Inflation/Deflation

Highlights Mario Draghi will signal the ECB's intention to further taper asset purchases during his Jackson Hole address later today, while cautioning that rate hikes remain a way away. The spread between long-term U.S. and euro area bond yields is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area. The upswing in Japanese growth is unlikely to prompt the BoJ to abandon its yield- curve targeting regime. Japanese stocks are cheap and corporate profits are rebounding smartly. Stay overweight Japanese equities in currency-hedged terms for the next 12 months. As one looks further ahead to the next decade, Japanese inflation will likely break out as labor shortages intensify. This will be part of a broad-based increase in global inflation. Stay long Japanese inflation protection and go short 20-year JGBs relative to their 5-year counterparts. Feature Mario Draghi: Action Jackson, The Sequel? Mario Draghi made shockwaves the last time he spoke at Jackson Hole on August 22, 2014. Draghi used that occasion to lay out the case for additional monetary easing. This paved the way for the ECB's own QE program. From that fateful speech to March 2015, EUR/USD fell from 1.33 to 1.05. Three years later, investors are anxious to hear what Draghi has to say, but this time around the expectation is that he will discuss plans for winding down QE. We agree that Draghi will signal the ECB's intent to further taper asset purchases. Growth is currently strong and the risk of a euro area breakup has all but disappeared. Nevertheless, although he may not publicly admit it, Draghi is cognizant of the fact that euro area financial conditions have tightened on the back of a strong euro, while U.S. financial conditions have continued to ease (Chart 1). Mario Draghi also knows that both inflation and wage growth remain depressed across the euro area, and that labor market slack outside Germany is still 6.7 percentage points higher than in 2008 (Chart 2). In addition, Draghi is undoubtedly aware of the likelihood that the neutral rate of interest is extremely low in the euro area, implying that the ECB would be constrained in raising rates even if the region were close to full employment.1 The spread between the 30-year U.S. Treasury yield and the 30-year GDP-weighted euro area bond yield - a reasonable proxy for the market's estimate of the difference in neutral rates between the two regions - currently stands at 86 basis points in nominal terms and 56 basis points in real terms. This is not especially wide considering that trend growth is higher in the U.S. and fiscal policy will add 4% of GDP more to U.S. aggregate demand over the next few years than it will in the euro area (Chart 3).2 Chart 1Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Chart 2Draghi Is Paying Attention Draghi Is Paying Attention Draghi Is Paying Attention Chart 3The State Of Fiscal Policy In The G4 Is The BoJ Next? Is The BoJ Next? We expect EUR/USD to pare back its gains, dropping to $1.05 by the end of 2018. However, most of the dollar's rebound is likely to occur next year, when it becomes apparent that the U.S. unemployment rate will fall well below the Fed's 2018 projection of 4.2%. This will force the Fed to step up the pace of rate hikes. For the time being, we see EUR/USD fluctuating within a broad range of $1.10-to-$1.20. BoJ: Time To Remove The Sake Bowl? Could the Bank of Japan follow in the Fed's and ECB's footsteps by signaling the desire to slowly withdraw monetary accommodation? On the surface, there are certainly some reasons to think so. Japanese growth has picked up recently, with real GDP rising at a blistering annualized pace of 4% in the second quarter (Chart 4). The acceleration in growth was driven entirely by stronger domestic demand. Consumer spending increased by 3.7%, while private nonresidential investment jumped by 9.9%. Inflation appears to be bottoming. The national core CPI index, which excludes fresh food prices but includes energy costs, rose for the seventh straight month in June to 0.4% on a year-over-year basis. Corporate goods inflation has reached 2.6%, up from a low of -4.6% in May 2016. Corporate service inflation moved to 0.8% this spring, the highest rate since 1993 (Chart 5). Nominal wage growth has also accelerated. Our Wage Trend Indicator, which uses statistical techniques applied to three separate data series to extract the underlying trend in Japanese wages, is now close to its 2007 highs (Chart 6). Chart 4GDP Growth Has Perked Up In Japan GDP Growth Has Perked Up In Japan GDP Growth Has Perked Up In Japan Chart 5Corporate Pricing Power Has Improved Corporate Pricing Power Has Improved Corporate Pricing Power Has Improved Chart 6Japanese Wages Are In An Uptrend Japanese Wages Are In An Uptrend Japanese Wages Are In An Uptrend The recovery in Japanese wage growth has occurred alongside a tightening of the labor market. The latest Economy Watchers Survey featured a litany of companies complaining of worsening labor shortages (Table 1). This is confirmed by the job openings-to-applicants ratio, which has surged to the highest level since 1974 (Chart 7). Table 1Japan: Evidence Of Shortages Of Workers, Part I Is The BoJ Next? Is The BoJ Next? Chart 7Japan: Evidence Of Shortages Of Workers, Part II Japan: Evidence Of Shortages Of Workers, Part II Japan: Evidence Of Shortages Of Workers, Part II Easy Does It, Kuroda-san Despite the good news on the economy, it is highly unlikely that the Bank of Japan will abandon its ultra-accommodative stance any time soon. There are a number of reasons for this: While inflation is rising, it is coming off a very low base, and is nowhere near the BoJ's 2% target. A deflationary mindset also remains firmly entrenched, as highlighted by both survey data and market expectations (Chart 8). Much of the recent pickup in inflation is attributable to higher energy prices and the lagged effects of a weaker yen. Excluding energy prices, core inflation has barely risen. The increase in corporate goods prices has also closely tracked the price of imports. Considering that the trade-weighted yen has appreciated of late, it is reasonable to assume that import price inflation will dissipate. This spring's annual shunto wage negotiations yielded smaller wage hikes among large companies than in 2016. This suggests that further near-term gains in wages will be hard to come by. Fiscal policy may turn less accommodative. The government passed a supplementary budget last summer (worth 1.5% of GDP according to the IMF). The effects of this package are being felt now. Public fixed investment surged by 21.9% in Q2. Under current law, however, fiscal policy is set to turn contractionary again over the next few years. Leading economic indicators are pointing to a modest slowdown in growth over the coming months (Chart 9). Chart 8Deflationary Mindset Has Been Hard To Shake Off Deflationary Mindset Has Been Hard To Shake Off Deflationary Mindset Has Been Hard To Shake Off Chart 9LEIs Pointing To Modest Slowdown LEIs Pointing To Modest Slowdown LEIs Pointing To Modest Slowdown The BoJ is not the same central bank that it was five years ago. The last two hawkish dissenters, Takehiro Sato and Takehide Kiuchi, both stepped down in July when their terms expired. They were replaced by Goshi Kataoka and Hitoshi Suzuki, neither of whom are expected to oppose Governor Haruhiko Kuroda's dovish approach. As such, it is highly likely that the BoJ will continue to anchor the 10-year yield at close to zero for at least the next 12 months. If bond yields elsewhere rise over this period - as we expect will be the case - the yen will weaken. Good News For Japanese Stocks... For Now A weaker yen is, of course, good news for Japanese stocks. Japanese equities are currently trading at a 16% discount to the MSCI World index based on forward earnings (Chart 10). Moreover, unlike in the past, both earnings and dividend growth have been strong, averaging 19% and 9%, respectively, over the last five years (Chart 11). Corporate governance reform - a key element of Abenomics - can take some credit for this. The share of companies with at least two independent directors rose from 18% in 2013 to 78% in 2016. The number of companies with performance-linked pay increased from 640 to 941, while the number that publish disclosure policies jumped from 679 to 1055. Analysts have been slow to factor in these positive developments. Chart 12 shows that Japan leads all other major stock markets in positive earnings surprises in the second quarter. We remain overweight Japanese equities in currency-hedged terms. Chart 10Good Value In Japanese Stocks Good Value In Japanese Stocks Good Value In Japanese Stocks Chart 11Solid Earnings And Dividend Growth Solid Earnings And Dividend Growth Solid Earnings And Dividend Growth Chart 12Japan And Positive Earnings Revisions: Follow The Leader Is The BoJ Next? Is The BoJ Next? . The Longer-Term Outlook: Japan (Eventually) Escapes Deflation As we discussed last week, it is likely that the U.S. will fall into recession in 2019 or 2020, dragging the rest of the world down with it.3 As a risk-off currency, the yen will strengthen, potentially reigniting deflationary forces. This will make it impossible for the BoJ to abandon its yield-curve targeting regime. Does that mean that Japan is condemned to a never-ending cycle of reflation/deflation? Not necessarily. As one looks at a longer-term horizon of 5-to-10 years, it is likely that Japan will finally escape deflation. This is because many of the structural forces that have sustained deflation will have either receded or reversed course by then. The simultaneous bursting of Japan's real estate and stock market bubbles in the early 1990s ushered in a prolonged period of falling property prices and corporate deleveraging. This suppressed both household consumption and business investment, leading to a persistent shortfall in aggregate demand. The latest data suggests that property prices are bottoming and corporate balance sheets have finally improved to the point where further aggressive cost-cutting is no longer necessary (Chart 13). Demographic trends are also likely to fuel higher inflation over the long haul. The deceleration in population growth in the early 1990s reduced the need for everything from new homes to new cars, shopping malls, and factories. This weighed on business capex and consumer durable spending, thereby exacerbating the deflationary forces that were already in place. In addition, a surge in the share of the population in their peak saving years - ages 30 to 50 - led to an increase in desired savings throughout the economy. More savings means less spending, so this also contributed to deflation. Looking out, population growth will remain anemic. However, two important developments will occur. First, the biggest cohort of Japanese baby boomers - those born in 1947-52 - will hit 70, the age at which most Japanese workers retire. Second, the secular rise in female labor force participation will plateau. Chart 14 shows that a larger percentage of Japanese women between the ages of 25 and 54 are employed than in the U.S., a massive shift from 20 years ago. Both these changes will exacerbate labor shortages, while further reducing national savings. Chart 13Deflationary Headwinds Are Abating Deflationary Headwinds Are Abating Deflationary Headwinds Are Abating Chart 14Female Employment In Japan Has Surpassed The U.S. Female Employment In Japan Has Surpassed The U.S. Female Employment In Japan Has Surpassed The U.S. Concluding Thoughts Contrary to popular belief, the Phillips curve remains intact, even in Japan (Chart 15). The market is not at all prepared for the prospect of higher Japanese inflation, as evidenced by the fact that CPI swaps are pricing in inflation of only 0.5% over the next two decades. As inflation picks up in the 2020s, nominal GDP will rise (even if real GDP growth remains anemic due to a shrinking labor force). The Bank of Japan will keep nominal rates low during the first half of the 2020s, ensuring that real rates sink further into negative territory. This will be the way by which Japan reduces its debt burden. Older savers may not like it, but the alternative of pension and health care cuts will be seen as even worse. We are currently long Japanese inflation protection through the CPI swaps market. As of today, we are adding a new long-term trade recommendation: Go short 20-year JGBs relative to their 5-year counterparts. The potential upside from this trade easily compensates for the negative carry of 66 bps. An upswing in Japanese inflation in the 2020s is very much in line with our secular view that global inflation will trend higher over the long haul, as articulated in a recent report.4 This will have a profound impact on fixed-income markets. While Japan's demographic transition has been and will continue to be more extreme than elsewhere, population aging is something that will affect all major economies. Chart 15Japan's Phillips Curve Is Alive And Well Is The BoJ Next? Is The BoJ Next? Chart 16Demographic Shifts: From Highly Deflationary To Highly Inflationary Is The BoJ Next? Is The BoJ Next? Chart 16 shows the IMF's estimate of how projected changes in the age structure of the population will affect inflation over the next few decades. The Fund's calculations suggest that demographic shifts will go from being very deflationary to very inflationary in every major economy. This will translate into significantly higher long-term nominal bond yields. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Future Of The Neutral Rate," dated August 4, 2017. 2 We calculate this number by taking the difference between the structural primary budget balance in the euro area (roughly 1.5% of GDP) and the U.S. (roughly -2.5% of GDP). The claim that this will translate into 4% more in aggregate demand in the U.S. implicitly assumes a fiscal multiplier of one. A larger multiplier would generate an even bigger gap in demand. 3 Please see Global Investment Strategy Weekly Report, "From Slow Burn Recovery To Retro-Recession?" dated August 18, 2017. 4 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature Dear client, This week we are publishing a brief Special Report highlighting ten charts that have captured our attention, charts we would like to emphasize before the summer lull ends. We will not be sending a report next week, but we will be resuming our regular publishing schedule on September 8, 2017. Warm regards, Mathieu Savary With both the Manufacturing Council and the Strategy and Policy Forum disbanded, markets have lost faith in the capacity of the Trump administration to pass on any meaningful tax reforms or tax cuts. However, as Chart 1 shows, the imperative for Republicans in Congress to do so before the 2018 mid-term election is in fact growing by the minute: The unpopularity of Donald Trump is becoming a major handicap for the GOP in Congress and the post-Charlottesville debacle is only making matters worse. Legislative action needs to materialize to compensate for this hurdle. The tax cuts or reforms ultimately passed are not likely to be what the administration envisage and are likely to be emanating from Congress itself and not the White House. This situation should also give Republicans an incentive to avoid an unpopular government shutdown around the debt ceiling negotiations, but we expect uncertainty around this question to remain elevated as rhetoric flairs up, which could potentially put our long USD/JPY position at risk. Chart 1If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 10 Charts For A Late-August Day 10 Charts For A Late-August Day While automation has received a lot of press, one of the key factors that keeps weighing on inflation on a structural basis is the continuation of a 30-year process: The entry of China and other key emerging markets into the global economy, which has massively expanded global aggregate supply relative to aggregate demand. Through the 1980s and 1990s, this expansion in supply mostly reflected the addition of billions of potential workers to the global labor force. However, as Chart 2 illustrates, since the turn of the millennium, the supply-side expansion has mostly taken the form of a massive increase in the EM and Chinese capital stock, which has lifted the global capital stock. As a result, this has created excess capacity for the world as a whole, which is keeping a lid on prices. As long as China keeps a very high savings rate, global demand is likely to remain inadequate relative to global supply, structurally limiting the upside to global inflation. Chart 2Global Excess Capacity Global Excess Capacity Global Excess Capacity While the structural anchor on inflation remains, this does not mean that cycles in prices are dead. In fact, from a cyclical perspective, U.S. core inflation is likely to bottom and slowly inch higher in the second half of 2017. Inflation remains a lagging indicator of the business cycle. Supported by very easy financial conditions, growth has regained some vigor while the U.S. is now at full employment. Additionally, as Chart 3 illustrates, the U.S. velocity of money has once again picked up, a reliable leading indicator of core inflation over the past 20 years. This supports our thesis that this year's downleg in the dollar is long in the tooth: A stabilization and uptick in inflation could force markets to push up the number of interest rates hikes anticipated from the Federal Reserve. Chart 3Cyclical Inflation Dynamics Cyclical Inflation Dynamics Cyclical Inflation Dynamics In 2015, the Chinese economy was losing speed at an accelerating pace. Beijing began to panic and pulled out all the stops to put a floor under growth: Fiscal spending increased at an incredible 25% annual pace by the end of 2015 and credit growth was encouraged. While the fiscal stimulus is long past, the Chinese credit impulse has continued to support economic activity, investment, construction, and imports. However, the People's Bank of China has begun engineering a tightening in monetary conditions and is slowly but surely putting the brakes on the expansion of off-balance sheet instruments in the Chinese financial system. As a result, the amount of financing raised by smaller Chinese financial institutions is decelerating. Historically, without this source of liquidity, total debt growth has tended to slow, adversely impacting the credit impulse (Chart 4). This is likely to weigh on investment and construction, thus negatively affecting the dollar-bloc currencies. Chart 4Key Risk To Chinese Credit Growth Key Risk To Chinese Credit Growth Key Risk To Chinese Credit Growth The euro has rallied violently this year. Some of this strength has been a reflection of the euro's nature as the anti-dollar. As investors began doubting the capacity of the Fed to stick to its plan of hiking interest rates to 2.9% by the end of 2019, and as political paralysis took over the U.S., the greenback suffered, lifting the euro in the process. In sharp contrast, the European economy and inflation picked up and political risk in continental Europe receded, adding fuel to the fire. Today, buying the euro has become the epitome of the "consensus trade," with investors massively long the common currency. However, while a pickup in U.S. inflation will be required to expect a full reversal of this trade, a correction in the euro is a growing risk: The EUR/USD's fractal dimension - a measure of groupthink - has hit 1.25, a level that in the past has warned of a potential countertrend move (Chart 5). Chart 5Correction In The Euro Correction In The Euro Correction In The Euro Betting on the yen remains the FX analogue to betting on bonds. JGB yields display a low beta to global government bond yields; thus, when global rates go up, interest rate differentials move against the yen. The opposite is true when global yields fall. The downside to the yen when global rates rise has now been supercharged by the yield cap implemented by the Bank of Japan, as JGB yields are now prohibited from rising when global bond yields rise. BCA's view is that U.S. bond yields should rise over the next 12 months, which will should prompt a period of pronounced weakness in the JPY. But what if a rise in bond yields causes an EM selloff - wouldn't this help the yen? As Chart 6 illustrates, the correlation between USD/JPY and bond yields is, in fact, stronger than that with stocks. In other words, the pain in EM has to become acute enough to cause bond yields to fall before the yen can rally. This means there is a window of opportunity to short the yen when bond yields rise even if EM assets depreciate. Chart 6The Yen Is A Play On Bonds The Yen Is A Play On Bonds The Yen Is A Play On Bonds Dollar-bloc currencies (CAD, AUD and NZD) tend to be prime beneficiaries of expanding global liquidity. This is because in an environment where global liquidity expands, the U.S. dollar weakens and commodity prices strengthen. Moreover, when global liquidity is plentiful, risk-taking and carry trades are emboldened, creating inflows of funds and liquidity into EM nations, which in turn, boosts their economic prospects. This also pushes up the expected returns of assets in the dollar-bloc countries, and thus incentivizes global investors to purchase the AUD, the CAD, and the NZD. This means that historically, the performance of dollar-bloc currencies has been tightly linked to the expansions in global central bank reserves - a good measure of global liquidity growth. This time around, dollar-bloc currencies have massively outperformed the growth in global reserves, leaving them vulnerable to any slowdown in global liquidity (Chart 7). Chart 7Dollar-Bloc Currencies Have Overshot Global Liquidity Dollar-Bloc Currencies Have Overshot Global Liquidity Dollar-Bloc Currencies Have Overshot Global Liquidity While commodity currencies are all likely to face headwinds over the course of the next 12 months, all dollar-bloc currencies are not created equal. The AUD looks much more vulnerable than the CAD. First, the AUD is trading at a 10.7% premium vis-à-vis its long-term fair value, while the CAD is only slightly expensive. Second, Canadian terms of trade are governed by dynamics in energy prices, its main commodity export, while Australian export prices are a function of base metal prices. BCA's Commodity And Energy Strategy service is currently more positive on energy prices than it is on industrial metals. The energy market is undergoing an important curtailment of supply that will lead to further drawdowns in oil inventories. Meanwhile, the supplies of metal are not as well controlled as those of energy, and China's desire to slow real estate speculation should weigh on construction activity in the Middle Kingdom. Finally, as Chart 8 illustrates, AUD/CAD rarely diverges from AUD/USD, but right now, AUD/CAD is trading at a large premium to AUD/USD. This means shorting AUD/CAD could be a nice way to benefit from a weakening in dollar-bloc currencies while limiting the direct exposure to aggregate commodity-price dynamics. Chart 8AUD/CAD Is A Short AUD/CAD Is A Short AUD/CAD Is A Short The Swedish economy has been strong and the output gap now stands at 1.26% of GDP. Yet, despite this positive backdrop, the Riksbank is keeping in place one of the easiest monetary policies in the world, with nominal policy rates standing at -0.5% and real rates at a stunning -2.6%. It is no wonder that the SEK trades at a 6.4% discount to its PPP fair value against the euro. Now, two developments warrant selling EUR/SEK. First, Stefan Ingves, the extremely dovish president of the Swedish central, is leaving the institution at the end of this year. While his replacement has yet to be announced, it will be difficult to find someone more dovish than him to take the helm of the oldest central bank in the world. Second, not only has Sweden inflation picked up violently, the Riksbank's resource utilization indicator continues to shoot up, pointing to a further acceleration in inflation (Chart 9). As a result, we expect the Swedish central bank to be the next one to join the Fed and the Bank of Canada in tightening policy, which will give additional support for the Swedish krona, especially against the euro. Chart 9The Riksbank Will Hike Soon The Riksbank Will Hike Soon The Riksbank Will Hike Soon EUR/NOK has rarely traded above current levels over the course of the last decade. It has only done so when Brent prices have fallen below US$40/bbl (Chart 10). BCA's base case is that oil is more likely to finish the year between US$50 and US$60 than it is to trade below US$40. With EUR/NOK trading 13% over its PPP fair value, and with Norway still sporting a current account surplus of 6% of GDP, even if the Norwegian economy continues to exhibit rather low inflation readings, there is a greater likelihood that EUR/NOK depreciates from current levels than appreciates. We thus recommend investors short this cross over the remainder of 2017. Chart 10If Brent Doesn't Fall Below , EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short If Brent Doesn't Fall Below $40, EUR/NOK Is A Short Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights U.S. Tax Cuts: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. Fed vs. ECB: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. We expect a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. U.S. Corporates vs. EM: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Feature Who's In Charge Here? Table 1A Rough Month For Risk A Lack Of Leadership A Lack Of Leadership Financial markets are sailing without a rudder at the moment. A clear risk-off flavor has swept over most risk assets, as can be seen in the returns seen so far in August in so many asset classes (Table 1). There have been a number of negative news events for investors to process, from President Trump's Charlottesville controversy to the never-ending staff changes in the White House to the North Korean tensions to last week's terror attack in Spain. On top of that, some of the major central banks have become a bit more wishy-washy in their guidance to the markets, even going as far as questioning their own understanding of the inflation process (does the Philips curve even work anymore?). Investors always prefer a clean narrative when it comes to the "big picture" macro backdrop. Right now, they are not getting that from political leaders and policymakers, especially in the U.S. (Chart of the Week). Trump's popularity rating is steadily declining, even now among Republican voters. This has raised concerns that any of his business-friendly policies tax cuts or initiatives to boost growth like infrastructure spending can be successfully enacted. At the same time, and perhaps for similar reasons, the gap between the market expectation and the Fed's projection for the funds rate is widening with only 24bps of hikes priced over the next year. This is driven largely by investors' persistent lack of belief that U.S. inflation will hit to the Fed's target in the next few years. Simply put, the market is saying that the Fed's current tightening cycle is essentially complete unless there is a turnaround in U.S. inflation and/or a sizeable fiscal stimulus enacted in D.C. On that latter point, we think it is critical to monitor measures of U.S. business confidence. The current cyclical upturn in global growth and corporate profits has certainly lifted optimism among business leaders. Yet it is clear that there was also a boost to business sentiment after the U.S. election (Chart 2) last November as it was believed that Trump's victory, and the likely policies that would follow, would be good for American companies. Right now, business optimism remains at strong levels whether looking at small business measures like the NFIB survey (top panel) or the big business series like the Conference Board CEO confidence index of the Duke University/CFO Magazine indicator for confidence among chief financial officers (middle panel). There has been a slight recent pullback from the post-election peak in all the business sentiment indicators, however, and any sign that Trump will have difficulty pushing his tax cuts through Congress could result in a bigger loss of confidence that could impact future hiring and capital spending activity. Our colleagues at BCA Geopolitical Strategy continue to believe that a tax reform package, including significant tax cuts, is still the most likely outcome. Congressional Republicans will not want to go into the 2018 U.S. mid-term elections "empty-handed". With Congress and the White House on the same page, focused by fears of losing seats next year, even an embattled and unpopular president should be able to get his tax cuts implemented. Any fiscal boost in the U.S. can only help to support the current global cyclical economic upturn. While growth indicators like our global PMI index have come off the highs a bit (Chart 3), the OECD's global leading economic indicator is still rising and pointing to rising real developed market bond yields (middle panel). In addition, the global data surprise index has bottomed out, leaving global bond yields exposed to any improvement in economic momentum (bottom panel). Chart of the WeekLosing Faith In##BR##Trump & The Fed Losing Faith In Trump & The Fed Losing Faith In Trump & The Fed Chart 2U.S. Businesses##BR##Are Still Confident U.S. Businesses Are Still Confident U.S. Businesses Are Still Confident Chart 3Global Bond Yields Are##BR##Vulnerable To Faster Growth Global Bond Yields Are Vulnerable To Faster Growth Global Bond Yields Are Vulnerable To Faster Growth The fiscal news flow out of D.C. is likely to remain volatile once Congress returns from its summer recess, particularly with regards to tax cut negotiations and the looming debt ceiling. Yet the big news that investors want to hear, regarding U.S. tax cuts, is more likely to be positive for growth and risk assets and negative for bond yields. Bottom Line: The ongoing turmoil in the White House, and the negative impact it is having on the popularity ratings of both President Trump and the Republican-led U.S. Congress, will intensify efforts to get a tax cut package done as quickly as possible. Success on this front will help buoy U.S. business confidence and lead to stronger U.S. economic growth, and likely more Fed rate hikes, in 2018. The Fed & ECB: Still Sticking To Their Script Chart 4Inflation Expectations Are##BR##Stable In The U.S. & Europe Inflation Expectations Are Stable In The U.S. & Europe Inflation Expectations Are Stable In The U.S. & Europe The markets continue to underestimate the likelihood of more Fed rate hikes in the next year. The odds of a hike in December now sit at only 32%, while essentially no hikes in 2018 are currently discounted. This is far too low, given the steady (if unspectacular) growth in the U.S. and tightening labor conditions. The market has clearly responded to the dip in realized U.S. inflation since March as a sign that the real fed funds rate is now close to equilibrium - a point that has also been suggested by some FOMC members - and that the Fed's inflation forecasts are hence unlikely to be realized. Yet measures of U.S. inflation expectations, both survey-based and market-based, have been fairly stable at levels consistent with the Fed's inflation target in recent months, even as headline U.S. inflation has slowed (Chart 4, 2nd panel).1 A similar dynamic is playing out in Europe. Both survey-based and market-based measures of inflation expectations have been stable at levels close to the ECB's inflation target of "just below" 2% on headline inflation (bottom panel), despite the dip in realized inflation. Stable inflation expectations are something that central bankers take very seriously as a sign that their monetary policies are seen as credible. If the recent dip in realized inflation also showed up as an equivalent decline in expected inflation, this would give policymakers in D.C. and Frankfurt second thoughts about making any policy changes in a less dovish/more hawkish direction. The latest readings on realized inflation in both the U.S. and Euro Area suggest some stabilization of the current downturn may be underway. Headline CPI inflation ticked higher from 1.6% to 1.7% in July, ending a streak of four consecutive months of deceleration since March. Core CPI inflation has been stable at 1.7% for three consecutive months up to July, after falling for four consecutive months from January. Data released last week for July inflation in Europe showed a similar dynamic, with core HICP inflation ticking up to 1.2%, the third consecutive month of faster year-over-year inflation. With growth on both sides of the Atlantic maintaining a steady, above-potential pace, amid stable inflation expectations and with realized inflation showing signs of bottoming out, we see both the Fed and the ECB sticking with their current messaging and forward guidance. That means one more rate hike this year by the Fed, most likely in December, following an announcement on beginning the process of reducing the Fed's balance sheet at the September FOMC meeting. After that, at least another 25-50bps of hikes in 2018 will be delivered, which is currently not discounted by the market. As for the ECB, expect a shift to a slower pace of asset purchases for 2018, to be announced at either the September or October monetary policy meetings. Chart 5Has The Euro Already Overshot? Has The Euro Already Overshot? Has The Euro Already Overshot? The Kansas City Fed's annual Jackson Hole conference, set to take place this weekend, is unlikely to produce any major surprises for investors. Both Fed Chair Janet Yellen and ECB President Mario Draghi will give speeches to an audience of their peers - other global central bankers. Much is being made of Draghi's speech, since he has not spoken at Jackson Hole since 2014 when he gave strong indications of the introduction of the ECB's asset purchase plan in 2015. After his speech at the ECB Forum in Portugal in late June of this year - also to an audience of central bankers - where he mentioned a "reflationary" impulse in Europe that could require some "adjustments" to the ECB's policy settings, investors will be on high alert for any indications that the ECB is about to announce a tapering of its asset purchases. The Account of the July ECB meeting released last week suggested some concern within the ECB Governing Council regarding the potential for an "overshoot" of the euro in response to any policy shift.2 Some are interpreting those comments as a sign that the ECB might be getting cold feet over making any changes to its asset purchase program given the 11% rise in the euro seen this year. However, we think that there was too much attention focused on the fears that a strong euro could derail any plans for an ECB taper, for two reasons: The ECB did note in the July Account that the rise in the euro was a reflection of both the relatively stronger growth seen in the Euro Area this year and the reduction in political risk premia after the French presidential elections in the spring. The Account also noted that the ECB was looking at the totality of its monetary policy measures - policy rates, forward guidance & asset purchases - when assessing its policy stance. This specific quote from the Account, shown with our emphasis on the key passages, highlights that the ECB thinks that a tapering of asset purchases, done on its own with no hikes in short-term interest rates, will still leave monetary policy at very accommodative settings: "...the point was made again that the overall degree of accommodation was determined by the combination of all the monetary policy measures implemented by the ECB, and that the Governing Council's assessment of progress regarding a sustained adjustment in the path of inflation should apply to the overall design and direction of the ECB's monetary policy stance as a whole, and not with reference to any particular instrument in isolation, such as the duration and pace of APP asset purchases." Investors should understandably be worried about the impact of the rising in the euro, which was one of the fastest rates of acceleration seen in the currency's history (Chart 5). Yet given that extreme in price momentum, the lack of support from higher short-term Euro Area interest rates, and with speculative positioning on the euro at very bullish levels, it is unlikely that much further gains in the currency can be expected. This is especially true for the euro versus the U.S. dollar if the Fed delivers additional rate hikes, as we expect. Unless there is decisive evidence that the latest rise in the euro was seriously dampening Euro Area economic growth or inflation, which is not currently visible in the data (bottom panel), then the ECB is still likely to downshift to a slower pace of asset purchases in 2018. Bottom Line: Economic growth is solid, and inflation expectations remain stable, on both sides of the Atlantic. The Fed and ECB remain on course to shift to a less accommodative policy stance towards year-end. That means a December rate hike by the Fed, with more likely in 2018, and a tapering of asset purchases by the ECB beginning in January. Maintain a defensive stance on portfolio duration. Trim EM Debt Exposure Versus U.S. Investment Grade Corporates Emerging market (EM) debt has been one of the strongest performing asset classes so far in 2017. EM USD-denominated sovereign bonds have delivered a total return of 7.5%, while USD-denominated EM corporates have returned 8.7%, according to Bloomberg Barclays index data. These returns have handily surpassed the majority of all other major USD-denominated fixed income sectors. A robust pace of inflows into EM debt, a record $48.6 billion year-to-date to August 9th according to the Wall Street Journal, has helped drive EM debt spreads to tight levels (Chart 6).3 The outperformance of EM debt, both versus its own history and compared with other pro-risk fixed income classes like U.S. corporates, would be justified if EM economic growth was faster than that seen in developed markets. Yet that is not currently the case. An EM (excluding China) PMI Index put together by our colleagues at BCA Emerging Markets Strategy has shown a sharp deceleration of EM growth for most of 2017 (Chart 7, top panel). This stands in sharp contrast to the improving growth seen in both the U.S. and Europe. Chart 6EM Debt Looks##BR##Fully Valued EM Debt Looks Fully Valued EM Debt Looks Fully Valued Chart 7Stronger U.S. Growth Favors##BR##U.S. IG Vs EM Sovereigns... Stronger U.S. Growth Favors U.S. IG Vs EM Sovereigns... Stronger U.S. Growth Favors U.S. IG Vs EM Sovereigns... The gap between the U.S. and EM (ex China) PMIs has widened to the largest level since 2014. This PMI gap has been a good directional indicator for the spread between U.S. corporate bond spreads (both for Investment Grade and High-Yield) and EM debt spreads (bottom two panels). Right now, it appears that U.S. High-Yield looks fairly valued versus EM USD-denominated sovereign debt but U.S. Investment Grade spreads still look a bit too wide relative to EM sovereigns. A similar story can be told when comparing U.S. corporates to EM USD-denominated corporate debt (Chart 8). Arthur Budaghyan, BCA's Chief Emerging Market strategist, recently made a trade recommendation to go short EM sovereign and corporate debt versus U.S. Investment Grade corporate debt.4 His argument was based on the relatively expensive valuations on EM debt, coming at a time when the outlook for economic growth and corporate profits looks healthier in the U.S. We could not agree more - especially if the Fed begins to hike rates, as we expect, and the U.S. dollar begins to strengthen anew, potentially triggering outflows from EM. Arthur has also pointed out that the gap between the option-adjusted spread (OAS) on EM corporates and U.S. corporates (both Investment Grade and High-Yield) has been an excellent leading indicator of the total return differential between the asset classes (Chart 9). The current relationships show that there is upside potential for U.S. Investment Grade versus EM corporates over the next 12 months, but not for U.S. High-Yield versus EM. Chart 8...And Vs. EM Corporates ...And Vs. EM Corporates ...And Vs. EM Corporates Chart 9Downgrade EM Debt Vs U.S. IG Corporates Downgrade EM Debt Vs U.S. IG Corporates Downgrade EM Debt Vs U.S. IG Corporates Thus, this week, we are cutting our allocations to both EM sovereign and corporate debt in our model bond portfolio, and increasing our allocation to U.S. Investment Grade corporates (see page 12). While this does move us into an asset class with a longer duration, the increase in our overall portfolio duration from this shift is very small given the small weight of EM debt in our custom benchmark. More importantly, U.S. Investment Grade is less risky than EM corporates using the duration-times-spread metric - our preferred measure for spread product risk. Bottom Line: Emerging market (EM) hard currency debt, both sovereign and corporate looks fully valued, even with a positive global growth backdrop. We see better value in U.S. higher-quality corporates vs. EM debt at current spread levels. Reduce EM sovereign and corporate debt in favor of U.S. Investment Grade corporates in global fixed income portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The inflation expectations data shown in Chart 4 is based off the U.S. Consumer Price Index (CPI) measure of inflation, while the Fed targets growth in the headline Personal Consumption Expenditure (PCE) deflator of 2%. The spread between the two measures have averaged around 50bps in recent years, which suggests that the current CPI-based inflation expectations around 2.5% are in line with the Fed's 2% PCE inflation target. 2 https://www.ecb.europa.eu/press/accounts/2017/html/ecb.mg170817.en.html 3 https://blogs.wsj.com/moneybeat/2017/08/17/emerging-market-bonds-attract-record-inflows/?mg=prod/accounts-wsj 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: The Focus Is On Profits", dated August 16th 2017, available at ems.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Lack Of Leadership A Lack Of Leadership

Highlights The strong labor market may be holding down wage inflation. The strength in sales and EPS is broad-based and sustainable. July FOMC minutes highlight internal debate at the Fed over inflation. Financial stability is the Fed's Third Mandate. Feature Risk assets struggled again last week but Treasury yields held steady as investors reacted to President Trump's latest controversy, the FOMC minutes, another round of solid economic data for Q3 and the final few earnings reports of the Q2 reporting season. The July FOMC minutes highlighted the internal debate at the Fed about the Phillips curve and financial stability. Nonetheless, we expect the Fed to continue to tighten policy later this year. In this week's report, we examine a study by the San Francisco Fed that highlights the negative impact of a strong labor market on wages. Profit margins continued to expand in Q2 and the BCA EPS model projects a solid 2H performance, driven by both domestic and globally oriented firms. Strong Labor Market, Weak Wages The labor market continues to tighten measures of overall labor market slack suggest that wage inflation should accelerate soon. Still, slack remains in some segments of the labor market and that may be depressing overall wage growth. The overall quit rate (2.1%) is slightly below its all-time peak and 65% of the 11 industry groups have quit rates that are at or close to pre-global financial crisis level (Chart 1). Moreover, fill rates, the ratio of hires to job openings, for most industries are at record lows, and job openings in all but the wholesale trade, information, mining & logging and construction areas have surpassed prior peaks (Chart 2). The implication is that economy-wide, there are more jobs seekers than jobs, which will ultimately force businesses to offer higher salaries. Chart 1Labor Market Strength Is Widespread... Labor Market Strength Is Widespread... Labor Market Strength Is Widespread... Chart 2...With Only A Few Industries Lagging Behind ...With Only A Few Industries Lagging Behind ...With Only A Few Industries Lagging Behind Moreover, wage pressures are mounting, especially for full-time employees. A recent study1 published by the San Francisco Fed found that at 3.4%, the year-over-year change in median weekly earnings was still below the 2007 peak. However, wage gains for continuously employed full-time workers (4.8%) are in line with rates seen a decade ago (Chart 3). Overall wage gains continue to be suppressed by new entrants to the labor force. Growth rates of median weekly earnings for this group are down 1.4%, and have been negative since the overall labor market began to recover in early 2010. The counter-intuitive implication of the SF Fed study is that substantial gains in the labor market may be depressing average wage rates. As individuals learn about better prospects for employment, they choose to join the workforce, either as new entrants (from school) or as reentrants (those who left either voluntarily or involuntarily). These groups, according to the study, have suppressed median weekly earnings growth by between 1.5% and 2.0% (Chart 4). Chart 3Wage Inflation Dragged##BR##Down By New Entrants Wage Inflation Dragged Down By New Entrants Wage Inflation Dragged Down By New Entrants Chart 41.5% To 2% Drag On Wage Inflation##BR##Due To Compositional Shifts In Workforce The Stage Is Set For Jackson Hole The Stage Is Set For Jackson Hole In addition, as 10,000 higher paid baby boomers reach 65 years of age each day and leave the labor force, they are replaced by lower wage earners. Bottom Line: The labor market is even tighter than the data suggests and the market's vigor may be understating wage inflation. Investors are mis-pricing the extent of rate hikes in 2017 and 2018. Bond yields are likely headed higher, but the stock market should take this in stride because of the favorable earnings backdrop. Corporate Profits Are Not Only A Weak Dollar Story EPS and sales growth in Q2 ran well ahead of consensus expectations as forecast in our July 3 preview. Moreover, the counter-trend rally in profit margins is still in place. So far, more than 90% of companies have reported results with 74% of companies beating consensus EPS projections, just above the long-term average of 70% (Chart 5). Furthermore, 69% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 6% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to ultimately re-assert itself, perhaps beginning early in 2018. Nonetheless, we saw another quarter of margin expansion in Q2. Average earnings growth (Q2 2017 versus Q2 2016) was strong at 12% with revenue growth at only 5%. The BCA Earnings model predicts EPS growth to hit roughly 20% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured this way, S&P 500 EPS growth in Q2 will be 18%, compared with 13% in Q1. Chart 5Positive Earnings Surprises Continued In Q2 Positive Earnings Surprises Continued In Q2 Positive Earnings Surprises Continued In Q2 Chart 6Strong EPS Growth Expected In 2H '17 Strong EPS Growth Expected In 2H '17 Strong EPS Growth Expected In 2H '17 Importantly, the strength in earnings and revenues is broadly based (Table 1). Earnings per share were higher in Q2 2017 versus Q2 2016 in all 11 sectors. Results were particularly strong in energy, technology and financials. Energy revenues surged by 16% in Q2 versus a year ago. Sales gains in technology (8%), materials (7%) and utilities (6%), are notable. Moreover, year-over-year sales gains in Q2 2017 in all but three sectors (telecom, consumer staples and consumer discretionary) ran ahead of nominal GDP (+3.7%) in the same period. Investors will turn their attention to earnings prospects in 2H 2017 and 2018 as the Q2 reporting season ends. Since the start of 2017, the trajectory of EPS estimates for 2017 and 2018 (not shown) has been encouraging. The forecast for 2017 is 11.6%, up from 11% at the outset of the Q2 reporting season and unchanged from the start of the year. Similarly, the 2018 estimate (10.9%) is little changed from estimates made in January 2017. In a typical year, earnings estimates tend to move lower as the year progresses. Like the financial markets, corporate managements have largely ignored President Trump during this earnings season. Trump's name was used only once in Q2 earnings calls held through August 11, down from 9 in Q1 calls and 32 in the Q4 2016 reporting season just after Trump took office (Chart 7). The single mention thus far matches the number of times that CEOs and CFOs cited Trump's name before last November's election. We are inclined to see fading concerns about government policy from the next Beige Book (due in early September) because Trump has managed to slow regulation2 during his first seven months in office, although uncertainty around the president's legislative agenda remains elevated. Table 1S&P 500: Q2 2017 Results* The Stage Is Set For Jackson Hole The Stage Is Set For Jackson Hole Chart 7Trump Fading As Topic On Earnings Calls Trump Fading As Topic On Earnings Calls Trump Fading As Topic On Earnings Calls BCA's case for improving profits in the second half of 2017 is supported by the August readings on the Empire State and Philadelphia Fed manufacturing indices, along with the June and July readings on industrial production (IP). IP has been a good proxy for sales of S&P 500 companies (Chart 8); a rollover in the 12-month change in IP would challenge BCA's constructive view towards earnings. However, strong readings on the ISM (July), the August Empire State and Philadelphia Fed indices suggest that IP should accelerate in the next six months. Moreover, the weaker dollar has boosted foreign demand for U.S. goods and services. The implication is that foreign demand (rather than domestic consumer or business spending) leads the U.S. manufacturing sector. Consistent with this perspective, the 3- and 12-month changes in the IP indices in advanced economies outside the U.S. have outpaced domestic growth (Chart 9). Chart 8Favorable Backdrop For Earnings And Sales Continues Into Q3 Favorable Backdrop For Earnings And Sales Continues Into Q3 Favorable Backdrop For Earnings And Sales Continues Into Q3 Chart 9U.S. IP Growth Still Lagging##BR##Other Developed Markets... U.S. IP Growth Still Lagging Other Developed Markets... U.S. IP Growth Still Lagging Other Developed Markets... Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, the weaker dollar has allowed profit and sales gains of globally oriented firms to rebound and outpace those of domestically focused businesses. (Table 2 and Chart 10) Margins for U.S. focused companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but are higher than margins of domestic companies. Chart 10Global EPS, Sales Playing Catch Up To Domestic Global EPS, Sales Playing Catch Up To Domestic Global EPS, Sales Playing Catch Up To Domestic Table 2Q2 Earnings Breakdown The Stage Is Set For Jackson Hole The Stage Is Set For Jackson Hole Bottom Line: EPS growth will continue to accelerate through 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth (Chart 6). The solid performance of manufacturing at home and overseas sets the stage for EPS growth in firms with both U.S. and global outlooks. BCA's bullish profit story for 2017 is still intact, supporting an overweight stance towards stocks versus bonds. The Fed will not get in the way of the equity rally unless inflation suddenly surges in the coming months (which we do not expect). FOMC Debate Still Centers On Inflation The minutes from July's FOMC meeting indicates little progress on the debate over low inflation and the appropriate monetary policy response. It will require at least a modest rise in inflation to break the deadlock. Policymakers appear to be pleased with the state of economic growth, which has rebounded from a lackluster first quarter. They agree that the expansion will be strong enough that the labor market will continue to tighten. As highlighted in previous minutes, the key debate still centers on the relationship between labor market tightness and inflation, the timing of the next Fed rate hike, and how policy should adjust to changing financial conditions. A majority of policymakers seem willing to believe that this year's soft inflation readings are driven by temporary 'one-off' factors. The hawks worry that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge of inflation. They also point to the risk that low bond yields are promoting excessive risk-taking in financial markets. Moreover, the recent easing in financial conditions is stimulative and should be counterbalanced by additional Fed tightening. Therefore, the hawks are anxious to resume tightening, despite the current inflation readings. Others are worried that inflation softness could reflect structural factors, such as restraints on pricing power from global developments and from innovations to business models spurred by advances in technology. If true, this would mean that the Phillips curve is very flat, or that the full employment level of unemployment is lower than the Fed estimates (or both). Either way, the doves would like to see the whites-of-the-eyes of inflation before resuming rate hikes. Some argued that the recent easing in financial conditions would add little to growth and thus, does not require tighter Fed policy. There was little movement toward capitulation by either camp evident in the minutes. Discussion of the Fed's balance sheet in the recent minutes reinforced that an announcement would likely occur in September, with tapering beginning shortly thereafter. "A number of participants" commented that financial conditions will be key to determining the pace of rate hikes. If the bond market and risk assets react negatively to balance sheet shrinkage, then it would be appropriate to slow rate increases to offset any economic repercussions. Given that only one rate gain is discounted in the money market curve over the next 12 months, it appears that investors are betting that balance sheet shrinkage will largely eliminate the need for higher short-term interest rates. Fed economists recently updated their quantitative assessments of FOMC minutes.3 The note provides a guide (Table 1 in the Fed paper) to the "quantitative words" used in the minutes (one, a couple, a few, etc.). We intend to comment on the findings of this paper in a future Weekly Report. An Update On The Fed's Third Mandate Financial stability remained a concern for Fed policymakers in July and that is why the hawks want to keep tightening even though inflation has not yet met the FOMC's target. BCA views "financial stability" as a third mandate4 for the central bank, along with low and stable inflation, and full employment. Financial stability was discussed at the July meeting by both Fed staff and voting FOMC members. Fed Chair Janet Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 20 of the 28 meetings she has presided over. Yellen will deliver a speech on financial stability on August 25 at the Fed's Jackson Hole conference. However, the Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in December 2013, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in 7 of the 13 subsequent meetings. FOMC participants have debated about financial stability at 4 of the 5 meetings this year, and 8 of the 11 since April 2016. As was the case at the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance in July.5 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. We conclude that the doves want inflation to rise closer to the 2% target before tightening again. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excessive risk-taking in markets according to some on the FOMC. Bottom Line: The FOMC minutes did not change our base case outlook: the FOMC will announce in September that it will begin to shrink the Fed's balance sheet. The next rate bump will take place in December. Nonetheless, this forecast hangs on the assumption that core inflation will edge higher in the coming months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 http://www.frbsf.org/our-district/about/sf-fed-blog/wage-growth-good-news/?utm_source=frbsf-home-sffedblog-title&utm_medium=frbsf&utm_campaign=sffedblog 2 Please see U.S. Investment Strategy Weekly Report, "Still Waiting For Inflation,"August 14, 2017, available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm 4 Please see U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017, available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170726.htm

Highlights The cyclical recovery in global earnings will trump, so to speak, ongoing political developments. Unlike the last three recessions, which resulted from burst asset bubbles, the next U.S. recession will be more akin to those of the 1970s and early 1980s. Those "retro" recessions were caused by the Fed's decision to raise rates aggressively in response to rising inflation. The good news is that it will take a while for inflation to accelerate, suggesting that the next recession will not occur until 2019 at the earliest. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Remain overweight global equities for now, favoring European and Japanese stocks over U.S. equities in currency-hedged terms. Look to reduce exposure in the second half of next year. Feature After Charlottesville Political developments continued to cast a pall over markets this week. Last week's worries about escalating tensions in the Korean peninsula subsided on comments from the North Korean regime that it would not launch a preemptive strike against Guam. As that issue moved off the radar screen, a new one emerged. President Trump's comments about the violent protests in Charlottesville generated outrage in many quarters, leading to the disbandment of two of the President's business advisory councils. We agree with those who argue that this latest incident will have far-reaching consequences. However, we disagree about the timeframe over which they will manifest themselves. As with most Trump scandals, this one is likely to fizzle into the background. Republicans in Congress would love nothing more than to change the subject. Plowing ahead with tax cuts is one way to do that. A limited infrastructure bill also remains a possibility - and unlike most issues up for debate, this one could actually attract bipartisan support. The market has essentially priced out any meaningful progress on either taxes or infrastructure, so the bar for success here is fairly low (Chart 1). While the implications of recent events in the U.S. are unlikely to put much strain on markets over the next year or so, the longer-term ramifications could be profound. The Democrats' "Better Deal" agenda moves the party to the left on most economic issues. Historically, the Republicans have been champions of small government. Increasingly, however, many Trump voters are asking themselves why exactly they should support lower business taxes when most companies seem openly hostile to the populist agenda that got Trump elected. In this respect, it is noteworthy that support for free trade among Republican voters has collapsed over the past 10 years (Chart 2). Wall Street, Silicon Valley, and the rest of the business establishment tends to be liberal on social issues and conservative on economic ones. The problem is that very few voters share this configuration of views (Chart 3). This contradiction cannot be ignored indefinitely. Chart 1The Markets Have Given Up On Infrastructure And Taxes The Markets Have Given Up On Infrastructure And Taxes The Markets Have Given Up On Infrastructure And Taxes Chart 2Republican Support For Free Trade Has Collapsed From Slow Burn Recovery To Retro-Recession? From Slow Burn Recovery To Retro-Recession? Chart 3An Absence Of Libertarians From Slow Burn Recovery To Retro-Recession? From Slow Burn Recovery To Retro-Recession? We predicted that "The Trumpists Will Win" back in September 2015 when most pundits were still scoffing at the idea that Trump could win the Republican nomination, let alone the election. This prediction was based on the view that "Trumpism" would resonate with American voters more forcefully than most experts thought possible. If the Republican Party does move to the left on economic issues, this could lead to more economic instability and larger budget deficits - and ultimately, much higher inflation. We discussed the reasons why inflation is heading higher over the long haul several weeks ago and encourage readers to review that report.1 Still Chugging Along Over a shorter-term horizon of one or two years, however, things still look reasonably bright. Earnings are in a solid uptrend. The profit recovery has been broad-based across countries and sectors. Our global leading economic indicator is trending higher, as are estimates of global growth (Chart 4). Chart 4Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth The current economic recovery in the U.S. has now lasted over eight years, making it the third-longest on record. If it continues until July 2019, it will take the top spot from the 1990s expansion. The fact that this expansion has endured for so long is not too surprising. The Great Recession was one of the deepest in history, while the recovery that followed has been fairly drawn out. Such "slow burn" recoveries are typical following financial crises, and this one has not been any different. However, now that the U.S. unemployment rate has returned to pre-recession levels, the question arises whether the curtain may finally be closing on this expansion. Our answer is "not yet." While this expansion is starting to get long in the tooth, the next recession probably won't roll around until 2019 - and perhaps even later. This means that a cyclically bullish stance towards risk assets is still appropriate. Searching For The Smoking Gun As the old saying goes, "Expansions don't die of old age. They are murdered by the Fed." Such a verdict is too harsh, but it does get to an underlying truth: Fed rate hikes have almost always preceded past U.S. recessions (Chart 5). Broadly speaking, post-war recessions can be broken down into two categories. The first consists of recessions that resulted from the bursting of asset bubbles. In those cases, Fed rate hikes were more the instigator of the recession than the cause of it. The second category consists of recessions where the Fed found itself behind the curve in normalizing monetary policy and was forced to raise rates aggressively in response to rising inflation. The last three recessions were all of the first variety. The 1990-91 recession stemmed from the commercial real estate bust and the ensuing Savings and Loan crisis. The 2001 recession was caused by the bursting of the dotcom bubble. And, of course, the Great Recession was largely the product of the housing bust and weak mortgage underwriting standards. Today's financial landscape is far from pristine. Corporate debt is close to record high levels as a share of GDP and asset valuations are stretched across the board (Chart 6). However, while these imbalances are bad enough to exacerbate a recession, they do not appear severe enough to cause one. This suggests that the next downturn may look less like the last three recessions and more like the "classic" or "retro" recessions of the 1960s, 70s, and early 80s. Chart 5Who Kills Economic Expansions? Who Kills Economic Expansions? Who Kills Economic Expansions? Chart 6Debt Is Rising, As Are Asset Values Debt Is Rising, As Are Asset Values Debt Is Rising, As Are Asset Values Inflation Remains Benign ... For Now If we are heading for a retro recession, investors should keep a close eye on inflation. This is simply because the Fed is unlikely to turn very hawkish until inflation starts accelerating. The good news is that inflation should remain dormant for at least the next 12 months. In fact, most measures of consumer price inflation have decelerated since the start of the year (Chart 7). Producer prices also fell unexpectedly in July, the first outright decline in 11 months. The St. Louis Fed's Price Pressures index remains near rock-bottom levels (Chart 8). Chart 7Consumer Inflation Has Decelerated Of Late Consumer Inflation Has Decelerated Of Late Consumer Inflation Has Decelerated Of Late Chart 8Price Pressures Are Muted... For Now Price Pressures Are Muted... For Now Price Pressures Are Muted... For Now Inflation expectations are still reasonably well anchored and trade unions have less clout than they once did. Shale producers also have the ability to ramp up production in response to higher oil prices. Past episodes of rapidly rising inflation were often accompanied by supply disruptions that led to spiraling energy costs. Moreover, at least for the time being, higher imports can absorb some of the excess in U.S. aggregate demand. The bad news is that once inflation does start rising in earnest, the Fed is likely to find itself flat-footed. Inflation is a highly lagging indicator. As we have noted before, inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 9). Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Chart 9Inflation Is A Lagging Indicator From Slow Burn Recovery To Retro-Recession? From Slow Burn Recovery To Retro-Recession? Timing Matters Too Doesn't a very low neutral real rate reduce the risk that the Fed will find itself behind the curve? The answer is "yes," but only to a limited extent. Suppose, for the sake of argument, that the Fed knew the exact level of the neutral real rate. It would still be the case that a major delay in bringing interest rates up to that magic number would cause the unemployment rate to fall below NAIRU, leading to an overheated economy. Such an economy may not generate inflation immediately, but both history and simple logic suggest that a situation where aggregate demand continues to outstrip supply will eventually produce upward pressure on prices. The lesson here is that successful monetary policy does not just require that central banks bring rates to the correct level. They also have to bring rates to the correct level at the right time. That is difficult to do, which is why soft landings following monetary tightening cycles are few and far between. Fed Dots Too Optimistic About Labor Force Growth And Productivity The Fed "dots" foresee the unemployment rate ending the year at the current level of 4.3% and falling marginally to 4.2% in 2018. The Fed also expects real GDP to grow by 2.2% in Q4 of 2017 and 2.1% in Q4 of 2018 over the previous year. This is similar to the average rate of GDP growth since the start of the recovery, a period where the unemployment rate fell by over five percentage points. Thus, the only way the Fed's math can add up is if labor force growth accelerates or productivity growth increases. Neither outcome is likely. The labor force participation rate has been flat for the past four years, despite the fact that an aging population has pushed more people into retirement. Chart 10 shows that the participation rate has fallen by three percentage points since 2008, only 0.3 points less than one would expect based solely on changes in the age distribution of the population. Much of the remaining gap can be explained by the secular decline in participation rates within young-to-middle age cohorts, offset in part by higher participation among the elderly (Chart 11). In particular, the downward trend in participation among less-educated workers appears to be more structural than cyclical in nature (Chart 12). As we noted last week, the growing shortage of workers is already visible in employer surveys and rising wage pressures at the lower end of the skill distribution.2 Thus, far from accelerating, chances are that labor force growth will decelerate as the economy runs out of people who can be persuaded to seek out gainful employment. This could cause the unemployment rate to fall further than the Fed expects. Chart 10Demographic Shifts Explain Most Of The Decline In Participation Rates Demographic Shifts Explain Most Of The Decline In Participation Rates Demographic Shifts Explain Most Of The Decline In Participation Rates Chart 11Participation Rates Across Age Cohorts Participation Rates Across Age Cohorts Participation Rates Across Age Cohorts Chart 12Labor Force Participation Has Fallen ##br##The Most Among The Less-Educated From Slow Burn Recovery To Retro-Recession? From Slow Burn Recovery To Retro-Recession? Productivity is also unlikely to make a significant rebound. The drop in productivity growth has been broad-based across industries and countries. Moreover, it began several years before the financial crisis, suggesting that the Great Recession was not the main culprit. All this points to underlying structural factors - such as a weaker pace of innovation and flagging educational achievement - as being the key drivers of the productivity slowdown.3 What Goes Down Must Come Up If labor force growth fails to accelerate and productivity growth remains weak, then the current pace of GDP growth of around 2% will push the unemployment rate down from current levels. Needless to say, if GDP growth accelerates above 2%, unemployment will drop even more. Such an outcome is, in fact, quite likely given the significant easing in financial conditions that the U.S. has experienced over the past few months. All this means that the unemployment rate may be on its way to falling below its 2000 low of 3.8% by next summer. This would leave it close to a full percentage point below the Fed's estimate of NAIRU. At that point, the unemployment rate would have nowhere to go but up. And, unfortunately, history suggests that once unemployment starts rising, it keeps rising. In fact, the U.S. has never averted a recession in the post-war era when the three-month average of the unemployment rate has risen by more than one-third of a percentage point (Chart 13). Chart 13Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The Not-So-Prescient Stock Market If the U.S. does succumb to a recession in 2019 or 2020 because the Fed is forced to hike rates aggressively in response to rising inflation, how quickly will the market sniff out an impending downturn? Chart 14 plots the value of the S&P 500 around the time of past recessions. On average, the stock market has peaked six months before the beginning of a recession. However, there is quite a bit of variation from one episode to the next (Table 1). The S&P 500 peaked only two months before both the Great Recession and the 1990-91 recession. It peaked seven months before the 2001 recession, but that downturn was arguably more the product of the stock market bust than the cause of it. Chart 14Profile Of U.S. Stocks Around Recessions From Slow Burn Recovery To Retro-Recession? From Slow Burn Recovery To Retro-Recession? Table 1Stocks And Recession: Case By Case From Slow Burn Recovery To Retro-Recession? From Slow Burn Recovery To Retro-Recession? On the whole, the stock market is not particularly good at anticipating recessions triggered by financial sector imbalances. The stock market is more adept at predicting downturns caused by excessively tight monetary policy - although even here, it is difficult to know how much of the weakness in equities leading up to such recessions was due to rising expectations of a downturn and how much was simply the result of higher interest rates. From this, we conclude that the stock market will likely peak a few months before the next recession. If we are correct about the timing of our recession call, this implies the cyclical bull market has another 12-to-18 months left. Cyclical Leading Indicators Still Benign The bond market has generally done a better job of anticipating economic downturns than the stock market. This is especially the case for the yield curve, which has inverted in the lead-up to every single recession over the past 50 years, with only one false positive (Chart 15). While the 10-year/3-month spread has compressed over the past few years, it is still above the level that has warned of recessions in the past. Most other forward-looking cyclical indicators continue to point to an economic expansion that has further room to run. The Conference Board's Leading Economic Indicator (LEI) has consistently fallen into negative territory on a year-over-year basis leading up to past recessions (Chart 16). The LEI has accelerated since last summer, suggesting little risk of a near-term downturn. Chart 15The Yield Curve Has Called 8 Of The Last 7 Recessions The Yield Curve Has Called 8 Of The Last 7 Recessions The Yield Curve Has Called 8 Of The Last 7 Recessions Chart 16LEI Also Good At Signaling Recessions LEI Also Good At Signaling Recessions LEI Also Good At Signaling Recessions A decline in the ISM new orders component in relation to the inventory component has warned that final demand is softening while the stock of unsold goods is piling up (Chart 17). The current gap stands at 10.4, consistent with a robust expansion. Likewise, initial unemployment claims have usually risen going into past recessions (Chart 18). Neither the current level of claims nor hiring intention surveys are signaling trouble ahead. Chart 17Economic Momentum Is Still Positive Based On The ISM Economic Momentum Is Still Positive Based On The ISM Economic Momentum Is Still Positive Based On The ISM Chart 18Initial Claims Claim Everything Is Okay Initial Claims Claim Everything Is Okay Initial Claims Claim Everything Is Okay Changes in financial conditions tend to lead GDP growth by around 6-to-12 months. Thus, it is not surprising that recessions have often occurred in the wake of a tightening in financial conditions (Chart 19). As noted above, U.S. financial conditions have eased sharply since the start of the year. Chart 19Recessions Tend To Occur When Financial Conditions Are Tightening Recessions Tend To Occur When Financial Conditions Are Tightening Recessions Tend To Occur When Financial Conditions Are Tightening Investment Conclusions Historically, recessions and equity bear markets have gone hand in hand. As my colleague Doug Peta likes to emphasize, it simply does not pay to be underweight stocks unless one has legitimate reasons for thinking that another economic downturn is just around the corner (Chart 20).4 Our analysis suggests that another recession is still at least 18 months away. This is confirmed by a variety of recession-timing models, all of which are signaling low risks of an impending downturn in growth (Chart 21). As we noted last week, wage growth is likely to accelerate over the next few quarters. This will prop up consumer spending. July's blockbuster retail sales report was no fluke - there are plenty more where it came from. Stronger U.S. growth will force the market to revise up the miserly 41 basis points in rate hikes that it has priced in over the next two years. This will push up Treasury yields and give the dollar a boost. The greenback has usually strengthened whenever an overheated labor market has caused labor's share of income to rise (Chart 22). We expect the broad trade-weighted dollar to appreciate by about 10% over the next 18 months. Chart 2050 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets 50 Years Of Recessions And Bear Markets Chart 21No Imminent Risk Of A Recession No Imminent Risk Of A Recession No Imminent Risk Of A Recession Chart 22Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar A stronger dollar is necessary for tilting U.S. consumption towards foreign-made goods, thereby allowing domestic spending to rise in the face of tighter supply constraints. This is good news for foreign producers in developed economies, but could cause trouble for firms in emerging markets which have taken out large amounts of dollar-denominated debt. We continue to prefer European and Japanese stocks over their U.S. counterparts in currency-hedged terms. In the EM space, Chinese H-shares are our preferred market. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017. 2 Please see Global Investment Strategy Weekly Report, "What's The Matter With Wages?," dated August 11, 2017. 3 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 4 Please see Global ETF Strategy Special Report, "A Guide To Spotting And Weathering Bear Markets," dated August 16, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Mantra 1 - Europe: First Among Equals - instils awareness that the euro area's long-term growth prospects and 'neutral' real interest rate are not meaningfully different to those in other developed economies. Mantra 2 - Mission Impossible: 2% Inflation - instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. Mantra 3 - Negative Skew: A Ticking Time-Bomb - instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. Feature The titles of three of our recent reports - Europe: First Among Equals,1 Mission Impossible: 2% Inflation,2 and Negative Skew: A Ticking Time-Bomb3 - can be regarded as mantras instilling awareness of major investment opportunities and threats. This week's report is a recap of the messages encapsulated within these three mantras. Mantra 1 - Europe: First Among Equals Mantra 1 instils awareness that long-term growth in the euro area, adjusted for population, is not meaningfully different to that in other developed economies (Chart of the Week). Through the past 20 years, the euro area has underperformed through multi-year periods encompassing around half the time; but it has outperformed through the multi-year periods encompassing the other half. Chart of the WeekThe Euro Area Is An Economic Equal The Euro Area Is An Economic Equal The Euro Area Is An Economic Equal Seen in this wider context, the euro area's 2008-14 phase of poor economic performance was not structural, it was cyclical - the impact of back to back recessions separated by an unusually short gap. And if the euro area continues its recovery to just the mid-point of its long-term relative cycle, then recent investment trends in the bond and currency markets have much further to run. Bond yield spreads closely follow relative real GDP per head (Chart I-2). As they must, given central banks' self-professed 'data-dependency'. Although nobody expects the ECB to hike interest rates any time soon, expectations for the long-term 'neutral' rate are correctly rising from overly-depressed levels. Hence, the yield spread between long-dated bonds in the euro area4 and the U.S. has compressed from -175 bps last year to -125 bps today. Still, to reach the mid-point of its long-term cycle, this yield spread must ultimately converge to around -40 bps. But why is the mid-cycle yield spread -40 bps? The simple answer is that, over this 20-year period, the euro area versus U.S. inflation differential has averaged -40bps (Chart I-3). In other words, the mid-cycle real yield spread is zero. Chart I-2Bond Yield Spreads Just Follow ##br##Relative GDP Per Head Bond Yield Spreads Just Follow Relative GDP Per Head Bond Yield Spreads Just Follow Relative GDP Per Head Chart I-3The Euro Area - U.S. Inflation Differential ##br##Has Averaged -40 Bps The Euro Area - U.S. Inflation Differential Has Averaged -40 Bps The Euro Area - U.S. Inflation Differential Has Averaged -40 Bps This leads to a very important empirical observation. The mid-cycle or 'neutral' real interest rates in the euro area and U.S. have been near-identical over the past 20 years. Bear in mind that the past 20 years captures a very wide spectrum of economic and financial backdrops: the launch of the euro, the dotcom bubble and bust, the U.S. subprime credit boom and financial crisis, the euro debt crisis, QE. If this disparate past is a reasonable representation of the disparate future, we should expect the neutral real interest rate in the euro area to remain broadly similar to that in the U.S. The implication is that the yield spread between long-dated bonds in the euro area and the U.S. can compress much more. On a 2-year horizon, stay underweight euro area bonds - especially German bunds - in a European and global bond portfolio. And expect euro/dollar eventually to break through 1.30. Mantra 2 - Mission Impossible: 2% Inflation Mantra 2 instils awareness that central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. The crux of the matter is that the monetary system and inflation form a classic non-linear system. A defining feature of a non-linear system is that it can be very difficult, even impossible, to achieve an arbitrary point target output like '2%' (Chart I-4). Chart I-4Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode Non-Linear: Inflation Flipped From One Mode To A Completely Different Mode In a linear system, if a small input produces a small output, then double the input will produce double the output and triple the input will produce triple the output. But in a non-linear system, double the input could produce no output, half the output, or ten times the output. To be clear, we have no doubt that a fiat monetary system makes it possible to generate rampant inflation, should policymakers be absolutely determined to create it. But central banks are now starting to ask. At what cost? And for what benefit? Central banks are realising that in the struggle to achieve 2% inflation, persistent ultra-accommodative policy endangers the healthy functioning of markets and poses a risk to financial stability. At the same time, the continued undershoot of 2% inflation is not such a terrible thing when the economy is growing well. Chart I-5Relative Interest Rate Expectations##br## Just Follow Relative GDP Per Head Relative Interest Rate Expectations Just Follow Relative GDP Per Head Relative Interest Rate Expectations Just Follow Relative GDP Per Head The latest to admit this is Kasumasa Iwata, a leading candidate to become the next governor of the Bank of Japan. With the demerits of extraordinary stimulus becoming clearer, the BoJ should slow purchases of government bonds and ETFs even though inflation is nowhere near its target, he said. This follows hot on the heels of respected and influential ECB Governing Council member, Ewald Nowotny, who recently asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." And in Sweden, even though inflation has just hit 2% for the first time in six years, the Riksbank has suggested (re)introducing a variation band of 1% either side of the target5 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve. Additionally, Riksbank Governor, Stefan Ingves, proposed that "central banks should also have the explicit responsibility for financial stability." The direction of travel is very clear. The most accommodative central banks are becoming less obsessed with subpar inflation and much more concerned about the danger that ultra-loose policy poses to financial stability. These central banks are set to dial back accommodation. Hence, the multi-year phase of divergent monetary policies across developed economies is over. The new multi-year phase is re-convergence of monetary policy, and specifically the ECB and Riksbank versus the Fed (Chart I-5). Therefore, mantra 2 - Mission Impossible: 2% Inflation - reinforces the investment conclusions that stem from mantra 1 - Europe: First Among Equals. Mantra 3 - Negative Skew: A Ticking Time-Bomb Mantra 3 instils awareness that low observed volatility categorically does not mean that equity market risk has diminished. If anything, it means the exact opposite. When the equity market is advancing, its observed volatility is low. But this is just a property of so-called 'negative skew'. Up weeks tend to generate small and regular positive returns which means that advances tend to be gradual and gentle. And the longer and more established the advance becomes, the lower the observed volatility goes. Unfortunately, some investors and risk-control algorithms mistakenly use the observed volatility of an investment as a gauge of its riskiness. They incorrectly equate low observed volatility with a lower risk premium, which justifies an additional advance in the market. The additional advance then takes observed volatility even lower - which justifies a further market advance. And so on, in a self-reinforcing positive feedback. Eventually, the truth dawns. Equity market risk hasn't actually declined, but the equity risk premium - the excess prospective return that equities offer over bonds - has almost disappeared. And suddenly, the self-reinforcing feedback phase-shifts from positive to negative. The equity risk premium is the excess prospective return that equities offer over bonds, but a good working approximation is the difference between the equity index earnings yield and the bond yield. The concerning thing is that this measure of the equity risk premium is moving exactly in line with the equity market's observed volatility (Chart I-6), when it shouldn't. Admittedly, it is difficult to know when the time-bomb will go off. But the good news is that when observed volatility is very low - as it is now - options become very cheap. And a long index plus at-the-money put option becomes an excellent absolute return strategy.6 Chart I-6The Equity Risk Premium Is Tracking The##br## Equity Market's Observed Volatility ...Is Just Tracking The Equity Market's Observed Volatility ...Is Just Tracking The Equity Market's Observed Volatility Chart I-7Record Low Observed Volatility ##br##Doesn't Last Record Low Observed Volatility Doesn't Last Record Low Observed Volatility Doesn't Last For those that cannot buy options, record low observed volatility tends to signify a good time to raise a little bit of cash. This should be set aside for reinvestment in the equity market when observed volatility spikes (Chart I-7), as it always ultimately does. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Published on August 3 2017 and available at eis.bcaresearch.com 2 Published on July 20 2017 and available at eis.bcaresearch.com 3 Published on July 27 2017 and available at eis.bcaresearch.com 4 Euro area average over 10-year sovereign yield, weighted by sovereign issue size. 5 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 6 For more details of the absolute return strategy, please see the European Investment Strategy Special Report titled "Negative Skew: A Ticking Time-Bomb", dated July 27, 2017 and available at eis.bcaresearch.com Fractal Trading Model Long USD/CAD successfully hit its 2.5% profit target and is now closed. This week's new trade is to short MSCI Turkey versus the Eurostoxx600 with a profit target and symmetric stop-loss set at 5%. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Short MSCI Turkey / Long Eurostoxx600 Short MSCI Turkey / Long Eurostoxx600 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Duration: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. The Fed & The Dollar: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. USD Sovereigns: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Feature Please note there will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on August 29, 2017. Chart 1Firm Growth, Despite Weaker $ Firm Growth, Despite Weaker $ Firm Growth, Despite Weaker $ Escalating tension between the U.S. and North Korea captured the market's attention during the past week, causing investors to ignore what in our view is a more important economic development: Global growth has managed to stay firm even in the face of significant dollar depreciation. Not only does this break the pattern of the past few years when periods of substantial dollar weakness were associated with slowing global growth (Chart 1), but in our view it sends a very bearish signal for U.S. bonds. Above all else, a weak dollar amidst strong global growth suggests that the breadth of the economic recovery is improving. This intuition is confirmed by the fact that our Global Manufacturing PMI Diffusion Index, which measures the net percentage of countries with PMIs above the 50 boom/bust line, is fast approaching 90% (Chart 2). Not only that, but PMIs from the four most important economic blocs are all showing signs of strength. Both the Eurozone and Japanese PMIs are holding firm at high levels, while the U.S. and Chinese PMIs have recently reversed their year-to-date downtrends (Chart 2, bottom two panels). Why is the breadth of the global recovery important? Precisely because a more synchronized recovery prevents the dollar from appreciating too quickly. All else equal, a stronger dollar causes investors to reduce their forecasts for future U.S. growth and inflation. This implies a slower expected pace of rate hikes and lower Treasury yields. Conversely, a weaker dollar causes investors to revise up their growth and inflation forecasts, leading to a quicker expected pace of rate hikes and higher yields. To capture the importance of both global growth and the exchange rate we turn to our 2-factor Treasury model (Chart 3). This is a simple model of the 10-year Treasury yield based on the Global PMI and bullish sentiment toward the dollar. A stronger Global PMI pressures the model's fair value higher, as does increasingly bearish dollar sentiment. Chart 2Synchronized Global Growth Synchronized Global Growth Synchronized Global Growth Chart 310-Year Treasury Yield Fair Value 10-Year Treasury Yield Fair Value 10-Year Treasury Yield Fair Value At present, the model pegs fair value for the 10-year Treasury yield at 2.6%, meaning the current 10-year Treasury yield of 2.22% is 38 bps below fair value. This is the most expensive Treasuries have appeared on our model since the immediate aftermath of last year's Brexit vote. Political Uncertainty & Flights To Quality While our 2-factor model does a good job, there is one important driver of Treasury yields it does not capture. That is the tendency for political events to drive a flight to safety into Treasuries (Chart 4). Typically, if it is possible to identify a purely politically-driven flight to safety - one that is unlikely to exert a meaningful economic impact during the next 6-12 months - then the correct strategy is to heed our model's message and position for higher yields. This strategy worked out perfectly following the Brexit vote, and we anticipate it will work again this time around. Chart 4Policy Uncertainty Is A Driver Of Bond Yields Policy Uncertainty Is A Driver Of Bond Yields Policy Uncertainty Is A Driver Of Bond Yields With regards to the catalyst for last week's flight to safety, our Geopolitical Strategy service wrote in a recent Special Report1 that a pre-emptive strike by the U.S. on North Korea is extremely unlikely. The theatrics of the past week demonstrate only that the U.S. needs to establish a "credible threat" if it wants to eventually open a new round of negotiations over North Korea - not unlike the Iranian nuclear negotiations of the past decade. Looking further down the road, if those talks eventually fail then the potential for military conflict is high. We therefore conclude that there is not much potential for U.S. / North Korean tensions to exert a meaningful economic impact during the next 6-12 months, and view the recent bond rally as an opportunity to position for sharply higher yields in the near-term. Bottom Line: An environment characterized by strong global growth and a weak dollar is very bearish for U.S. bonds. According to our model, fair value for the 10-year Treasury yield is 2.6%. Stay at below-benchmark duration. How The Fed Views A Weaker Dollar Financial Conditions Chart 5Weak $ Eases Financial Conditions Weak $ Eases Financial Conditions Weak $ Eases Financial Conditions The Fed views the 7% year-to-date depreciation of the dollar as a significant easing of financial conditions. In fact, most broad indicators of financial conditions have eased this year, even though the Fed has lifted rates by 75 bps since December (Chart 5). In the Fed's framework, this means that the pace of rate hikes might need to increase in order to tighten financial conditions as much as desired. New York Fed President William Dudley summed up this approach in a 2015 speech:2 All else equal, if financial conditions tighten sharply, then we are likely to proceed more slowly. In contrast, if financial conditions were not to tighten at all or only very little, then - assuming the economic outlook hadn't changed significantly - we would likely have to move more quickly. In the end, we will adjust the policy stance to support financial market conditions that we deem are most consistent with our employment and inflation objectives. Of course, all else is not equal. Core inflation has disappointed so far this year and our current assessment of monetary policy is that while the Fed will take action to start shrinking its balance sheet next month, rate hikes are on hold until inflation turns higher. We remain optimistic that inflation will show sufficient strength in time for the Fed to lift rates in December.3 Inflation Chart 6Weak $ = Higher Inflation Weak $ = Higher Inflation Weak $ = Higher Inflation A weaker dollar also increases the Fed's confidence that inflation will head higher. Although so far we have not seen much evidence that this is occurring. Last Friday's July CPI report showed that core CPI rose only 0.1% month-over-month, while the year-over-year growth rate held flat at 1.7%. However, evidence is mounting that core inflation will soon put in a bottom. Our CPI diffusion index bounced back into positive territory in July (Chart 6) and our PCE diffusion index is at its highest level since last October.4 Both of these measures have excellent track records capturing the near-term swings in core inflation. The year-to-date weakness in the dollar has led to a surge in import prices. Stronger import prices will soon translate into higher core goods inflation (Chart 6, panels 2 and 3). Unfortunately, any increase in core goods inflation is unlikely to be sustained beyond the next 12 months. If the year-to-date dollar weakness starts to reverse, as our currency strategists anticipate,5 then import prices will decline anew. Eventually, this will translate into a deceleration in core goods inflation. For core inflation to sustainably reach the Fed's target, improvement in the lagging core services (excluding shelter and medical care) component will be required. Historically, this component is the most tightly linked to wage growth (Chart 6, bottom panel). A Rising Wage Growth Environment Two related methods do an excellent job predicting the direction of wage growth on a cyclical horizon. First, wages accelerate when the unemployment rate is falling, and second, wages accelerate when the prime-age (25-54) employment-to-population ratio is increasing. The top two panels of Chart 7 show the relationship between wage growth and the unemployment rate. The shaded regions in both panels correspond to periods when the unemployment rate is falling. As can be seen, wage growth always rises during these periods. That being the case, we calculate that non-farm employment needs to grow by more than 125k per month (on average) for the unemployment rate to continue its downtrend, assuming the labor force participation rate remains flat. Chart 7A Rising Wage Environment A Rising Wage Environment A Rising Wage Environment Of course it is not guaranteed that the labor force participation rate will stay flat. In a recent report we discussed the risk that a large cyclical increase in the participation rate might cause the unemployment rate to rise even as the economy continues to recover.6 This is why we also look at the shaded regions in the bottom two panels of Chart 7 and see that wages always rise during periods when the prime-age employment-to-population ratio is rising. By looking at the employment-to-population ratio instead of the unemployment rate we do not need to make an assumption about the trend in labor force participation. Using this method, we calculate that monthly employment growth must exceed 140k (on average) for the prime-age employment-to-population ratio to keep increasing. Non-farm payroll growth has averaged 184k per month so far in 2017 and averaged 187k per month in 2016. In other words, the U.S. jobs machine is running at a fairly steady pace, well above the thresholds we see as necessary for the recovery in wage growth to continue. Bottom Line: A weak dollar eases financial conditions and supports higher core goods inflation. All else equal, this will strengthen the Fed's hawkish resolve in the near term. However, a rebound in core services (excluding shelter and medical care) inflation will be necessary for core inflation to reach the Fed's target on a sustained basis. Sovereigns Not Buying The Weak Dollar USD-denominated sovereign bonds should benefit from a falling dollar. A weaker U.S. dollar makes the debt obligation cheaper in the issuing nation's local currency. However, the USD Sovereign index has actually underperformed the duration-matched Baa U.S. Credit index during the past six months, despite a depreciating U.S. currency (Chart 8). The duration-matched Baa-rated U.S. Credit index is the closest comparable we can find for the Sovereign index. It matches the Sovereign index in terms of duration and average credit rating, although historically it also delivers less excess return volatility (Chart 8, bottom panel). The two main factors we consider when deciding whether to add USD-denominated sovereigns to our portfolio at the expense of domestic U.S. credit are relative valuation and the outlook for the dollar. Historically, spread differential has been an important driver of relative returns. Attractive starting valuations even allowed sovereigns to outperform credit in 2014 and 2015 despite the dollar's surge. But at the moment, relative value is skewed heavily in favor of domestic U.S. credit (Chart 8, panel 1). Chart 8Sovereigns Too Expensive Sovereigns Too Expensive Sovereigns Too Expensive Added to that, with U.S. growth likely to remain strong and U.S. inflation poised to rebound, we think there is a high likelihood that the Fed will deliver more rate hikes than are currently priced in. This will make it difficult for the dollar to decline further from current levels. Taken together, poor relative valuation and a bullish outlook for the dollar lead us to continue underweighting USD-denominated sovereigns in our portfolio. The Sovereign Index: Country Breakdown Even though the overall index is unappealing, opportunities might still exist at the country level. Chart 9 shows a risk/reward picture for each country in the Bloomberg Barclays Sovereign index. The upper panels show the option-adjusted spread for each country relative to its duration and credit rating. The lower panels show a risk-adjusted spread on the y-axis. This risk-adjusted spread is the excess spread that remains after we adjust for differences in credit rating and duration using a cross-sectional model. What sticks out immediately is that Finland, Colombia and Mexico all offer compelling spreads after adjusting for differences in credit rating and duration. The outlook for each country's currency versus the U.S. dollar is obviously also important. And in fact, the lower-right panel of Chart 9 shows that exchange rate volatility is positively correlated with the risk-adjusted spreads from our cross-sectional model. This implies that the extra compensation available in Mexican and Colombian sovereigns is probably compensation for assuming highly volatile currency risk. By this measure, Finland looks even more attractive given the euro's slightly lower volatility. Chart 9USD Sovereign Index: Country Breakdown The Upside Of A Weaker Dollar The Upside Of A Weaker Dollar Bottom Line: USD-denominated sovereigns are not attractive compared to domestic Baa-rated U.S. credit. Remain underweight. At the country level, Finland, Mexico and Colombia offer the most attractive spreads and Finnish debt offers the best risk/reward trade-off. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "North Korea: Beyond Satire", dated April 19, 2017, available at gps.bcaresearch.com 2 https://www.newyorkfed.org/newsevents/speeches/2015/dud150605 3 For further details on our outlook for the near-term path of monetary policy please see U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 4 For a chart of the PCE diffusion index please see page 11 of U.S. Bond Strategy Portfolio Allocation Summary, "On Hold, But Not For Long", dated August 8, 2017, available at usbs.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "Fade North Korea, And Sell The Yen", dated August 11, 2017, available at fes.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Still Waiting For Inflation Still Waiting For Inflation Chart 2The Trump Put The Trump Put The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher LEIs Pointing Higher LEIs Pointing Higher Chart 5Supports For Global Growth In Place Supports For Global Growth In Place Supports For Global Growth In Place Chart 6Global Economic Activity Brightening bca.usis_wr_2017_08_14_c6 bca.usis_wr_2017_08_14_c6 Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Widespread Evidence That Labor Market Is Tightening Widespread Evidence That Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Not Much Wage Pressure Yet Not Much Wage Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Labor Market, Inflation And Stocks In The Long 80's & 90's Expansions Labor Market, Inflation And Stocks In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On On Inflation In The 80s & 90s Wage Growth Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries Leading Indicators Of Inflation In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.

Highlights Strong corporate earnings growth will drown out worries about North Korea. Stay cyclically overweight global equities. Underlying wage growth in the U.S. is stronger than the official data suggest. Surveys point to a further acceleration in U.S. wages, as do pay gains at the lower end of the income distribution. Labor's share of income will resume its cyclical recovery. This will lead to more consumer spending, and ultimately, higher price inflation. Wage growth elsewhere in the world will also pick up as labor slack declines. Global fixed-income investors should underweight duration and increase exposure to inflation-linked securities. Feature Focus On Corporate Earnings, Not Korea Chart 1EPS Estimates Have Remained ##br##Resilient This Year EPS Estimates Have Remained Resilient This Year EPS Estimates Have Remained Resilient This Year Global equities dropped over the past few days on the back of rising risks of conflict in the Korean peninsula. Our geopolitical strategists believe that neither the U.S. nor North Korea will launch a preemptive strike.1 Despite its bluster, North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty. The U.S. has forsworn regime change as a policy goal. China has recommitted to new sanctions and the South is pro-engagement. This raises the likelihood that a diplomatic solution will be found. Unfortunately, getting from here (open hostilities) to there (negotiated solution) will take time, which leaves the door open to increased market volatility. Nevertheless, we expect any selloff to be short-lived, owing to the positive earnings picture. More than anything else, strong profit growth has underpinned the cyclical bull market in stocks, and we expect this to remain the case over the coming months. More than 80% of S&P 500 companies have reported Q2 results. Based on these preliminary numbers, EPS appears to have increased by 11% over the previous year, marking the fourth consecutive quarter of margin expansion. The strength has been broad based, with all eleven sectors reporting positive growth. U.S. earnings estimates for both 2017 and 2018 have remained steady since January, bucking the historic pattern of downward revisions throughout the course of the year (Chart 1). The picture is even more impressive outside the U.S., where earnings estimates continue to move higher. The Euro STOXX 600 is now expected to deliver EPS growth of 12.6% this year. EPS of stocks listed on the Japanese Topix is expected to rise 14.8% this year and 7.3% next year, giving them an attractive 2018E P/E of 13.6. We recommend overweighting euro area and Japanese stocks over their U.S. counterparts in currency-hedged terms. EM stocks have seen the strongest positive earnings revisions this year. We continue to worry about some of the structural headwinds facing emerging markets (high debt levels, poor governance, etc.). However, the cyclical picture remains more upbeat. Chinese H-shares remain our favorite EM market, trading at just 7.5 times 2017 earnings estimates. The U.S. Labor Market Gets A JOLT, But Where's The Wage Growth? The Job Openings and Labor Turnover Survey (JOLTS) released on Tuesday provided more good news about the state of the U.S. labor market (Chart 2). The number of job openings rose to 6.2 million in June. There are now 28% more unfilled jobs in the U.S. than at the prior peak in April 2007. The number of unemployed workers per job opening fell to 1.1, the lowest level in the history of the series. One might think that with numbers like these, wage growth would be skyrocketing. Yet, it is not. While monthly average hourly wages did surprise to the upside in the June payrolls report, the year-over-year change remained stuck at 2.5%. This week's productivity report showed that compensation per hour increased by only 1% in Q2 relative to the same period in 2016. Other measures of wage growth generally point to some softening this year (Chart 3). Chart 2More Good News For The U.S. Labor Market More Good News For The U.S. Labor Market More Good News For The U.S. Labor Market Chart 3U.S. Wage Growth Remains Soft U.S. Wage Growth Remains Soft U.S. Wage Growth Remains Soft Many commentators regard the lackluster pace of wage inflation - coming at a time when the unemployment rate has fallen below its 2007 lows - as a "mystery" that needs to be solved. As we argue in this report, there is less to this mystery than meets the eye. Properly measured, underlying wage growth in the U.S. has been rising for some time, and may actually be stronger than the "fundamentals" warrant. Wage inflation elsewhere in the world is more subdued. However, this is largely because progress towards restoring full employment has been slower outside the U.S. Is Wage Growth Being Mismeasured? How can U.S. wage growth be characterized as "strong" when it is still so weak by historic standards? Part of the answer has to do with that old bugbear: measurement error. Low-skilled workers have been re-entering the labor force en masse over the past few years, after having deserted it during the Great Recession. This has put downward pressure on average wages, arithmetically leading to slower wage growth. Most of the official wage series, including the Employment Cost Index, do not adjust for this statistical bias.2 In a recent research report, economists at the San Francisco Fed concluded that "correcting for worker composition changes, wages are consistent with a strong labor market that is drawing low-wage workers into full-time employment."3 In addition to cyclical factors, demographic shifts have depressed official measures of wage inflation. Historically, population aging has pushed up average wages because older workers tend to earn more than younger ones. The retirement of millions of well-paid baby boomers over the past few years has reversed this trend, at least temporarily. Chart 4 shows that the median age of employed workers has fallen for the past three years, the first time this has happened since the 1970s. Weak Productivity Growth Dragging Down Wages Unfortunately, there is more to the story than measurement error. Today's young workers are not better skilled or educated than those of previous generations. This, along with other factors that we have discussed extensively in past reports, has dragged down productivity growth.4 Nonfarm productivity has increased at an average annualized pace of less than 1% over the past few years, down from 3% in the early 2000s (Chart 5). Slower productivity growth gives firms less scope to raise wages. In fact, for all the talk about how wages are stagnant, real wages have risen by more than productivity since 2014. This has pushed labor's share of income off its post-recession lows. Chart 4Median Age Of Workers No Longer Rising Median Age Of Workers No Longer Rising Median Age Of Workers No Longer Rising Chart 5Real Wages Have Increased Faster ##br##Than Productivity Over The Past Few Years Real Wages Have Increased Faster Than Productivity Over The Past Few Years Real Wages Have Increased Faster Than Productivity Over The Past Few Years It remains to be seen whether the structural downtrend in the share of income going to labor will be reversed. One can make compelling arguments for both sides of the issue.5 But over a cyclical horizon of one-to-two years, it is highly likely that labor's share will rise. Labor's share of income is fairly procyclical. It increased significantly in the late 1990s and rose again in the years leading up to the Great Recession. Considering how low unemployment is today, it is not unreasonable to assume that it will maintain its cyclical uptrend. If so, this will lead to more consumer spending, and ultimately, higher inflation. Surveys Point To Faster Wage Growth... Surveys such as those conducted by the National Federation of Independent Business, Duke University/CFO Institute, National Association for Business Economics, and various regional Federal Reserve banks suggest that employers are becoming increasingly willing to raise compensation in order to fill vacancies (Chart 6). Workers, in turn, are becoming more choosy. This can be seen in an improving assessment of job availability and a rising quits rate. Both of these measures lead wage growth (Chart 7). Chart 6ASurveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Chart 6BSurveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Surveys Show Employers More Willing To Raise Compensation Chart 7Workers Are Feeling More Confident Workers Are Feeling More Confident Workers Are Feeling More Confident ...As Do Wage Gains Among Low-Income Workers Median weekly earnings of low-income workers have accelerated this year, even as wage gains among higher-income workers have hit an air pocket (Chart 8). For example, restaurant workers have seen pay hikes of nearly 5% this year, up from 1% in 2014. Wage growth among lower-income workers tends to be less noisy than for higher-income workers. The incomes of better-paid workers are often influenced by bonuses and other variables that may be driven more by industry-specific or economy-wide profit trends rather than labor slack per se. Less-skilled workers are usually the first to get fired and the last to get hired. Thus, wage pressures at the lower end of the skill distribution often coincide with an overheated labor market. This makes the trend in lower-income wages a more reliable gauge of underlying labor market slack. Wage Inflation Will Slowly Pick Up As Global Slack Diminishes We expect U.S. wage growth to rise over the next few quarters by enough to allow the Fed to raise rates in line with the dots. However, a more rapid acceleration - one that forces the Fed to raise rates aggressively - is improbable, at least over the next 12 months. This is mainly because the relationship between domestic labor market slack and wage growth is not as tight as it once was. Trade unions have less clout these days, which means it takes longer for a tight labor market to produce larger negotiated pay hikes. The labor market has also become less fluid, as evidenced by the structural decline in both the rate of job creation and job destruction (Chart 9). Wages tend to adjust more slowly when there is less hiring and firing going on. Chart 8Better Pay For Low-Wage Earners: ##br##A Sign Of A Tighter Labor Market Better Pay For Low-Wage Earners: A Sign Of A Tighter Labor Market Better Pay For Low-Wage Earners: A Sign Of A Tighter Labor Market Chart 9Structural Declines In Job Creation##br## And Destruction Structural Declines In Job Creation And Destruction Structural Declines In Job Creation And Destruction Perhaps most importantly, an increasingly globalized workforce has given firms the ability to move production abroad in response to rising wages at home. This suggests that wage growth in the U.S. is unlikely to increase significantly until falling unemployment begins to push up wages abroad. Wage Growth Around The World For now, wage growth in America's trading partners remains subdued. Euro area wage inflation is stuck between 1% and 1.5%, although with important regional variations (Chart 10). Wage inflation has accelerated to over 2% in Germany, but is still close to zero in Italy and Spain. Considering that unemployment in both countries remains well above pre-recession levels, it will be difficult for the ECB to tighten monetary policy to any great degree over the next few years. Japanese wage growth has picked up since 2010, but is still below the level consistent with the BoJ's 2% inflation target (Chart 11). Wage inflation is likely to ratchet higher over the next few years, now that the ratio of job openings-to-applicants has risen to the highest level since 1974 (Chart 12). In a sign of the times, Yamato Transport, Japan's largest parcel delivery company, recently told Amazon that it would not be able to make same-day deliveries due to a shortage of available drivers. Chart 10Euro Area Wage Growth Remains ##br##Weak Outside Of Germany Euro Area Wage Growth Remains Weak Outside Of Germany Euro Area Wage Growth Remains Weak Outside Of Germany Chart 11Modest Pickup In Japanese Wages Modest Pickup In Japanese Wages Modest Pickup In Japanese Wages Wage growth in Canada has actually declined since 2014. However, that is likely to change given that the unemployment rate has fallen close to nine-year lows. Falling unemployment rates should also boost wage inflation in the U.K., Australia, and New Zealand. Chinese wage growth also remains brisk. Chart 13 shows that urban household future income confidence has picked up notably of late, as growth has improved and the labor market has tightened. Chart 12Job Openings Ratio Will Push Wages Higher Job Openings Ratio Will Push Wages Higher Job Openings Ratio Will Push Wages Higher Chart 13Optimism Over The Labor Market In China Optimism Over The Labor Market In China Optimism Over The Labor Market In China Faster Wage Growth Will Ultimately Lead To Higher Inflation Chart 14The Decline In Inflation Expectations ##br##Have Weighed On Wage Growth The Decline In Inflation Expectations Have Weighed On Wage Growth The Decline In Inflation Expectations Have Weighed On Wage Growth Going forward, the combination of falling labor slack abroad and an overheated labor market at home will cause U.S. wage inflation to increase more rapidly starting in the second half of 2018. This will be a break from the past. Lower longer-term inflation expectations have tempered nominal wage growth over the past eight years (Chart 14). Both market-based inflation expectations and inflation expectations 5-to-10 years out in the University of Michigan's survey have fallen by about half a point since the financial crisis. The recent decline in headline CPI inflation from 2.7% in February to 1.6% in June may also explain why wage growth has dipped this year even as payroll gains have rebounded. Rising wage growth could begin to feed on itself. As we have discussed before, the Phillips curve tends to steepen once an economy reaches full employment (Chart 15). If the unemployment rate falls from 7% to 6%, this is unlikely to have a huge effect on wages. But if it falls from 4.5% to 3.5%, the effect could be substantial. A recent Fed paper concluded that "evidence strongly suggests a non-linear effect of slack on wage growth and core PCE price inflation that becomes much larger after labor markets tighten beyond a certain point."6 The implication is that once inflation does start rising, it could rise more quickly than investors (or the Fed) expect. Concluding Thoughts The past three U.S. recessions were all caused by the unravelling of financial sector and asset market excesses: The housing bust lay the groundwork for the Great Recession; the collapse of dotcom stocks ushered in the 2001 recession; and the failure of hundreds of banks during the Savings and Loan crisis paved the way for the 1990-91 recession. Unlike the last few recessions, the next one may end up being more akin to those of 1960s, 70s, and 80s. Those earlier recessions were generally triggered by aggressive Fed rate hikes in the face of an overheated economy and rising inflation (Chart 16). Chart 15The Phillips Curve Appears To Be Non-Linear What's The Matter With Wages? What's The Matter With Wages? Chart 16Are We Heading Towards A "Retro-Recession"? Are We Heading Towards A "Retro-Recession"? Are We Heading Towards A "Retro-Recession"? The good news is that neither wage nor price inflation is likely to soar over the next 12 months. This means that the bull market in global equities can continue for a while longer. The bad news is that complacency about inflation risk is liable to cause central bankers to fall increasingly behind the curve. Rising inflation will force the Fed to pick up the pace of rate hikes in the second half of 2018. This is likely to lead to a stronger dollar and higher Treasury yields. The resulting tightening in U.S. financial conditions could trigger a recession in 2019 or 2020. Investors should remain overweight risk assets for now, but prepare to scale back exposure next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Geopolitical Strategy Special Report titled "North Korea: Beyond Satire," dated April 19, 2017. 2 Unlike the widely followed average hourly wage series published every month in the payrolls report, the quarterly Employment Cost Index (ECI) does control for shifts in the weights of different industries in total employment. Thus, an increase in the relative number of low-paid hospitality workers would depress average hourly wages, but would not affect the ECI. Nevertheless, the ECI does not control for the possibility that the composition of the workforce within industries may change over time. The Atlanta Fed's Wage Tracker does overcome this bias because it uses the same sample of workers from one period to the next. However it, too, is subject to a number of methodological problems. 3 Mary C. Daly, Bart Hobijn, and Benjamin Pyle, "What's Up with Wage Growth?" FRBSF Economic Letter 2016-07 (March 7, 2016). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016; and The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education and Growth In The 21st Century," February 24, 2011. 5 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; and The Bank Credit Analyst Special Report, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June, 2014. 6 Jeremy Nalewaik, "Non-Linear Phillips Curves With Inflation Regime-Switching," Federal Reserve Board, Finance and Economics Discussion Series 2016-078 (August 2016). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights U.S. Treasuries: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. Treasury-Bund Spread: The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to an underperformance of Treasuries. We are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. Central Bank Balance Sheets: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is in a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Chart 1UST Yields Have Some##br## Catching Up To Do UST Yields Have Some Catching Up To Do UST Yields Have Some Catching Up To Do Feature Is the surprising 2017 downdraft in U.S. inflation starting to bottom out? The latest set of readings on growth in prices and wages provides some evidence that the decline may be over. Core PCE inflation rose on a year-over-year basis in June for the first time since January. In July, Average Hourly Earnings had the largest monthly increase since October of last year (Chart 1). With oil prices up 16% off the mid-June lows, and the trade-weighted U.S. dollar down nearly 5% over the same period, the stars are aligned for a pickup in U.S. inflation in the coming months. A sustained rebound in realized inflation would be the catalyst for a renewed rise in U.S. Treasury yields, particularly with U.S. economic data starting to show more upside surprises. With the market only priced for 28bps of Fed rate hikes over the next twelve months, Treasuries are exposed to any improvement in U.S. growth and inflation. Treasuries are certainly due for a bit of catchup to the moves in global bond yields seen over the past couple of months. Rate hike expectations have ratcheted higher in a number of countries that have left policy rates at very low levels as growth has accelerated, such as Canada, the U.K. and Sweden (bottom panel). This has put mild upward pressure on government bond yields in those markets. Yields in the Euro Area have also been rising, not because of rate hike expectations but rather a growing belief that the European Central Bank (ECB) will soon begin paring back the pace of its asset purchases. Reduced central bank buying by the Fed, ECB and the Bank of Japan (BoJ) remains a major threat to the global bond market. It will likely take higher yields to entice other investors to absorb the supply of global duration risk currently taken down by central banks. This is a longer-term factor that will place a gently rising floor underneath global bond yields. In the meantime, the path of least resistance for bond yields in the next 6-12 months remains upward as expectations for U.S. inflation and Fed rate hikes shift higher. The Fed Will Soon Be Back In Play Chart 2Low Unemployment, ##br##But With A Low Equilibrium Rate Low Unemployment, But With A Low Equilibrium Rate Low Unemployment, But With A Low Equilibrium Rate The July U.S. employment report released last week showed continued strength in hiring activity. The headline number of +209k jobs created was above expectations, bringing the 2017 monthly average up to +184k which is almost identical to the +187k average seen in 2016. The headline U-3 unemployment rate dipped back to a cyclical low of 4.3%, in line with the lows of the previous two business cycles (Chart 2). The broader U-6 measure was unchanged at 8.6% - within hailing distance of the low seen during the last business cycle (8.0% in 2007). Yet despite the historically low levels of unemployment, wage inflation is still only holding steady and not yet accelerating. The annual growth rate of Average Hourly Earnings remains stuck around 2.5%, while other measures like the Employment Cost Index are also showing little upward momentum. Yet as long as wage growth is not decelerating, the Fed is likely to remain confident that inflation should eventually drift back up to the central bank's 2% target IF the economy grows in line with its forecasts and additional spare capacity in labor markets is absorbed. The Fed has been openly debating the appropriate level of the real funds rate in recent weeks. Measures such as the Laubach-Williams "R-star" have been cited as evidence that the Fed may be getting very close to a neutral funds rate. However, this is only true if realized inflation stays at current levels. If inflation begins to reaccelerate, additional interest rate increases would be needed to restore the real Fed funds rate back even to current levels. More increases would be needed to get the real funds rate back to even just the current R-star estimate of -0.2%. A level of the real funds rate above R-star could even be necessary if realized inflation was above the Fed's target, as occurred in the late-1990s and mid-2000s when the U.S. Employment/Population ratio climbed higher alongside a steadily growing economy (bottom panel). For now, however, we see the Fed as remaining in a wait-and-see mode, holding off on any additional rate hikes until higher inflation begins to manifest itself in the actual data. In the meantime, market expectations for U.S. inflation are already starting to drift higher. The 10-year TIPS breakeven is at 1.80%, up +13bps since June 16th. The model for breakevens developed by our sister publication, U.S. Bond Strategy, based on financial market variables has also increased by 6bps to 1.82% over the same period, suggesting that current breakevens are now essentially at fair value. (Chart 3). While breakevens remain well below the 2.5% level that we deem to be consistent with the Fed's inflation mandate, this shift in the direction of expectations is critical given the current low level of Treasury yields.1 Chart 3A Weaker USD Should Soon##br## Boost Growth & Inflation A Weaker USD Should Soon Boost Growth & Inflation A Weaker USD Should Soon Boost Growth & Inflation The sharp decline in financial market volatility seen across risk assets over the past few months can largely be traced back to that pullback in realized U.S. inflation since February. Interest rate volatility has collapsed alongside the drop in inflation, as investors have priced in a less hawkish Fed outlook. This also triggered a bout of U.S. dollar weakness that has helped boost demand for assets that typically suffer during periods of U.S. dollar strength, like Emerging Market equities and credit. If inflation begins to soon perk up again, as we expect, then Fed rate hikes will come back into play and both bond volatility and the U.S. dollar will increase, providing a challenge to the current stable return profiles for both equities and corporate credit. We still see the Fed only slowly nudging the funds rate up towards equilibrium levels over the next year, unless inflation rises at a much faster rate than both the Fed and markets expect. Coming at a time when the U.S. economy will continue to churn along at a steady above-potential pace, risk assets can continue to outperform Treasuries even with some appreciation of the U.S. dollar, although with a higher level of market volatility. We still see a December rate hike as the most likely next move on rates by the Fed, with an announcement on reducing the Fed's balance sheet, which has been well-telegraphed, likely in September. This sequence will give the Fed time to assess developments in inflation while still incrementally "normalizing" its monetary policy by beginning to reduce the reinvestment of maturing bonds in its portfolio. A shift to more hawkish Fed expectations would open up the potential for a tactical widening of the spread between U.S. Treasuries and German Bunds. The current spread is too low relative to differentials at the short ends of the respective yield curves, and is holding at the rising trendline that began in 2014 (Chart 4, top panel). At the same time, the gap between the Citigroup economic data surprise indices for the U.S. and Euro Area is starting to widen in a direction that should trigger a wider Treasury-Bund spread (middle panel) - especially given the large net long positions still seen in Treasury bond futures (bottom panel). A tactical widening of the Treasury-Bund spread is not inconsistent with our views on the ECB (Chart 5). We still expect some additional upward pressure on Euro Area bond yields as the ECB announces a tapering of its asset purchases at next month's monetary policy meeting. However, there has already been a considerable adjustment higher in European yields since ECB President Mario Draghi's relatively hawkish Portugal speech in June - one that was not matched by U.S. Treasuries. The next move in "leadership" for global bonds will come from a return of U.S. inflation and Fed hawkishness, not from Europe. Chart 4Higher Volatility On The Horizon? Higher Volatility On The Horizon? Higher Volatility On The Horizon? Chart 5Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread Position For A Tactically Wider UST-Bund Spread On the back of this, we are opening up a new trade in our Tactical Overlay portfolio this week, going short 10-year U.S. Treasuries vs 10-year German Bunds. Bottom Line: The downturn in U.S. inflation looks to be stabilizing, while the U.S. economy continues to churn along at an above-potential growth pace. Treasury yields are now at risk of a repricing of both inflation expectations and Fed rate hike probabilities. The "leadership" of the global bond market is likely to switch back to the U.S. from Europe in the next few months, which will lead to underperformance of Treasuries. Thus, we are entering a new Tactical Overlay trade this week, shorting 10-year U.S. Treasuries versus 10-year German Bunds. The State Of The "QE5" The current coordinated cyclical upturn in global growth, combined with booming equity and credit markets, is forcing central bankers to contemplate shifting to a less dovish monetary policy stance. Only the Fed and the Bank of Canada have actually raised interest rates since the oil-driven deflation scare of 2014/15. Yet policymakers in regions that have undertaken asset purchase programs - the U.S., Euro Area, the U.K., Japan and Sweden which we will call the "QE5"- also must consider policy moves that will impact the future size, and composition, of central bank balance sheets. The sums involved are enormous and will have major implications for financial markets. In Table 1, we present data first published in the 2017 BIS Annual Report published in late June (that we have since updated ourselves), showing the details of the QE5's balance sheets.2 A few numbers stand out from the table: Table 1The State Of The "QES" Central Bank Balance Sheets The Global Duration "Hot Potato" Shifts Back To The U.S. The Global Duration "Hot Potato" Shifts Back To The U.S. The Fed owns 13% of U.S. general government debt, with an average maturity of 8.0 years; 43% of the holdings mature within two years The BoJ owns 40% of Japanese general government debt, with an average maturity of 6.9 years; 49% of the holdings mature within two years The Bank of England owns 25% of U.K. general government debt, with an average maturity of 12.0 years; 20% of the holdings mature within two years The Riksbank owns 15% of Swedish general government debt, with an average maturity of 5.0 years; 37% of the holdings mature within two years The ECB owns 17% of Euro Area general government debt, with an average maturity of 8.0 years; the specific maturity structure is not publically known, however, as the ECB does not provide the same level of detail on its bond holdings as the other QE5 central banks. It is clear from the data that the Fed essentially has little choice but to begin the process of letting bonds run off its balance sheet, given that nearly half of its holdings will mature by 2019. With the U.S. economy at full employment, there is little need for the Fed to continue sending an unnecessarily dovish message by rolling over its bond holdings and maintaining such a large balance sheet. Similar arguments can be made for the Bank of England and the Riksbank, with both the U.K. and Sweden at full employment and a large share of bond holdings set to mature within two years. Chart 6BoJ Will Peg JGB Yields And Hope ##br##For A Weaker Yen BoJ Will Peg JGB Yields And Hope For A Weaker Yen BoJ Will Peg JGB Yields And Hope For A Weaker Yen Japan is a unique case, as always. With the economy still struggling to avoid deflation, even with an unemployment rate below 3%, the BoJ must maintain a hyper-easy monetary policy to keep the yen weak enough to generate some imported inflation (Chart 6). Yet the sheer size of its balance sheet, and its bond holdings, makes it increasingly difficult to roll over all of its maturing debt without severely impairing liquidity in the JGB market. Thus, it is no surprise that the BoJ has chosen to shift to a "yield curve" target that aims to peg the benchmark 10-year JGB yield at 0% - a policy which, presumably, would entail only buying bonds when there is upward pressure on yields from growth and inflation. The BoJ has already "tapered" to an annualized rate of bond buying of 70 trillion yen in 2017 - below the central bank's official 80 trillion yen per year target - and even slower amounts of buying could occur in the next couple of years as the maturing bonds in the BoJ's portfolio are not fully replaced. Which brings us to the ECB. The current economic expansion has been impressive in its scope and breadth, with even perpetual laggards like Italy enjoying a solid cyclical upturn. Although inflation remains below the ECB's 2% target, core inflation has clearly bottomed out and is even slowly accelerating in some countries, like Germany and Spain (Chart 7). The central bank has been sending out signals that an adjustment in its monetary policy settings will likely be needed soon. The markets have interpreted this as a sign that the ECB will announce a tapering of its asset purchases in 2018. The ECB has to be a little surprised, and perhaps nervous, over the market reaction to this shift in its communication with the markets. Longer-term bond yields rose sharply, with the benchmark 10-year German Bund more than doubling in a matter of weeks in late June and early July. The central bank has been clear in stating that no change in short-term interest rates is imminent, and there has been very little movement in shorter maturity bond yields. Yet the euro has appreciated 5% since Mario Draghi's Portugal speech on June 26th, following the rise in long-term bond yields rather than the typical short-rate moves that guide currency fluctuations (Chart 8). Chart 7The Case For A Less Accommodative ECB The Case For A Less Accommodative ECB The Case For A Less Accommodative ECB Chart 8Could A Stronger Euro Delay The Taper? Could A Stronger Euro Delay The Taper? Could A Stronger Euro Delay The Taper? The surge in the euro has largely been due to capital inflows by global investors chasing the improving growth in the Euro Area, combined with some short covering of the large short positioning on the currency from earlier this year. Without the support of actual interest rate hikes that more sustainable boost the attractiveness of the currency, additional gains in the euro may be hard to come by - especially if the Fed soon shifts back to a more hawkish stance, as we discussed earlier in this report. As long as the rising euro does not materially impact broader Euro Area financial conditions through falling equity prices or wider corporate credit spreads, the ECB can continue on a path towards signaling a slower pace of asset purchases next year. They essentially have no choice on that front, given the approaching constraints on its bond buying program. The ECB has set internal rules that its asset purchases must: a) be allocated across the Euro Area countries according to the weights of the ECB "Capital Key"; and b) not result in the ECB owning more than 33% of any single countries stock of government debt. Following the first rule means buying far more German and French debt than Spanish or Austrian debt. Yet if they continue to follow the first rule, the second rule will be violated for some countries, most notably Germany. In Chart 9, we show the share of government bonds owned by the ECB for Germany, France, Italy and Spain. We also show projections for the ownership shares based on four scenarios for the pace of ECB asset purchases in 2018. If the ECB was to maintain the current €60bn/month rate of buying, then the 33% threshold for Germany would be breached next year (the green dotted line in the top panel) and the limit would almost be reached for Spain (the green dotted line in the bottom panel). Given these projections, it is perhaps no surprise that the ECB is sending signals about a taper even with inflation still south of the 2% ECB target. The ECB has already starting altering the composition of its monthly asset purchases, buying a lower share of German bonds between April and June, while buying a larger share of French and Italian bonds in excess of the Capital Key limits (Chart 10). To continue to do this would invite potential political criticism of the ECB's policies from Germany and other "hard money" countries in the Euro Area that do not wish to subsidize the high deficit governments. Chart 9ECB Holdings Of German Debt ##br##Approaching Limits ECB Holdings Of German Debt Approaching Limits ECB Holdings Of German Debt Approaching Limits Chart 10This Is Politically Unsustainable This Is Politically Unsustainable This Is Politically Unsustainable For that reason, we consider it to be very unlikely that the ECB will maintain the same level of bond purchases next year, but while also moving away from the Capital Key as the weighting scheme. The single country issuer limit could be raised from 33%, but this is also not a sustainable solution as it would potentially create the same problems faced by the other QE5 countries where the central bank ends up absorbing increasing shares of new government bond issuance, impairing market liquidity. We see the ECB as having no choice but to reduce the pace of asset purchases next year. We expect a true taper announcement next month that sets a date when the pace of buying goes to zero. The most "dovish" decision we can envision is a reduction in the pace of buying to €40bn/month that is maintained for all of 2018. This would be an identical move to the decision made last December, but even this would result in the ECB coming very close to the 33% issuer limit for Germany (the black dotted line in the top panel of Chart 9). Net-net, we see the ECB buying fewer Euro Area government bonds in 2018, no matter what. This will continue to put a rising floor underneath bond yields, with risks of bigger increases if inflation begins to accelerate in line with the ECB's projections. Bottom Line: Central banks with large amounts of maturing bonds on their balance sheets, like the Fed and the Bank of Japan, have had no choice but to signal a slower pace of future bond buying. The ECB is a similar boat, as its holdings of German debt approach issuer limits in the ECB portfolio. A slower pace of ECB bond buying is certain in 2018, to the detriment of European government bond market performance. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Fed targets a growth rate of 2% on the headline Personal Consumption Expenditure (PCE) deflator, but the inflation rate reference in TIPS pricing is the growth of the headline Consumer Price Index (CPI). Given that the spread between headline PCE and headline CPI inflation has averaged around 50bps in recent years, a CPI inflation rate of 2.5% would be consistent with the Fed's stated inflation target. 2 http://www.bis.org/publ/arpdf/ar2017e4.pdf Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Duration "Hot Potato" Shifts Back To The U.S. The Global Duration "Hot Potato" Shifts Back To The U.S.