Inflation/Deflation

Highlights The end of the low volatility regime could mark a leadership change in global equities away from EM to DM. The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows RMB appreciation to head off major protectionist threats from the U.S. This could delay the U.S. dollar rally and support EM risk assets. The EM and commodities equity rallies might be facing formidable technical resistances. These equity segments have to break out these technical resistances decisively to confirm the sustainability of the bull market. Feature Global stocks have corrected, and volatility measures have surged. The low volatility regime appears to have come to a decisive end. Even though in the short run volatility measures could well decline after their steep surge of the past week, the cyclical outlook points to higher volatility relative to last year. Financial markets are likely to be re-priced to adjust to the end of this low-volatility period. This entails more stress, and an additional selloff in risk assets. Periods of low volatility historically sow the seeds of their own reversal. Investors tend to embrace high-risk strategies amid low volatility, and take on more leverage. As a result, market excesses and froth arise, increasing the market's vulnerability in the event of a reversal. The latest period of low volatility lasted for more than a year, and no doubt facilitated the build-up of froth and excesses in global financial markets. Chart I-1 illustrates that the aggregate volatility measure of various financial markets was at its lows of the past 12 years before surging in recent days. Chart I-1Rising Volatility Coincides With A U.S. Dollar Rally Rising Volatility Coincides With A U.S. Dollar Rally Rising Volatility Coincides With A U.S. Dollar Rally What does rising volatility mean for emerging market (EM) relative performance vis a vis developed markets (DM)? It is primarily contingent on the U.S. dollar. If the U.S. dollar rebounds along with the rise in volatility, as it has done in the past (Chart I-1), EM equities will commence underperforming DM bourses. If the U.S. dollar fails to rebound and drifts lower, EM stocks are likely to outperform DM equities. With respect to exchange rates, we believe one of the major driving forces for currencies is the relative growth trajectory. The latter can be approximated by relative equity market performance in local currency terms. Chart I-2 shows that U.S. share prices - of both large and small caps - have been outperforming their global counterparts in local currency terms. Persisting periods of outperformance of U.S. stocks versus their global peers eventually, albeit sometimes with a considerable time lag, instigates a stronger trade-weighted U.S. dollar. U.S. large-cap share prices are making new highs versus their global peers in local currency terms. This entails that the selloff in the broad trade-weighted dollar is at a very late stage. The dollar rebound is a missing trigger for EM relative equity outperformance to reverse. A Risk To Our View: The U.S. Dollar One risk to our negative stance on EM risk assets and our recommendation of underweighting EM versus DM is the continuation of the U.S. dollar selloff. The greenback has been trading very poorly despite jitters in global equity markets. The recent surge in the RMB versus the U.S. dollar may be indicative that the Chinese authorities are tolerating RMB appreciation to defuse a threat of major protectionist measures from the U.S. (Chart I-3). If the RMB continues to appreciate versus the greenback, Asian and other EM currencies will stay well supported, and EM outperformance will persist. Chart I-2U.S. Relative Equity Outperformance ##br##Warrants A Stronger Dollar U.S. Relative Equity Outperformance Warrants A Stronger Dollar U.S. Relative Equity Outperformance Warrants A Stronger Dollar Chart I-3Will Beijing Tolerate A Stronger RMB? Will Beijing Tolerate A Stronger RMB? Will Beijing Tolerate A Stronger RMB? We suspect that Chinese policymakers are reluctantly allowing the RMB to appreciate. Indeed, Chinese policymakers have been both vocal and public about their understanding of Japan's experience with deleveraging, and specifically the mistake made by Japanese policymakers of allowing the yen to appreciate in the early 1990s. As most know, deflationary forces stemming from the combined effects of deleveraging and currency appreciation set off a formidable deflationary adjustment in Japan in the 1990s. Given Japan's experience, our conjecture is that Chinese policymakers would rather opt for a stable-to-mildly weaker currency. This has been one of the cornerstones of our bullish bias on the U.S. dollar versus emerging Asian currencies. If China allows the RMB to appreciate further versus the U.S. dollar, a potential U.S. dollar rally versus EM currencies will be delayed. In turn, this will likely allow EM equity, currency and credit markets to outperform their DM peers. That said, a strong currency will add to the ongoing policy tightening in China. The cumulative impact of this policy tightening combined with currency appreciation will weigh on China's growth later this year. As such, our fundamental thesis on China-slowdown is still valid in the medium term. However, political interference in the currency markets could delay EM risk assets' response to it. Bottom Line: The near-term risk to our negative stance on EM risk assets is a scenario where Beijing allows further RMB appreciation to head off potentially major protectionist threats from the U.S. May 2006 Redux? The current riot in global stocks resembles the May 2006 correction to a certain extent. Back in the spring of 2006, then Federal Reserve Chairman Ben Bernanke had just taken the helm at the Fed. Global growth was strong, the U.S. dollar was selling off, and global share prices were surging and overbought. Chart I-4May 2006 And Now: EM Stocks, ##br##U.S. Bond Prices And U.S. Dollar May 2006 And Now: EM Stocks, U.S. Bond Prices And U.S. Dollar May 2006 And Now: EM Stocks, U.S. Bond Prices And U.S. Dollar In May-June 2006, markets sold off because of the then-prevailing narrative that Chairman Bernanke would be too dovish and would allow U.S. inflation to get out of hand. U.S. bond yields spiked, inflicting particular damage on EM. It seems that February 2018 may play out like May 2006. It will not be exactly the same, but there are enough similarities to draw parallels: Global growth is robust, inflationary pressures are accumulating. DM bond yields are rising and the greenback is selling off. The new Fed Chairman, Jerome Powell, just took over the reins at the Fed, and there are growing odds that U.S. inflation will soon begin to rise, justifying more Fed rate hikes. Chart I-4 illustrates the similarities between financial market dynamics in 2005-2006 and now. If we take 2006 as a guide, we can infer that the selloff is not yet over. In a matter of only five weeks EM share prices plunged by 25% in U.S. dollar terms, and the S&P 500 dropped by 7%. From a big-picture perspective, the May 2006 selloff was a sharp correction in a bull market that lasted for another year or so. Importantly, the 25% plunge in EM share prices that took place in 2006 occurred despite EM corporate profit growth expanding at a double-digit rate in 2006-'07. All that said, the 2006 selloff marked an important regime shift in the global economic landscape - the rate of U.S. growth peaked in the second quarter 2006, and began to decelerate. We believe that the current equity market riot will likely mark a bottom in U.S. inflation and the beginning of a slowdown in China. The U.S. Bond Market Selloff Is Not Over... Yet The selloff in the U.S./DM bond markets has not yet run its course: The U.S. inflation model - constructed by our colleagues in the Foreign Exchange Strategy service and based on U.S. capacity utilization and broad money supply - is pointing to higher inflation in the months ahead (Chart I-5). U.S. bond yields will likely move higher as forthcoming inflation prints validate our expectations for higher U.S. inflation. Fiscal stimulus amid robust growth and a tight labor market in the U.S. as well as record-high optimism among consumers and businesses have created fertile ground for rising inflation. The weak dollar of the past 12 months will also manifest in rising inflationary pressures. The U.S. bond term premium is still extremely low. Yet, budding uncertainty over inflation and the gradual end of QE programs in DM, will likely cause the U.S. bond term premium to rise from current depressed levels. Finally, simple DM bond markets technicals are still pointing to higher yields ahead (Chart I-6). Chart I-5U.S. Core Inflation Set To Rise U.S. Core Inflation Set To Rise U.S. Core Inflation Set To Rise Chart I-6U.S. Bond Yields: The Path ##br##Of Least Resistance Is Up U.S. Bond Yields: The Path Of Least Resistance Is Up U.S. Bond Yields: The Path Of Least Resistance Is Up Overall, the path of least resistance for DM bond yields is up. This will make EM local currency bond yields less attractive versus DM and especially versus U.S. Treasurys. Yield differentials between EM and the U.S. are already at a 10-year low (Chart I-7). Low risk premiums on EM local bonds and rising global financial market volatility suggest that flows to EM fixed income markets will slow over the course of this year. That said, near-term risks still remain due to the massive inflows that previously went into EM funds, and might not have been deployed yet. China's Tightening And Pending Slowdown It is not unusual for an equity market riot to begin with inflation and high-interest-rate fears and then culminate with a growth scare - with a rebound in between. 2018 may shape up to fit this pattern. Global equity markets seem to be immersed with inflation and policy tightening in the U.S. - and potentially in China. At some point, share prices could well stage a rebound but then relapse again as materially slower Chinese growth spills over to global trade.1 We have discussed our view on China and its spillover effect on EM in past reports, and will not reiterate our views and analysis here. We will only bring to clients' attention that manufacturing production volume in Asia has already been weakening for a couple of months (Chart I-8). Chart I-7EM Local Currency Bonds Over ##br##U.S. Treasurys: Yield Differential U.S. Bond Yields: The Path Of Least Resistance Is Up EM Local Currency Bonds Over U.S. Treasurys: Yield Differential U.S. Bond Yields: The Path Of Least Resistance Is Up EM Local Currency Bonds Over U.S. Treasurys: Yield Differential Chart I-8Asia's Manufacturing ##br##Production Growth Is Slowing Asia's Manufacturing Production Growth Is Slowing Asia's Manufacturing Production Growth Is Slowing Leadership changes in the equity markets occur amid selloffs. Hence, it is reasonable to expect a leadership shift within global equity market sectors and countries as well as currency markets. One major equity leadership shift could be that EM begins underperforming DM. A combination of rising U.S. inflation and bond yields and a slowdown in China are negative for EM financial markets, especially relative to DM ones. Reading Markets' Tea Leaves It remains to be seen how much further this selloff in global equities will last and whether this is the beginning of a major downtrend in EM risk assets. It is impossible to have perfect foresight. To help investors in their portfolio decisions, we combine our fundamental analysis with tools that assist us in forecasting business cycles as well as various chart patterns that may be indicative of the market's potential trajectory. The following charts illustrate that the EM and commodities equity rally may be facing formidable technical resistance. These equity markets have to break out decisively through these technical resistance lines to confirm the sustainability of the bull market. Global energy stocks have corrected after reaching their long-term moving average (Chart I-9, top panel). The latter served as a floor in the 2008 crash. It was a key technical level in the 2014-'15 bear market that did not hold up and was followed by a collapse in crude prices. Similarly, global steel stocks are exhibiting the same pattern (Chart I-9, bottom panel). Relative performance of emerging Asian share prices versus the global equity benchmark is also at a similar critical juncture (Chart I-10, top panel). Chart I-9Global Energy And Steel Stocks: ##br##A Technical Resistance Global Energy and Steel Stocks: A Technical Resistance Global Energy and Steel Stocks: A Technical Resistance Chart I-10Select EM Equity Markets ##br##Are Facing A Critical Test Select EM Equity Markets Are Facing A Critical Test Select EM Equity Markets Are Facing A Critical Test Finally, Brazilian share prices in U.S. dollar terms have also reached a crucial technical threshold (Chart I-10, bottom panel). Bottom Line: Share prices of a few equity sectors and markets that are imperative to the EM equity outlook are at important technical junctures. Failure to break above these technical resistance lines will corroborate our negative stance on EM/China growth and related financial markets. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 We elaborated the relationship between China/EM and DM growth in November 29, 2017 Emerging Markets Strategy Weekly Report, the link is available on page 12. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Japan's reflationary economic policies will be reinforced ahead of the constitutional referendum; The Bank of Japan is a long way from a 2% inflation overshoot; Fiscal thrust will continue to surprise to the upside; Wage law revisions are significant and, on net, inflationary; Go long JPY/EUR as a tactical play on the countertrend yen rally. Feature Despite a 8.5% selloff in Japanese equities over the past week amid the global equity pullback, Japan's underlying economic growth is strong. The unemployment rate has collapsed to 2.8%, the economy is humming along at an impressive 2.1% clip, and inflationary pressures are building at last. A variety of indicators - from sentiment surveys to household incomes to manufacturing output - attest to the fact that "Abenomics" is keeping the fire well lit (Chart 1). Before the pullback began, investors were wondering whether the BoJ's reduction of long-term government bond purchases signaled that a less dovish turn in monetary policy was underway (Chart 2). BoJ Governor Haruhiko Kuroda tried to quiet these rumors by reiterating the need to keep current, easy monetary policy in place. The latest financial shakeup reinforces this message. Chart 1Japan's Macro Fundamentals Are Strong Japan's Macro Fundamentals Are Strong Japan's Macro Fundamentals Are Strong Chart 2The BoJ Has Cut Back Asset Purchases The BoJ Has Cut Back Asset Purchases The BoJ Has Cut Back Asset Purchases Over the long run, the BoJ's moves, and "Abenomics" in general, should be assessed from the perspective of Japan's broader geopolitical revival.1 Prime Minister Shinzo Abe needs reflation to continue for a range of reasons. Policymakers are not constrained by inflation; rather, inflation is constrained by the yen, global growth, and the increasing danger of a Chinese policy mistake. The BoJ Will Not Betray Abenomics Japan's strong consumer and business confidence, white-hot economic growth, and multi-year equity rally have stemmed from three factors: positive fiscal thrust, an EM rebound, and a weak yen.2 As a result, real interest rates have fallen (Chart 3), prompting the BoJ to downgrade its quantitative and qualitative easing policy (QQE). But cutting back bond-buying does not mean that the BoJ is removing accommodative policy. The central bank stopped targeting the quantity of asset purchases when it introduced its "yield curve control" policy in September 2016. Yield curve control ensures that long-term JGB yields stay around 0%, with a de facto cap of 10 basis points that can be adjusted as needed. Therefore the gross amount of asset purchases is arbitrary; it only needs to be sufficient to achieve the yield target. In fact, the BoJ's official annual target of asset purchases, 80 trillion yen, was until recently well above the annual net issuance of JGBs at 35 trillion yen (Chart 4). Fiscal policy, while surprising upward as expected, has not produced the volumes of new bond issuance that would be necessary to justify such a lofty target. Hence the BoJ can reduce bond-buying without turning more hawkish. As for inflation, the core price level has only barely begun to perk up (Chart 5) - and that has occurred after five years of reflationary efforts, which, in turn, followed a sea change in Japanese politics. Prime Minister Abe came to power by declaring war on deflation, putting Governor Kuroda in charge of the BoJ, and seeking a broad-based revival of Japan from the "lost decades" of the 1990s and 2000s. Neither Abe nor Kuroda can afford to remove accommodation too soon and snatch defeat from the jaws of victory. Chart 3Real Interest##br## Rates Have Fallen Real Interest Rates Have Fallen Real Interest Rates Have Fallen Chart 4Bond Purchases Had ##br##Exceeded New Issuances Bond Purchases Had Exceeded New Issuances Bond Purchases Had Exceeded New Issuances Chart 5Weak Yen, Easier Financial ##br##Conditions Pushed Up Inflation Weak Yen, Easier Financial Conditions Pushed Up Inflation Weak Yen, Easier Financial Conditions Pushed Up Inflation Kuroda has repeatedly stressed that he will allow inflation to "overshoot" the 2% target before normalizing policy.3 While it is possible that he will step down when his first term ends on April 8, it is neither required nor probable. We highly doubt that he will. Further, the likeliest candidates to replace him are those that would maintain policy continuity.4 Hence the wind-down of QQE does not portend any additional moves away from easy policy. Any such moves would drive the yen upward, and neither Kuroda nor his acolytes at the BoJ can allow yen strength to undermine their quest to whip deflation. Bottom Line: The BoJ's yield curve control framework will remain intact even if the quantity of asset purchases remains much smaller. No leadership change at the BoJ will alter this new monetary policy framework. With the Fed and other central banks in the midst of rate-hike cycles, and the ECB winding down its QE, the persistent dovishness of the BoJ will act as a depressant on the yen as it experiences upward pressure from abroad. Policy Is Inflationary... Significant inflationary pressures are building in Japan, and reflationary policy will be resolute in the face of any headwinds. First, Abe's political career depends on maintaining the economic revival. His most treasured policy objective - reforming the Japanese constitution to revise the pacifist Article Nine and clear the legal path for the normalization of the country's military - ultimately requires a majority vote in a popular referendum.5 This is no easy task. Abe will almost certainly win the leadership poll within the Liberal Democratic Party in September this year, but he may not wait till then to try to push a constitutional amendment through the Diet. The tentative plan is to present a bill in March and proceed to the national referendum in late 2018. Certainly it is imperative for him to secure two-thirds majority votes in each chamber before the House of Councillors elections in July 2019, since that event puts his near-supermajority in the upper house at risk (Chart 6). The constitutional referendum could coincide with that vote or precede it, but Abe wants the process finished before the 2020 Tokyo summer Olympics. It will be a stretch but it is feasible. Chart 6Abe Has A Virtual Supermajority In Both Houses, Necessary For Constitutional Change Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 7A Popular Referendum Will Be Very Close Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Opinion polls have consistently showed the public almost evenly split on the topic of revising Article Nine, with the hawkish advocates of revision usually trailing dovish opponents (Chart 7). While Abe's approval rating ranges in the high forties, his constitutional tinkering has similar, sub-50% levels of support. Pacifism runs deep in Japan. The LDP and New Komeito ruling coalition has not won more than 47% of the popular vote in the 2012, 2014, and 2017 general elections (Chart 8). And it has never scored above 50% in popular opinion polls over the course of Abe's term (Chart 9). Chart 8Abe's Coalition Has Not Won 50% Of The Vote... Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 9...Nor Polled Above 50% In Popular Opinion ...Nor Polled Above 50% In Popular Opinion ...Nor Polled Above 50% In Popular Opinion Abe will not have forgotten Italy's former Prime Minister Matteo Renzi, who gambled his political career on controversial constitutional reforms in 2016 only to fall from power when he lost the popular referendum. More to the point, Abe knows that large-scale protests - bigger than those he faced in 2015 - could attend his final push to secure the constitutional revision. After all, Abe's grandfather, Nobusuke Kishi, faced mass protests in 1960 and was forced to resign upon concluding a new Treaty of Mutual Cooperation and Security with the United States. This was a consequential update to the "U.S.-Japan Security Treaty" that enabled Japan to build up de facto military forces despite its pacifist constitution. Kishi fell from power even though he had presided over a rapid expansion of real GDP and real wages and a steep drop in unemployment (Chart 10). True, Japan was a very different place in 1960. At that time, the Cold War was raging, and a large and restless youth population energized the protests. Today's youth are complacent and outnumbered by comparison. Nevertheless, Kishi did not need to put his treaty to a popular vote, unlike Abe's constitutional revisions. His grandson has a higher threshold to overcome. It follows that Japan will maintain dovish monetary policy and will continue to outperform conventional estimates of fiscal thrust (Chart 11).6 Abe's decision to abandon the goal of achieving a primary balance budget surplus by 2020 is a clear indication of this policy direction.7 Chart 10Treaty Protests In 1960 Despite Strong Economy Treaty Protests In 1960 Despite Strong Economy Treaty Protests In 1960 Despite Strong Economy Chart 11Fiscal Thrust Surprises To Upside Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Wages will be a decisive factor in Abe's economic success.8 Wage growth has remained in the black for most of his term, marking a contrast with the past twenty years of at best sporadic and short-lived wage rises (Chart 12). This is likely to continue. In this spring's "shunto" negotiations between businesses and unions, both the Abe administration and Keidanren, the top business group, are asking for 3% wage increases. The biggest union, Rengo, is only asking for one percentage point more.9 Abe has dedicated the current Diet session, beginning January 22, to "work-style reforms" that should be, on net, positive for wage growth.10 He wants to remove disparities between regular and irregular workers, particularly regarding wages, training opportunities, and welfare benefits. He also wants to impose limits on the workweek - putting a cap on the average 80-hour workweek of Japan's full-time workers so as to force companies to hire more irregular workers on a full-time basis (and to encourage employed people to have children). Companies that raise wages by 3% or more will see a cut in the corporate tax rate from around 30% to 25%. Economic conditions should push wages up regardless of central government policies. The jobs-to-applicants ratio is at the highest level since 1990. The labor participation rate is 60.8%, with female participation at 51.3%, up from 47.8% when Abe took power in 2012. Neither does the adoption of robotics, for which Japan is famous, counteract the tight labor market and inflationary consequences over time.11 In short, wages and core inflation should rise as long as the economic expansion is not derailed. As our colleague Peter Berezin of BCA's Global Investment Strategy has shown, the Phillips Curve will eventually kick in - and it even looks like Japan (Chart 13)!12 Chart 12Wage Growth Is The Key To Abe's Success Wage Growth Is The Key To Abe's Success Wage Growth Is The Key To Abe's Success Chart 13The Phillips Curve In Japan Looks Like Japan Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Bottom Line: A growing economy with real wage growth is Abe's only hope not only of beating deflation but also of getting his planned constitutional amendments over the line. Reflationary policy is essential to his legacy and vision of reviving Japan. ... But Not Too Inflationary Still, fiscal thrust is hardly going to explode unless an economic slowdown calls for it. Despite Abe's adoption of a twenty first-century "Takahashi Plan," i.e. simultaneous monetary and fiscal expansion, his administration's fiscal spending has remained relatively restrained. Strong revenue growth has actually improved the primary balance (Chart 14). Until very recently, Abe's "fiscal arrow" has disappointed his cheerleaders - he even raised the consumption tax from 5% to 8% in 2014, undermining his pro-growth fiscal packages. By law Abe is required to raise the consumption tax again, from 8% to 10%, in October 2019. In the latest election he campaigned on using the proceeds of this tax increase to expand social spending.13 Of course, he reserves the option of postponing this decision if he should deem a tax hike detrimental to the economic recovery (or to his odds of revising the constitution). But this flexibility means that any and all inflationary pressures in 2018-19 will increase under the shadow of a statutorily scheduled slug to consumer spending. There are also some constraints on wage growth. First, the reforms are intended to liberalize the labor market, which means their effects are not likely to be exclusively inflationary. "Performance" metrics that put less emphasis on seniority and working overtime, insofar as they are successful, could weigh on wage growth, at least initially. Second, Japan is starting to allow immigration - the number of foreign workers hit a record of 1.28 million total in October 2017 (Chart 15).14 This trend runs contrary to Japan's long status as the least hospitable destination for migrants in the developed world. The influx is apparently not limited to construction workers for the 2020 Olympics, as manufacturing is still the sector with the largest number of foreign workers. The Abe administration is committed to breaking the mold in the name of pro-growth structural reform and immigration is a meaningful change, albeit still in its early stages. Given existing labor market tightness and rising labor costs for companies, we expect this trend to outrun expectations, nudging up labor force growth and at least mildly counteracting wage rises, especially in low-skill sectors.15 Chart 14Primary Balance Improves On Growth Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Chart 15Japan Finally Allowing Immigration Japan: Kuroda Or No Kuroda, Reflation Ahead Japan: Kuroda Or No Kuroda, Reflation Ahead Bottom Line: Inflation will continue building if the global economy continues expanding and additional fiscal thrust and wage hikes are added to Japan's negative output gap, tight labor market, and rock-bottom unemployment rate. Nevertheless Japan is far from runaway inflation, and fiscal and labor market policies are nuanced. The BoJ's desired inflation overshoot is still a long way off. China And EM Pose Deflationary Risks Meanwhile deflationary forces lurk in China and emerging markets, which have been key factors in Japan's recent economic outperformance. Japan's trade exposure to China is substantial: The latter accounts for 18% of Japan's total exports, 2.7% of Japan's GDP (Chart 16). At the moment, Japanese manufacturing appears resilient in the face of China's slowdown, especially relative to the "newly industrialized" Asian neighbors. But Chinese Premier Li Keqiang's famous proxy for economic activity is closely correlated with Japanese export growth, and it is slowing. China's monetary conditions and credit and fiscal spending impulse - key leading indicators - also bode ill for Japanese exports (Chart 17). Chart 16Japan Exposed To Chinese Economy Japan Exposed To Chinese Economy Japan Exposed To Chinese Economy Chart 17China Policy Will Hit Japan Directly China Policy Will Hit Japan Directly China Policy Will Hit Japan Directly Beijing has so far tightened policy into the slowdown. It is adding new financial, environmental, and property sector regulations while expanding its anti-corruption campaign into finance, industry, and local government.16 Central government regulatory discipline - and reforms meant to reduce capital and energy intensity - will weigh on China's monetary and credit growth, capex, capital and commodity imports, and hence EM as a whole (Chart 18). And EM ex-China accounts for a further 25% of Japanese exports. In other words, Chinese reforms will bite in 2018-19 and thus encourage Japan to maintain loose fiscal and monetary policy. Recent market turbulence may add to this predicament as it is not easy for China to abandon its newly launched economic reforms - meaning China may ease policy too late if conditions worsen. We put the risk of a policy induced mistake in China at 30%. There are also significant geopolitical risks in East Asia that could cause headwinds to Japan's economy. China's strategic challenge is the key driver of Japan's attempts to revive its economy (including through higher military spending) and normalize its military operations (Chart 19). With Japan re-arming, China and Japan could easily suffer a breakdown in diplomatic relations - and China has already shown the willingness to use sanctions to punish Japan when strategic spats occur.17 Frictions over the Koreas or Taiwan could also encourage safe-haven flows into the yen. In short, Abe and Kuroda must be prepared for any eventuality, which is another reason to expect policy to stay looser for longer. Chart 18China Policy Will Hit Japan Via EM China Policy Will Hit Japan Via EM China Policy Will Hit Japan Via EM Chart 19Strategic Tensions Still A Serious Risk Strategic Tensions Still A Serious Risk Strategic Tensions Still A Serious Risk Bottom Line: Japan's exposure to both China and EM ex-China makes it vulnerable to growth wobbles as China intensifies reforms. Meanwhile Japan's constitutional revisions and remilitarization could spark a spat with China. These are compelling reasons for policymakers to stay the course with loose monetary and fiscal policies. Investment Recommendations In the short run, we would suggest clients go long JPY/EUR. The euro is expensive relative to fair value and purchasing-power-parity models (Chart 20). And investor positioning is skewed heavily in favor of the euro versus the yen (Chart 21).18 Chart 20EUR/JPY Is Expensive EUR/JPY Is Expensive EUR/JPY Is Expensive Chart 21Skewed Positioning In EUR/JPY Skewed Positioning In EUR/JPY Skewed Positioning In EUR/JPY We are closing our long USD/JPY for a loss of 3.23%. In the long run, as long as global growth holds up, any yen rally is likely to be a countertrend one, as a stronger yen will exert deflationary pressures and reinforce persistent, easy policy. Japanese policymakers have little need to fear inflation; they will focus on nurturing the country's economic and strategic rebound. Therefore, investors need not worry about the BoJ pulling the rug out from under the equity and bond markets. While BCA's House View favors Japanese equities over the U.S., BCA Geopolitical Strategy's China view prevents us from sharing this conviction in 2018. We would favor U.S. equities, which are low-beta and poised for continued strong earnings growth due to tax cuts and growth. The big risk for Japanese equities comes if China's central government makes a policy mistake and "overcorrects," triggering a precipitous drop in Chinese imports. We put a 30% subjective probability to such a scenario given the difficulty of reforming the financial sector in a highly leveraged economy. The yen would rally on safe-haven flows and Japanese markets would sell off. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Japan's Political Paradigm Shift: Investment Implications," dated December 21, 2012, available at gps.bcaresearch.com. 2 Please see BCA Foreign Exchange Strategy Weekly Report, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018, available at fes.bcaresearch.com. 3 See for example Haruhiko Kuroda, "Quantitative and Qualitative Monetary Easing and Economic Theory," speech at the University of Zurich, Bank of Japan, November 13, 2017, available at www.boj.or.jp. 4 Technically, Kuroda's term ends on April 8, 2018 but he can be reappointed by the prime minister for another five-year term. Please see "Experts say Haruhiko Kuroda likely to remain at BOJ helm despite failures," Japan Times, October 7, 2017, available at www.japantimes.co.jp. Both of Kuroda's deputies, Hiroshi Nakaso and Kikuo Iwata, as well as other possible successors (Masayoshi Amamiya, Etsuro Honda, and Takatoshi Ito) are dovish candidates likely to maintain continuity with his policies if at the BoJ helm. Nobuchika Mori is the only potential exception but it is still not clear that he would deviate from Abe's and Kuroda's framework if given the top job. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016; and Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 7 Abe abandoned the 2020 budget target while campaigning in the general election of October 2017 and has stuck with his higher spending proposals. 8 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. 9 Please see "Japan business lobby seconds call for 3% pay hikes," Nikkei Asian Review, January 17, 2018, available at asia.nikkei.com. 10 Abe is attempting to amend the Labor Standards Law. Please see Heizo Takenaka, "A prologue to work-style reforms," Japan Times, January 30, 2018, available at www.japantimes.co.jp. 11 Despite labor shortages, Japanese firms are using robots less often. Also, companies with high technology and robot usage are actually companies that tend to pay higher wages, contrary to popular belief. Please see BCA's The Bank Credit Analyst Special Report, "The Impact Of Robots On Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 12 Please see BCA Global Investment Strategy, "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 13 Abe reiterated his plans for more social spending, for instance on expanded child care support and free preschool education, in his policy speech ahead of the opening Diet session this year. Please see "Abe delivers policy speech," NHK, January 22, 2018, available at www3.nhk.or.jp. 14 Please see "Number of Foreign Workers in Japan at Record High," NHK, January 26, 2018, available at www3.nhk.or.jp. 15 Please see "Japan quietly accepting foreign workers -- just don't call it immigration," Japan Times, November 3, 2016, available at www.japantimes.co.jp 16 Please see BCA Geopolitical Strategy Special Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Does It Pay To Pivot To China?" dated July 5, 2017, available at gps.bcaresearch.com. 18 For full discussion, see footnote 2 above. Geopolitical Calendar

Dear Client, In light of recent market turbulence, we are publishing our weekly report earlier than usual. Caroline Miller, Garry Evans, and I will also be hosting a webcast Wednesday morning at 10am EST to discuss the investment outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Monday's stock market rout was largely driven by technical factors. Strong economic growth and positive earnings surprises should keep the equity bull market intact. Nevertheless, investors need to adjust to the fact that volatility is likely to pick up, just as it did in the last few years of the 1990s bull market. The market's expectations of where the funds rate will be over the next two years have almost converged with the Fed dots. In the near term, this will limit the ability of the 10-year Treasury yield to rise much above 3%. Looking further out, inflation is likely to move above the Fed's target early next year, setting the stage for a recession starting in late 2019. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Feature VIX Kicks Last week's Global Investment Strategy report, entitled "Take Out Some Insurance," argued that equities had become dangerously overbought and were highly vulnerable to a correction.1 We noted that the VIX had likely bottomed for the cycle and that going long volatility had now become an attractive hedge against stock market declines. As many of my colleagues have noted, betting on continued low volatility had become an increasingly crowded trade in recent years. Back in January, we observed that net short volatility positions had reached record-high levels (Chart 1). We warned that "traders have been able to reap huge gains over the past few years by betting volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility."2 Precisely such a vicious cycle erupted on Monday, causing the S&P 500 to suffer its worst daily percentage loss since August 18, 2011. The question is where do we go from here? So far, the sell-off in stocks looks largely technical in nature. Chart 2 shows that the VIX soared by roughly four times more on Monday than one would have expected based solely on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction of other "risk gauges" such as junk bonds, EM stocks, and gold prices over the past few days is consistent with this thesis. Chart 1Volatility Is Back Volatility Is Back Volatility Is Back Chart 2Monday's VIX Spike Was Abnormally Large The Return Of Vol The Return Of Vol Cyclical Outlook Still Solid It is impossible to know if today's rebound will persist or if the correction still has further to run. What we do know is that the cyclical underpinnings for the bull market remain intact. Leading economic data remain buoyant (Chart 3). Corporate earnings continue to come in above expectations (Chart 4). Chart 3Global Economic Backdrop Remains Buoyant Global Economic Backdrop Remains Buoyant Global Economic Backdrop Remains Buoyant Chart 4Optimism Over 2018 Earnings Growth Optimism Over 2018 Earnings Growth Optimism Over 2018 Earnings Growth None of our recession-timing indicators are flashing red (Chart 5). The Conference Board's LEI is 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. Likewise, while the U.S. 2/10-year Treasury curve has flattened, it has not inverted yet. Moreover, even once the yield curve inverts, the lags can be quite long before the recession begins. For example, in the last cycle, the yield curve inverted in early 2006, but the recession did not begin until December 2007. This does not mean that everything will be smooth sailing from here. Monday's sell-off marked an inflection point in the low-volatility world that has prevailed over the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Going forward, volatility will remain elevated relative to what investors have come to expect. As the experience of the 1990s shows, stocks can still go up when volatility is trending higher (Chart 6), but this is going to make for a much more challenging investment environment. Chart 5No Signs Of An Imminent End To This Business Cycle No Signs Of An Imminent End To This Business Cycle No Signs Of An Imminent End To This Business Cycle Chart 6Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise The Powell Put? How the Fed and other central banks react to this new world will be critical. It is perhaps not a complete coincidence that Monday's crash occurred on the first day that Jay Powell took over the helm of the Fed. Investors are increasingly worried that the Fed will turn from friend to foe. The faster-than-expected increase in average hourly earnings in January put those fears in stark relief. Accelerating wage growth suggests supply-side constraints are beginning to bite. This, in turn, means that the runway for low inflation and easy monetary policy may not be as long as some had hoped. As BCA editors discussed in our 2018 Outlook, "Policy And The Markets: On A Collision Course," central banks are in the process of winding down the extraordinary stimulus that investors have gotten used to.3 Whether this undermines the case for holding stocks and other risk assets depends on how quickly the adjustment occurs. On the plus side, we continue to think the adjustment will be fairly gradual, at least for the time being. Core CPI inflation outside of shelter is still running at 0.7% (Chart 7). This gives the Fed plenty of wiggle room. Just like Janet Yellen, Jay Powell will seek to build a consensus among his colleagues. Granted, the composition of the FOMC is likely to shift in a somewhat more hawkish direction. However, the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important, and often underappreciated, source of continuity. As in the past, the Fed will continue to monitor incoming economic and financial data and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. and most other countries remain more expansionary than they were six months ago (Chart 8). Chart 7Core Inflation Outside Housing Is Still Low Core Inflation Outside Housing Is Still Low Core Inflation Outside Housing Is Still Low Chart 8Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Just as importantly, the implosion of volatility funds is unlikely to reverberate across the financial system in the same way as it did during the financial crisis. What made the mortgage crisis so toxic was that the losses were concentrated in the books of highly leveraged financial institutions. In the case of volatility funds, that does not appear to be the case. Investment Implications Global bond yields remain quite low by historic standards and this should continue to support stocks. Indeed, even after the recent bond sell-off, average global bond yields are still close to half of what they were in 2011 - a time when global excess capacity was much greater than it is today (Chart 9). In keeping with our structurally bearish view on bonds, which we first articulated on July 5, 2016 in a note entitled "The End of 35-Year Bond Bull Market," we expect global bond yields to grind higher.4 However, in rate-of-change terms, the swift repricing of yields over the past few months has likely run its course. Chart 10 shows that market expectations of where the funds rate will be at the end of 2018 and 2019 have almost converged with the Fed dots. This convergence helped our short December-2018 fed funds futures trade, which we closed at our stop for a gain of 70 bps last Friday. A sustained move above 3% on the 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we do expect core inflation to move above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this is likely to be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of recessions (Table 1). If the next recession occurs in late 2019, as we expect, the equity bull market could last a while longer. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Chart 9Yields Are Still Low By Historic Standards Yields Are Still Low By Historic Standards Yields Are Still Low By Historic Standards Chart 10Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Table 1Too Soon To Get Out The Return Of Vol The Return Of Vol Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Please see Global Investment Strategy Weekly Report, "Will Bitcoin Be DeFANGed?" dated January 12, 2018. 3 Please see The Bank Credit Analyst, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017. 4 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, In light of recent market turbulence, we are publishing our weekly report earlier than usual. Caroline Miller, Garry Evans, and I will also be hosting a webcast Wednesday morning at 10am EST to discuss the investment outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Monday's stock market rout was largely driven by technical factors. Strong economic growth and positive earnings surprises should keep the equity bull market intact. Nevertheless, investors need to adjust to the fact that volatility is likely to pick up, just as it did in the last few years of the 1990s bull market. The market's expectations of where the funds rate will be over the next two years have almost converged with the Fed dots. In the near term, this will limit the ability of the 10-year Treasury yield to rise much above 3%. Looking further out, inflation is likely to move above the Fed's target early next year, setting the stage for a recession starting in late 2019. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Feature VIX Kicks Last week's Global Investment Strategy report, entitled "Take Out Some Insurance," argued that equities had become dangerously overbought and were highly vulnerable to a correction.1 We noted that the VIX had likely bottomed for the cycle and that going long volatility had now become an attractive hedge against stock market declines. As many of my colleagues have noted, betting on continued low volatility had become an increasingly crowded trade in recent years. Back in January, we observed that net short volatility positions had reached record-high levels (Chart 1). We warned that "traders have been able to reap huge gains over the past few years by betting volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility."2 Precisely such a vicious cycle erupted on Monday, causing the S&P 500 to suffer its worst daily percentage loss since August 18, 2011. The question is where do we go from here? So far, the sell-off in stocks looks largely technical in nature. Chart 2 shows that the VIX soared by roughly four times more on Monday than one would have expected based solely on the decline in equity prices. This suggests that the spike in volatility caused the stock market plunge, rather than the other way around. The relatively muted reaction of other "risk gauges" such as junk bonds, EM stocks, and gold prices over the past few days is consistent with this thesis. Chart 1Volatility Is Back Volatility Is Back Volatility Is Back Chart 2Monday's VIX Spike Was Abnormally Large The Return Of Vol The Return Of Vol Cyclical Outlook Still Solid It is impossible to know if today's rebound will persist or if the correction still has further to run. What we do know is that the cyclical underpinnings for the bull market remain intact. Leading economic data remain buoyant (Chart 3). Corporate earnings continue to come in above expectations (Chart 4). Chart 3Global Economic Backdrop Remains Buoyant Global Economic Backdrop Remains Buoyant Global Economic Backdrop Remains Buoyant Chart 4Optimism Over 2018 Earnings Growth Optimism Over 2018 Earnings Growth Optimism Over 2018 Earnings Growth None of our recession-timing indicators are flashing red (Chart 5). The Conference Board's LEI is 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. Likewise, while the U.S. 2/10-year Treasury curve has flattened, it has not inverted yet. Moreover, even once the yield curve inverts, the lags can be quite long before the recession begins. For example, in the last cycle, the yield curve inverted in early 2006, but the recession did not begin until December 2007. This does not mean that everything will be smooth sailing from here. Monday's sell-off marked an inflection point in the low-volatility world that has prevailed over the past few years. The VIX Humpty-Dumpty has been irrevocably broken. Going forward, volatility will remain elevated relative to what investors have come to expect. As the experience of the 1990s shows, stocks can still go up when volatility is trending higher (Chart 6), but this is going to make for a much more challenging investment environment. Chart 5No Signs Of An Imminent End To This Business Cycle No Signs Of An Imminent End To This Business Cycle No Signs Of An Imminent End To This Business Cycle Chart 6Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise Volatility Can Increase As Stock Prices Rise The Powell Put? How the Fed and other central banks react to this new world will be critical. It is perhaps not a complete coincidence that Monday's crash occurred on the first day that Jay Powell took over the helm of the Fed. Investors are increasingly worried that the Fed will turn from friend to foe. The faster-than-expected increase in average hourly earnings in January put those fears in stark relief. Accelerating wage growth suggests supply-side constraints are beginning to bite. This, in turn, means that the runway for low inflation and easy monetary policy may not be as long as some had hoped. As BCA editors discussed in our 2018 Outlook, "Policy And The Markets: On A Collision Course," central banks are in the process of winding down the extraordinary stimulus that investors have gotten used to.3 Whether this undermines the case for holding stocks and other risk assets depends on how quickly the adjustment occurs. On the plus side, we continue to think the adjustment will be fairly gradual, at least for the time being. Core CPI inflation outside of shelter is still running at 0.7% (Chart 7). This gives the Fed plenty of wiggle room. Just like Janet Yellen, Jay Powell will seek to build a consensus among his colleagues. Granted, the composition of the FOMC is likely to shift in a somewhat more hawkish direction. However, the evolution will be slow. In the meantime, the recommendations of career Fed staff will represent an important, and often underappreciated, source of continuity. As in the past, the Fed will continue to monitor incoming economic and financial data and react accordingly. The stock market rout has led to some tightening in financial conditions, but FCIs in the U.S. and most other countries remain more expansionary than they were six months ago (Chart 8). Chart 7Core Inflation Outside Housing Is Still Low Core Inflation Outside Housing Is Still Low Core Inflation Outside Housing Is Still Low Chart 8Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Financial Conditions Have Tightened Recently, But Are Still Easier Than They Were Last Year Just as importantly, the implosion of volatility funds is unlikely to reverberate across the financial system in the same way as it did during the financial crisis. What made the mortgage crisis so toxic was that the losses were concentrated in the books of highly leveraged financial institutions. In the case of volatility funds, that does not appear to be the case. Investment Implications Global bond yields remain quite low by historic standards and this should continue to support stocks. Indeed, even after the recent bond sell-off, average global bond yields are still close to half of what they were in 2011 - a time when global excess capacity was much greater than it is today (Chart 9). In keeping with our structurally bearish view on bonds, which we first articulated on July 5, 2016 in a note entitled "The End of 35-Year Bond Bull Market," we expect global bond yields to grind higher.4 However, in rate-of-change terms, the swift repricing of yields over the past few months has likely run its course. Chart 10 shows that market expectations of where the funds rate will be at the end of 2018 and 2019 have almost converged with the Fed dots. This convergence helped our short December-2018 fed funds futures trade, which we closed at our stop for a gain of 70 bps last Friday. A sustained move above 3% on the 10-year Treasury yield will require a more durable increase in inflation. Ultimately, we do expect core inflation to move above 2%, forcing the Fed to lift interest rates into restrictive territory. However, this is likely to be a story for 2019 rather than 2018. Stocks tend to peak about six months before the start of recessions (Table 1). If the next recession occurs in late 2019, as we expect, the equity bull market could last a while longer. A modest overweight on global risk assets is warranted for now, but investors should consider reducing risk exposure later this year. Chart 9Yields Are Still Low By Historic Standards Yields Are Still Low By Historic Standards Yields Are Still Low By Historic Standards Chart 10Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Market Pricing Has Almost Caught Up To The Fed's Dots Table 1Too Soon To Get Out The Return Of Vol The Return Of Vol Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Please see Global Investment Strategy Weekly Report, "Will Bitcoin Be DeFANGed?" dated January 12, 2018. 3 Please see The Bank Credit Analyst, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017. 4 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016. Strategy & Market Trends* The Return Of Vol The Return Of Vol Tactical Trades The Return Of Vol The Return Of Vol Strategic Recommendations The Return Of Vol The Return Of Vol Trades Closed In 2015-2018 The Return Of Vol The Return Of Vol

Highlights Market participants should be asking why yields are higher, and not worry about how much they have climbed. While the bond market has begun to price in higher inflation (via the move in the TIPS breakeven rate), wage and price inflation remains muted for now. Sentiment has deteriorated more than valuations or technicals as the S&P 500 climbed to fresh all-time highs in December and January. Our U.S. Equity Strategy service downgraded small caps to neutral from overweight. Feature Chart 1The January Jobs Report Keeps The Fed##BR##On Track For Gradual Hikes This Year The January Jobs Report Keeps The Fed On Track For Gradual Hikes This Year The January Jobs Report Keeps The Fed On Track For Gradual Hikes This Year Last week marked Janet Yellen's final FOMC meeting and the first week in many years that the U.S. Treasury and equity markets worried about inflation. The strongest year-over-year reading in average hourly earnings in 9 years (+2.9% in January) added to the market's inflation concerns (Chart 1). The 10-year Treasury yield climbed 15 bps to 2.84%, while the S&P 500 moved lower by 2.5% as of midday on Friday, February 2. It was the worst week for the stock market since September 2016. Individual investor sentiment on the equity market has surged recently, and valuations are at extremes. However, BCA's technical indicator for U.S. stocks is not at an extreme. BCA's stance is that while the risk/reward for stocks over bonds has narrowed, it is too soon to call an end to the bull market. However, we are monitoring real yields closely. At 2.13% on Friday morning, February 2, the 10-year TIPS breakeven yield was still below the 2.4 to 2.5% range where markets should begin to worry about the Fed falling behind the curve. While the acceleration in average hourly earnings in January cements the case for continued gradual Fed rate hikes this year, inflation is not about to spiral higher. Wage inflation remains muted, and patience is still required as market participants await signs of a pickup in broader measures of consumer price inflation. The market is now fully priced for three rate hikes this year. Also, longer-term rate expectations have moved close to the Fed's estimate of the terminal rate. It would be reasonable to expect some short-term pause to recent near-relentless uptrend in rate expectations. For the market to price tightening beyond the Fed's dots, the economy and inflation would need to outperform the Fed's forecasts (which are 2.5% GDP growth, 1.9% core inflation and 3.9% unemployment for 2018). For now at least, it's not clear that is the case. Why Rates Are Rising Matters The relentless increase in 10-year Treasury yields spooked investors early last week, but it is too soon for equity investors to worry about an overly aggressive Fed. At 2.84%, the 10-year Treasury yield is above the FOMC's view of the neutral Fed funds rate, and has moved nearly 80 bps higher since early September. Market participants should be asking why yields are higher, and not worry about how much they have climbed. Chart 2Breaking Down The Rise In Yields Breaking Down The Rise In Yields Breaking Down The Rise In Yields BCA's U.S. Bond Strategy service noted in mid-January1 that in the current environment, it is useful to split the nominal 10-year yield into its two main components - the compensation for inflation protection and the real yield (Chart 2). The 10-year TIPS breakeven inflation rate has moved from 1.66% last June to 2.13% late last week, but is still too low. Historically, the 10-year TIPS breakeven rate has traded in a range between 2.4 and 2.5% when inflation is well-anchored near the Fed's 2% target. BCA's stance is that inflation will move back to the Fed's target soon. The implication is that there is still another 25 to 35 bps of upside in the 10-year breakeven rate. The reason why this threshold is important is because a rise in inflation expectations to that level would be a signal that the FOMC will need to become more aggressive in slowing economic growth. This could occur even if actual inflation is below the 2% target, as long as it is rising toward the target. This will be especially true if the unemployment rate is heading to 3.5%, as we suspect. BCA's U.S. Bond strategists' model of real yields2 projects that real yields will rise 4 bps by the end of the year to 0.61%, but it could be more depending on how quickly the Fed wants to slow growth. Bottom Line: BCA expects that the nominal Treasury yield should move into a range between 3.0 and 3.25% by the time inflation reaches the Fed's target. BCA's stance is that risk assets will get into trouble once inflation expectations rise above 2.4%. Bond yields will presumably be moving higher along with inflation expectations. However, investors should not ignore higher Treasury yields rates. That said, equity investors do not need to be too concerned until inflation expectations hit that 2.4% threshold. Inflation itself may not be at 2% as this occurs, but if inflation is climbing and the unemployment rate is still falling, then the market will believe that the Fed is behind the curve. That is a bearish environment for equities. Inflation: Still A Waiting Game While the bond market has begun to price in higher inflation (via the move in the TIPS breakeven rate), wage and price inflation remains muted for now. Chart 3 illustrates various measures of wage inflation. Panel 1 shows that the Employment Cost Index (ECI) is in a clear uptrend. The acceleration in the wages and salaries component of ECI is broad-based across geography and industry (Chart 4, panel 1). Moreover, at 86%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 4, panels 2 and 3). Chart 3Most Wage Metrics Are Rolling Over Most Wage Metrics Are Rolling Over Most Wage Metrics Are Rolling Over Chart 4The Employment Cost Index Is In A Definitive Uptrend... The Employment Cost Index Is In A Definitive Uptrend... The Employment Cost Index Is In A Definitive Uptrend... Although the year-over-year increase in average hourly earnings accelerated to 2.9% in January, many other wage indicators have stalled out recently (Chart 3, panel 4). The Atlanta Fed Wage Tracker rolled over recently along with weekly usual earnings (Chart 3, panels 2 and 3). In short, despite a robust global economy, a U.S. economy running above its long term potential and the unemployment rate (4.1% in January) below NAIRU (4.6%), labor shortages are not yet strong enough to push up wage inflation. Chart 5Shift Towards Service Economy Led##BR##To Shift Away From Capacity Utilization Shift Towards Service Economy Led To Shift Away From Capacity Utilization Shift Towards Service Economy Led To Shift Away From Capacity Utilization That said, the historical evidence suggests that once the labor market tightens, inflation eventually does accelerate. However, wages do not always lead inflation at bottoms and may be a lagging indicator in this cycle.3 In long economic cycles (1980s and 1990s), wage inflation was a lagging indicator. BCA recommends that investors should monitor a broad range of inflation indicators. Most of these indicators show that inflation pressures are building, but only gradually. The low readings on manufacturing capacity utilization suggest low odds of a rapid acceleration in inflation. Furthermore, the shift in composition of the U.S. economy in the past three decades suggests that the metric is no longer an accurate measure of wage or price bottlenecks in the economy (Chart 5, panels 1 and 2). Manufacturing capacity utilization hit a post WWII low in mid-2009 at 63.5%, before recovering to a well below average 75%-76% range for the past half-decade. In December 2017, utilization hit a 9-year high at 77%. Chart 5, (panels 3 and 4) shows that prior to 1980, inflation accelerated and the output gap closed as utilization breached 80%. Since early 1990s, the relationship is not as clear. Is 5% The Magic Number On Rates? History suggests that rising rates are not an impediment to higher stock prices, as long as rates remain below 5%. Chart 6 is a reminder that the 10-year yield and stock prices climbed together in the 1950s. The rise in yields in the 50s primarily reflected better economic growth rather than fears of inflation. Nonetheless, investors are concerned that a rise in yields will flip the positive correlation between bond yields and stock prices. Table 1 shows that since 1980, long treasury yields and stock prices move in the same direction until the 10-year moves above 5%. Chart 7 shows the relationship between the level of nominal bond yields and stock to bond yield correlations back to 1874. Moreover, since 1980, a move from 2 to 3% on the 10-year is accompanied by an average gain for the S&P 500 of 1.2%, with a median move of 1.8%. On average, the S&P 500 posts a modest decline (24 bps) as the 10-year Treasury elevates from 3 to 4%, but the median return (98 bps) is still positive. Our July 2016 Special Report provides an in-depth discussion of the impact of rates and inflation on equity prices. Historically, even the move from 4 to 5% on the 10-year is not an impediment to higher stock prices.4 Moreover, in a 2016 report our Global ETF Strategy service provides a detailed overview of equity returns in various phases of the Fed cycle.5 Chart 6Stock Can Rise##BR##With Bond Yields Stock Can Rise With Bond Yields Stock Can Rise With Bond Yields Table 13-Year Correlation* Between Stock Prices##BR##And Bond Yield Level (1980-2018) Yellen's Last Week Yellen's Last Week BCA's stance is that the stock-to-bond ratio will climb this year. However, the risk/reward embedded in that stance has shifted given the move in both bond yields and stock prices in the past few months. Our U.S. bond strategists peg fair value for the 10-year Treasury yield at 3.0%, just 18 bps above the yield last Friday morning. Chart 8 illustrates this point across three time horizons given our view of fair value on the 10-year Treasury yield (3.0%). Our analysis assumes a 1.75% annualized dividend yield on the S&P 500. Panel 1 illustrates that the ratio between now and mid-year will remain positive if stocks are flat. The same holds true though September 2018 and year end. Just a 5% drop in the S&P 500 by year-end 2018 signals a localized peak in the stock-to-bond ratio. Declines of 10 or 20% indicate a reversal of the uptrend in stocks versus bonds that has been in place since early 2016. Chart 7Stock To Bond Correlations Remain Positive With Nominal Yields Below 4.25% Yellen's Last Week Yellen's Last Week Chart 8Scenarios For Stock-To-Bond Ratio Scenarios For Stock-To-Bond Ratio Scenarios For Stock-To-Bond Ratio Bottom Line: BCA's view is that Treasury yields will top out at around 3 to 3.25% in this cycle, as inflation returns to the Fed's 2% target. Our base case is that stocks will do well in 2018, and will not be subject to concerns over an aggressive Fed until 2019. However, investors should closely monitor the 10-year TIPs spread, as noted above. We do not expect to breech 2.4% this year, but the timing is unclear. Moreover, we may take profits on our overweight stance well before the market senses the Fed is behind the curve, earlier than that, especially given stretched valuation and stretched market sentiment. Seismic Sentiment Shift Rising rates are not the only concern for U.S. equities. In late November, we noted6 that our technical and sentiment indicators are not flashing red as in previous bear markets, but neither are they giving an all-clear for U.S. equity investors. Sentiment levels are a bigger concern than technical indicators, and investors should monitor both for signs of an equity sell-off. These indicators have become even more stretched since we highlighted them in November and more clearly since the most recent equity market lull in late August 2017. BCA's technical indicator deteriorated since our late November report, but remains below levels that, in the past, have preceded bear markets (Chart 9, panel 1). The S&P 500 is testing the top end of the recovery trend channel in place since 2009 (Panel 2). A break above that level suggests more upside to stocks. However, a definitive failure to breakout may signal a period of consolidation for equities. BCA's equity valuation metric pushed further into extreme overvalued territory. Stretched valuations say more about medium- and long-term returns than near-term performance.7 However, the shift in the equity sentiment indicators we track is notable. BCA's investor sentiment composite index is at an all-time high (Chart 10, panel 1). Moreover, the surge in sentiment is led by individual investors and advisors who serve them (panels 2 and 4). Traders are a bit more complacent. Furthermore, individuals' optimism toward stocks is at an all-time high in surveys conducted by the Conference Board and the University of Michigan (Chart 11, panels 1 and 2). Chart 9Technical Picture For##BR##Equities Still Looks OK Technical Picture For Equities Still Looks OK Technical Picture For Equities Still Looks OK Chart 10Investor Sentiment##BR##Is Flashing Red Investor Sentiment Is Flashing Red Investor Sentiment Is Flashing Red Chart 11Surge In Consumer Optimism##BR##Toward Year Ahead Returns For Equities Surge In Consumer Optimism Toward Year Ahead Returns For Equities Surge In Consumer Optimism Toward Year Ahead Returns For Equities A similar survey from Yale University suggests that consumers' expectations about future equity market returns remains subdued. However, this may be due to the fact that the Yale survey is only available to December, and thus misses the equity 'melt up' in January that followed the news of the U.S. tax cuts. The other surveys mentioned are up to January. Notably, the Yale panel includes wealthy individual investors and a sample of institutions. The respondents in the Michigan and Conference Board surveys are more representative of the average U.S. household. Despite elevated attitudes toward equities, readings from the Fed's Flow of Funds on household ownership of stocks suggest that individuals may still have room in their portfolios for equities. Chart 12 shows that as of Q3 2017, equity holdings as a share of total household financial assets remains below prior peaks. As the U.S. stock market soared in the late 1990s, equities accounted for 31% of assets at the peak. Just before the global financial crisis, the figure was 23%. Today, equities account for just 25% of households' financial portfolios. The bottom panel of Chart 12 illustrates that individuals have allocated away from debt securities in the past half-decade. Chart 12Household Holdings Of Equities Still Below Prior Peaks Household Holdings Of Equities Still Below Prior Peaks Household Holdings Of Equities Still Below Prior Peaks Bottom Line: Sentiment has deteriorated more than valuations or technicals as the S&P 500 climbed to fresh all-time highs in December and January. While we are sticking with our stance that stocks will beat bonds in 2018, we are concerned about small caps. BCA's U.S. Equity Strategy service notes8 that rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth, signal that the time is right to shift from overweight to neutral on U.S. small caps. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Long And Short Of It", published January 23, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "Ill Placed Trust?", published December 19, 2017. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst "Monthly Report", published September 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Special Report "Stock-To-Bond Correlation: When Will Good News Be Bad News?", published July 6, 2015. Available at usis.bcaresearch.com. 5 Please see BCA Research's Global ETF Strategy Special Report "Equity Factors And The Fed Funds Rate Cycle", published December 21, 2016. Available at getf.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Technically Speaking", published November 27, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Global Asset Allocation Special Report "What Returns Can You Expect?", published November 15, 2017. Available at gaa.bcaresearch.com. 8 Please see BCA Research's U.S. Equity Strategy Weekly Report "Too Good To Be True?", published January 22 , 2018. Available at uses.bcaresearch.com.

Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? USD: Times Up? USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro A 3-Factor Model To Explain The Euro A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Oversold Dollar Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? Because The Narrative Is Scary Blood In The Street? Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account The Euro's Tricky Spot The Euro's Tricky Spot Chart I-7Money Velocity To Pick Up Money Velocity To Pick Up Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present Euro: Future Versus Present Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Inflation Expectations Point To A Correction Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants Euro Is Stronger Than Global Trade Warrants Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade A Headwind For Global Trade A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe The Slowdown Will Come To Europe The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Higher FX Vol: A Risk For EUR/USD... Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY ...And EUR/JPY ...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through U.K.: Less Pass-Through U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch The British Consumer Is Feeling The Pinch The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Private Credit Growth Is Slowing Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut GBP: Stuck In A Rut GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Watch Inflation Expectations How much longer can this go on? Global equities were up 6% in January alone (the 15th consecutive month of positive returns), and investors are increasingly asking how much further this bull market has to run. There are no signs we can see that suggest it will end imminently. Our watch-list of key recession indicators (decline in global PMIs, inverted yield curve, rise in credit spreads - Chart 1) is sending no warning signals. U.S. GDP growth was a little weaker than expected in Q4, at 2.6% QoQ annualized, but this was mainly due to inventories and strong imports: final private demand, a better guide to future growth, was strong at 4.3%. Fed NowCasts for Q1 growth point to 3.1-4.2%. The euro zone grew even faster than the U.S. last year, and even Japan probably saw 1.8% GDP growth. Corporate earnings expectations have accelerated sharply over just the past few weeks - particularly in the U.S. as a result of the tax cuts (Chart 2) - with analysts now expecting 16% EPS growth for the S&P 500 this year. BCA U.S. Equity Strategy service's earnings models suggest that this forecast may still be too cautious (Chart 3). Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1No Recession Signals Flashing No Recession Signals Flashing No Recession Signals Flashing Chart 2A Dramatic Rise In Earnings Forecasts... A Dramatic Rise In Earnings Forecasts... A Dramatic Rise In Earnings Forecasts... Chart 3...But Forecasts May Still Be Too Cautious ...But Forecasts May Still Be Too Cautious ...But Forecasts May Still Be Too Cautious While it is true that equity valuations are stretched, particularly in the U.S. (with BCA's Composite Valuation Index having just tipped into the "Extremely Overvalued" zone - Chart 4), valuations are not usually a good timing tool. Investor euphoria seems not yet to have reached the extremes that usually characterize a bull-market peak. The message we hear consistently from wealth managers is that their clients who missed last year's rally are now looking to get into risk assets. The American Association of Individual Investors' latest weekly survey shows 45% bulls to 24% bears - not especially optimistic by past standards (Chart 5). Flows into equity funds have started to accelerate, but have been weaker than bond flows over the past year (Chart 6). Chart 4U.S. Equities Now 'Extremely Overvalued' U.S. Equities Now 'Extremely Overvalued' U.S. Equities Now 'Extremely Overvalued' Chart 5Investors Are Not Particularly Bullish Investors Are Not Particularly Bullish Investors Are Not Particularly Bullish Chart 6Flows Into Equities Starting To Accelerate Flows Into Equities Starting To Accelerate Flows Into Equities Starting To Accelerate Chart 7Key: Inflation Expectations Getting to 2.5% Key: Inflation Expectations Getting to 2.5% Key: Inflation Expectations Getting to 2.5% We think the key to timing the top lies in inflation expectations. With the U.S. economy at full capacity and unemployment at 4.1%, well below the NAIRU of 4.6%, the Fed believes that a pick-up in inflation is just a matter of time - an analysis we agree with. The market has started to come round to this view too, with implied inflation rising by about 40 BPs over the past two months (Chart 7). The market has now priced in a 65% probability of the Fed's projected three rate hikes this year, and even a 27% probability of four. Inflation expectations hitting 2.5% (which would be compatible with the Fed's 2% PCE inflation target - CPI inflation is typically 50 BPs higher) could be the tipping-point. This is because it would remove the Fed put - with inflation expectations elevated, the Fed would no longer be able to back off from tightening in the event of a global risk-off event such as a stock-market correction or a slowdown in China. Such a rise in inflation expectations would also push the 10-year U.S. Treasury yield above 3%, which would increase the attraction of fixed income, and represent a threat to highly indebted borrowers, especially in emerging markets. This is how bull markets typically end: with the Fed having to raise rates to choke off inflation, and either making a policy mistake or tightening monetary policy enough to slow growth. But all this is probably quite a few months away. We expect to turn more defensive perhaps late this year, ahead of a recession that we have for some time now penciled in for the second half of 2019. Given how advanced the cycle is, conservative investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now. But investors focused on quarterly performance should ride the bull market until some of the warning signals mentioned above begin to flash. For now, therefore, we continue to recommend an overweight in equities relative to bonds on the 12-month investment horizon, and mostly pro-risk and pro-cyclical tilts. Equities: We continue to prefer developed over emerging equities. EM will be hurt by the slowdown likely in China (where money supply and credit growth have fallen in response to the authorities' tighter policies - Chart 8), rising U.S. interest rates, sluggish productivity growth, and valuations that are no longer particularly cheap (Chart 9). Within DM, we are overweight euro zone and Japanese equities, which should benefit from their higher beta, more cyclical earnings, still accommodative monetary policy, and cheaper valuations than the U.S. Our sector bets are tilted to late-cycle value sectors such as financials, industrials and energy. Chart 8Tighter Monetary Conditions in China bca.gaa_mu_2018_02_01_c8 bca.gaa_mu_2018_02_01_c8 Chart 9EM No Longer Cheap EM No Longer Cheap EM No Longer Cheap Fixed Income: Rising inflation expectations should push the 10-year U.S. Treasury bond yield up to 3% this year, with German Bunds rising by a similar amount. We recommend an underweight on duration, and a preference for inflation-linked over nominal bonds, in these markets. In the U.K. and Australia, however, central banks are unlikely to tighten as quickly as futures markets have priced in and so we prefer their government bonds. While the expansion continues, spread product should continue to outperform in the fixed-income bucket. The default-adjusted spread on U.S. high-yield bonds remains over 200 BP and, though we see little further spread contraction, carry alone makes this attractive. Currencies: BCA was correct last year to predict a widening of interest-rate differentials between the U.S. and the euro zone, but wrong to conclude that this would lead to a stronger dollar (Chart 10). The drivers of currencies can undergo regime shifts, and it seems now that valuation (both the euro and yen are cheap compared to their purchasing power parity, 1.32 and 99 to the U.S. dollar respectively), current account surpluses (3.3% for the euro zone and 3.7% for Japan), and other factors have become more important. Tactically, the euro, in particular, looks very overbought. Speculative investors are very long euros, the ECB is likely to remain dovish relative to the Fed, and the strong euro could put some downward pressure on growth in the short-term. However, if the dollar were to rebound by 5% or so we would be likely to end our dollar bull call. Chart 10Rate Differentials No Longer Moving Currencies Rate Differentials No Longer Moving Currencies Rate Differentials No Longer Moving Currencies Chart 11Oil Supply To Increase In 2019 Oil Supply To Increase In 2019 Oil Supply To Increase In 2019 Commodities: Oil prices have risen on the back of strong global demand, OPEC discipline, and a lag in the response of U.S. shale oil producers. We forecast an average of $67 a barrel for Brent crude this year, with spikes to as high as $80 in the event of disruptions in producer countries such as Venezuela. However, with one-year forward crude prices around $62, shale producers (whose marginal costs average about $52 a barrel) are likely to pick up production soon. OPEC, too, should be happy with crude around $50-60. Our energy team forecasts a pick-up in supply next year (Chart 11), which should bring the crude price down to an average of $55 in 2019. Industrial commodities are a product of Chinese demand, global growth, and the U.S. dollar. These drivers look likely to be mixed over the coming months and so we remain neutral. Gold has risen, in the face of rising interest rates, because of the weak dollar - it remains an excellent hedge against inflation, recession, and geopolitical risks and so should be a modest part of any balanced portfolio. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com GAA Asset Allocation

Highlights Even though our baseline scenario calls for four rate hikes out of the Fed this year - more than markets have priced in - gold will be supported by increasing inflation and inflation expectations, heightened geopolitical risks, and greater volatility in equity markets. Further out, we expect gold will provide a good hedge against a likely equity downturn, as the bull market turns into a bear market in 2H19. For now, keep gold as a strategic portfolio hedge. Energy: Overweight. After popping above $70 and $66/bbl last week, Brent and WTI prices retreated ~ $2.00/bbl on the back of a stronger USD and increased rig counts in the U.S. shales, particularly in the prolific Permian Basin, where 18 rigs were added. We continue to expect Brent and WTI prices to average $67 and $63/bbl this year. Base Metals: Neutral. Spot copper continues to trade on either side of $3.20/lb on the COMEX. We remain neutral, given our view upside risk - chiefly supply-side disruptions at the mine and refined levels - will be balanced on the downside by a stronger USD and a slowdown in China. Precious Metals: Neutral. Gold will draw support from rising inflation and inflation expectations this year and next (see below). Ags/Softs: Underweight. NAFTA negotiations ended this week in Montreal with the U.S. rejecting proposals from Canada to advance the talks. However, the U.S. side stated it would seek "major breakthroughs" at the next round of negotiations in Mexico City beginning February 26, according to agriculture.com. Feature Gold Price Risks Skewed To The Upside Price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here. Higher inflation and inflation expectations, which normally would be bullish for gold, will be countered by Fed policy-rate hikes, which will boost the USD and lift real rates in our base case (Chart of the Week). Inflation's Revival Would Support Gold ... Despite above-trend global growth last year, subdued inflation limited the Fed's willingness to proceed with interest rate normalization in earnest. However, we do not put this down to structural forces, and instead expect core inflation to be near its bottom.1 In fact, inflation's soft readings are typical of the expected 18-month lag between U.S. economic growth and a pick-up in inflation, and as our Global Investment Strategists point out, several key indicators including the ISM manufacturing index, the New York Fed's Inflation Gauge, as well as BCA's proprietary pipeline inflation index are already moving in this direction (Chart 2).2 Chart of the WeekInflation And U.S. Financial Variables Matter Inflation And U.S. Financial Variables Matter Inflation And U.S. Financial Variables Matter Chart 2Signs Of Life In U.S. Inflation Signs Of Life In U.S. Inflation Signs Of Life In U.S. Inflation Inflation tends to pick up once the unemployment rate falls below the 5% mark. With the latest unemployment reading coming in at 4.1%, the U.S. economy has reached the steep end of the Phillips Curve - a workhorse model used by the Fed, which depicts the trade-off between unemployment and inflation. Indeed, BCA's Global Investment Strategists expect the U.S. unemployment rate to continue falling to a 49-year low of 3.5% by year-end. These further declines in the unemployment rate will push up wages, pressuring service inflation (Chart 3). At the same time, we expect the lagged impact of the weak USD will begin to show up in goods price inflation, along with higher energy prices. While some components of the Fed's preferred inflation gauge may face a slowdown in price pressure - most notably rent - this will likely be mitigated by accelerating prices in other components, such as health care, which we expect will return to its historic trend. In fact, U.S. inflation expectations - supported by higher energy prices and a strong December core CPI reading - have already started to increase (Chart 4). As our U.S. Bond Strategists point out, by the time core inflation returns to the Fed's target, the 10-year TIPS breakeven inflation rate will be between 2.4% and 2.5%.3 Chart 3At The Steep End Of The Philips Curve At The Steep End Of The Philips Curve At The Steep End Of The Philips Curve Chart 4A Breakout In Inflation Expectations A Breakout In Inflation Expectations A Breakout In Inflation Expectations Thus the 2018 inflation outlook is showing signs that it is in the process of bottoming, and will soon begin its ascent. We expect core PCE inflation, the Fed's preferred gauge, to reach the central bank's 2% target by year-end. This pick-up in inflation and inflation expectations is positive for gold, which we've shown to be an attractive hedge against rising prices. However, inflation's comeback will likely embolden the Fed to proceed more aggressively with its hiking cycle. ... But A Hawkish Fed Counters Inflation ... While our modelling showcases an inverse relationship between real rates and gold prices, what is crucial to our outlook is our expectation of how the Fed will proceed with its interest rate normalization process this year. Given that gold's correlation with inflation is strengthened during periods of low real rates, the ideal condition for gold would be for the Fed to stay behind the inflation curve. But we are not expecting that just yet.4 Rather than waiting to see the "whites of inflation's eyes," our expectation is the Fed will tighten ahead of inflation. This has in fact already materialized with three hikes in 2017 amid muted inflation. Upward surprises in U.S. growth, coupled with an upward trend in inflation will keep the Fed on its normalization path with greater confidence. We expect four rate hikes in 2018 - above both market expectations and what is implied by the "dot plot". Net, the pre-emptive Fed rate hikes we expect will lead to higher real rates, and will limit gold's upside this year. ... As Does A Stronger Greenback An increase in U.S. real rates vis-à-vis other economies, as well as a shift in the composition of global growth to favor the U.S., will support the USD. In addition to higher real rates, this would also limit gold's upside in 2018. Stronger growth ex-U.S. last year weakened the USD. This year, we expect the U.S. economy to outperform. Financial conditions have eased in the U.S. relative to the rest of the world, while fiscal policy is expected to be comparatively more favorable in the U.S. The U.S. surprise index has reflected this shift in comparative growth, outperforming most regions (Chart 5).5 While the Euro has been exceptionally resilient, the fallout from a stronger currency will eventually begin to show up in slower growth. The EUR/USD cross has diverged from the spread in expected policy rates, leaving the euro looking expensive (Chart 6). Since the beginning of the year, spreads have widened in favor of the dollar, while the USD has weakened. Although we do not expect the ECB to hike until mid-2019, our expectation of four Fed rate hikes this year will support the greenback. This will push spreads back in line. Such decoupling is not the norm, and we expect a 5% appreciation in the dollar in broad trade weighted terms.6 Chart 5Economic Surprises Favor The U.S. Economic Surprises Favor The U.S. Economic Surprises Favor The U.S. Chart 6EUR Looks Expensive EUR Looks Expensive EUR Looks Expensive Still, The Fed Could Surprise, And Tilt Dovish Chart 7A Policy Change Would##BR##Tolerate Higher Inflation A Policy Change Would Tolerate Higher Inflation A Policy Change Would Tolerate Higher Inflation A risk to our base case outlook is a change in the Fed's monetary policy framework. Here we note an increasing number of statements advocating the exploration of an alternative policy framework have been emerging from the Fed. This line of attack observes the Fed's current 2% inflation target is unsatisfactory, as it is too close to the zero-lower bound on interest rates, thus constraining the Fed's ability to exercise expansionary monetary policy when rates are low.7 Alternative policy proposals include price-level targeting, as well as an increase in the inflation target. Additionally, former Fed Chair Bernanke recently proposed a temporary price level target be implemented during low-rate periods.8 The net effect of these alternatives would be a higher inflation rate - above the current 2% target (Chart 7). If the Fed were to adopt a new monetary policy framework, it will likely occur before the next recession - in order to allow it to better respond to economic weakness. While we do not expect a regime change this year, these discussions and an eventual shift, may make the Fed more dovish this year, and more likely to tolerate higher inflation in the future. This would be an upside risk to gold, as it would assume its role as a store-of-value against higher inflation. The net effect of such a policy change - were it to occur - would be higher inflation expectations, lower real rates, and a weaker USD, all of which would bid up the gold market. Bottom Line: The revival of U.S. inflation and inflation expectations will bolster gold. However, our expectation that the Fed will continue hiking ahead of a realized uptick in inflation, and more aggressively than is currently priced in the market, will increase real rates and limit gold's upside potential. A stronger USD on the back of higher real rates, as well as a shift in global growth in favor of the U.S., will work against gold this year. Geopolitical Risks: Understated In 2018 We expect geopolitical risks to support gold prices this year. Gold's safe-haven attributes will be highlighted by a combination of events spread across the calendar year, which we believe will put a floor under the metal's price (Chart 8).9 Political and economic policy uncertainty will remain elevated this year (Chart 9). Our Geopolitical Strategists see this year's gold-relevant risks stemming from two main factors: (1) U.S. political risks, and (2) Exogenous tail risks. The former is likely to be a more significant source of upside pressure. Chart 8Gold Outperforms During##BR##Geopolitical Crises Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Chart 9Elevated Policy Uncertainty##BR##Supports Gold Elevated Policy Uncertainty Supports Gold Elevated Policy Uncertainty Supports Gold U.S. Foreign Strategy Risks Will Keep Gold Bid U.S. political risks are rooted in President Trump's strategic decisions, and boil down to two mutually exclusive schemes ahead of the midterm elections: Domestic Strategy or Foreign Strategy (Table 1). Our Geopolitical strategists note: "... policymakers often play "two-level games," with the domestic arena influencing what is possible in the international one. As Donald Trump loses political capital on the domestic front, his options for affecting policy will become constrained. However, the U.S. constitution places almost no constraints on the president when it comes to foreign policy."10 Trump's propensity to take on a more aggressive stance in foreign policy - which would be boosted by an unfavorable outcome in the immigration bill - will set the stage for a volatile year, supporting gold via its ability to hedge against geopolitical risks (Chart 10). Table 1Trump's Two-Level Game Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Chart 10Trump Will Look To Revive His Political Capital Trump Will Look To Revive His Political Capital Trump Will Look To Revive His Political Capital In addition to the U.S. political risks, many low-probability high-impact risks will keep volatility elevated this year and could support gold as a strategic portfolio hedge in 2018. Most notable are the following: A meaningful slowdown in China would have a negative impact on the global economy, as well as increase the risk of a monetary policy mistake in the U.S. The Fed's monetary policy decision is important for EM growth, while EM growth contributes to U.S. inflation, this feedback system makes the expected slowdown in Chinese growth relevant to the U.S. monetary stance. If China slows more than expected, this would reduce the global demand for commodities and goods, diminishing U.S. inflation expectations, potentially forcing the Fed to reassess its rate hike pace. If no adjustments are made, the Fed risks overshooting the equilibrium interest rate, increasing the risk of an equity correction. A downward rate hike adjustment, would keep the USD and real rates at low levels. A global oil-supply disruption caused by a collapse of the Venezuelan economy would lead to a short-lived spike in oil prices (Chart 11). In low-spare-capacity environments - as we are in today - oil prices become more responsive to supply shocks. Based on our simulations, a 600k b/d drop in Venezuelan oil supply in 2018 could spike oil prices by ~$10/bbl, leading to higher cost-push inflation. Our modelling shows U.S. CPI is highly responsive to oil price variation. This spike in headline inflation would push gold prices higher. Chart 11Cost-Push Inflation Risk From Venezuela Collapse Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates In addition to U.S.-Iran tensions, we see other potential catalysts to instability in the Middle East - mainly regarding a severe deterioration of the U.S.-Turkish relationship, and Iraqi-Kurdish clashes ahead of Iraqi elections. Lastly, Europe: Italian elections and Euro-skepticism are a longer-term risk; however, news around the Italian elections in March has the potential to fuel talk of a potential breakup, which could lift gold.11 Bottom Line: Increased tensions due to Trump's controversial foreign strategy (China and Iran), as well as exogenous tail risks throughout the year will keep risks elevated in 2018, supporting gold prices. In fact our geopolitical strategists believe risks are understated this year, increasing the utility of gold's ability to hedge against political turmoil. Gold Outperforms In Equity Bear Markets In addition to its ability to hedge against rising inflation and increased geopolitical risks, gold outperforms during equity downturns and amid market volatility.12 Specifically, during periods of negative equity returns, gold outperformed the S&P500 79% of the time, with an average excess return of 3.7%. Furthermore, gold outperforms equities 60% of the time in periods of rising VIX with an average excess monthly return of 1.6% in these periods, and only 30% of the time in decreasing VIX periods with an average monthly excess return of -1.8% (Chart 12).13 We expect the equity bull market to remain intact throughout 2018. An equity downturn is not expected before 2H19. Nevertheless, we expect volatility to increase this year as investors fret about the sustainability of the bull market, and amid heightened geopolitical tensions. Moreover, domestic U.S. developments - e.g., the evolution of Special Counsel Robert Mueller's investigation; a larger-than-expected Democrat win in the midterm elections or a Fed policy mistake - could affect investor sentiment and trigger a rise in volatility and a temporary sell-off in S&P 500. In our view, consumer confidence is a key contributor to the current equity bull market and currently stands at very elevated levels (Chart 13). Thus, any meaningful disappointment could derail this high-confidence environment. Chart 12Gold Outperforms Amid##BR##Volatility & Equity Downturns Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Chart 13High Confidence##BR##Environment At Risk High Confidence Environment At Risk High Confidence Environment At Risk Therefore, we believe the larger-than-expected tail risks and the monetary and political risks in the U.S. are not fully reflected in the gold market (Chart 14). The above risks assessment would suggest a fatter right tail in out-of-the-money gold options. Chart 14Rising Volatility Will Support Gold Rising Volatility Will Support Gold Rising Volatility Will Support Gold Chart 15Understated Geopolitical Risks This Year Understated Geopolitical Risks This Year Understated Geopolitical Risks This Year Bottom Line: While geopolitical risks were overstated in 2017, they are understated this year (Chart 15). Thus we do not expect a repeat of last year's low-VIX high-confidence environment. Rather gold will gain support from increased equity volatility this year. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Please see BCA Research The Bank Credit Analyst Special Report titled "The Impact of Robots on Inflation," dated January 25, 2018, available at bca.bcaresearch.com. 2 Please see BCA Research Global Investment Strategy Weekly Report titled "Three Tantalizing Trades - Four Months On," dated January 19, 2018, available at gis.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy Weekly Report titled "It's Still All About Inflation," dated January 16, 2018, available at usbs.bcaresearch.com. 4 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 5 Please see BCA Research Global Investment Strategy Weekly Report titled "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Research Global Investment Strategy Weekly Report titled "The Indefatigable Euro," dated January 26, 2018, available at gis.bcaresearch.com. 7 Please see "Fed Officials See Benefits In Letting Inflation Run Above Target," dated January 19, 2018, available at Bloomberg.com. 8 Please see https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/ 9 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 10 Please see BCA Research Geopolitical Strategy Weekly Report titled "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com. 11 For a comprehensive analysis of this issue, please see BCA Research Geopolitical Strategy Special Report titled "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 12 Please see BCA Research Commodity & Energy Strategy Weekly Report titled "Go Long Gold As A Strategic Portfolio Hedge," dated May 4, 2017, available at ces.bcaresearch.com. 13 Excess returns = (Gold - S&P 500) monthly returns. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates Trades Closed in 2018 Summary of Trades Closed in 2017 Gold Still Shines Despite Threat Of Higher Rates Gold Still Shines Despite Threat Of Higher Rates

Highlights A potential rise in U.S. inflation and China's growth slowdown represent formidable headwinds to EM risk assets. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices. These two will dent the EM risk asset rally. Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. A new fixed-income trade: bet on a steeper swap curve in Mexico relative to Canada. Feature The global macro landscape in 2018 will be shaped by the two tectonic shifts: U.S. fiscal stimulus amid vigorous growth, and policy tightening in China amid lingering credit and money excesses. The former will grease the wheels of the already robust U.S. economy, generating a whiff of inflation and fueling a further selloff in the U.S. bond market. China's tightening will in turn weigh on commodities prices and curtail the emerging market (EM) economic recovery. A manifestation of these tectonic macro shifts will be a U.S. dollar rally and weakening commodities prices producing formidable headwinds to EM risk assets. As such, we are reiterating our recommendation to underweight EM risk assets versus their DM peers. As to the absolute performance, we believe EM risk assets are close to a major market top. A Whiff Of U.S. Inflation Strong U.S. growth could in fact be damaging to EM financial markets, as it will likely augment U.S. consumer price inflation. Investors are currently extremely sanguine on U.S. inflationary pressures. An upside surprise to inflation will lift U.S. interest rate expectations further, supporting the greenback and hurting EM carry trades. There is some evidence that U.S. inflation is about to pick up: The New York Federal Reserve underlying inflation gauge is rising, signaling higher inflation ahead (Chart I-1). The nascent revival in the MZM (money of zero maturity) impulse presages a trough in inflation (Chart I-2). Chart I-1Fed Price Pressure Gauge Signifies Higher Inflation Fed Price Pressure Gauge Signifies Higher Inflation Fed Price Pressure Gauge Signifies Higher Inflation Chart I-2U.S. Money Growth And CPI U.S. Money Growth And CPI U.S. Money Growth And CPI The weak U.S. dollar will also help augment inflation in America. U.S. import prices from emerging Asia and Mexico have been rising - even before the latest carnage in the U.S. dollar (Chart I-3). This will filter through into higher domestic price pressures. Chart I-3U.S. Import Prices Are Rising U.S. Import Prices Are Rising U.S. Import Prices Are Rising In brief, fiscal stimulus amid buoyant growth as well as overwhelming optimism among consumers and businesses is creating fertile ground for companies to raise prices. This will amplify corporate profit growth but will also lead to higher inflation. We are not making a case that U.S. inflation is about to surge. Our thesis is that market participants are very complacent on inflation. The money market is pricing in only 96 basis points in rate hikes in 2018-'19. In the meantime, the term premium in the U.S. yield curve is extremely depressed. Therefore, even modest inflation surprises will likely produce an additional meaningful selloff in U.S./DM bond markets. Will global share prices rise in response to strong corporate profit growth, or sell off in the face of higher U.S. inflation? Our hunch is that share prices will suffer as rising bond yields cause multiples to shrink. Rising bond yields will overpower the profit growth impact on share prices. The basis is that multiples are disproportionately and inversely linked to percentage change interest rates but are proportionately and positively linked to EPS.1 At still-low yields, a 50-basis-point rise in bond yields constitutes a sizable percentage change in the bond yield, likely leading to a meaningful P/E de-rating. Current sky-high bullish sentiment towards equities combined with elevated valuations and overbought conditions will mean that even a modest rise in inflation readings will likely trigger equity market jitters. EMs will underperform DMs amid such a selloff, as the former has benefited much more than the latter from low interest rates. Bottom Line: U.S. fiscal stimulus is arriving at a time when final demand is robust, the labor market is tight and business and consumer confidence is buoyant. This will encourage companies to raise prices, resulting in a whiff of U.S. inflation. The latter will rattle markets in the months ahead. China: Tightening Amid Credit/Money Excesses Inflation in China has already been steadily rising (Chart I-4). Interest rates adjusted for inflation remain low. Rising inflation along with still-lingering credit and money excesses necessitates policy tightening. We have written extensively about China's ongoing tightening trifecta - liquidity tightening, increased regulatory oversight and clampdown as well as an anti-corruption crackdown in the financial industry.2 Regulatory tightening in particular could inflict a particular bite as it outright constrains banks' ability to originate credit. This tightening has already led to record low broad money growth, and credit growth is downshifting too (Chart I-5). The cumulative impact of this tightening will play out in the months ahead, weighing further on money and credit growth and ultimately on final demand. Chart I-4China: Inflation Is In Steady Uptrend China: Inflation Is In Steady Uptrend China: Inflation Is In Steady Uptrend Chart I-5China: Broad Money And Credit Growth bca.ems_wr_2018_01_31_s1_c5 bca.ems_wr_2018_01_31_s1_c5 On the fiscal front, local government spending has languished in recent months (Chart I-6, top panel) and general (central plus local) government spending growth has been lackluster (Chart I-6, bottom panel). In 2017, local government annual spending amounted to RMB 19 trillion, or 22% of nominal GDP. Central government expenditures are about 6-fold smaller. Local governments rely on land sales to replenish their coffers, but timid money growth points to weaker land sales ahead (Chart I-7). In the meantime, their annual borrowing is restricted by the central government. Overall, this will constrain local government expenditures in 2018. Chart I-6China: Government Expenditures China: Government Expenditures China: Government Expenditures Chart I-7China: Land Sales To Slump bca.ems_wr_2018_01_31_s1_c7 bca.ems_wr_2018_01_31_s1_c7 The combined credit and fiscal spending impulse heralds a relapse in mainland imports of goods and commodities (Chart I-8). This constitutes a major threat to commodities prices, and consequently to EM. A pertinent question is whether financial markets will react to rising U.S. inflation or a slowdown in Chinese growth. Clearly, one could argue that strong U.S. growth would offset a mainland growth slump, resulting in a stable global macro environment. However, financial markets are an emotional discounting mechanism, and they do not always follow rational thinking. For example, in the first half of 2008 - just a few months ahead of the Global Financial Crisis - global financial markets were preoccupied with mounting global inflation due to strong growth in EM/China. At the time, oil and many other commodities prices were literally surging, and U.S. bond yields were climbing (Chart I-9). Global financial markets were not concerned with the ongoing U.S. recession, shrinking bank loans and deflating house prices. Chart I-8China's Impact On Rest Of The World China's Impact On Rest Of The World China's Impact On Rest Of The World Chart I-92008: An Inflation Scare Just ##br##Before Deflationary Bust 2008: An Inflation Scare Just Before Deflationary Bust 2008: An Inflation Scare Just Before Deflationary Bust In retrospect, financial markets traded on the theme of rising global inflation in the first half of 2008 even though the U.S. was already in a recession, and was heading into the most severe deflationary bust of the past 80 years. Similarly, the financial markets today could trade on the U.S. inflation theme for a couple months, even though China will be slowing. Bottom Line: China's policy tightening is particularly dangerous because it is occurring amid substantial and still-lingering credit, money and property market excesses. Won't Strong DM Growth Support China And Other EMs? Our investment stance on EM has been and remains negative, despite our positive view on U.S. and European growth. The key rationale for this stance is that EMs are much more leveraged to China than to the U.S. and Europe. Hence, our view assumes de-synchronization of growth between EM and DM. In our opinion, an EM slowdown will be largely due to China's deceleration and the latter's impact on commodities prices and non-commodity economies in Asia via trade. South America, Russia, South Africa, Malaysia and Indonesia are commodities producers, and as such are sensitive to fluctuations in commodities prices. The rest of Asia - Korea, Taiwan, Singapore, Thailand and the Philippines - are still exposed to the mainland economy as the latter is their largest export destination. Thus out of the EM sphere, China's dynamics will have a limited impact on only Mexico, India, and Turkey. However, Mexico is at risk of a NAFTA abrogation, while Turkey is at risk of runaway inflation and monetary profligacy. India on the other hand has its own problems and its bourse is unlikely to do well, given it is overbought and expensive. Furthermore, while we are bullish on the growth outlook in central European economies, they are too small to matter from an EM benchmark perspective. It might be useful to contemplate the late 1990s macro dynamics when major decoupling occurred between DM and EM. The booming economies of the U.S. and Europe did not prevent recurring crises in EM in the second half of the 1990s. Chart I-10 illustrates that U.S. and European imports growth was surging at that time, but EM stocks and currencies collapsed. What's more, despite the economic boom in DM during that period - U.S. and euro area real GDP growth rates averaged 4.2% and 2.6%, respectively, between 1996 and 1998 - commodities prices were in a bear market (Chart I-11). Chart I-10EM Crises In 1997-98: U.S. And ##br##Europe's Imports Were Booming EM Crises In 1997-98: U.S. And Europe's Imports Were Booming EM Crises In 1997-98: U.S. And Europe's Imports Were Booming Chart I-11Booming DM GDP And ##br##Falling Commodities Prices Booming DM GDP And Falling Commodities Prices Booming DM GDP And Falling Commodities Prices One might suspect that EM crises in the second half of the 1990s occurred because booming DM growth led to rising U.S. bond yields. However, Chart I-12 portrays that U.S. bond yields actually fell in 1997 and 1998 due to the deflationary shock stemming from the EM turmoil. Chart I-12EM Crises Occurred Amid ##br##Falling U.S. Bond Yields EM Crises Occurred Amid Falling U.S. Bond Yields EM Crises Occurred Amid Falling U.S. Bond Yields By and large, the 1997-98 EM crises occurred despite buoyant DM growth and falling DM bond yields. Nowadays, advanced economies carry much smaller weight in global trade and GDP than they did 20 years ago. Furthermore, EMs are much less dependent on exporting to DMs than they were two decades ago. In addition, China was not an economic powerhouse 20 years ago like it is today, and it did not buy as much from the rest of EMs as it does today. Presently, China holds the key to the EM outlook, and the link is through Chinese imports of goods and commodities. As China's credit and fiscal spending impulse suggests, mainland imports are likely to slow, weighing on commodities prices (refer to Chart I-8 on page 6). To be sure, we are not suggesting that EMs are facing crises similar to what transpired in 1997-98. The point of this comparison is to highlight that robust DM growth in of itself is not sufficient to head off an EM downturn if the latter faces a negative shock from China. With respect to DM growth benefiting China itself, it is critical to realize that China's exports to the U.S. and EU together account for only 6.6% of Chinese GDP (Chart I-13). By far, the largest component of the mainland economy is capital spending, constituting 42% of GDP. Construction and infrastructure are an integral part of capital expenditures, and they are very sensitive to money/credit cycles. Finally, from a global trade perspective, China and the rest of EM account for 46% of global imports, while the U.S. and EU account for 20% and 15%, respectively (Chart I-14). Hence, the total import bill of EM including China is larger than that of the U.S.'s and EU's imports combined. This entails that the pace of global trade growth is set to moderate if EM/China domestic demand decelerates. Chart I-13What Drives Chinese Economy: ##br##Capex Not Exports To DM What drives Chinese Economy: Capex Not Exports To DM What drives Chinese Economy: Capex Not Exports To DM Chart I-14Important Of EM/China In Global Trade Important Of EM/China In Global Trade Important Of EM/China In Global Trade Bottom Line: Strong DM growth will not offset the impact of a slower Chinese economy on EMs and commodities. Investment Conclusions A manifestation of the above-discussed tectonic macro shifts - a rise in U.S. inflation and China's slowdown - will be a U.S. dollar rally and weakening commodities prices. These two macro shifts will produce a perfect storm for EM risk assets. As a harbinger of a forthcoming selloff in EM exchange rates and DM commodities currencies (AUD, NZD and CAD), their implied volatility measures are already picking up (Chart I-15). As to a China/Asia slowdown, Korean, Taiwanese and Singaporean manufacturing output volume growth rates have already relapsed (Chart I-16). Their exports and corporate profits still appear robust because of rising prices. This certifies that there are inflationary pressures, even in Asia. Chart I-15Currency VOLs Are Rising Currency VOLs Are Rising Currency VOLs Are Rising Chart I-16Asian Manufacturing Output Volume Asian Manufacturing Output Volume Asian Manufacturing Output Volume All in all, we maintain a negative stance on EM risk assets in absolute terms and recommend underweighting them versus their DM peers. Within the EM universe, our equity market overweights are Taiwan, India, Korean technology, Thailand, Russia, central Europe and Chile. Our underweights are South Africa, Turkey, Brazil, Peru and Malaysia. Among currencies, our favorite shorts are the TRY, the ZAR, the MYR and the BRL. For investors who prefers relative EM currency trades, we recommend the following longs for crosses: RUB, TWD, THB, CNY and INR. For fixed-income trades, please refer to our open position table on page 18. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Bet On A Steeper Swap Curve Relative To Canada For Mexican financial markets, the key uncertainty at the moment is the outcome of the ongoing NAFTA negotiations. Mexico's macro backdrop argues for considerable central bank easing, as inflation is about to roll over and domestic demand is extremely weak. However, if the U.S. pulls out of NAFTA - the odds of which are considerable, as our Geopolitical Strategy team has argued3 - the peso will sell off and interest rates are likely to rise. How should investors position themselves in Mexican fixed-income markets given this binominal outcome from the NAFTA negotiations and uncertainty over its timing? One way is to position for a swap curve steepening in Mexico, and hedge it by betting on a swap curve flattening in Canada by entering the following pair trades (Chart II-1): Chart II-1Mexico, Canada And Their ##br##Relative Swap Curve Mexico, Canada And Their Relative Swap Curve Mexico, Canada And Their Relative Swap Curve Receive 6-month and pay 10-year swap rates in Mexico Pay 6-month and receive 10-year swap rates in Canada In A Scenario Where The U.S. Withdraws From NAFTA: The Mexican swap curve would invert due to short-term rates going up more than long-term rates. In Canada, potential risks from NAFTA abrogation and tightening monetary policy amid frothy property markets and high household debt will cap upside in its long-term interest rates. With its long-term bond swap rates at par with those in the U.S., it seems as though the Canadian fixed income market is underpricing the risk of potential growth disappointments beyond the near run. In essence, should the U.S. withdraw from NAFTA, the loss realized on the Mexican steepener leg would partially be offset by the potential gain on the Canadian flattener leg. In A Scenario Where The U.S. Does Not Withdraw From NAFTA: The Mexican swap curve would start steepening. The rationale is that domestic dynamics suggest inflation has peaked and Banxico should begin its easing cycle soon. Monetary and fiscal policies have been extremely restrictive in Mexico, and considerable monetary easing is justified going forward: A significant part of the rise in inflation in 2017 was caused by peso depreciation in 2016. Last year's peso rally suggests that inflation should start to roll over soon (Chart II-2). Besides, one-off effects on inflation - such as the gasoline subsidy removal that took place at the end of 2016 - will subside as the base effect it has caused fades. In brief, the consumer inflation rate will rapidly decline, justifying substantial monetary easing. Banxico's 425 basis points in rate hikes since the end of 2015 are still filtering through the economy. The persistent slowdown in money and credit growth will continue to weigh on domestic demand for the time being. Notably, retail sales volume and gross fixed capital formation are both contracting while domestic vehicles sales are shrinking sharply (Chart II-3). Chart II-2Mexico: Inflation Is Set To Drop Mexico: Inflation Is Set To Drop Mexico: Inflation Is Set To Drop Chart II-3Mexico: Consumer And Business ##br##Spending Are Extremely Weak Mexico: Consumer And Business Spending Are Extremely Weak Mexico: Consumer And Business Spending Are Extremely Weak Due to currently high inflation, real wage growth remains weak. This will continue to weigh on consumer spending (Chart II-4). Fiscal policy has been tightening. Fiscal expenditures, excluding interest payments, are contracting in nominal terms (Chart II-5). Chart II-4Mexico: Real Wage Growth Is Very Timid Mexico: Real Wage Growth Is Very Timid Mexico: Real Wage Growth Is Very Timid Chart II-5Mexico: Fiscal Policy Is Super Tight Mexico: Fiscal Policy Is Super Tight Mexico: Fiscal Policy Is Super Tight Canada is currently on the opposite side of the business cycle spectrum relative to Mexico. The Canadian economy is very strong, being led by domestic demand. Real consumer spending is growing at its fastest pace in nearly 10 years, while the unemployment rate is at 40-year lows. Moreover, a record proportion of Canadian firms are having difficulty meeting demand because of capacity constraints and a tight labor market (Chart II-6, top and middle panel). Chart II-6Canadian Economy Is ##br##Above Full-Employment Canadian Economy Is Above Full-Employment Canadian Economy Is Above Full-Employment As such, the output gap is positive and growing, which has historically led to rising inflation (Chart II-6, bottom panel). Robust growth and rising inflation will force the Bank of Canada to hike rates further. In the meantime, real estate and consumer credit in Canada are overextended, leaving the Canadian consumer at risk from much higher interest rates. The threat that monetary tightening will hurt domestic demand in the future will cap the swap curve in Canada relative to Mexico. On the whole, in the scenario where the U.S. remains in NAFTA, the potential for swap curve steepening in Canada is less than in Mexico. Investment Recommendations We have been recommending that investors maintain a neutral stance across all asset classes in Mexico and wait for clarity on NAFTA negotiations before going overweight the country's currency, fixed-income markets and possibly equities relative to their EM peers. In the face of lingering NAFTA uncertainty, fixed-income investors should contemplate the following relative trade: Receive 6-month and pay 10-year swap rates in Mexico / pay 6-month and receive 10-year swap rates in Canada. Overall, this trade is exposed to minimal losses in the scenario where the U.S. withdraws from NAFTA but is exposed to considerable gains where the U.S. remains in NAFTA, making the overall risk/reward attractive. Provided the NAFTA negotiations could drag till year-end, this trade offers a reasonable risk-reward for traders. It offers a profitable opportunity to profit from Mexico's swap curve steepening, while limiting downside in case NAFTA is terminated before year-end. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 This is due to the fact that interest rates are in the denominator of the Gordon Growth model while EPS/dividends are in the numerator. 2 Please refer to Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, the link is available on page 19. 3 Please refer to the Geopolitical Strategy Special Report, titled "Nafta - Populism Vs. Pluto-Populism," dated November 10, 2017, the link is available at gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, In addition to this Special Report written by my colleagues Mark McClellan and Brian Piccioni, we are sending you an abbreviated weekly report. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Feature Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart 1Robots Are Getting Cheaper Robots Are Getting Cheaper Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart 1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart 2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart 3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart 2Global Robot Usage Global Robot Usage Global Robot Usage Chart 3Global Robot Usage By Industry (2016) The Impact Of Robots On Inflation The Impact Of Robots On Inflation As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart 4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart 5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart 4Stock Of Robots By Country (I) Stock Of Robots By Country (I) Stock Of Robots By Country (I) Chart 5Stock Of Robots By Country (II) (2016) The Impact Of Robots On Inflation The Impact Of Robots On Inflation While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart 6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 Chart 6U.S. Investment In Robots U.S. Investment In Robots U.S. Investment In Robots The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart 7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart 7Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix 1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart 8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart 8U.S.: Productivity Vs. Robot Density The Impact Of Robots On Inflation The Impact Of Robots On Inflation Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart 9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart 10). Chart 9GPT Contribution To Productivity The Impact Of Robots On Inflation The Impact Of Robots On Inflation Chart 10U.S.: Unit Labor Costs Vs. Robot Density The Impact Of Robots On Inflation The Impact Of Robots On Inflation In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart 11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart 11Inflation Vs. Robot Density The Impact Of Robots On Inflation The Impact Of Robots On Inflation 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box 1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart 12). Box 1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart 12U.S. Job Rotation Has Slowed The Impact Of Robots On Inflation The Impact Of Robots On Inflation The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart 13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix 2 for more details. Chart 13Global Manufacturing Jobs Vs. Robot Density The Impact Of Robots On Inflation The Impact Of Robots On Inflation The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix 1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart 14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart 14U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix 2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart 4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart 15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart 16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart 15Japan: Earnings Vs. Robot Density The Impact Of Robots On Inflation The Impact Of Robots On Inflation Chart 16Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood Of Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017) "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against the Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com. 10 OECD Productivity Working Papers, No. 05 (2016) "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 8.