S. imports of steel and aluminum make up less than 1% of global goods exports, and Chart 2 presents a long-term history of average U.S. tariff rates along with our estimate of the impact of the U.S.' proposal. While the imposition of the announced tariffs would certainly change the trend that has been in place for some time, the rise is not very significant. Critically, even after the tariffs are imposed, U.S. tariffs rates will still be fractional when compared with those that prevailed during the early-1930s, when the Smoot-Hawley Tariff Act materially exacerbated the Great Depression. Chart 1Chinese Steel And Aluminum Exports##br## Are Not Significant Chinese Steel And Aluminum Exports Are Not Significant Chinese Steel And Aluminum Exports Are Not Significant Chart 2We're A Long, Long Way Away##br## From Smoot-Hawley We're A Long, Long Way Away From Smoot-Hawley We're A Long, Long Way Away From Smoot-Hawley China's cautious stance towards retaliation is, at first blush, an encouraging development, but it may not be as hopeful of a sign as it seems. First, despite a general feeling among investors that China was the intended target of the U.S.' proposed tariffs, a global tariff on steel and aluminum is likely to disproportionately affect developed countries rather than China. It is therefore not surprising that China has signaled a somewhat conciliatory stance. In our view, the likelihood of Chinese retaliation is considerably higher if further tariffs are announced on goods that make up a larger share of their exports. In addition, as we noted above, the European Union has already highlighted some U.S. goods that may be subject to higher retaliatory tariffs in response to the news (which already elicited a threat of counter-retaliation from the U.S.), and both Canada and Mexico have also threatened retaliation if they are not granted an exemption from the proposed tariffs. In our view, these threats should be treated seriously, especially after revisiting the lessons of one of the most famous experiments in game theory. Bottom Line: The direct impact of proposed U.S. import tariffs on steel and aluminum is likely to be small, both for China and the world. Retaliation Risk And The Prisoner's Dilemma The dynamics of trade renegotiations can be examined, at least conceptually, through the lens of game theory. It is difficult to model these dynamics precisely because of the complexity of the relationship between trade and potential growth, but it is worth revisiting the lessons learned by the repeated playing of Prisoner's Dilemma, one of the most well-known examples of the application of game theory. To summarize, the Prisoner's Dilemma scenario describes two criminals who have been arrested, and whose statement to the authorities affects the manner in which punishment (if any) is distributed between the two of them. The standard payoff structure of the game is set up such that one prisoner is able to largely avoid punishment if (s)he accuses the other of the crime and the other prisoner remains silent, but that both prisoners receive a punishment if they both accuse each other that is greater than the punishment received if they both remain silent (Table 1). Given that tariffs and other forms of trade protectionism can only durably succeed at improving net domestic economic outcomes if they do not result in retaliation, from the perspective of trade renegotiation, accusing the other player in the game of Prisoner's Dilemma is tantamount to restricting trade, and remaining silent is equivalent to allowing existing trade relationships to persist. Table1In The Prisoner's Dilemma, It's Better To Return Defection With Defection China And The Risk Of Escalation China And The Risk Of Escalation The success of strategies employed in repeated games of Prisoner's Dilemma was studied most famously by Robert Axelrod in 1980.1 The winning strategy (in both of Axelrod's tournaments) was "Tit for Tat", which follows two very simple rules: cooperate initially, and thereafter copy the other player's decision in the previous round. This strategy has three attributes that Axelrod showed to be highly successful when playing repeated games of Prisoner's Dilemma: niceness (not being the first player to accuse/defect/renege), being provocable (responding to defections with in-kind retaliation), and forgiveness (not allowing one-time defections to impact future choices beyond a one-time retaliation). Chart 3 illustrates the performance of the "Tit for Tat" strategy in the first Axelrod tournament, along with the average scores of several other strategies. The most important lesson from both tournaments is summarized nicely in the chart: the average score of a series of "nice" strategies was considerably higher than those that were not nice. But Chart 4 also highlights that niceness is only a relatively successful strategy because of its ability to produce an optimal outcome with other nice strategies: all strategies, nice or not, tend to generate poor outcomes when played against strategies that are not nice. This is because the payoff structure of Prisoner's Dilemma is such that, compared with defection, co-operation makes a player worse off if their opponent defects. Chart 3In Repeated Games Of Prisoner's Dilemma,##br## "Nice" Strategies Pay Off... China And The Risk Of Escalation China And The Risk Of Escalation Chart 4...But Only Because They Do Well Against ##br##Other "Nice" Strategies China And The Risk Of Escalation China And The Risk Of Escalation In the context of global trade, this can be seen as the likelihood of outsized job losses (or the lack of job gains in a protected industry) from a failure to retaliate. The key point for investors is that the most basic lesson of the Prisoner's Dilemma suggests that market participants should be legitimately concerned about retaliation from the U.S.' trade partners (and subsequent counter-retaliation) if it continues to pursue a protectionist agenda, because it can be a rational response for an individual country even if it leads to poor outcomes for everyone involved. In addition, three assumptions of the Prisoner's Dilemma game are not valid in the real world (or the current environment), which in two of these cases further increases the risk of an iterative exchange of retaliation: Chart 5The U.S. Has A Trade Deficit ##br##With Many Trading Partners The U.S. Has A Trade Deficit With Many Trading Partners The U.S. Has A Trade Deficit With Many Trading Partners In terms of the payoffs associated with the game, Prisoner's Dilemma assumes an equal starting position (of zero "points") on both sides, which is not the case in the current environment. The U.S. has a sizeable trade deficit with the world (Chart 5), and several important trading partners with the U.S. (especially China) maintain significant non-tariffs barriers to trade. Regardless of whether this inequity has been caused by an unfair trading relationship, in the parlance of Axelrod's tournaments, this implies that the U.S. strategy is likely to be not nice due to the perception on the part of the Trump administration of an unequal starting position. The implication is that the odds of an escalation of the imposition of relatively small tariffs into a full-blown trade war are higher than would normally be the case. Prisoner's Dilemma has clear and symmetric payoffs, which is also not the case in the current environment. The Trump administration apparently feels that the payoff to the U.S. of certain trade restrictions is a net positive even assuming retaliation, which raises the possibility of a negative outcome for the global economy. Worryingly, in our view the chances are high that calculations of the net benefit of any trade restriction are being done on a political basis, rather than an economic one. Prisoner's Dilemma assumes that the participants are unable to communicate, which is a limitation that does not exist in a real-world trade negotiation scenario. This lowers the probability that the U.S. and its major trading partners will engage in a spiraling tit-for-tat trade war relative to what the game of Prisoner's Dilemma would imply, even if the recently announced tariffs on steel and aluminum stand and major partners do retaliate. Bottom Line: The lessons learned from studying the game of Prisoner's Dilemma suggest that investors should be legitimately concerned about an iterative "tit-for-tat" exchange of retaliation between the U.S. and its major trade partners if the Trump administration continues to pursue aggressively protectionist trade policies. No Help From The Domestic Economy A protectionist agenda from the U.S. is also coming at an inconvenient time for Chinese policymakers, even if they were not blindsided by the move. Policymakers already have to contend with managing the impact of renewed reforms on economy's financial and industrial sectors, and the potential addition of the external sector to this list of problems needing attention is unwelcome. While a cooling of the economy was an inevitable result from the government's deleveraging campaign and shadow banking crackdown, Table 2 highlights how broadly leading economic indicators have decelerated. The table presents recent data points for several series that we identified in November Special Report as having leading properties for the Chinese business cycle,2 as well as the most recent month-over-month change, an indication of whether the series is currently above its 12-month moving average, how long this has been the case. Table 2No Convincing Signs Of An Impending Upturn In China's Economy China And The Risk Of Escalation China And The Risk Of Escalation Among the components of the BCA Li Keqiang Leading Indicator (an index designed to lead turning points in the Li Keqiang index), all six series are in a downtrend and 5 out of these 6 fell in January (the growth in M2 was the exception). A similar story is borne out in the housing price data, with a variety of diffusion indexes having also fallen in January.3 The Caixin Manufacturing PMI remains the one bright spot, having recently risen above its 12-month moving average and having risen in January, in stark contrast to the official PMI (which fell a full point). But as Chart 6 highlights, following the last four episodes when the Caixin PMI exceeded the official PMI by this magnitude, the subsequent trend in the average of the two was down in every case. The implication is that the outlier nature of the current Caixin PMI shown in Table 2 is just that, and not a heralding a major upturn in China's economy. Chart 6The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal The Caixin PMI Is Probably The Noise, Not The Signal Bottom Line: Recent data releases show that the ongoing economic slowdown continues. While the Caixin manufacturing PMI is a bright spot, it is not likely heralding a major turning point for the Chinese economy. Conclusions For Investment Strategy Chart 7 illustrates the decision tree for Chinese stocks that we presented in our first report of the year. While there has been a modest further deterioration in the industrial sector, the pace of the decline is still consistent with the controlled slowdown scenario that we outlined in an October Weekly Report.4 As such, the recent softness in the data is not significant enough to cause us to change our recommended investment strategy. The key change over the past week has been the threat posed by U.S. protectionism to the global economy, which is the very first question to answer in our decision tree. The now high-beta nature of the Chinese stock market underscores that U.S. protectionism can significantly (negatively) impact the relative performance of Chinese equities if it destabilizes the global stock market, even if Chinese exports were to emerge from the exchange relatively unscathed. For now, we judge the likelihood of a full-blown tit-for-tat trade war to be a risk, and thus not a probable event. For now, market participants seem to agree: U.S. and global equities rebounded earlier this week in response to a feeling that the negative repercussions for global growth are likely to be minimal. Nonetheless, this is a risk that needs to be monitored closely, and to facilitate this our Geopolitical Strategy service has highlighted the following three bellwethers that they will be watching in order to judge the likelihood of a major escalation:5 Chart 7The Chinese Equity "Decision Tree" China And The Risk Of Escalation China And The Risk Of Escalation Tariff exceptions for allies: Given the national security basis for the steel and aluminum tariffs, it is likely that exceptions will be made for allies such as Canada and Europe. If yes, then the measure is unlikely to be part of a truly "America First" mercantilist strategy and is instead a veiled swipe at China to satisfy Trump's base ahead of the midterm elections NAFTA: Our geopolitical team has argued that the probability of NAFTA abrogation is around 50%.6 If the administration continues the negotiations in light of tariff announcements, however, it suggests that the revealed preference of the White House is less protectionist than it appears. Chinese intellectual property (IP) theft: The Trump administration is investigating Chinese technology transfer and IP theft under Section 301 of the Trade Act of 1974. If China is found to have acted unfairly, penalties would likely include a combination of tariffs and restrictions on Chinese investment in the U.S. This might include an indemnity for cumulative losses from past violations, which would be rare, if not unprecedented, and which China would reject outright. This could produce across-the-board tariffs of a sort that the U.S. has not imposed since the Nixon shock. Chart 8China Is Outperforming Global In Ex-Tech Terms China Is Outperforming Global In Ex-Tech Terms China Is Outperforming Global In Ex-Tech Terms In the meantime, Chart 8 highlights that investable Chinese ex-technology stocks (proxied by the MSCI China Index ex-technology) remain in an uptrend versus their global peers, which underscores that investors should have a high threshold for reducing exposure to China. This underscores that investors should have a high threshold for reducing exposure to China. While the ongoing slowdown in China's economy is likely to cause earnings growth to decelerate over the coming year, the continued likelihood of decently positive earnings growth coupled with a sizeable valuation discount relative to global signals that Chinese ex-tech stocks are remain attractive on a risk/reward basis. Investors should stay overweight. Bottom Line: Investors should closely watch three bellwethers to judge the likelihood of a full-blown global trade war. Barring a major deterioration on this front, or a sharp further slowdown in Chinese economic growth, investors should stay overweight Chinese ex-tech stocks vs global. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 "Effective Choice in the Prisoner's Dilemma" and "More Effective Choice in the Prisoner's Dilemma" by Robert Axelrod, The Journal of Conflict Resolution, Vol. 24 Nos.1 and 3, March and September 1980. 2 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of The Chinese Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 3 However, as discussed in our February 8 Weekly Report, we are keeping an eye on residential floor space sold given its history of leading China's housing market cycles. 4 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, available at cis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War", dated March 6, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "NAFTA - Populism Vs. Pluto Populism", dated November 10, 2017, available at gps.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

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

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 Seasonal environmental restrictions on Chinese aluminum output are due to ease going into spring, which will restore some of the output taken off line when inefficient smelters were shuttered last year. Global demand likely will slow later this year, largely because we expect GDP growth in China, which accounts for more than half of global aluminum consumption, to moderate in 2H18. In addition, expected U.S. tariffs and quotas will limit imports and revive output in that market. This will contribute to the easing of a tight global balance, and take some of the pressure off prices, but we do not expect a significant move lower. We remain neutral. Energy: Overweight. Our long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls - recommended last week on the back of our updated price forecast - closed with a 3.1% gain on Tuesday. We took profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, realizing a 20.7% gain since it was recommended January 18, 2018. Base Metals: Neutral. We are expecting a secular increase in aluminum supplies this year, on the back of Chinese environmental policies and more difficult global trading conditions. Precious Metals: Gold markets awaited Fed Chair Powell's Humphrey-Hawkins testimony beginning Tuesday, as vice chair for financial supervision, Randal Quarles, warned U.S. economic growth could exceed expectations the day before. Ags/Softs: Underweight. Argentina's drought looks like it will stress that country's grain harvests, and tighten markets at the margin. Feature Chart of the WeekAluminum In Large Deficit Last Year Aluminum In Large Deficit Last Year Aluminum In Large Deficit Last Year Easing of winter supply restrictions in China, as well as tighter controls on U.S. aluminum imports, will dominate the aluminum market in the near term. In both cases, the net effect likely will be an increase in global supply. The latter would also support aluminum's price in the U.S. market - as measured by the U.S. Midwest premium. These events will ease the global physical deficit in aluminum, which last year came in at its widest since 1995 (Chart of the Week). The current tight conditions are driven by Beijing's elimination of overcapacity, which, along with environmental reform policies implemented last year, led to a reduction in China's output. The price dynamics that dominated the aluminum market over the past couple years will shift as a result. This already can be seen in the behavior of prices on the LME and the SHFE: LME prices have been gyrating around $2,200/MT, while SHFE prices have dipped by more than 5% since the beginning of the year. Unwinding China's Supply-Side Policies? At first blush, it may not be apparent China's primary aluminum production sector experienced significant changes last year. After stalling at 1% year-on-year (y/y) growth in 2016, output grew 1.2% y/y in 2017, a sharp deceleration from the 16% y/y average growth rates registered between 2010 and 2015. However, the annual gain masked a 10% y/y increase in output in 1H17, which was almost completely reversed by the negative impacts of China's environmental policies and its efforts to eliminate overcapacity. These policy-led initiatives ultimately caused output to fall 7% y/y in 2H17 (Chart 2). The resulting 1 mm MT of production cuts in the second half of last year reflects China's 2017 supply-side policies. Beijing's strategy is two-fold: Chart 2Sharp Fall In 2H17 Output From China ... Sharp Fall In 2H17 Output From China ... Sharp Fall In 2H17 Output From China ... Eliminate outdated and unlicensed capacity by forcing it to close. This has removed an estimated 3-4 mm MT of annual capacity. The policy targets capacity lacking proper building and expansion permits, as well as the smelters that do not meet strict environmental standards. However, not all the shutdowns are permanent. Among this shuttered capacity is 2 mm MT of outdated smelter capacity belonging to China Hongqiao, which the company plans to replace with new capacity.1 The other major supply-side policy implemented by Beijing last year is a restriction on smelter activity during the mid-November to mid-March period. As is the case in the steel sector, this winter-curtailment policy seeks to reduce pollution during the smog-prone winter months. Aluminum smelters in the cities targeted in the winter plan were ordered to cut output by ~ 30% during this period. This policy is expected to be an annually recurring event until 2020. However, while 3 mm MT of annualized capacity would have been closed during the winter if the full 30% curtailment target had been met, reports surfaced in mid-December that compliance was low, and suggested only ~ 0.6 mm MT of capacity (just 20% of the goal, or 6% of the curtailment target) had been closed.2 The total aluminum annual capacity affected by both the winter environmental curtailments and capacity-reduction policies implemented last year could potentially reach 7 mm MT. China's total smelting capacity was a reported 40 mm MT in 2016. Lower Chinese Production ... And Consumption On a year-on-year basis, global primary aluminum production has been falling since August. This is, for the most part, true on a month-on-month basis, as well. The 12-month moving average for global aluminum production peaked in July, and has been coming down consistently since then. Although 2017 production came in higher than the previous year, this is due to a ~ 6% y/y increase in the first half, which preceded a ~ 4% y/y decline in output in the second half of the year. These dynamics are driven by China, which accounts for 55% of global primary production. Chinese firms raised primary output in 1H17, which was followed by a sharp contraction in 2H17. Chinese primary aluminum production peaked in June, recording an all-time record of 2.98 mm MT before falling in the subsequent months. On the other hand, primary production from the rest of the world has remained largely unchanged over the past two years, at 26 mm MT. Data from the International Aluminum Institute shows month-on-month production increases in China in December and January; however, output is still lower vs. the same period a year earlier. Chinese production drove global aluminum production higher in the past, but falling output from the world's leading producer now is causing global primary aluminum supply to contract. The impact of China's supply curtailments has been muted by lower demand for the metal (Chart 3). Again, lower consumption has been driven by the top-demand market - China - which typically consumes ~ 55% of the primary metal. Chinese primary consumption and production each came down by more than 1 mm MT y/y in the second half of last year. Falling aluminum demand in China is consistent with a slowdown in Chinese automobile production as well as fixed asset investments in infrastructure and transportation (Chart 4). Furthermore, China's scrap aluminum imports increased in 2H17, reflecting a preference for the secondary metal as the price of primary aluminum increased. Chart 3... Coincided With Falling Chinese Consumption ... Coincided With Falling Chinese Consumption ... Coincided With Falling Chinese Consumption Chart 4Slowdown In Chinese Demand Slowdown In Chinese Demand Slowdown In Chinese Demand A Divergence In Global Dynamics ... Despite the improved balance in China, the global primary aluminum balance in the rest of the world recorded a large deficit last year - the largest since 1995 (Chart 5). While both consumption and production in China came down by more than 1 mm MT in 2H17, consumption in the rest of the world increased by ~ 0.4 mm MT, even as production remained largely unchanged. This tightened the global market, as more stringent aluminum production policies in China meant that there was no flooding of Chinese aluminum to ease the deficit. In fact, the world excluding China deficit is the largest at least since the World Bureau of Metal Statistics (WBMS) started collecting data in 1995. ... Is Reflected In Inventory Dynamics This also coincides with rising aluminum stocks on the Shanghai Futures Exchange and falling inventory on the LME. In fact, Chinese aluminum imports have been falling and were down almost 30% y/y in 2H17. At the same time, Chinese net exports picked up slightly (Chart 6). Chart 5Record Aluminum Deficit Outside China Record Aluminum Deficit Outside China Record Aluminum Deficit Outside China Chart 6Chinese Net Exports On The Rise Chinese Net Exports On The Rise Chinese Net Exports On The Rise In response to lower output, LME inventories have been falling since 2Q14, and they continued their descent last year, ending 2017 at roughly the same level as mid-2008. On the other hand, stocks at the SHFE have been rising steeply since the beginning of last year and are at record highs (Chart 7). Whether the tight global market fundamentals will persist depends on whether China's outdated capacity cuts prove to be temporary or permanent. Chart 7Dynamics Reflected In Stock Changes Dynamics Reflected In Stock Changes Dynamics Reflected In Stock Changes U.S. Tariffs And Quotas Would Offset Tight Markets In what appears to be an effort to revive U.S. aluminum and steel production, the U.S. Commerce Department launched an investigation into these domestic industries late last year. Last month, Commerce proposed tariffs and quotas that would impact all aluminum imports with the exception of aluminum scrap and aluminum powders. There appear to be two main objectives of this investigation: 1. Increase capacity utilization in the U.S. aluminum and steel industries; and 2. Penalize China for subsidizing its aluminum sector at the expense of those in other countries. Among the Commerce proposals: 1. A 7.7% tariff on all aluminum imports to the U.S. 2. A 23.6% tariff on all aluminum imports from certain countries, while other countries would be subject to quotas equal to 100% of their 2017 exports to the U.S.3 3. A quota on all aluminum imports from other countries equal to a maximum of 86.7% of their 2017 exports to the U.S. In a memo issued last week, the U.S. Department of Defense expressed its support for the targeted tariffs (option 2 above), as well as a recommendation to postpone action on the aluminum sector. President Trump has until April 19 to make a decision on the aluminum recommendations. While he may not stick to the exact details outlined in the three options, our Geopolitical Strategists expect him to go through with implementing protectionist measures to limit aluminum imports. U.S. production of primary aluminum is at its lowest level since 1951 (Chart 8). To reach the 80% target of smelter capacity utilization envisioned by Commerce, the U.S. will have to add ~ 0.67 mm MT of supply. This represents just ~ 1.16% of world supply in 2016. Imports currently make up 90% of U.S. primary aluminum consumption. Chart 8U.S. Producers Took A Big Hit U.S. Producers Took A Big Hit U.S. Producers Took A Big Hit In fact, even if this amount of aluminum was supplied domestically in the U.S. last year, the world aluminum market would have remained in deficit. Furthermore, this additional supply would pale in comparison to the cuts China has already implemented in its aluminum sector last year. China's primary production in the August to December period last year came in 1.15 mm MT below the same period in 2016. Annual smelter capacity in the U.S. is estimated to be a combined 1.82 mm MT. Of this capacity, Alcoa has 0.34 mm MT of idle capacity, Century Aluminum has 0.27 mm MT, while ARG International's Missouri plant has 0.27 mm MT of idle capacity. U.S. producers have started communicating plans to restart idled capacity. According to Century Aluminum's CEO, the company's eastern Kansas operation, which shuttered more than half of its production, could ramp output at one of its smelters to full capacity of up to 0.27 mm MT by early next year. Similarly, Alcoa has committed to partially restarting production at its Warwick, Indiana, facility, which would bring 0.16 mm MT of capacity online by the second quarter of this year. However, imports are not the sole reason output in the U.S. aluminum sector is falling. High power costs also have contributed, but this is not addressed in the Department of Commerce's report. In any case, we would not be surprised to witness an increase in aluminum imports by U.S. consumers before a final decision is made. If import controls do in fact fall into place, prices in the U.S. - as reflected by the U.S. Midwest transaction premium - will likely increase. Bottom Line: Supply- and demand-side developments, mostly in China, which accounts for more than half of global production and consumption, will combine to ease a global supply deficit this year. Expected U.S. tariffs and quotas will limit imports and revive output in that market. This will take some pressure off prices, but, we do not expect levels to move significantly lower. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "China Hongqiao says to cut 2 mln T/year of outdated aluminum capacity," published on August 2, 2017, available at reuters.com. 2 Please see "Aluminum Under Pressure After China Smog Cutbacks Fall Short," published on December 20, 2017, available at reuters.com. 3 The countries noted are China, Hong Kong, Russia, Venezuela, and Vietnam. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Global Aluminum Deficit Set To Ease Global Aluminum Deficit Set To Ease Trades Closed in 2018 Summary of Trades Closed in 2017 Global Aluminum Deficit Set To Ease Global Aluminum Deficit Set To Ease

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 We are shifting our U.S. recession call from late-2019 to 2020. A cheap dollar and fiscal support will give the Fed more scope to raise rates before monetary policy moves into restrictive territory. The fiscal impulse will fall sharply in 2020. By then, financial conditions will be tighter and economic imbalances will be more pronounced. As is usually the case, a downturn in the U.S. will infect the rest of the world. Emerging markets with large current account deficits and high debt levels are most vulnerable. A cyclical overweight to global equities is still appropriate, but long-term investors should begin to scale back risk exposure. Feature Records Are Meant To Be Broken The NBER Business Cycle Dating Committee, which contrary to popular belief does not serve as a matchmaking service for lonely-heart economists, estimates that the current economic expansion is going on nine years. If it makes it to July 2019, it will be the longest in history (Chart 1). Considering that records begin in 1854 - encompassing 33 business cycles - that will be an impressive achievement. Chart 1Nine Years And Still Going Strong Nine Years And Still Going Strong Nine Years And Still Going Strong There is an old adage that says "Expansions do not die of old age. They are murdered by the Fed." A year or so ago, it looked like the Fed would pull the trigger sometime in 2019. Now, however, it looks more likely that the deed will be committed in 2020. Two things have changed since the start of last year. First, the real trade-weighted dollar has fallen by 8%. According to the Fed's SIGMA macroeconomic model, this should boost growth by about 0.3% over the next two years. Chart 2U.S. Fiscal Policy Has Become##BR##Much More Stimulative The Next Recession: Later But Deeper The Next Recession: Later But Deeper Second, U.S. fiscal policy has become much more stimulative, a point very much in keeping with our Geopolitical Strategy team's long-standing view that age of austerity is giving way to a new age of populism.1 My colleague Mark McClellan estimates that the U.S. fiscal impulse will reach 0.8% of GDP in 2018 and 1.3% of GDP in 2019, up from -0.4% and 0.3%, respectively, in the IMF's October 2017 projections (Chart 2). Mark's calculations incorporate the CBO's assessment of the tax cuts, the recent Senate deal to raise the caps on defense and nondefense expenditures, and $45 billion in hurricane relief. He assumes some delay between when the bill is passed and when the spending takes place. According to the Congressional Budget Office, a little more than half of the expenditures in the 2013 and 2015 spending bills occurred in the same year the funding was authorized. These fiscal measures will cause the federal budget deficit to swell by about 2.3 percentage points to 5.6% of GDP in FY2019. Even that may be an understatement, as this does not include any additional infrastructure spending nor the possible restoration of "earmarks"- the widely criticized practice that allows members of Congress to add appropriations to unrelated bills to fund what often turn out to be politically motivated projects in their districts - which could add a further $25 billion in annual spending. Meanwhile, federal government revenue is coming in below target, which the Office of Management and Budget (OMB) has attributed to lower-than-expected taxable income from pass-through businesses and capital gains realizations. This problem could worsen over the next few years as creative accountants find new loopholes to exploit in the recently passed tax bill. Too Much, Too Late All this stimulus is arriving when the economy least needs it. The unemployment rate currently stands at 4.1%, 0.5 points below the level the Fed regards as consistent with full employment. It has been stuck at that number for four straight months, largely because job growth in the Household survey (which the unemployment rate is based on) has lagged the Establishment survey by a considerable margin. Given the underlying strength in GDP growth, it is likely the job gains in the Household survey will rebound strongly over the course of 2018, taking the unemployment rate down to 3.5% by year-end, well below the Fed's end-2018 projection of 3.9%. A lower-than-projected unemployment rate will permit the Fed to raise rates four times this year, one more hike than currently implied by the dots. The Fed will probably also hike rates three or four times next year. Yet, even those additional rate hikes will not come close to offsetting all the fiscal stimulus coming down the pike. In the absence of a sustained increase in productivity or labor force growth - neither of which appear forthcoming - the economy will continue to overheat. Inflation is a highly lagging indicator. It typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 3). The Fed knows this perfectly well, but has chosen to let the economy run hot for fear that a premature tightening will sow the seeds for a deflationary spiral. Chart 3Inflation Is A Lagging Indicator The Next Recession: Later But Deeper The Next Recession: Later But Deeper By the time the next recession rolls around, inflation will be higher and financial and economic imbalances will be greater. The fiscal impulse will also fall back towards zero in 2020 as the budget deficit stabilizes at an elevated level. It is the change in the budget balance that is correlated with GDP growth. If output is already being constrained by a lack of spare capacity going into late-2019, the subsequent decline in the fiscal impulse in 2020 could push growth below trend, leading to rising unemployment. And, as we have often noted, once unemployment starts rising, it keeps rising. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point that was not associated with a recession (Chart 4). Chart 4Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle A recent IMF report highlighted that changes in U.S. financial conditions strongly influence growth abroad.2 As the U.S. falls into a recession, equity prices will tumble and credit spreads will widen. Financial conditions will tighten, transmitting the downturn to the rest of the world. Emerging markets with large current account deficits and high debt levels will be the most vulnerable. The only saving grace is that interest rates will be higher in 2020 than they would have been if the recession had begun in 2019. This will give the Fed a bit more scope to ease monetary policy again. As discussed last week, this will likely set the stage for a stagflationary episode following the recession.3 For Now, Leading Indicators Look A-Okay While our baseline view is that the next recession will occur in 2020, this is more of an educated guess than a firm prediction. Many things, including an overly aggressive Fed, a sharp appreciation in the dollar, and a variety of political shocks, could cause the recession to occur sooner than anticipated. As such, we continue to watch a wide swathe of data to help guide our investment recommendations. The good news is that right now, none of our favorite leading economic indicators such as the level of ISM manufacturing new orders minus inventories, capital goods orders, initial unemployment claims, and building permits are flashing red (Chart 5). Many of these indicators appear in The Conference Board's LEI, which is still rising at a healthy 5.5% y/y pace. Historically, a decisive break below zero in the year-over-year change in the LEI has been a reliable recession indicator (Chart 6). We are still far from that point. Chart 5U.S. Leading Indicators Looking A-OKAY U.S. Leading Indicators Looking A-OKAY U.S. Leading Indicators Looking A-OKAY Chart 6U.S. LEI Is Not Flashing Red U.S. LEI Is Not Flashing Red U.S. LEI Is Not Flashing Red The same goes for leading financial variables such as credit spreads and the yield curve. The yield curve has inverted in the lead-up to every recession over the past 50 years (Chart 7). The fact that the 10-year/3-month slope has steepened by 30 basis points since the start of the year gives us some comfort that the next recession is still some time away. Chart 7An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession Keep An Eye On Credit Credit spreads remained well contained during the recent bout of market turbulence but we continue to watch them closely. Credit typically starts to underperform before equities do, which makes it a good leading indicator for the stock market. This is likely to be especially the case over the next two years. If there is one area where financial imbalances have accumulated to worrying levels, it is in the corporate debt arena. This month's issue of the Bank Credit Analyst estimates that the interest coverage ratio for U.S. companies would drop from 4 to 2½ if interest rates were to increase by 100 basis points across the corporate curve.4 This would take the coverage ratio to the lowest level in the 30-year history of our sample (Chart 8). Consumer staples, tech, and health care would be the most affected. Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) U.S. Interest Coverage Ratio Breakdown By Sector (I) Chart 8U.S. Interest Coverage Ratio##BR##Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) U.S. Interest Coverage Ratio Breakdown By Sector (II) We currently maintain an overweight to equities and spread product but expect to move to neutral later this year and to underweight sometime in 2019. Long-term investors should consider paring back exposure to both asset classes already, given that valuations have become stretched. The Dollar And The Return Of "Twin Deficits" Bigger budget deficits will drain national savings. Since the current account balance is simply the difference between what a country saves and what it invests, the U.S. current account deficit is likely to increase. How the emergence of these twin deficits will affect the dollar is a tough call. Historically, there is no clear relationship between the sum of the fiscal and current account balance and the value of the trade-weighted dollar (Chart 9). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a decline in the household saving rate from the booming housing market. Much depends on what happens to real interest rates. If investors come to believe that persistently large budget deficits will lead to higher inflation, long-term real yields could decline, pushing the dollar lower. In contrast, if investors conclude that the Fed will raise rates by enough to keep inflation from spiraling upwards, real yields could rise. U.S. real yields have gone up across all maturities since the start of the year. As a result, real rate differentials have widened between the U.S. and its developed market peers (Chart 10). However, some of the increase in U.S. real rates has been due to a rising term premium, with the rest reflecting an upward revision to the expected path of policy rates. The latter is good for the dollar. The former is not, because it means that investors are starting to worry about the ability of the market to absorb the increasing supply of Treasurys. Meanwhile, rising interest rates threaten to put further pressure on the U.S. current account deficit. The U.S. net international investment position has deteriorated from -10% of GDP to -40% of GDP since 2007 (Chart 11). The U.S. owes the rest of the world about 68% of GDP in debt - almost all of which is denominated in dollars - but holds only 23% of GDP in foreign debt. Thus, a synchronized increase in global bond yields would cause U.S. net interest payments to rise. If yields in the U.S. increase more than elsewhere, net payments would rise even more. Chart 9Twin Deficits And The Dollar:##BR##No Clear-Cut Relationship Twin Deficits And The Dollar: No Clear-Cut Relationship Twin Deficits And The Dollar: No Clear-Cut Relationship Chart 10Real Rate Differentials Have##BR##Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Real Rate Differentials Have Widened Between The U.S. And Its DM Peers Chart 11Deterioration In U.S. Net##BR##International Investment Position The Next Recession: Later But Deeper The Next Recession: Later But Deeper America's status as a major net external debtor could also constrain the extent to which the dollar appreciates. If the greenback were to strengthen, the dollar value of U.S. external assets would decline, as would the dollar value of interest or dividend payments that the U.S. receives from abroad. This would result in a deterioration in the current account balance and in a worsening in the U.S. net international investment position. Some Positives For The Greenback While the discussion above is bearish for the dollar, it needs to be put into some context. The U.S. current account deficit stands at 2.3% of GDP, down from almost 6% of GDP in 2006 (Chart 12). Much of the improvement in the U.S. balance of payments can be traced back to the plunge of almost 70% in net oil imports, a development that is likely to be permanent given the shale boom. Furthermore, the U.S. trade balance should benefit over the coming quarters from the lagged effects of a weaker dollar. And while we estimate that the primary income balance will deteriorate by about 0.6% of GDP over the next two years, it should still remain in positive territory and above the levels from a decade ago (Chart 13). Chart 12U.S. Balance Of Payments:##BR##Improvement Due To Sinking Oil Imports U.S. Balance Of Payments: Improvement Due To Sinking Oil Imports U.S. Balance Of Payments: Improvement Due To Sinking Oil Imports Chart 13Primary Income Balance Will Decline,##BR##But Will Remain In Positive Territory Primary Income Balance Will Decline, But Will Remain In Positive Territory Primary Income Balance Will Decline, But Will Remain In Positive Territory On the fiscal side, the projected rise in U.S. government debt levels at a time when the economy is booming is concerning. Nevertheless, the U.S. debt profile still compares favorably to countries such as Japan and Italy, two economies with worse growth prospects than the U.S. Italian 30-year bond yields are actually lower than in the United States. If one of the two countries is going to have a debt crisis over the next decade, our guess is that it will be Italy and not the U.S. A Cresting In Global Growth Could Help The Dollar Our preferred explanation for why the dollar began to weaken in 2017 focuses on the role of global growth as well as on technical factors. Chart 14USD Is A Momentum Winner The Next Recession: Later But Deeper The Next Recession: Later But Deeper Strong global growth - especially when concentrated outside the U.S., as was the case last year - tends to hurt the dollar. There are a number of reasons for this. First, a robust global economy pushes up natural resource prices, which boosts the terms of trade for commodity-exporting economies. Second, manufacturing represents a smaller share of the U.S. economy than it does in most other countries. Since manufacturing activity is quite cyclically-sensitive, faster global growth benefits economies such as Germany, Sweden, Japan, China, and Korea more than the U.S. Third, stronger global growth tends to boost risk appetites. This has translated into large inflows into EM funds and peripheral European debt markets. The latter have also seen an ebbing of political risk, which has translated into sharply lower sovereign spreads. The acceleration in global growth came at a time when long dollar positions had reached elevated levels. As those positions were unwound, the dollar began to tumble. At that point, the strong upward momentum that fueled the dollar rally following the U.S. presidential election was replaced by downward momentum. The U.S. dollar is one of the most momentum-driven currencies out there (Chart 14). Weakness led to even more weakness. It is impossible to know when the dollar's downward momentum will exhaust itself. What can be said is that speculative positioning has become increasingly dollar bearish. This raises the odds of a short-covering dollar rally (Chart 15). Chart 15Speculative Positioning Has Gotten Increasingly Dollar Bearish The Next Recession: Later But Deeper The Next Recession: Later But Deeper Perhaps more importantly, global growth may be peaking. China's economy has slowed, as gauged by the Li Keqiang index, which combines electricity production, freight traffic, and bank lending (Chart 16). Growth in Europe and Japan has also likely reached top velocity. U.S. financial conditions have eased sharply relative to the rest of the world (Chart 17). This, in conjunction with an easier U.S. fiscal policy, suggests that the composition of global growth will shift back towards the U.S. over the coming months. If this were to happen, the dollar could recoup some its losses. Chart 16Chinese Economy##BR##Has Slowed Chinese Economy Has Slowed Chinese Economy Has Slowed Chart 17U.S. Financial Conditions Have##BR##Eased Sharply Relative To ROW U.S. Financial Conditions Have Eased Sharply Relative To ROW U.S. Financial Conditions Have Eased Sharply Relative To ROW Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016. 2 Please see "Getting The Policy Mix Right," IMF Global Financial Stability Report, April 2017. 3 Please see Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018. 4 Please see The Bank Credit Analyst, "Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector," dated February 22, 2018. Available at bca.bcaresearch.com. 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