Inflation/Deflation

Highlights Monetary Policy: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Economy: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. High-Yield: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Feature Chat 1A Hawkish Market Reaction A Hawkish Market Reaction A Hawkish Market Reaction After having been relatively subdued in the two months since the Fed's last rate increase, rate hike expectations priced into money market curves awakened last week following Janet Yellen's semi-annual Congressional testimony. Expectations priced into the overnight index swap curve have returned close to levels last seen on the day of the December 2016 FOMC meeting (Chart 1). As of last Friday's close, the market was priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. The implied probability of a March hike peaked at 34% last Wednesday.1 In this week's report we discuss why a March rate hike is unlikely. We also consider the outlook for U.S. economic growth in 2017, which we expect will remain decidedly above trend. Above-trend growth will allow the gradual increase in core inflation to persist, reaching the Fed's target by the end of the year. As a result, the Treasury curve will bear-steepen during this timeframe. To position for this outcome, investors should maintain below-benchmark duration and favor the belly (5-year bullet) of the curve relative to the wings (2/10 barbell) in duration-matched terms.2 Yellen's Hawkish Turn? Most news reports of Janet Yellen's testimony last week perceived a hawkish tone in her remarks and focused specifically on the following sentence: As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession.3 However, more important than the above boilerplate is the simple fact that inflation remains below target and the Fed has an incentive to tread cautiously to support its eventual recovery. There is no pressing need to move quickly on rate hikes and we expect that the next rate increase will not occur until June. One reason is that, in the current cycle, the Fed has not lifted rates without having first guided market expectations in the months leading up to the hike. As can be seen in Chart 2, rate hike probabilities implied by fed funds futures were already well above 50% one month prior to each of the last two rate hikes. If there was a strong desire to lift rates in March, Yellen would have likely sent a more powerfully hawkish signal in her testimony last week. Instead, Yellen chose not to mention the March meeting specifically and said only that the Fed would continue to evaluate the case for further rate hikes at its upcoming "meetings". Chart 2Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Market-Implied Rate Hike Probabilities: March Looks Too High Second, as was alluded to above, core PCE inflation is running at 1.7% year-over-year, still below the Fed's 2% target. What's more, long-dated TIPS breakeven inflation rates are also below levels that are consistent with inflation being anchored near the Fed's target (Chart 3). At present, the 5-year/5-year forward TIPS breakeven rate is 2.17%. Historically, a range of 2.4% to 2.5% is consistent with inflation at the Fed's target. Further, even though a strong January core CPI print, released last week, seemed to strengthen the case for a March hike, the details of the report show that only a few components (new cars +0.9% m/m, apparel +1.4% m/m, and airline fares +2.0% m/m) accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in contractionary territory (Chart 4), it is very likely that inflation will soften in the coming months. Chart 3Inflation Still Too Low Inflation Still Too Low Inflation Still Too Low Chart 4Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Inflation Recovery Not Broad Based Both our own and the Fed's forecasts for continued inflation increases are contingent on the view that tight labor markets are causing wage pressures to mount, and certainly wages have accelerated during the past few years. However, wage growth in both real and nominal terms is still below where the Fed would like it to be, and there has been scant evidence of wage acceleration during the past few months. While the Atlanta Fed's Wage Growth Tracker remains strong in nominal terms, it has leveled off in real terms, and both the Employment Cost Index and Average Hourly Earnings have recently been flat (Chart 5). A final factor that will prevent the Fed from lifting rates in March is the extremely high degree of policy uncertainty. As shown in Chart 6, economic policy uncertainty traditionally correlates with financial conditions. With financial markets having already discounted a very positive fiscal policy outcome, there is a heightened risk that some disappointing news on the fiscal front will lead to a sharp tightening of financial conditions in the near term. Such an event would definitely put the Fed on hold until financial markets recovered. Chart 5Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Fed Needs Wage Growth To Pick Up Chart 6Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Policy Uncertainty Remains Elevated Bottom Line: Investors should fade the recent increase in expectations of a March rate hike. Still-low inflation and elevated policy uncertainty will keep the Fed on hold until June. Continue to position for a bear-steepening of the Treasury curve, driven by the combination of above-trend growth and accommodative Fed policy. Policy Aside, U.S. Growth Is Heating Up Chart 7ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth ISM Surveys Point To Strong Growth Most recent economic discussion has focused on when President Trump will get around to enacting some of the more stimulative parts of his policy agenda, and whether or not the impact of these policies (tax cuts, infrastructure spending) will ultimately be offset by other spending cuts. But in the meantime, leading indicators of GDP growth have been picking up steam. Both the manufacturing and non-manufacturing ISM surveys point to an increase in GDP growth in the first quarter (Chart 7), and consistently, the New York Fed's tracking model suggests Q1 GDP will grow by 3.1%. The Atlanta Fed's GDP tracking model pegs Q1 growth slightly lower at 2.4%. Our own sense is that GDP growth will remain solidly above trend this year, in the range of 2.5% to 3%, even in the absence of major fiscal stimulus. This forecast hinges on the view that both residential and non-residential investment will rebound from the depressed levels seen last year and that consumer spending will remain strong. Residential Investment Chart 8Residential & Non-Residential Investment Residential & Non-Residential Investment Residential & Non-Residential Investment Residential investment was actually a drag on GDP growth for two quarters in 2016, even though leading indicators such as the months supply of new homes and homebuilder confidence remained supportive (Chart 8, panels 1 & 2). The progress made on foreclosures since the financial crisis has driven housing inventory to its lowest level since the mid-1990s,4 meaning that housing supply no longer poses a headwind to construction. Further, demographics should also help boost the housing market during the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.5 While rising mortgage rates will be a drag on housing at the margin, they will not pose a significant headwind to residential investment in 2017. At least so far, mortgage purchase applications have been resilient in the face of rising rates (Chart 8, panel 3). Non-Residential Investment Non-residential investment was a small drag on growth in 2016, but this was largely related to depressed investment in the energy sector (Chart 8, panel 4). Now that the oil price has recovered, non-residential investment should return to being a small positive contributor to growth. Our composite indicator of New Orders surveys also suggests that non-residential investment will trend higher this year (Chart 8, bottom panel). While there is some concern that the optimism displayed in these survey measures may not filter through to the "hard" economic data, a Special Report from our Bank Credit Analyst publication that will be published on Thursday concludes that a tangible growth acceleration is indeed underway throughout the G7. Consumer Spending As always, the consumer is the main driver of U.S. growth and we expect consumer spending will remain firm in 2017. Our U.S. Investment Strategy service recently undertook a detailed analysis of consumer spending,6 focusing on its two main drivers - income growth and the savings rate (Chart 9). A look at past cycles suggests that income growth can remain strong even after the economy reaches full employment as rising wages compensate for decelerating payroll growth (Chart 10). The recent spike in consumer income expectations suggests that the impact from rising wages might be particularly important in the current cycle (Chart 10, panel 1). Chart 9Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Consumer Spending Is Driven By Income Growth And The Savings Rate Chart 10Wages Can Drive Income Growth Wages Can Drive Income Growth Wages Can Drive Income Growth Another benefit of the economy reaching full employment is that increased job security can translate into greater consumer confidence and a lower savings rate (Chart 9, bottom panel). Confidence trends suggest that the savings rate has scope to decline during the next few months. One possible headwind to consumer spending is the recent tightening of consumer lending standards. The Fed's Senior Loan Officer Survey for the fourth quarter of 2016 shows that lending standards on auto loans have tightened for three consecutive quarters and that credit card lending standards also recently spiked into "net tightening" territory. In other words, more banks are now tightening lending standards on consumer loans than easing them. Prior to the financial crisis, consumer lending standards were strongly correlated with the savings rate (Chart 11). More stringent lending standards slowed the pace of consumer credit growth and led to reduced consumer spending. But this relationship broke down following the financial crisis. After the housing bust, households were no longer eager to supplement their consumption with as much credit as possible. Their chief concern became repairing their own balance sheets. As such, the supply of credit is no longer the most important driver of the savings rate. In the data, we observe that the savings rate did not fall by as much as would have been predicted by easing lending standards in the early years of the recovery. As a result, we do not think that modestly tighter lending standards will have much of an impact either. The Fed's latest Senior Loan Officer Survey also showed that demand for consumer credit declined sharply in 2016 Q4. This is potentially more worrisome for the savings rate since lower credit demand may still suggest a reduced appetite for spending, even in the wake of the Great Recession. However, a look back at prior cycles shows that loan demand from the Senior Loan Officer Survey tends to decline several years prior to the next recession, but the savings rate has tended to stay low until the next recession actually hits (Chart 11, bottom panel). We would not be surprised to see the same dynamic play out again. Bottom Line: U.S. growth will be higher this year than in 2016, driven mainly by rebounds in residential and non-residential investment. Consumer spending should also remain firm, driven by solid income growth and a savings rate that has scope to decline in the coming months. Chart 11Lending Standards Less Of A Risk Lending Standards Less Of A Risk Lending Standards Less Of A Risk Chart 12Default-Adjusted Spread Default-Adjusted Spread Default-Adjusted Spread A High-Yield Valuation Update With the release of the Moody's default report for January we are able to update our forecast for High-Yield default losses during the next 12 months, and also our High-Yield default-adjusted spread. The default-adjusted spread is our preferred valuation indicator for both High-Yield and Investment Grade corporate bonds. It is calculated by taking the option-adjusted spread from the Bloomberg Barclays High-Yield index and subtracting an estimate of expected default losses during the next twelve months (Chart 12). Default loss expectations are calculated using the Moody's baseline forecast for the 12-month High-Yield default rate and our own forecast of the recovery rate based on its historical relationship with the default rate (Chart 12, bottom two panels). The current reading from our default-adjusted spread is 152 basis points. Most of the time, a reading of 152 bps on the default-adjusted spread is consistent with small positive excess returns for both High-Yield and Investment Grade corporate bonds (Chart 13 & Chart 14). This is also consistent with the excess returns we expect from corporate credit this year. Chart 1312-Month Excess High-Yield Returns Vs. Ex-Ante ##br##Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March Chart 1412-Month Excess Investment Grade Returns Vs. Ex-Ante High-Yield##br## Default-Adjusted Spread (2002 - Present) The Odds Of March The Odds Of March In fact, when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns to High-Yield have been positive in 65% of cases, with a 90% confidence interval placing 12-month excess returns in a range between -5.0% and +1.7%. Given the favorable economic back-drop of strong economic growth and accommodative Fed policy, we would expect High-Yield excess returns to be positive during the next 12 months. But given the tight starting valuation, probably not above +1.7%. Bottom Line: High-Yield valuations are tight, but still consistent with small positive excess returns to corporate credit during the next twelve months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculations of rate hike probabilities implied by fed funds futures are lower than those shown on Bloomberg terminals. Our measure differs because we use the actual data for the effective fed funds rate and also adjust for the well-known fact that the effective fed funds rate tends to fall by approximately 10 basis points on the last day of the month. 2 For further details on our recommended yield curve trade please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/testimony/yellen20170214a.htm 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see "The State Of The Nation's Housing 2016", Joint Center for Housing Studies of Harvard University. 6 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Recent economic and inflation data can be characterized as Goldilocks: strong enough to keep recession fears at bay, yet not hot enough to warrant Fed tightening. Historical precedent suggests that the current period of positive economic surprises could persist for at least another month or two, fueling ever-more lopsided positioning into equities. Despite a lot of good news already discounted, we retain a cyclical bias toward small caps. Currently, the main driver of style performance is sector weightings. Value stocks are likely to perform slightly better than Growth by virtue of a smaller weighting in technology and larger weighting to financials. Higher conviction in Value stocks outperformance awaits better credit growth trends. Feature The term Goldilocks is used to describe an economy that is growing, but is not quite hot enough to create serious inflation risks, and not so cold that it fosters recession fears. Last week's major data reports fit this view of the world and helped U.S. equity prices soar to a new all-time high (Chart 1): NFIB Small Business Survey: Since small businesses have long been considered the job engine of the U.S. economy, monitoring the sentiment of small businesses owners, their likelihood to undertake expansion plans, and raise/cut prices, can often give a good glimpse into the likelihood of financial market trends to be sustained on a cyclical basis. In January, the NFIB small business sentiment indexes surged and to our surprise, the positive sentiment did not correct in February (Chart 2). The expectations component actually rose even further! Chart 1Rotation Into Stocks Rotation Into Stocks Rotation Into Stocks Chart 2Will Hopes Be Dashed? Will Hopes Be Dashed? Will Hopes Be Dashed? We continue to believe the survey reflects a lot of hope and is likely to reverse substantially. According to the survey, business conditions are the best in thirty years, save for a brief period in the early 2000s. Even the most ardent of Trump supporters will find it difficult to explain how a handful of executive orders and memoranda have so significantly altered the business landscape in such a short space of time! This radical shift in sentiment makes risk asset prices vulnerable: the pace of economic expansion has only gradually improved, but investors and other economic agents have drastically revised upward their expectations. Retail Sales: A number of cyclical tailwinds are beginning to finally align for consumers, as discussed in January 16 Weekly Report, and consumers appear to be in slightly better shopping moods in 2017. January retail sales beat expectations and prior months were revised higher. Spending improved across categories and these broad-based gains reinforce our view that the consumer can lead a gradual, self-reinforcing economic recovery (Chart 3). Inflation: We do not worry that cyclical inflation trends will be strong enough to force the Fed to raise rates faster than the FOMC's current expectations (three rate hikes by end-2017). True, both headline and core CPI were stronger than consensus expectations in January, and producer prices are in a noticeable uptrend. But this should not be viewed as the beginning of a new, more dangerous inflation problem. As Chart 4 shows, producer prices - at all stages of production - have been rising for the past few months. But only a fraction of any price rise at the producer level is likely to be passed on to consumers. Chart 5 shows that core goods prices have decoupled with finished goods producer prices (i.e. the last stage of production) since 2000. This speaks to the massive deflationary impulse at the end of the supply chain: a combination of deflation via imported goods, major technological advances in supply chain management and logistics, and changing consumer behavior in an e-commerce age means that consumers are not price takers. These factors imply that any budding inflation pressures will stay "trapped" at the earlier stages of the supply chain and it should not be a foregone conclusion that PPI can drive CPI prices higher. Chart 3Consumer Supports Are In Place Consumer Supports Are In Place Consumer Supports Are In Place Chart 4Producer Prices Turning Higher... Producer Prices Turning Higher... Producer Prices Turning Higher... Chart 5...But PPI Barely Leaks Into CPI ...But PPI Barely Leaks Into CPI ...But PPI Barely Leaks Into CPI Similarly, the rise in the headline inflation rate - for the first time since 2013 above core CPI - should not be viewed as an omen for what lies ahead for broader inflation trends. As Chart 6 shows, the relationship between energy prices and core CPI broke down during the early 1980s: a rise in energy prices does not correlate with non-energy consumer prices. Chart 6Energy Prices Uncorrelated With Core CPI Since The 1980s Energy Prices Uncorrelated With Core CPI Since The 1980s Energy Prices Uncorrelated With Core CPI Since The 1980s Finally, we note that despite general optimism about business conditions in the NFIB survey, the pricing backdrop remains a glaring exception. In the most recent survey, the number of businesses expecting to raise prices actually fell. With respect to last week's core CPI print, the monthly increase of 0.3% is unlikely to be sustained. A few components were behind the upside surprise. For example, new car prices increased 0.9% m/m, apparel prices rose 1.4% m/m and airline fares spiked 2.0% m/m. The usual suspects behind outsized price gains were actually quite tame in January. Homeowners' equivalent rents increased by 0.2% m/m versus several months of 0.3% gains. Similarly, medical care was up 0.2% m/m. Our CPI diffusion index fell further below the zero line, confirming that inflation pressures are not broad based. Perhaps the only negative development last week was that positive data surprises, combined with a slightly hawkish interpretation of Janet Yellen's testimony, have pushed forward the bond market's expectations of the next Fed interest rate hike. We expect the most likely outcome will be that the next rate hike will be in June. If that forecast proves correct, then any upward pressure on bond yields should be modest in the next few months. We do not expect a resumption of the cyclical bond bear market to be a headwind for stocks until later this year at the earliest. How long can the Goldilocks backdrop persist? As Chart 7 shows, positive economic surprises have been propping up financial markets alongside optimism about a Trump-led Republican government. Importantly, for the first time since 2011, positive economic surprises are occurring in the first quarter of the calendar year. During past episodes, this level (i.e. above 40) in the Economic Surprise Index has persisted for upwards of three months. The implication is that economic surprises may continue to help fuel the momentum in equity prices for another month or even longer. Chart 7Economic Surprises Could Persist A While Longer Economic Surprises Could Persist A While Longer Economic Surprises Could Persist A While Longer This corroborates our review two weeks ago of technical indicators, which showed that apart from extreme sentiment and despite the persistent run-up in equity prices, most short-term indicators are not yet flashing warning signs. In sum, recent data prints show that the U.S. economy is on sturdier footings. The absence of a meaningful inflation threat implies that a prolonged economic cycle can feed positive gains in the stock/bond ratio over a cyclical horizon. But these positive underpinnings cannot explain the speed and magnitude of the recent financial market adjustments. Although the bulk of our indicators suggest that positioning may become more lopsided in the short term, the current phase of the rally is high-risk. Size And Style Guide Several clients have asked about size and style investing in recent weeks. We remain overweight small caps relative to large, and are only slightly more optimistic about Value versus Growth. In the case of Value versus Growth, we echo the advice of our Global ETF strategy:1 the Value/Growth decision has become, more than ever, a matter of sector preference. As Table 1 shows, there are three sectors with vastly differing weights between S&P Growth and Value Indexes. The Value index is dominated by Financials (27% of the index, versus a 4% weight in the Growth index and 15% in the S&P 500) and Energy (12% in the Value Index versus 3% and 7% in the Growth and S&P 500 Indexes, respectively). Meanwhile, technology stocks make up a whopping 34% of the Growth Index. It is no wonder then that Value stocks shot higher on the back of a post-election financial sector outperformance streak (Chart 8). Financials (as well as the energy sector) received a big boost due to the promise of drastic de-regulation of the industry under a majority-Republican government. TABLE 1Sector Composition Goldilocks: For How Long? Goldilocks: For How Long? Our U.S. Equity Strategy service is underweight the technology sector, but only neutral on financials and energy stocks. On this basis, only a slight Value bias would make sense. At present, relative sector weightings appear to be the highest conviction argument in favor of a particular style, since many indicators that have reliably gauged style performance are not convincingly tilting in one direction or another. For example, growth stocks tend to need rising long-term earnings expectations to help them outperform. But this cycle, Growth stocks outperformed long before long-term earnings expectations started to move higher. Now that EPS have adjusted upward, it is hard to see - absent a repeat of the tech bubble in the late 1990s - long-term earnings growth rising enough to drag relative share performance higher. Conversely, the conditions for a plunge in long-term earnings expectations do not exist (Chart 8). Similarly, Value stocks tend to require improving global growth conditions in order to sustain relative outperformance over Growth stocks (Chart 8, bottom panel). That condition is in place, though the strength of the trend is unclear. In an upcoming publication by our Bank Credit Analyst, BCA editors uncover that although it is clear that an upswing in global growth is occurring in both the "soft" and "hard" data, there is little concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles so far in this lackluster expansion. The bottom line is that the outperformance in Value stocks relative to Growth may endure, by virtue of Value stocks having a comparably small allocation to technology stocks and a relatively larger allocation to financials (and energy). A more compelling case for Value stocks requires a higher conviction view in a prolonged financial sector outperformance phase. The latter awaits a move from promises to watch action on financial deregulation and more importantly, a more positive outlook on credit creation. As for small caps relative to large, we expect that the cyclical outperformance trend in small caps is sustainable (Chart 9). True, in the near term, there is room for overbought conditions to be further unwound. The consensus opinion that corporate tax reform and Trump trade policy will disproportionately benefit small companies is likely already fully discounted, making small cap share prices vulnerable to political disappointment. Chart 8Growth Will Struggle ##br##To Keep Up With Value Growth Will Struggle To Keep Up With Value Growth Will Struggle To Keep Up With Value Chart 9Small Cap Outperformance##br## Is Not Constrained By Valuation Small Cap Outperformance Is Not Constrained By Valuation Small Cap Outperformance Is Not Constrained By Valuation Meanwhile, if the dip in the U.S. dollar becomes a more sustainable trend, then small caps will be at further risk. However, that is not our base case: we expect broad dollar strength to be supportive of small cap stocks over the next six to twelve months. The U.S. economy is on sounder footing than its global counterparts and the Fed is far out in front; both of these conditions are supportive of a stronger dollar. Fortunately, small caps earnings are far more insulated from dollar strength, by virtue of the fact that small caps revenues are much more domestically oriented than large caps. The one area that small caps earnings may come under more pressure than large caps is margins. As noted above, small businesses are not yet particularly optimistic about their ability to raise prices in order to match wage hikes. Nonetheless, we expect better domestic (and thus small-cap positive) top-line growth to outweigh a margin squeeze felt more heavily for small caps versus large. Finally, small caps are often viewed as a higher beta play on growth (although this has not always been the case). Since relative valuations are not yet problematic, then if our base case of a prolonged, albeit not necessarily overly robust, non-inflationary economic expansion pans out, then the small cap outperformance phase could also endure for a prolonged period. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Global ETF Strategy/ETS Equity Trading Strategy Special Report “Smart-Beta ETF Selection, Part I - Value Funds,” dated February 15, 2017, available at bcaresearch.com.

Highlights Duration: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. USTs vs. Bunds: U.S. Treasury yields will remain under upward pressure from a hawkish Fed with the U.S. economy operating at full employment. The opposite is true in Europe, at least until Euro Area inflation is much higher. Stay overweight core Europe versus the U.S. in global hedged bond portfolios Feature Chart of the WeekCan The Bond Selloff Continue? Can The Bond Selloff Continue? Can The Bond Selloff Continue? Last week brought the first serious test of the bond bear phase that has been in place since last July. The 10-year U.S. Treasury yield dipped as low as 2.33% after a benign January U.S. Payrolls report that substantially reduced the odds of a March Fed rate hike. German Bund yields also dipped as renewed worries about the upcoming French election triggered a flight to quality out of French and Peripheral sovereign debt. Even the chartists got in on the act, talking of an imminent breakdown below the "head & shoulders neckline" on the 10-year U.S. Treasury that would herald a 25bp decline in yields. Adding to the growing sense of nervousness among investors is a fear that the "Trumpflation" trade could soon run out of gas, with a correction of both elevated equity prices and bond yields likely in the absence of concrete economic news from the White House. Yet all it took was for Trump to simply mention that a "phenomenal" announcement on his tax plan was coming in the next few weeks to restart the Trump trades, pushing equity indices to new highs and driving up bond yields. Given all the conflicting forces at play in developed bond markets - accelerating growth, rising inflation, fiscal and political uncertainties, bearish bond investor positioning - we believe it is important to stay grounded by focusing only on the most relevant factors while trying to sift out the signal from the noise. This week, we are introducing a new "Duration Checklist" for both U.S. Treasuries and German Bunds, highlighting the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio duration stance. From this checklist, we can confirm that the bond-bearish backdrop remains intact, with more indicators pointing to higher yields in the U.S. relative to core Europe. Describing The Elements Of Our Checklist The individual components of bond yields that we typically monitor - term premia, inflation expectations and shifts in the market-implied path of policy rates - have all contributed to the rise in U.S. and European bond yields since last July (Chart of the Week). Some of the factors that have driven yields higher are global in nature, like faster economic growth and rising energy prices, while others are more country-specific, like rising wage inflation in the U.S. To account for those different factors, we need to include a variety of indicators in our new GFIS Duration Checklist. The goal of list is to answer the specific question: "what should we watch to maintain a below-benchmark duration stance in the U.S. and core Europe?" The items in the Checklist are shown in Table 1, broken down into the following groupings: Table 1Stay Bearish On Treasuries & Bunds A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Accelerating Global Growth: Here, we are looking at indicators that are pointing to a quickening pace of global economic growth that would put upward pressure on all developed market bond yields. Specifically, we are looking to see if: a) the annual growth in the global leading economic indicator (LEI) is accelerating; b) our diffusion index for the global LEI is above 50 (suggesting a majority of countries with an expanding LEI) and rising; c) the global ZEW economic sentiment index is increasing; d) the global data surprise index is moving higher; and e) our measure of the global credit impulse (the 6-month change in credit growth among the major economies, one of BCA's favorite leading economic signals) is expanding. These global indicators are all shown in Chart 2. The global LEI growth rate, the global ZEW index and global data surprises are all moving higher, consistent with upward pressure on bond yields, and thus warrant a "check" in our GFIS Duration Checklist. The LEI diffusion index is well above 50, but has hooked down slightly in the past few months, as has the global credit impulse. These moves are relatively modest, and it is not yet certain whether they represent a change in trend in these series. For now, we are giving these indicators a "check", but with a question mark attached. If we see additional declines in the diffusion index and the global credit impulse in the next few months, we would interpret that as a sign that the cyclical global upturn is in danger of losing momentum, thus reducing the upward pressure on bond yields. Accelerating Domestic Growth: These are economic data that are specific to each country that would be consistent with higher yields; a) manufacturing purchasing managers' indices (PMIs) that are above 50 and rising; b) expanding consumer confidence; c) rising business confidence; d) faster growth in corporate profits. The relevant data for the U.S. are shown in Chart 3, which shows that all elements are increasing in a fashion that is bearish for U.S. Treasuries. The popular perception is that the recent surge in business confidence (both for corporate CEOs and small business owners) is simply a "Trump effect" from the new president's pro-business economic platform. However, the acceleration in corporate profit growth, which our own models are suggesting will continue in the coming quarters, is a sign that there is a more fundamental reason for firms to feel more optimistic. Chart 2Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Chart 3U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid We give all the U.S. domestic growth indicators a "check" pointing to a need to stay below-benchmark U.S. duration. The specific Euro Area growth data is shown in Chart 4. Similar to the U.S., all the indicators are moving higher in a bond-bearish direction, warranting a "check" on the Euro Area Duration Checklist. The political tensions stemming from the busy election calendar in Europe this year represent a potential negative shock to confidence. As we discussed in our Special Report published last week, however, we do not foresee a populist election shock in France akin to Brexit or Trump that would derail the Euro Area economic expansion.1 Rising Domestic Inflation Pressures: These are data that are specific to each country that would be consistent with faster inflation and higher yields: a) the annual growth in the oil price, in local currency terms, is accelerating; b) wage inflation is rising; c) the unemployment gap (the difference between the unemployment rate and the full employment NAIRU rate) is closed or nearly closed; The U.S. inflation data is shown in Chart 5, with all the indicators warranting a bond-bearish "check" in our U.S. Duration Checklist. The rising trend in oil prices continues to put upward pressure on headline U.S. inflation, even with the strong U.S. dollar. Meanwhile, the unemployment gap is now closed and U.S. wage inflation is grinding higher. This should be consistent with additional modest gains in core inflation that will put upward pressure on the inflation expectations component of U.S. Treasury yields (bottom panel). Chart 4Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Chart 5U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs It is a different story in the Euro Area, as can be seen in Chart 6. While the rapid acceleration in the Euro-denominated price of oil is starting to feed through into faster headline inflation, there still exists a positive unemployment gap that is helping keep wage growth, and core inflation, muted. A continuation of the recent economic upturn will likely put more downward pressure on Euro Area unemployment, but, for now, only the oil price acceleration justifies a "check" in the Euro Area Duration Checklist. Chart 6Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Central Bank Policy Stance: Here, we are not including any charts, but are only stating whether the central bank has a bias to tighten monetary policy. That is certainly the case in the U.S., where the Fed has already delivered a 25bp hike in December and continues to signal that up to three more hikes will occur in 2017 if the FOMC growth forecasts are realized. So we put a "check" in this box on the U.S. side of the checklist. The European Central Bank (ECB) continues to maintain an unusually accommodative monetary stance, using a combination of asset purchases, negative policy rates and dovish forward guidance. We continue to see a potential shift away from this super-easy policy bias in the latter half of the year - in response to the upturn in economic growth and acceleration of Euro Area inflation towards the ECB's 2% target - as the biggest risk for both Euro Area bonds, in particular, and global bonds, in general. For now, however, the ECB is signaling no imminent shift to a more hawkish stance, so we are placing an "x" in the central bank portion of the Euro Area checklist. Risk-Seeking Behavior In Financial Markets: Here, we are checking to see if pro-growth, pro-risk asset classes are outperforming and whether market volatilities are rising. Risk asset outperformance and stable vol suggests that investors are less interested in risk-free government bonds: a) the domestic equity index is rising but is not yet 10% above the 200-day moving average (a level that has coincided with post-crisis equity market and bond yield peaks); b) domestic corporate bond spreads are either flat or falling rapidly; c) domestic equity market volatility is low and falling rapidly. The U.S. indicators are shown in Chart 7, while the Euro Area data is shown in Chart 8. The story is the same in both regions, with equity markets in a bullish trend but not yet at a fully-stretched extreme, credit spreads (both for Investment Grade and High-Yield) tight, and equity market volatility at multi-year lows. We view these indicators as signs that investors are less interested in owning U.S. Treasuries and German Bunds than owning equities and corporate debt. This will help bond yields drift higher on the margin as economic growth and inflation rise in the coming months. Thus, we place a "check" on all three elements in both the U.S. and Euro Area Duration Checklists. Chart 7Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Chart 8Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Contrarians may look at those same charts and say that this is more of a sign that investors are too optimistic and are now exposed to any negative growth shock, potentially representing a trigger for a selloff of risk assets and a move into government debt. We prefer to view the bullish performance of growth-sensitive assets as a sign of underlying investor risk appetite. Domestic Bond Market Technicals: Here, we are simply looking at measures of price momentum and market positioning in government bonds, to assess if there is room for additional yield increases as investors reduce exposure: a) the domestic 10-year bond yield is not stretched to the upside versus the 200-day moving average; b) the domestic Treasury index total return momentum (26-week rate of change) is not stretched to the downside; c) bond investor positioning is not already short. The 10-year U.S. Treasury technicals are shown in Chart 9, while the German Bund technicals are shown in Chart 10. The story is quite simple here - the rapid run-up in global bond yields late last year has led to stretched, oversold conditions on both sides of the Atlantic. Sentiment remains bearish in U.S. Treasuries, with massive net shorts in bond futures, suggesting that an overhang of positions remains a major headwind to higher yields. While we do not have positioning data for Euro Area bond investors, the momentum charts for German Bunds look very similar to the U.S. Treasury charts. Clearly, we must place an "x" in all these boxes on both Duration Checklists. Chart 9Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Chart 10...And In German Bunds ...And In German Bunds ...And In German Bunds So What Are The Checklists Telling Us? Adding it all up, and the vast majority of the indicators in both checklists are pointing to continued upward pressure on bond yields, justifying a below-benchmark duration stance. The lack of core inflation pressure in the Euro Area, however, suggests that there is less upward pressure on German Bund yields relative to U.S. Treasuries, thus we continue to recommend an overweight stance on Bunds versus Treasuries in global hedged bond portfolios. Oversold conditions suggest that yields will have a tough time rising quickly from here while the market continues to consolidate the late 2016 bond selloff. However, a major bond market reversal is unlikely given the solid upturn in global growth. Bottom Line: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. Maintain a below-benchmark portfolio duration stance in the near term, favoring German Bunds over U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Our View On French Government Bonds", dated February 7, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights In this report, we outline our tactical, cyclical and long term views on French government bonds, linked to France's political situation, cyclical dynamics, and structural outlook. Tactical View: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds. Cyclical View: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Secular View: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Feature Chart 1Fade The France Spread Widening Fade The France Spread Widening Fade The France Spread Widening After the stunning political victories in the U.K. and U.S. last year, there has been considerable speculation as to which country will fall next to the "populist wave." With a major political party aiming to take the country out of the Euro Area, France has naturally popped up on investors' radar screens. While it is easy to draw a parallel from Brexit to Trump to a possible "Frexit", the political and economic realities in France are very different from those in the U.K. and U.S. The upcoming presidential election will not provide a similar surprise, but could impact the economy's long trajectory. Meanwhile, this economy should beat expectations in the next twelve months. In this Special Report, we lay out our views on France from a political, cyclical and structural perspective and introduce two French bond trade ideas to benefit in the short and medium term. Tactical View: No Political Shocker Ahead In the short term (3-6 months), the domestic political landscape will dictate a large part of France's bond market price action leading up to the two-round French presidential election in April and May. Lately, political uncertainty surrounding the election has had a clear negative impact on French government bond yields (Chart 1). The spread between the benchmark 10-year French OAT and German Bund has widened 46bps off of the 2016 lows and is now close to levels seen during the Global Financial Crisis in 2008-9. The spread is still well below the wides seen during the European debt crisis in 2011-12, when markets were pricing in a serious Eurozone break-up risk. The current more moderate level seems reasonable to us, as a significantly wider spread to compensate for the political risk of a potential "Frexit" is not required, given the long odds of a Trump/Brexit-like upset victory. Last week, our colleagues at the BCA Geopolitical Strategy and Foreign Exchange Strategy services published a joint Special Report updating their view on the election, and concluded that Le Pen's odds of victory now stand at 15%.1 Either Francois Fillon (who is currently embroiled in a corruption scandal) or Emanuel Macron will win the French presidency, both of whom are running on structural reform platforms that should be market friendly. Moreover, Marine Le Pen has only a long-shot possibility to win the French presidential election, for several reasons:2 Assuming Le Pen becomes one of the final two candidates in the run-off election after the first round of voting in April, her probability of winning is low, as she continues to trail her centrist opponents by a massive 20% in the polls. That lead would have to fall to 3-5%, within the margin of error of the polling data, before investors would have to worry seriously about a Le Pen victory. Le Pen's personal approval rating peaked in 2012 (Chart 2). It fell despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, all of which should have helped boost her popularity. The problem for Le Pen is that 70% of the French support the euro (bottom panel), and she is running on an explicit campaign promise to try and pull France out of the euro if she wins the presidency. Leaving the euro area would mean a redenomination cost for Baby Boomer retirees, higher interest rates, higher inflation, and a likely economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks. Given BCA's relatively sanguine view of the true political risks of the French election, the recent spread widening represents a tactical trade opportunity to go the other way and position for French outperformance. A Le Pen defeat will cause French policy uncertainty to recede and French bond yields will converge back to German levels. Vanishing uncertainty and lower bond yields will further fuel the current economic recovery, as explained in the next section. Bottom Line: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds on a tactical basis (a trade we are adding to our Overlay Trades list on Page 20). Cyclical View: An Outperforming Economy Over the medium-term (6 to 12 months), the cyclical dynamics of French growth and inflation, as well as potential shifts in Euro Area monetary policy, will drive the evolution of French bond yields. On this basis, there is room for French yields to rise in absolute terms. Current pricing in the French forward curve has the 10-year government bond yield reaching 1.40% by the end of 2017, up 26bps from the current level. That yield target will be easily exceeded based on the budding upturns in French economic growth and inflation. A low growth hurdle to overcome The Bloomberg survey of economists currently pencils in a French GDP growth forecast of 1.3% in 2017, almost unchanged from 1.2% in 2016. That figure should be surpassed, in our view. The current situation component of the French ZEW economic sentiment survey has spiked recently but still sits far from previous peaks (Chart 3). As this unfinished economic cycle progresses, growth will drift inevitably higher. Chart 2Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Chart 3An Un-finished Cycle An Un-finished Cycle An Un-finished Cycle More specifically, the business sector could positively surprise in 2017. Business sentiment and industrial production already started to hook upward toward the end of 2016, and the December surge in the French Manufacturing PMI signals that the economy is accelerating. Even the previously lagging French service sector PMI has now caught up to the Euro Area average (Chart 4). This upturn looks very well supported. Firms' order books have been replenished, and corporations are now in a position to hike prices, indicating that pricing power has returned (Chart 5). This is a crucial development, it will allow for further increases in corporate profit margins, and, in turn, give them some leeway to lift wages, hire more workers and/or invest anew. Chart 4A Solid Economic Upturn A Solid Economic Upturn A Solid Economic Upturn Chart 5Improving Business Sector Outlook Improving Business Sector Outlook Improving Business Sector Outlook Moreover, business cycle dynamics should then boost consumption. An improving labor market has already translated into confidence-building momentum among households. Consumers' disposable income growth has risen steadily, while households' intentions to make important purchases have reached levels not seen since before the Global Financial Crisis (Chart 6). Also, labor slack is diminishing in France, with the number of job seekers falling for the first time in a decade (bottom panel). If French households remain upbeat, the broader economy should do well. Historically, the INSEE survey of households' assessment of the future economic situation has been closely linked to GDP growth. Advancing that series by three months clearly shows that France's growth is set to accelerate. Using a simple regression, growth could reach a 1.7% year-over-year pace in the first half of 2017 (Chart 7). Chart 6Better Fundamentals For French Consumers Better Fundamentals For French Consumers Better Fundamentals For French Consumers Chart 7GDP Will Beat Expectations GDP Will Beat Expectations GDP Will Beat Expectations One note of caution on this optimistic French economic outlook comes from capital spending. The elevated political uncertainties from the upcoming election, as well as the potential U.K.-E.U. Brexit negotiations, have left French firms less inclined to expand business through increased investments. However, robust activity in the housing market should support overall gross fixed capital formation, as housing permits sprang to life in 2016 (Chart 8). To ensure that this economic expansion gains momentum, ample credit growth will be paramount. This could be a potential headwind, as France's non-financial private sector credit has reached high levels, especially compared to its European peers (Chart 9). These excesses could act as a speed limit on the overall economy, at some point. Chart 8Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Chart 9Private Non-Financial Leverage: High Private Non-Financial Leverage: High Private Non-Financial Leverage: High However, in the current cycle, this doesn't seem to be the case. Both money and loan growth are accelerating after several years of weakness (Chart 10, top panel). The ECB's Bank Lending Survey, which shows slowly increasing demand for credit (middle panel) and no tightening of lending standards (bottom panel) will help fuel this trend.3 The central bank's loose overall monetary stance will keep this positive credit impulse alive over the course of the year, while also helping exports by keeping the Euro weak. Finally, on the fiscal side, the IMF projects France's cyclically-adjusted primary budget balance to go from -0.6% of potential GDP in 2016 to -0.7% in 2017, representing a fiscal thrust of +0.1% (Chart 11). This modest number will obviously not supercharge the current cycle, but does represent a big change from the years of austerity since the last recession. Chart 10A Positive Credit Impulse A Positive Credit Impulse A Positive Credit Impulse Chart 11No More Austerity No More Austerity No More Austerity Building inflationary pressure The Bloomberg consensus forecast calls for French consumer price inflation to reach 1.2% in 2017, a modest advance from the current rate of 0.7%. That level should be reached, and likely surpassed, as most inflation measures have already entered an expansionary phase (Chart 12). That trend should persist in 2017 for several reasons: First, French unemployment will soon fall below the non-accelerating inflation rate of unemployment (NAIRU), which typically results in a rise in French underlying CPI inflation soon afterward (Chart 13). Chart 12Inflation Moving Higher Inflation Moving Higher Inflation Moving Higher Chart 13France Is Close To Full Employment France Is Close To Full Employment France Is Close To Full Employment Second, current French inflation appears about half a percentage point too low relative to the unemployment rate, based on the Phillips curve relationship since 2000 (Chart 14). Chart 14Inflation Should Be Higher Our Views On French Government Bonds Our Views On French Government Bonds Third, our French CPI diffusion index is well off the cyclical lows and points towards higher underlying inflation in the months ahead (Chart 15).4 In sum, French inflation will follow, and likely exceed, the current consensus expectation of 1.2%. This is important to appreciate, as inflation was a more important driver of higher nominal bond yields, relative to the real yield component, last year (Chart 15, bottom two panels). There is more to come in 2017. How to position for this view? In terms of valuation, French government bonds still appear quite expensive. Our bond valuation indicator shows that yields remain well below fair value, even after the recent backup (Chart 16). Combine this with our optimistic view on French growth and inflation, and investors should move to reduce duration within the French component of hedged global bond portfolios. Today, we open a new position in our model fixed income portfolio: reducing the exposure in the longest duration (+10 years) bucket in France, and placing the proceeds in the 1-3 year France bucket. This combination will lower our overall French duration exposure by one full year. If yields finish the year higher than currently priced on the forward curve, as we expect, this position will contribute positively to the excess return versus our benchmark. Bottom Line: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher this year. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Chart 15Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Chart 16French Bonds: Still Expensive French Bonds: Still Expensive French Bonds: Still Expensive Secular View: A Structural Ceiling On French Yields In the very long run (5 to 10 years), structural considerations are needed to forecast bond yields. Ten years ago, the French forward yield curve was implicitly forecasting that the 10-year French bond yield would be close to 4% today. Currently standing at 1.13%, the market missed the mark by 287bps! The forwards are now priced for the 10-year bond yield to reach 2.84% in ten years, possibly making the same mistake of over-estimating future bond yields. To gauge a fair value of the 10-year bond yield, using nominal potential GDP growth has proved to be useful in the past. From 2004 to 2014, and before the deflationary shock experienced since, France's 10-year bond yield was indeed trading very close to growth in French nominal potential GDP (Chart 17, shaded portion). Chart 17Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields As inflation will most likely return to more "normal" levels in the next few years, the relationship between the two should be reestablished soon. If so, the current 2.84% level on the 10-year French government bond yield, 10-years forward should translate to a nominal potential growth rate of around 2.8% in ten years' time (Chart 17). This outcome would represent an 80bp increase in the rate of trend French nominal potential growth from current levels, which could be difficult to achieve, in our view. Lots of work to do... Most likely, France's nominal potential growth will only slowly grind lower. Faster potential growth could be achieved either through increasing demographic growth or improving productivity. Unfortunately, neither outcome appears imminent. Since the French working age population is already expanding at a very slow pace, and is projected to decelerate in the years ahead, productivity increases are the only candidate to improve potential growth. On that front, a lot needs to be done; many structural weaknesses in the French economy have to be addressed. For years, France has been plagued by weak productivity, which has constrained growth. Compared to its European peers, inefficient use of available capital has led to a loss of competitiveness through higher unit labor costs. Clearly, France needs to improve workers' skills to lift total factor productivity growth (Chart 18). This will become increasingly difficult as France now faces - more than ever - difficulty attracting and retaining talent due to the recent turmoil that has hit the country such as the terrible rise in terrorist attacks. At the source, the poor productivity performance in France is grounded in the overly protective employment system. Like other European countries, high employment costs have led to misallocation of capital, potentially affecting the optimal capital labor input mix and total factor productivity.5 Indeed, friction in the labor market is often cited as the source of the problem. We tend to agree. French workers work too few hours, even fewer than in the Peripheral European economies. As the divide between the unemployment rate of persons under and over 25 years old gets larger, resolving the growing generational disparities has become paramount. Plus, upward mobility opportunities are scant - not everyone gets an equal chance to rise in status in French society (Chart 19). Chart 18Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Chart 19Friction In The Labor Market Friction In The Labor Market Friction In The Labor Market Recent reforms have the potential to fix some problems. The Pacte de Responsabilité et Solidarité (PRS) and the Crédit d'impôt compétitivité emploi (CICE) should help reduce unit labor costs through a reduced labor tax wedge.6 The Macron Law could raise real GDP growth by 0.3 percent per year through 2020, according to the OECD. However, the effectiveness might be fleeting in some other cases. For example, studies by the IMF suggest that the El Khomri Law - aimed at making the labor market more flexible - might have little impact on overall French unemployment, potentially reducing it by only 0.14 percentage points.7 Meanwhile, France's enormous public sector continues to crowd out the private sector. At 54% of GDP, government expenditures are simply too big, forcing the government to tax profits at a whopping 63% rate. This leaves little space for national savings - which now sit at a lowly 21.4% of GDP - to increase (Chart 20). Additionally, France ranks 115th out 136 countries in the Global Competitiveness Report in terms of the burden of government regulation, which further constrains productivity-enhancing investments.8 In sum, boosting potential GDP growth will remain an uphill battle. Everyone agrees that reforms are necessary. But will they happen? ...and France still has a tough crowd to win over It is not impossible that the next president will have a serious structural reform agenda. For example, the most reformist presidential contender, Francois Fillon, has made these proposals in his campaign platform: Abandon the national limit on weekly hours worked and leave that decision to individual companies; Decrease corporate taxation; Allow companies to fire employees when undergoing structural/managerial changes; Extend the retirement age; Cut public spending; Reduce the size of the state by cutting government employees. From a structural perspective, these measures would surely be promising for the future, and would lift French potential GDP growth over time. However, in the populist world we live in, we are skeptical that the electorate will give him an unambiguous mandate of this sort. That kind of mandate usually comes after a crisis, not before. More pain might be needed. Chart 20France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector Chart 21"Silent Majority" Wants Reform Our Views On French Government Bonds Our Views On French Government Bonds Moreover, reforming France has always proved very challenging. As such, will Mr. Fillon (or Mr. Macron) really be able to comply with his campaign promises, if elected? Winning a majority at the parliamentary election would be a necessary precondition. Although every President has been given a parliamentary majority since 2002, the elections have not happened yet. Confronting the unions on these measures will prove difficult for the next French president. The latest labor market reform push unveiled last year was met with massive resistance. Surely, deregulation that makes it easier to fire workers will inevitably dissatisfy insiders that benefit from high barriers to entry for new employees. This obstacle will be difficult to remove. In any case, it has always been puzzling why things have to be this way in France. According to economists Yann Algan and Pierre Cahuc, one possible response might lie in the French tendency to distrust their fellow citizen. Their theory, introduced more than ten years ago, posits the following: ...the French people's lack of trust gets in the way of their ability to cooperate, which brings the State to regulate work relations in minute detail. By emptying social dialogue of its content, these interventions prevent the adoption of favorable reforms to improve the function of the job market. Distrust even induces a fear of competition, leading to the set-up of regulatory barriers-to-entry, that create rent-seeking which favors corruption and mutual distrust. The French social model fosters a truly vicious circle. Corporatism and state intervention undermine the mechanisms of solidarity, destroy social dialogue and reinforce mutual distrust - that which in turn feeds categorical demands and the constant call for regulation, and thereby favors the expansion of corporatism and state intervention.9 Of course, their angle on things could sound somewhat extreme. But it might also explain why the issues discussed ten or twenty years ago concerning France's predicament remain mostly the same today. There might be something else besides pure rational thinking at play behind the French citizenry's propensity to stiff-arm reforms. Nonetheless, if these authors are correct, true changes will continue to be hard to come by in France. Meaning this invisible hand of distrust will continue to lead potential GDP growth lower, and, as history dictates, will represent a ceiling on how high long-term French bond yields can ever rise. That said, maybe our view could prove to be too backward looking. The new report co-written by our Geopolitical Strategy and Foreign Exchange Strategy teams takes a more optimistic view on the chances of French economic reform. They argue that France's recent economic underperformance will motivate its citizens to demand real action from their politicians, as occurred in Australia during the mid-1980s and 1990s and Germany in the 2000s - episodes of real structural reform occurring without any dramatic crisis to prompt them. A desire to compete with Germany economically, combined with government spending excesses and protest fatigue, could be leading France to elect a pro-reform government. As the French polling data shows, there is a "silent majority" in France that would favor supply side reforms (Chart 21). Plus, even those that traditionally favor the status quo, like "blue collar" and "left leaning" employees, are opposing reforms by extremely narrow margins. Undoubtedly, our colleagues raise very good points. As such, we will be watchful to see if reforms gain a greater chance of meaningfully transforming France in the next few years. The onus will be on the reformers to change the system. Bottom Line: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/Foreign Exchange Strategy Special Report, "The French Revolution", dated February 3, 2017, available at gps.bcaresearch.com and fes.bcaresearch.com 2 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?", dated November 16, 2016, available at gps.bcaresearch.com 3 https://www.ecb.europa.eu/stats/pdf/blssurvey_201701.pdf?6c44eff3bac4b858969b9cb71bd4a8fa 4 The diffusion index is the percentage of sectors within the French Consumer Price Index that are growing faster than their 24-month moving average. This indicator leads underlying inflation by 10 months. 5 For further details on this idea, please see "Employment Protection Legislation, Capital Investment and Access to Credit: Evidence from Italy", available at https://ideas.repec.org/p/sef/csefwp/337.html 6 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44080.0 7 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44081. 8 http://www3.weforum.org/docs GCR2016-2017/05FullReport TheGlobalCompetitivenessReport2016-2017_FINAL.pdf 9 http://voxeu.org/article/france-price-suspicion and more on these authors theory on the impact of trust on economic development can be found here: http://econ.sciences-po.fr/sites/default/files/file/yann%20algan/HB_FinalVersion1.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Views On French Government Bonds Our Views On French Government Bonds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature The FX Market has a strange way of proving everyone wrong. Currently, we are finding ourselves uncomfortable with our cyclically bullish stance on the dollar as it has become a consensus view. A review of the rationale and risks to our view is in order. To begin with, let's review valuations. The dollar is overvalued by 8% at the current juncture. However, this overvaluation is still much more limited than the overvaluation of 22% registered in 1985 and of 17.7% recorded in 2002 (Chart I-1). Chart I-1Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive Dollar Is Not Cheap, Yet It Can Get More Expensive This has two implications. First, we have always considered valuations as the ultimate measure of sentiment. After all, it is a reflection of how much people are willing to pay for an asset or currency, and therefore, how optimistically they view the prospects for that asset/currency. The USD's overvaluation being limited compared to previous instances suggests that investors' love affair with the greenback has yet to reach the exuberant heights reached in 1985 and 2002. In fact, at this point in time, the U.S. basic balance has improved considerably, especially vis-à-vis the euro area (Chart I-2). This suggests that investors are finding more attractive investments in the U.S. than in the euro area, and that so far, the strong dollar has not had a deleterious enough effect to hurt the perceived long-term earning power of the U.S. This can continue to weigh on EUR/USD, lifting DXY in the process. Second, the dollar has yet to represent the same drag on the U.S. economy that it did at its previous peaks. It is true that U.S. potential GDP growth is now lower than previously, dragged down by both lower labor force growth and lower trend productivity growth. However, manufacturing represents a much smaller share of employment than in these two instances, suggesting that the labor market should prove more robust in the face of the strong USD (Chart I-3). Chart I-2Basic Balance Dynamics Have ##br##Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Basic Balance Dynamics Have Favored The USD Until Now Chart I-3The U.S. Dwindling ##br##Manufacturing Employment The U.S. Dwindling Manufacturing Employment The U.S. Dwindling Manufacturing Employment Thus, we continue to expect that the ongoing labor market tightening can run further. With the amount of slack in that market having now vanished, we are disposed to expect a quickening in wage growth in the coming quarters (Chart I-4). Additionally, we expect the U.S. labor market to promote a virtuous circle for the economy. As the job market tightens, wages and salary as a share of the economy rise. This skews the income distribution away from the top 1% of households - families who derive more than 50% of their incomes from profits, rents, and proprietors' incomes - toward the middle class. This redistribution effect should support consumption: middle class and poor households have marginal propensities to spend ranging between 90% and 100% while rich families have a marginal propensity to spend of around 60% Not only does household consumption represent nearly 70% of the U.S. economy, but also 70% of this consumption goes toward services. Services are principally domestically sourced and are a sector of the economy where productivity is hard to come by. As a result, we expect the boost in household consumption to be a key mechanism that will support employment and wage growth. Additionally, the strength of wages and salaries as a share of gross national income, coupled with the high degree of consumer confidence, could be a harbinger of a revival in capex. Historically, when these two measures of household health are behaving as they currently do, investment in the economy increases (Chart I-5). A few factors can explain this relationship: First, this strength in households boosts residential investment; Second, it also gives confidence to the business sector that final domestic demand is durable, a key factor boosting domestic producers willingness to invest; Third, the boost to residential investment lifts investment in the sectors of the economy linked to consumer durable goods. Moreover, the stabilization of U.S. profits, along with the narrowing of U.S. corporate spreads have boosted the capex intentions of businesses, a move that began even before Trump won the election. This has historically been a reliable leading indicator of both capex and the overall business cycle (Chart I-5). Chart I-4A Tight Labor Market ##br##Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... The Labor Market Is Tight A Tight Labor Market Will Support Households... Chart I-5...And Households Support ##br##Domestic Businesses ...And Households Support Domestic Businesses ...And Households Support Domestic Businesses With U.S. trend GDP growth having fallen, lower growth is needed than in prior cycles to absorb the slack in the economy. In fact, our composite capacity utilization gauge currently shows an absence of slack (Chart I-6). Any further acceleration of growth would move the economy into "no slack" territory, an environment that has historically coincided with protracted Fed tightening campaigns. Chart I-6If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken If The Fed Doesn't Heed The Message From Capacity Utilization, The Dollar Will Weaken However, if the Fed does let capacity move much above its constraint and does not react as much as it ought to, the inflationary outcome created by such a move would be devastating for the dollar: Rapidly rising U.S. price levels would hamper the USD's long-term PPP fair value; The process would also result in falling U.S. real yields, especially vis-à-vis nations with more signs of excess capacity, like the euro area, pushing down the greenback from a real interest-rate parity perspective; The easy Fed policy would ease global liquidity conditions, creating a shot in the arm for the global economy and EM in particular. Historically, an accelerating global economy hurts the dollar. We remain with the view that the Fed is unlikely to let such an outcome materialize. Yellen has gone out of her way to highlight that generating a "high-pressure" economy in the U.S. was a dangerous outcome that the FOMC wanted to avoid. In fact, the potential for Trump's fiscal stimulus, whenever it may be enacted, only raises the likelihood that the Fed leans against the inflationary under-current created by dissipating economic slack. The second risk to the dollar is the growing talk of a new Plaza Accord in the U.S. At this point, with Trump attacking China, the EU, and in fact, most trading partners, we think that the likelihood of moral suasion achieving its goal is low. However, we want to study this topic in more detail before coming to definitive conclusion. So where does this leave us with regard to our original discomfort with standing in the middle of the crowd? We continue to expect the dollar cycle to expand. However, we expect that the correction that begun after the December Fed meeting could run further before exhausting itself. This would be the key mechanism through which the stale longs that are accumulating will get shaken off. In fact, the current push-back against Trump by the political establishment, from both the republicans and the bureaucratic apparatus could raise doubts on Trump's ultimate capacity to achieve his fiscal policy goals. While we expect that these doubts will stay just that, doubts, and that Trump will ultimately make stimulus into law, this period of questioning could be enough to hurt a dollar still too loved by investors. Bottom Line: We are finding ourselves in the middle of the consensus with our cyclical dollar-bullish stance. However, U.S. economic fundamentals are still firmly bullish for the dollar and valuations are not yet potent enough to prompt the end of the dollar bull market. Short AUD/NZD After a long hiatus, inflation is making a comeback in New Zealand. Last week, inflation numbers for Q4 came in at 1.3%, marking the first time since 2014 that it exceeded 1%. This has significant implications for the RBNZ, given that persistently low inflation was the shackle that kept its dovish bias in place. As inflation starts to creep up, this should put upward pressure in rates and lift the NZD. Chart I-7Domestic Factor Points Will Help ##br##The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Domestic Factor Points Will Help The Kiwi Outperform The Aussie Nevertheless, we are reticent to buy NZD/USD outright, as the dollar bull market should continue to weigh on the kiwi as well as on other commodity currencies. Instead we are expressing our view by shorting AUD/NZD. The outlook for these Oceanian countries could not be more different. New Zealand has been the best performing economy in the G10 with real GDP rising by 3.5% and employment growing at a staggering 6% pace, the highest level of the last 23 years. Meanwhile, Australia's real GDP growth has slowed down to 1.7% while employment growth is currently in negative territory. This contrast in economic performance is likely to dramatically increase inflationary pressures in New Zealand relatively to Australia, particularly if one considers that New Zealand's economy is growing at 2% above potential GDP while Australia's output gap is far from closed. Furthermore, growing divergences in housing and stock prices are also pointing to a widening in rate differentials (Chart I-7). These factors along with inflation should push kiwi rates up vis-à-vis Australian rates, and consequently weigh on AUD/NZD. The outlook for New Zealand's and Australia's main commodities (dairy products and iron ore respectively) also points to further downside in this cross. As previously highlighted, a weakening Chinese industrial sector and a tightening of global dollar liquidity should translate to an underperformance of base metals in the commodity space, given that China consumes roughly half of the world's industrial metals and that these commodities are highly sensitive to EM liquidity conditions. Meanwhile, although China is also the main consumer of dairy products, prices should hold up thanks to the recent loosening in the "One child" policy, which should increase demand for baby formula.1 This view is not without risks. The all-time low for AUD/NZD of 1.02 is not that far away, and could likely provide significant support to this cross. Indeed, one could argue that much of the widening in rate differentials is probably already priced in the cross. However, the difference in overnight rates between the central banks of these countries is a measly 25 basis points (with roughly another 25 basis points priced by the market until the end of 2017). Given the stark difference between the outlooks for these two economies we believe further widening could be warranted. Moreover, while it is true that the recent disappointment in kiwi unemployment numbers might provide fuel for the doves in the RBNZ for a bit longer, the markets have already reacted accordingly, with AUD/NZD rallying sharply since. Thus, we think that this recent rally provides a good entry point to short this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "The OPEC Debate", dated November 24, 2016, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The FOMC held the federal funds rate at 0.75%, as expected. The Committee highlighted that the economy is growing "at a moderate pace", also as expected. The labor market, consumer and business sentiment, and household spending all are improving. It is also expected that this trend continues and eventually leads to their 2% inflation target. Unlike the other G10 central banks, the FOMC sees near-term risks to the economic outlook as "roughly balanced", which may warrant a greenlight for their planned hikes. ISM Prices Paid, Manufacturing PMI, and the change in employment all beat expectations, confirming the economy's healthy path. The dollar will likely display limited movements, according to both seasonality and the economy developing as expected, and will likely remain relatively weak, in wait of fiscal policy information. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic activity within the common market this week was mixed, however the overall euro area is accelerating: Confidence indicators (consumer, services, overall economic, and industrial) beat expectations across the board; Annual GDP growth outperformed at 1.8%; Unemployment came at better than expected at 9.6%; Most importantly, inflation was recorded at 1.8% - more or less in line with the ECB target. Nevertheless, core inflation remains at 0.9%, which is corroborated by the mixed performance of the major euro states - Germany, in particular, performed relatively poorly. The European Commission upgraded their forecasts for GDP, unemployment and inflation, however, highlighted that risks can emanate from emerging markets and the U.S, affecting financial markets and global trade. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data continues to show indications of a recovery in the Japanese economy: The jobs/applicants ratio beat expectations, and now stands at 1.43 The contraction in spending seems to be receding, with overall household spending falling by 0.3% vs a 1.5% contraction in November. December industrial production also outperformed expectations, growing by 0.5%. In their latest monetary policy report the BoJ took into account the good economic data that we have been highlighting as they have raised their forecast in GDP growth going forward. This should not be taken as a sign that the BoJ is starting to back off from its radical policies, as they project that inflation will reach 2% in 2018 (the target, as we have mentioned before lies above this level). Thus, the cyclical outlook for the yen remains bearish. Report Links: Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 In their monetary policy meeting yesterday, the BoE decided to keep their policy rate unchanged. While it is true that they raised their inflation forecast for the short term, they also decreased their forecast for inflation for the long term compared to their last meeting. More importantly they adjusted their equilibrium unemployment rate to 4.5% from 5%, a development which makes the BoE more dovish than otherwise. Markets have taken notice of this, as the pound has depreciated against all major currencies. Despite this development we continue to have a bullish bias towards the pound, as we still believe that both the BoE and the market are overestimating the negative effects that Brexit can have on the British economy. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Just as the dollar began to correct, AUD displayed an upbeat performance, appreciating 6.75% since then. The weak dollar has helped commodity prices rally, iron and copper prices have appreciated in anticipation of U.S. infrastructure spending, Chinese Manufacturing PMI beat expectations, and the trade balance also outperformed expectations. While it is possible that a weak dollar can help alleviate much of the pressure off AUD, we remain obstinate on the fundamental weakness of the AUD. The Australian economy is still haunted by the mining industry slump, with the labor market feeling much of the pain. As mentioned before, a longer-term bull market in the dollar, and Trump's expected policies, can have very adverse effects on EM, global growth, global trade, and thus commodity currencies. AUD is also approaching overbought RSI-levels, as well as an important resistance level, and is likely to see some downside soon. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 On Tuesday unemployment came in at 5.2%, significantly above the market expectation of 4.8%. This caused the NZD to fall off, particularly against its crosses. However we believe that the bullish story for the NZD is still intact. Immigration continues to increase, with visitor arrivals increasing by 11% YoY. This should continue to add fuel to the stellar kiwi economy. On the commodity side, in spite of a slowdown, dairy prices continue to grow at an astonishing 47% YoY pace. Moreover the relative robustness of dairy prices to EM liquidity conditions should help the NZD outperform the AUD, as base metals are more likely to bear the brunt of a shortage in EM liquidity triggered by a rising dollar. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 On Tuesday, USD/CAD fell below 1.30 for the first time since September, breaking through an important trend line, displaying newfound strength on the back of a weak greenback. As the USD continues its corrective phase, the strong CAD could hurt Canadian exports in the near future. Canada's exports represent 25% of its GDP, and 77% of its exports are to the U.S. An implementation of the Border-Adjustment Tax could have adverse consequences for this export-oriented economy. Although this tax will likely be bullish for the greenback, Trump has emphasized his view on the excessively strong dollar. The recent GDP monthly figure of 0.4% beat consensus due to the improving domestic economy. However, the aforementioned points can be a very real threat to this improvement, and should be monitored closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 After falling to an 18-month low, below 1.065, EUR/CHF has once again rallied and is now close to reaching 1.07. This is the third time that our recommendation of buying this cross whenever it falls below the crucial 1.07 level proves successful. We continue to reiterate that whenever EUR/CHF approaches this level, the SBN will not be shy to intervene, as a strong franc would accentuate the deflationary pressures that plague the Swiss economy. Recent data has been disappointing, and one should expect that the SNB will be more overzealous in its management of the franc: The KOF leading indicator stood at 101.7, falling from the previous month and underperforming expectations. SVME Manufacturing PMI also fell short of expectations and fell relative to November. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 This week, the Norwegian Krone built on its stellar 2017 rally. Indeed, USD/NOK has fallen by almost 5% since the start of the year. This rally in the krone has been particularly surprising, as it has happened in an environment where oil prices have stayed relatively flat. Thus, If OPEC cuts start to cause significant inventory drawdowns, the NOK could rally much further. Additionally it is worth reminding that Norwegian inflation is a unique case in the G10, as it is the only country which has an inflation level above their central bank target. A breaking point will eventually come, where the Norges Bank will have to choose between backing off their dovish bias and letting inflation run amok. Thus, we will continue to monitor inflation in Norway closely. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Sweden's economy continues to show strength. Producer prices increased at a 6.5% yearly pace, and a 2.1% monthly pace; Consumer confidence increased to 104.6 from last month's 103.2; Manufacturing PMI increased to 62; The monthly trade balance is positive for the first time since August. The data paints a positive picture of the economy: improving inflation, high consumer confidence, and a healthy industrial and export sector. Sweden's future for its exports seems hopeful on the back of an increasing manufacturing PMI and the lagged effects of a weak SEK. Additionally, Sweden is unlikely to be majorly affected by U.S. protectionism. Exports to the U.S. only account for 2% of GDP, and 7.7% of overall exports, whereas exports to the euro area account for 11% of GDP and 40.6% of exports. The risk of a strong SEK will be limited as the Riksbank monitors its pace of strength, and the USD will eventually resume its appreciation. Report Links: Outlook: 2017's Greatest Hits -December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Synchronized Global Growth... Synchronized Global Growth... Chart 2...Is Lifting Inflation Expectations ...Is Lifting Inflation Expectations ...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Fed Most Likely On Hold Until June Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à-vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Gold Hedges Inflation And USD Risk As Well As Oil, With Lower Volatility Gold Hedges Inflation And USD Risk As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Oil And Gold Vol Likely Rise Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Gold Will Perform... Gold Will Perform...

Table 1Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession One Year On From A Mini Recession One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through China's Reflation Still Coming Through China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Euro Hasn't Weakened Much Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High The Percentage Of The Euro Area Population In Work Is Near An All-Time High The Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend Euro Area Labour Participation Is In A Strong Uptrend Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Italy And Greece Are The Laggards, But Even They Are Making Progess Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Apples For Apples: Little Difference In Euro Area And U.S. Headline Inflation... Apples For Apples: Little Difference In Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation ...Or Core Inflation ...Or Core Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. House Price Inflation Is Now Identical In The Euro Area And U.S. House Price Inflation Is Now Identical In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Owner Occupied Housing Inflation Follows House Price Inflation Owner Occupied Housing Inflation Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Inflation Expectations Move Together In The Euro Area And U.S. Inflation Expectations Move Together In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long NOK/RUB Long NOK/RUB * 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 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. 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-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights U.S. policy uncertainty has increased again early in the New Year. President Trump's inaugural speech highlighted that he has not tempered his "America First" policy prescription. The Trump/GOP agenda is still a moving target, but three key risks have emerged for financial markets. A border tax could see a 10% rise in the U.S. dollar. It would also be bearish for global bonds and EM stocks. Position accordingly. Second, President Trump has his sights on China. U.S. presidents face few constraints on the trade and foreign policy side. Investors seem to be under-appreciating the risk of a trade war. Third, the plan to slash Federal government spending could completely offset the fiscal stimulus stemming from the proposed tax cuts and infrastructure spending. The good news is that the major countries, including China, appear to have entered a synchronized growth acceleration. There is more to the equity market rally than a "sugar high". The global profit recession is over and the rebound has been even more impressive than we predicted. As long as any U.S. protectionist policies do not derail the growth acceleration, corporate EPS in the major countries should rival (traditionally overly-optimistic) bottom-up expectations in 2017. The Fed will hike three times this year, one more than is discounted. The Bank of Japan will continue to target a 10-year JGB yield of 0%, but the ECB will begin hinting at another taper in the fall. Our bond team tactically took profits on a short-duration position, but expect to move back to below-benchmark duration before long. The U.S. policy backdrop is very fluid but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine U.S. growth (our base case), then stocks will beat bonds by a wide margin. Investors should consider long VIX positions, but add to equity exposure on dips. Feature It has become a cliché to describe the economic and financial market outlook as "unusually uncertain". Since 2007, investors have had to deal with rolling financial crises, deleveraging, recession, deflation pressures, quantitative easing, negative interest rates, re-regulation, a collapse in oil prices and Brexit. Chart I-1Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Now, there is Donald Trump. The new President's inaugural speech highlighted that he has not tempered his "America First" policy prescription. Protectionism, de-regulation and tax reform are high on the agenda but details are scant, leaving investors with very little visibility. There are many policy proposals floating around that have conflicting potential effects on financial markets. Which ones will actually be pursued and how will they be prioritized? Is the U.S. prepared to fight a trade war? Is a border tax likely? Will President Trump push for a "Plaza Accord" deal with China? Even the prospect for fiscal stimulus is a moving target because the Trump Administration is reportedly considering a plan to slash Federal spending by $10 trillion over the next decade! Some have described the global equity rally as just a "sugar high" that will soon fade. No doubt, some of the potentially growth-enhancing parts of the Trump agenda have been discounted in risk assets. Given the highly uncertain policy backdrop, it would be easy to recommend that investors err on the side of caution if the U.S. and global economies were still stuck in the mud. The level of the S&P 500 appears elevated based on its relationship with the policy uncertainty index (shown inverted in Chart I-1). Nonetheless, what complicates matters is that there is more to the equity rally than simply hope. Both growth and profits are surprising to the upside in what appears to be a synchronized global upturn. If one could take U.S. policy uncertainty out of the equation, risk assets are in an economic sweet spot where the deflation threat is waning, but inflation is not enough of a threat to warrant removing the monetary punchbowl. Indeed, the Fed will proceed cautiously and official bond purchases will continue through the year in Japan and the Eurozone. We begin this month's Overview with two key protectionist policies being considered that could have important market implications. We then turn to the good news on the economic and earnings front. The conclusion is that we remain positive on risk assets and bearish bonds on a 6-12 month investment horizon. It will likely be a rough ride, but investors should use equity pullbacks to add exposure. Protectionism Risk #1 A U.S. border tax has suddenly emerged on the U.S. policy program. More formally, it is called a destination-based cash flow tax. Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference the between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred the U.S.). The mechanics are fairly complicated and we encourage interested clients to read a Special Report on the topic from BCA's Global Investment Strategy service.1 The result would be a significant increase in taxes on imported goods and a reduction in taxes paid by exporters. One benefit is that the border tax would generate a large amount of revenue for the Treasury, which could be used to offset the cost of corporate tax cuts. Another benefit is that the tax change would eliminate the use of international "transfer pricing" strategies that allow American companies to avoid paying tax. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field! In reality, there are reasons to believe that the dollar's adjustment would not be fully offsetting. First, much depends on how the Fed responds. Second, some central banks would take steps to limit the dollar's ascent. To the extent that the dollar did not rise by the full amount (25% in our example), then the border tax would boost exports and curtail imports. The resulting tailwind for U.S. growth would eventually be reflected in higher inflation to the extent that the economy is already near full employment. The result is that a border tax would be bullish the dollar and bearish for bonds. Our base case is that a 20% border tax would lift the dollar by about 10% over a 12-month period, above and beyond our current forecast of a 5% gain. The 10-year Treasury yield could reach 3% in this scenario. Subjectively, we assign a 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. It appears that investors are underestimating the likelihood that the U.S. proceeds with this new tax, suggesting that the risks to the dollar and bond yields are to the upside. This is another reason to underweight U.S. bonds relative to Bunds on a currency-hedged basis. For stocks, any growth boost from the border tax would benefit corporate profits, at least until the Fed responded with a faster pace of rate hikes. It is another story for EM equities as a shrinking U.S. trade deficit implies less demand for EM products and shrinking international dollar liquidity. A border tax could be seen as the first volley in a global trade war, souring investor sentiment towards EM stocks. Another major upleg in the U.S. dollar could also spark a financial crisis in some EM countries with current account deficits and substantial dollar-denominated debt. Protectionism Risk #2 Chart I-2Trade War Risk Is Elevated Trade War Risk Is Elevated Trade War Risk Is Elevated While President Trump wants a smaller trade deficit generally, he has his sights on China because of the elevated U.S. bilateral trade deficit (Chart I-2). His choices for Commerce Secretary, National Trade Council and U.S. Trade Representative are all China critics. U.S. presidents face few constraints on the trade and foreign policy side. He can order tariffs on specific goods, or even impose a surcharge on all dutiable goods, as Nixon did in 1971. Congress is unlikely to be a stumbling block. Trump's election was a signal that the U.S. populace wants protectionist policies. His electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. We expect the Trump Administration to give a largely symbolic "shot across China's bow" in the first 100 days, setting the stage for formal trade negotiations in the subsequent months. The initial shot will likely rattle markets. A calming period will follow, but this will only give a false sense of security. The U.S. is in a relatively good negotiating position because China's exports to the U.S. are much larger than U.S. exports to China. However, tensions over the "One China" policy and international access to the South China Sea will greatly complicate the trade negotiations. The bottom line is that there is little hope that U.S./China relations will proceed smoothly.2 A long position in the VIX is prudent given that the market does not appear to be adequately discounting the possibility of a trade war. Synchronized Global Growth Upturn While the U.S. policy backdrop has become more problematic for investors, the global economic and profit picture has brightened considerably. We were predicting a pickup in global growth before last November's election based on our leading indicators and the ebbing of some headwinds that had weighed on economic activity early in 2016. As expected, the manufacturing sector is bouncing back after a protracted inventory destocking phase. The stabilization in commodity prices has given some relief to emerging market manufacturers. The drag on global growth from capex cuts in the energy patch is moderating even though the level of capital spending will contract again in 2017. Moreover, the aggregate fiscal thrust for the advanced economies turned positive in 2016 for the first time in six years. The major countries, including China, appear to have entered a synchronized growth acceleration. The pick-up is confirmed by recent data on industrial production, purchasing managers' surveys and the ZEW survey (Chart I-3). The global ZEW composite has been a good indicator for world earnings revisions and the global stock-to-bond return ratio. The synchronized uptick in global coincident and leading economic data, including business and consumer confidence, suggests that there is more going on than a simple post-election euphoria. Euro Area sentiment measures hooked up at the end of 2016 and the acceleration in growth appears to be broadly based (Chart I-4). A simple model based on the PMI suggests that Eurozone growth could be as much as 2% this year, which is well above trend. Chart I-3Positive Global Indicators bca.bca_mp_2017_02_01_s1_c3 bca.bca_mp_2017_02_01_s1_c3 Chart I-4Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates While Japan will not be a major contributor to overall global growth given its well-known structural economic impediments, the most recent data reveal a slight uptick in consumer confidence, business confidence and the leading economic indicator (Chart I-5). We have noted the impressive rebound in China's leading and coincident growth indicators for some time. Some indicators are consistent with real GDP growth well in excess of the 6.7% official growth figure for 2016 Q4. Both the OECD leading indicator and our proprietary GDP growth model are calling for faster growth in 2017 (Chart I-6). A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny picture. Nonetheless, given what we know about the underlying economy at the moment, China looks poised to deliver another year of solid growth. Chart I-5Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Chart I-6Upside Risk To China's Growth Upside Risk To China's Growth Upside Risk To China's Growth In the U.S., President Trump appears to be stirring long-dormant animal spirits. CEOs are much more upbeat and several regional Fed surveys indicate a surge in investment intentions (Chart I-7). Spending on capital goods has the potential to soar given the historical relationship with the survey data shown in Chart I-8 (the caveat being that Congress will need to deliver). Even the long depressed small business sector is suddenly more optimistic. The December reading of the NFIB survey showed a spike in confidence, with capital expenditures, hiring plans and overall optimism returning to levels not seen in this expansion. Chart I-7Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Chart I-8...Which Will Spark Capital Spending ...Which Will Spark Capital Spending ...Which Will Spark Capital Spending There is a good chance that a deal between the White House and Congress on tax reform will occur in the first half of 2017, including a major tax windfall for the business sector that would boost the after-tax rate of return on equity. Nonetheless, past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer demand is on the upswing. In other words, consumers need to move first. On that score, a number of cyclical tailwinds have aligned for household spending. Credit scores have largely been repaired since the recession and income growth is on track to accelerate (Chart I-9). Despite a moderation in monthly payrolls, overall income growth is likely to stay perky, now that wage gains are on an upward path. And, importantly, various surveys highlight an improvement over the past year in consumer confidence about long-term job prospects. The propensity to spend rather than save is higher when households feel secure in their jobs. Chart I-10 highlights that the saving rate tends to decline when confidence is elevated. The wealth effect from previous equity and housing price gains has been a tailwind for some time but, until now, consumers have held back because it seemed to many that the recession had never ended. Chart I-9Share Of Home Mortgage Borrowers ##br##Who Recovered Pre-Delinquency Credit Score After Foreclosure February 2017 February 2017 Chart I-10Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend In other words, there are increasing signs that the scar tissue from the Great Recession is finally fading, at a time when tax cuts are on the way. We expect that U.S. real GDP growth will be in the 2½-3% range this year with risks to the upside, as long as the Trump Administration does not start a trade war that undermines confidence. Corporate Earnings Liftoff Chart I-11Profits Are Bouncing Back Profits Are Bouncing Back Profits Are Bouncing Back The good news on the economy carries over to corporate earnings. The profit recession is over and the rebound has been even more impressive than we predicted (Chart I-11). Eurozone EPS "went vertical" near the end of 2016. Blended S&P 500 Q4 bottom-up estimates reveal a huge increase in EPS last year to $109 (4-quarter trailing), providing an 8.5% growth rate for 2016 as a whole. The 4-quarter trailing growth figure will likely surge again to 16% in 2017 Q1, even if the sequential EPS figure is flat. Some of the growth acceleration is technical, reflecting a particularly sharp drop in profits at the end of 2015 (which will eventually fall out of the annual growth calculation). Of course, a spike in energy earnings on the back of higher oil prices made a major contribution to the overall growth rate, but there is more to it than that. Consumer Discretionary, Financials and Health Care all posted solid earnings figures last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is benefiting from favorable comparisons. Dollar strength has pushed the U.S. earnings revisions ratio slightly into negative territory, while revisions have surged into positive terrain in the other major markets (Chart I-12). The sharp upturn in our short-term EPS indicators corroborates the more upbeat earnings outlook for at least the next few months (Chart I-13). Chart I-12Earnings Revisions Earnings Revisions Earnings Revisions Chart I-13Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Our medium-term profit models also paint a constructive picture for equities. These are top-down macro models that include oil prices, exchange rates, industrial production (to capture top-line dynamics), and the difference between nominal GDP and labor compensation (to capture margin effects). Given our more optimistic economic view, the model forecasts for 2017 EPS growth have been revised higher for the global aggregate and each of the major developed markets (Chart I-14). The U.S. is tricky because of the impact of comparison effects that will add volatility to the quarterly growth profile as we move through the year. We are now calling for a 10% gain for 2017 as a whole, which is just shy of the roughly 12% increase expected by bottom-up analysts. This is impressive because actual market expectations are typically well below the perennially-optimistic bottom-up estimates. A 10% EPS growth figure might seem overly optimistic in light of the dollar appreciation that has occurred since last November. Some CEOs will no doubt guide down 2017 estimates during the current earning season. However, in terms of EPS growth, the annual change in the dollar matters more than its level. Chart I-15 shows that the year-over-year rate of change in the dollar is moderating despite the recent rise in the level. This is reflected in a diminishing dollar drag on EPS growth as estimated by our model (bottom panel in Chart I-15). We highlighted in the December 2016 monthly report that it does not require a major growth acceleration to overwhelm the negative impact of a rising dollar on earnings. Chart I-14Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Chart I-15Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS The models for Japan and the Eurozone point to 2017 EPS growth in the mid-teens. Both are roughly in line with bottom-up estimates which, if confirmed this year, would be quite bullish for stock indexes. Keep in mind that these projections do not include our base case forecast that the U.S. dollar will appreciate by another 5% this year (more if a border tax is enacted). Incorporating a 5% dollar appreciation would trim U.S. EPS growth by 1 percentage point and add the same amount to profit growth in Japan and the Eurozone. The bottom line is that we expect corporate profits to be constructive for global bourses this year. Within an overweight allocation to equities in the advanced economies, we continue to favor the European and Japanese markets versus the U.S. As we discussed in the 2017 Outlook, political risks in the Eurozone are overblown. Currency movements and relative monetary policies will work against U.S. stocks on a relative (currency hedged) basis. FOMC: Hawks Gradually Winning The Debate Fed officials are in a state of quandary over how the policies of the incoming Administration will affect the growth and inflation outlook. Nevertheless, the last FOMC Minutes confirmed that the consensus on the Committee is still shifting in a less dovish/more hawkish direction. The tone of the discussion was decidedly upbeat, especially on the manufacturing and capital spending outlook. "Most" of the meeting participants felt that the U.S. economy has reached full employment, although there is still an ongoing debate on the benefits and costs of allowing the unemployment rate to temporarily move below estimates of full employment. Running the economy "hot" for a while might draw more discouraged workers back into the workforce and thereby expand the supply side of the economy. Other members, however, highlight that past attempts by the Fed to fine tune the economy in this way have always ended in recession. Our view is that the FOMC will not follow the Bank of Japan's example and explicitly target a temporary inflation overshoot. Conversely, the Fed will not attempt to pre-emptively offset any forthcoming fiscal stimulus either (if indeed there is any net fiscal stimulus). Policymakers will watch the labor market and, especially, wage and price inflation to guide them on the appropriate pace of rate hikes. Core PCE inflation is roughly 30 basis points below target and has only edged erratically higher over the past year. The pickup in shelter inflation has been largely offset by falling core goods prices, reflecting previous dollar strength. We expect shelter inflation to soon flatten off, but goods prices will continue to contract if the dollar rises by another 5% this year. Year-ago comparison effects will also depress the annual rate of change over the next couple of months. However, the key to the underlying inflation trend will be wage pressures, which are most highly correlated with the non-shelter part of the service component. Up until recently, the structural and cyclical forces acting on wage gains were pulling in the same downward direction. Structural factors include automation and population aging; as high-paid older workers leave the workforce, the vast majority of new entrants to full-time employment do so at below-median wages, putting downward pressure on median earnings growth.3 These structural factors will not disappear anytime soon, but the cyclical forces have clearly shifted. The main measures of U.S. wage growth are all trending higher. Excess labor market slack appears to have been largely absorbed. Only the number of people working part time for economic reasons suggests that there is some residual slack remaining. To what extent will cyclical wage pressures exert upward pressure on inflation? That will depend on the ability of companies to raise prices in order to protect profit margins. Wage inflation trends do not lead, and sometimes diverge from, inflation in goods and services. Theory suggests that there is a two-way relationship between wages and prices. Sometimes inflation starts in the labor market and spills over into consumer prices (cost-push inflation), and sometimes it is the other way around (demand-pull inflation). At the moment, the corporate sector appears to have limited ability to pass on rising wage costs. Balancing off the opposing factors, we believe that core PCE inflation will grind higher and should be near the 2% target by year end. This would end the Fed's debate over whether to run the economy hot, helping to keep upward pressure on Treasury yields. Bond Bear To Return Chart I-16Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Global yields troughed a full four months before the U.S. election. As discussed above, the U.S. and global economies were showing signs of increased vigor even before Trump won the Presidency. The new President's policies reinforce the bond-bearish backdrop, especially protectionism and fiscal stimulus, at a time when the economy is already near full employment. Long-term inflation expectations imbedded in bond yields have shifted up in recent months across the major markets. Real yields have been volatile, but generally have not changed much from late last year. We remain modest bond bears over a 6-12 month horizon. Inflation and inflation expectations will continue to grind higher in the major markets and we expect the FOMC to deliver three rate hikes in 2017, one more than is discounted in the Treasury market. A rise in 10-year TIPS breakevens into a range that is consistent with the Fed's 2% inflation target (2.4%-2.5% based on history) would be a strong signal that the Fed will soon lift the 'dot plot.' ECB bond purchases will limit the increases in the real component of core European yields, but any additional weakness in the euro would result in a rise in European inflation. The ECB was able to announce a tapering of monthly purchases last year while avoiding a bond rout by extending the QE program to the end of 2017, but this will be more difficult to pull off again if inflation is on the rise and growth remains above-trend this year. We expect the ECB to provide hints in September that it will further taper its QE program early in 2018. Thus, the Eurozone bond market could take over from U.S. Treasurys as the main driver of the global bond bear market late in 2017. The Japanese economy is also performing impressively well, reducing the probability of a "helicopter drop" policy. The dollar's surge has depressed the yen and lifted inflation expectations, relieving some pressure on PM Abe to ramp up fiscal spending beyond what is already included in the supplementary budgets. In any event, the BoJ will keep the 10-year yield pinned near to zero, limiting the upside for bond yields to some extent in the other major bond markets. That said, we are neutral on JGBs, not overweight, because most of the yield curve is in negative territory. We remain overweight Bunds versus both Treasurys and JGBs on a currency-hedged basis. In terms of the duration call, our bond strategists felt in early December that the global bond selloff had progressed too far, too fast (Chart I-16). They recommended temporarily taking profits on short-duration positons and shifting to benchmark, which turned out to be excellent timing. Yields have drifted lower since then and the technicals have improved enough to warrant shifting back to below-benchmark duration. Investment Conclusions Chart I-17A Better Growth ##br##Backdrop For USD Strength A Better Growth Backdrop For USD Strength A Better Growth Backdrop For USD Strength Equity markets have gone into a holding pattern as investors weigh heightened U.S. policy risk against the improving profit and global macro backdrop. The latter appears to have broken the Fed policy loop that had been in place for some time. Expectations for a less dovish Fed helped to drive the dollar and Treasury yields higher late in 2016. But, rather than sparking a correction in risk assets as has been the case in recent years, stock indexes surged to new highs (Chart I-17). The difference this time is that there has been a meaningful improvement in the growth and profit outlook that has overwhelmed the negative impact of a stronger dollar and higher borrowing rates. The protectionist policies currently being considered are clearly dollar bullish, and bearish for global bonds and EM stocks. Investors should be positioned accordingly. It is more complicated for stocks. The passing of a major tax reform package would no doubt buttress the budding revival in private sector animal spirits, but a nasty trade war has the potential to do the opposite. The multitude of policy proposals floating around greatly complicate asset allocation. It is a very fluid situation but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine global growth (our base case), then corporate earnings growth will be solid in 2017 and stocks will beat bonds by a wide margin. We wish to be clear, though, that equities are on the expensive side in most of the main markets. This means that overweighting equities and underweighting cash and bonds in a balanced global portfolio is essentially playing an equity overshoot. It may end badly, but the overshoot is likely to persist for as long as the economic and profit upswing persists. Investors should consider long VIX positions, but add to equity exposure on dips. Our view on corporate bonds is unchanged this month. Poor value and deteriorating corporate balance sheet health make it difficult to recommend anything more than a benchmark position in the U.S. relative to Treasurys. However, investors can pick up a little spread in the Eurozone corporate bond market, where balance sheet health is better and the ECB is soaking up supply. Mark McClellan Senior Vice President The Bank Credit Analyst January 26, 2017 Next Report: February 23, 2017 1 U.S. Border Adjustment Tax: A Potential Monster Issue for 2017. BCA Global Investment Strategy service, January 20, 2017. 2 For more information, please see: Trump, Day one: Let the Trade War Begin. BCA Geopolitical Strategy Weekly Report, January 18, 2017. 3 For more information in the structural and cyclical wage pressures, please see: U.S. Wage Growth: Paid in Full? U.S. Investment Strategy Service, November 28, 2016. II. Global Debt Titanic Collides With Fed Iceberg? The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. The "cash flow" effect on debt service is a headwind for growth as rising interest payments trim the cash available to spend on goods and services. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will be so severe this time that it will quickly derail the economic expansion. However, a number of factors make projecting interest payments complicated, such that back-of-the-envelope estimates are quite misleading. In order to provide a sense of the size of the cash-flow effect, in this Special Report we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100 basis points from today's levels. It would require a 300 basis point jump to really "move the dial". Interest rate shocks are more dramatic for the Japanese government interest burden due to the size of the JGB debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. We are not downplaying the risks posed by the rapid accumulation of debt since the Great Recession. Rather, our aim is to provide investors with a sense of the debt-service implications of a further rise in borrowing rates. Our main point is that the cash-flow effect of higher interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Investors are justifiably worried that the bond selloff will get ahead of itself, spark an economic setback and a corresponding flight out of risk assets. After all, there have been several head fakes during this recovery during which rising bond yields on the back of improving data and optimism were followed by an economic soft patch and a risk-off phase in financial markets. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. Indeed, global debt has swollen by 41½ percentage points of GDP since 2007 (Chart II-1). Households, corporations and governments tried to deleverage simultaneously to varying degrees in the major countries since the Great Recession and Financial Crisis, but few have been successful. Households in the U.S., U.K., Spain and Ireland have managed to reduce the level of debt relative to income. U.K. and Japanese corporations are also less geared today relative to 2007. Outside of these areas, leverage has generally increased in the private and public sectors (see Chart II-2 and the Appendix Charts beginning on page 37). The astonishing pile-up of debt in China has been particularly alarming for the investment community (Chart II-3). Chart II-1Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Chart II-2Leverage In Advanced Economies Leverage In Advanced Economies Leverage In Advanced Economies Chart II-3China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up Governments can be excused to some extent for continuing to run fiscal deficits because automatic stabilizers require extra spending on social programs when unemployment is high. Fiscal policy was forced to at least partially offset the drain on aggregate demand from private sector deleveraging, or risk a replay of the Great Depression. More generally, history shows that it is extremely difficult for any one sector or country to deleverage when other sectors and countries are doing the same. The slow rate of nominal income growth makes the job that much harder. Borrowing Rates And The Economy There are several ways in which higher borrowing rates can affect the economy. Households will be incentivized to save rather than spend at the margin. Borrowing costs surpass hurdle rates for new investment projects, causing the business sector to trim capital spending. Uncertainty associated with rising rates might also undermine confidence for both households and firms, reinforcing the negative impact on demand. Banks, fearing a growth slowdown ahead and rising delinquencies, may tighten lending standards and thereby limit credit availability. These negative forces are normally a headwind for growth, but not something that outweighs the positive Keynesian dynamics of rising wages, profits and employment until real borrowing rates reach high levels. However, if the neutral or "equilibrium" level of interest rate is still extremely low today, then it may not require much of a rise in market rates to tip the economy over. A lot depends on confidence, which has been quite fragile in the post-Lehman world. The "cash flow" effect on debt service is another headwind for growth as rising interest payments trim the cash available to spend on goods and services. For the government sector, a swelling interest burden will add to the budget deficit and may place pressure on the fiscal authorities to cut back on spending in other areas. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will quickly derail the expansion in the U.S. and potentially in other countries as the Treasury market selloff drags up yields across the global bond market. This is an argument that has circulated at the beginning of every Fed tightening cycle as far back as we can remember. Some even predict that central banks will be forced to use financial repression for an extended period to prevent the interest burden from skyrocketing and thereby short-circuiting the economic expansion. Back-of-the-envelope estimates that simply apply a 100 or 200 basis point increase in borrowing rates to the level of outstanding debt, for example, imply a shocking rise in the debt service burdens. Fed rate hikes could be analogous to the iceberg that took down the Titanic in 1912. Key Drivers Of Interest Sensitivity However, back-of-the-envelope calculations like the one described above paint an overly pessimistic picture for three reasons. First, the starting point for debt service burdens in the corporate, household and government sectors is low (Chart II-4). These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China.1 Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years (Chart II-5). The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5-years and more in some countries. Households have been extending the maturity structure of their debt in recent decades (Chart II-5, bottom panel). Chart II-4Debt Service Has Generally Declined Debt Service Has Generally Declined Debt Service Has Generally Declined Chart II-5Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100 basis points in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). In this Special Report, we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. We could not include China in this month's analysis because data limitations precluded any degree of accuracy, but the sheer size of China's debt mountain justifies continued research in this area. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates rise immediately by 100 basis points from today's levels. It would require a 300 basis point rise in yield curves to really "move the dial" in terms of the cash-flow impact on spending. An interest rate shock of that size would be particularly dramatic for the Japanese government interest burden given the size of its debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. Consumer Sector U.S. households have worked hard at deleveraging since their net worth was devastated by the housing bust. Still, the overall debt-to-income level is elevated by historical standards. U.S. household leverage has generally trended higher since the Second World War and has been a source of angst for investors as far back as the late 1950s. Yet, we find no evidence that U.S. consumers have become more sensitive to changes in borrowing rates over the decades.2 This counter-intuitive result partially reflects the fact that consumers have partially insulated themselves from rising interest rates by adopting a greater proportion of fixed-rate debt. The bottom panel of Chart II-6 presents the two-year change in debt service payments expressed as a percent of income (i.e. the swing or the "cash flow" effect). The fact that these swings have not grown over time suggest that the cash-flow effect of changes in interest rates on debt service has not increased.3 Chart II-6U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates Another way to demonstrate this point is to compare disposable income growth with a measure of "discretionary" disposable income that subtracts debt service payments (Chart II-6, top panel). This is the amount of money left over after debt servicing to purchase goods and services. The annual rate of growth in disposable income and discretionary income are nearly identical. In other words, growth in spending power is determined almost exclusively by changes in the components of income (wages, hours and employment). Moreover, the fact that some households are net receivers of interest income provides some offset to rising interest payments for other households when rates go up. This conclusion applies to households in the other major countries as well. Charts II-7 to II-10 present projections for household interest payments as a percent of GDP under three scenarios: no change in yield curves, an immediate 100 basis point parallel shift up in the yield curve and a 300 basis point shift. Assuming an immediate increase in yields across the curve is overly blunt, but the scenarios are only meant to provide a sense of how much interest payments could rise on a medium-term horizon (say, one to five years). The exact timing is less important. Chart II-7U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection Chart II-8U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection Chart II-9Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Chart II-10Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Unsurprisingly, household interest payments as a fraction of GDP are flat-to-slightly lower in "no change" interest rate scenario for the major countries. The interest burden increases by roughly 1 percentage point in the 100 basis point shock, although the level remains well below the pre-Lehman peak in the U.S., U.K. and Eurozone. In Japan, the interest payments ratio returns to levels last seen in the late 1990s, although this is not particularly onerous. A 300 basis point shock would see interest burdens ramp up to near, or above, the pre-Lehman peak in all economies except in the U.K. For the latter, borrowing rates would still be below the 2007 peak even if they rise by 300 basis points from current levels. This scenario would see the household interest burden surge well above 3% of GDP in Japan, a level that exceeds the entire history of the Japanese series back to the early 1990s. Also shown in the bottom panel of Chart II-7, Chart II-8, Chart II-9, Chart II-10 is the associated 2-year swing in interest expense as a percent of GDP under the three scenarios. The 2-year swing moves into positive (i.e. restrictive) territory for all economies under the 100 basis point shock, although they remain in line with previous monetary tightening cycles. It is only for the 300 basis point scenario that the cash-flow effect appears threatening in terms of consumer spending power over the next two years. Corporate Sector The starting point for interest payments and overall debt-service in the corporate sector is also quite low by historical standards, although less so in the U.S. Falling interest rates have been partially offset by the rapid accumulation of American company debt in recent years. We modeled national accounts data for non-financial corporate interest paid using the stock of corporate bonds, loans and (where relevant) commercial paper, together with the associated interest or coupon rates. The model simply sums interest payments across these types of debt to generate a grand total, after accounting for the maturity structure of the loans and debt. Chart II-11, Chart II-12, Chart II-13 and Chart II-14 present the three yield curve scenarios for corporate interest payments. The interest burden is flat-to-somewhat lower if yield curves are unchanged, as old loans and bonds continue to roll over at today's depressed levels. Even if market yields jump by 100 basis points tomorrow, the resulting interest burdens would rise roughly back to 2012-2014 levels in the U.S., Eurozone and the U.K., which would still be quite low by historical standards. The resulting two-year cash-flow effect is modest overall. The rate increase feeds into corporate interest payments somewhat more quickly in the Eurozone and Japan because of the relatively shorter average maturity of the corporate debt market, but a shock of this size does not appear threatening to either economy. Chart II-11U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection Chart II-12U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection Chart II-13Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Chart II-14Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection It is a different story if yields rise by 300 basis points. The interest ratio approaches previous peaks set in the 2000s in the U.S. and Eurozone. The interest ratio rises sharply for the U.K. corporate sector as well, although it stays below the 2000 peak because interest rates were even higher 17 years ago. Japanese companies would also feel significant pain as the interest ratio rises back to where it was in the late 1990s. Government Sector Government finances are not at much risk from a modest increase in bond yields either (Chart II-15). We focus on the level of the interest burden rather than the cash-flow effect for the government sector since changes in interest payments probably have less impact on governments' near-term spending plans than is the case for the private sector. Chart II-15Government Sector Interest Payment Projection Government Sector Interest Payment Projection Government Sector Interest Payment Projection As discussed above, Treasury departments in the U.K., Eurozone and Japan have taken advantage of ultra-low borrowing rates by extending the average maturity of public debt. The average maturity of the Barclays U.K. government bond index has extended to 16 years, while it is close to 10 years in Japan and the Eurozone (Chart II-5). The U.S. Treasury has not followed suit; the Barclays U.S. index is about 7½ years in maturity. The lengthy average maturity means that index coupon rates will continue to fall for years to come if rates are unchanged in the U.K., Japan and the Eurozone, resulting in a declining interest burden. Even if rates rise by another 100 basis points, the interest burden is roughly flat as a percent of GDP for the U.K. and Eurozone, and rises only modestly in Japan. The limited impact reflects the fact that the starting point for current yields is well below the average coupon on the stock of government debt. In contrast, the U.S. interest burden is roughly flat in the "no change" scenario, and rises by a half percentage point by 2025 in the 100 basis point shock scenario. Keep in mind that we took the neutral assumption that the stock of government debt grows at the same pace as nominal GDP growth. This assumes that governments deal effectively with the impact of aging populations on entitlement programs in the coming years. As many studies have shown, debt levels will balloon if entitlements are not adjusted and/or taxes are not raised to cover rising health care and pension costs. We do not wish to downplay this long-term risk, but we are focused on the impact of higher interest rates on interest expense over the next five years for the purposes of this Special Report. As with the household and corporate sectors, the pain becomes much more serious in the event of a 300 basis point rise in interest rates. Interest payments rise by about 1 percentage point of GDP in the U.S. and U.K. to high levels by historically standards. It takes a decade for the full effect to unfold, although the ratios rise quickly in the early years as the short-term debt adjusts rapidly to the higher rate environment. For the Eurozone, the roughly 100 basis points rise takes the level of the interest burden back to about 2003 levels (i.e. it does not exceed the previous peak). Given Japan's extremely high government debt-to-GDP ratio, it is not surprising that a 300 basis point rise in interest rates would generate a whopping surge in the interest burden from near zero to almost 5% of GDP by the middle of the next decade. Nonetheless, this paints an overly pessimistic picture for two reasons. First, the Bank of Japan is likely to hold short-term rates close to zero for years as the authorities struggle to reach the 2% inflation target. This means that only long-term JGB yields have room to move higher in the event of a continued global bond selloff. Second, 40% of the JGB market is held by the central bank and this proportion will continue to rise until the Bank of Japan's QE program ends. Interest paid to the BoJ simply flows back to the Ministry of Finance. The net interest payments data used in our analysis are provided by the OECD. These data net out interest payments made between all arms of the government except for the central bank. The implication is that rising global bond yields in the coming years will not place the Japanese government under any fiscal strain. The same is true in the U.S., U.K. and Eurozone, where the respective central banks also hold a large portion of the stock of government debt (although this conclusion does not necessarily apply to the peripheral European governments). Conclusion The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs given the sea of debt that has accumulated. As discussed in our 2017 BCA Outlook, we believe that the secular bond bull market is over but foresee only a gradual uptrend in yields in the coming years. Inflation is likely to remain subdued in the major countries and bond supply will continue to be absorbed by the ECB and Bank of Japan. The stock of government bonds available to the private sector will drop by $750 billion in 2017 for the U.S., Eurozone, Japan and the U.K. as a group. This follows a contraction of $546 billion in 2016. Forward guidance from the BoJ and ECB will also help to cap the upside for global bond yields. Still, we believe that the combination of gradually rising U.S. inflation, Fed rate hikes and the Trump fiscal stimulus plan will push Treasury yields above current forward rates in 2017. Other bond markets will outperform in local currency terms, but will suffer losses via contagion from the U.S. Despite the dizzying amount of debt accumulated since the Great Recession, it does not appear that debt service will sink the economies of the advanced economies as the Fed continues to normalize U.S. monetary policy. Debt service will rise from a low starting point and the swing in interest payments as a percent of GDP is unlikely to exceed previous cycles on a 2-year horizon for a 100 basis point rise in yields. The level of the interest payments/GDP ratio should not exceed previous peaks in most cases. The picture is much more threatening if yields were to surge by 300 basis points over the next couple of years, although this scenario would require an unexpected acceleration of inflation in the U.S. and/or the other advanced economies. We are not making the case that the buildup of debt is benign. Academic research has linked excessive leverage with slower trend economic growth and a higher risk of financial crisis. For governments, elevated debt can result in a rising risk premium that will crowd out spending in important areas, such as health and pensions, in the long run. For consumers and the corporate sector, excessive leverage could result in financial distress and a spike in defaults in the next downturn, reinforcing the contraction in output. The Bank for International Settlements agrees: "Increased household indebtedness, in and of itself, is not likely to be the source of a negative shock to the economy. Rather the primary macroeconomic implication of higher debt levels will be to amplify shocks to the economy coming from other sources, particularly those that affect household incomes, most notably rises in unemployment." 4 Debt lies at the heart of BCA's longstanding Debt Supercycle thesis. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness for monetary policy. During times of economic and/or financial stress, it was relatively easy for the Fed and other central banks to improve the situation by engineering a new credit upcycle. That all ended with the 2007-09 meltdown. Since then, even zero policy rates have been unable to trigger a strong revival in private credit growth in the major developed countries because the starting point for leverage is already elevated. Growth headwinds finally appear to be ebbing, at least in the U.S., prompting the FOMC to begin the process of "normalizing" short-term interest rates. The U.S. economy could suffer another setback in 2017 for a number of reasons. Nonetheless, the key point of this report is that the cash-flow effect of rising interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Mark McClellan Senior Vice President The Bank Credit Analyst 1 For China, the BIS only provides an estimate of the debt service ratio for the household and non-financial corporate sectors combined. 2 See: U.S. Consumer Titanic Meets the Fed Iceberg? The BCA U.S. Fixed Income Analyst, July 2004. 3 The absence of a rise in volatility of the cash flow effect is partly due to the decline in, and the volatility of, interest rates after the 1980s. 4 Guy Debelle, "Household Debt and the Macroeconomy," BIS Quarterly Review, March 2004. Appendix Charts Chart II-16, Chart II-17, Chart II-18, Chart II-19 Chart II-16U.S. Debt By Sector U.S. Debt By Sector U.S. Debt By Sector Chart II-17U.K. Debt By Sector U.K. Debt By Sector U.K. Debt By Sector Chart II-18Japan Debt By Sector Japan Debt By Sector Japan Debt By Sector Chart II-19Euro Area Debt By Sector Euro Area Debt By Sector Euro Area Debt By Sector III. Indicators And Reference Charts Global equities have been in a holding pattern so far in 2017, consolidating the gains made at the end of last year. Our key equity indicators are mixed at the moment. The Valuation indicator continues to hover at about a half standard deviation on the expensive side. The effect of the rise in global equity indexes late last year on valuation was offset by a surge in profits. Stocks are not cheap but, at this level, valuation not a roadblock to further price gains. Our Monetary indicator deteriorated further over the past couple of months, driven by a stronger dollar and higher bond yields. A shift in this indicator below the zero line would be negative for stock markets. Sentiment is also frothy, which is bearish from a contrary perspective, although our Technical indicator is positive. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have all turned higher from a low level for the Japanese, the European and the U.S. markets. This suggests that investors, after loading up on bonds last year, have "dry powder" available to buy stocks as risk tolerance improves. The U.S. WTP has risen the fastest and is closing in on the 0.95 level. Our tests show that, historically, investors would have reaped impressive gains if they had over-weighted stocks versus bonds when the WTP was rising and reached 0.95. The WTPs suggest that the U.S. market should outperform the Eurozone and Japanese markets in the near term, although for macro reasons we still believe the U.S. will lag the other two. We expect the global stock-to-bond total return ratio to rise through this year. The latest selloff has pushed U.S. Treasurys slightly into "inexpensive" territory based on our Valuation model. Bonds are still technically oversold and sentiment remains bullish, suggesting that the consolidation phase may last a little longer. Nonetheless, we expect to recommend short-duration positions again once the overbought conditions unwind. The U.S. dollar is near previous secular peaks according to our valuation measure. Nonetheless, policy divergences are likely to drive the U.S. dollar to new valuation highs before the bull market is over. Technically overbought conditions have almost unwound, clearing the way for the next leg of the dollar bull run. Commodities have been on a tear on the back of improving and synchronized growth across the major countries (and some dollar weakness very recently). The commodity price outlook is clouded by the prospect of a border tax, which could send the U.S. dollar soaring. The broad commodity market is also approaching overbought levels. The cyclical growth outlook is positive for commodity demand, although supply factors favor oil to base metals. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. The global inflationary versus deflationary impact of U.S. trade protectionism will depend on the magnitude of exchange rate adjustments. Currencies will adjust to redistribute the inflationary and deflationary impact of U.S. tariffs and Border Adjustment Taxes between the U.S. and the rest of the world. Go long three-month volatility in the KRW, the MYR and the THB. The Turkish lira has approached our target of TRY/USD 3.9. Investors should book profits for now and reinstate short if the lira rebounds to 3.5 Feature Chart I-1Are Share Prices Discounting ##br##U.S. Trade Protectionism? Are Share Prices Discounting U.S. Trade Protectionism? Are Share Prices Discounting U.S. Trade Protectionism? The odds of a considerable rise in U.S. trade protectionism have ratcheted up since President Donald Trump's victory in early November, yet global share prices have been sanguine about it. Equities have instead focused on the positives of Trump's agenda such as fiscal stimulus and deregulation. Does this mean that the marketplace is overly complacent? One can argue that potential trade wars are a well-known risk, and as such are already discounted in share prices. It is also possible to argue that the equity markets did not fall at all ahead of and following Trump's victory to discount potential negatives from trade protectionism. The only market that has reacted to discount looming trade restrictions is Mexico, specifically the peso and its fixed-income markets. However, the ramifications of U.S. trade protectionism will reverberate well beyond Mexico. Global ex-U.S. share prices have not corrected at all to discount the potential negatives (Chart I-1). Unless the U.S. dollar surges, U.S. manufacturers will likely benefit from protectionist measures. However, U.S inflation and interest rates will rise in this scenario, weighing on equity valuation multiples. Overall, the majority of America's trade partners are at risk. In this week's report, we assess the vulnerability of various EM countries to the U.S. trade assault. U.S. trade restrictions will take the form of either import tariffs, a Border Adjustment Tax (BAT),1 or a mix of both. We conclude that buying volatility of select EM currencies is one way to profit from budding U.S. protectionism. Vulnerability To A U.S. Trade Assault Below we analyze which EM economies are most at risk from U.S. import tariffs and BAT. Given it is impossible to know whether the U.S. will adopt import tariffs, a BAT, or some combination of the two, we evaluate the impact on developing countries from both measures. Import tariffs: To assess each country's exposure to potential import tariffs, we examine the size of export shipments to America relative to that country's GDP. Table I-1 shows that Mexico, Canada, Malaysia, Taiwan and Thailand have the largest exports to the U.S. as a share of their economy. For Mexico, Canada and Malaysia, we exclude oil shipments to the U.S., as it is not clear whether oil will be subject to import tariffs. BAT: The principal variable gauging a country's vulnerability to a BAT is its trade balance with the U.S. This is because a BAT is both a penalty on imports into the U.S. as well as a subsidy on American exports. Hence, this analysis has to take into consideration not only a country's shipments to the U.S. but also American producers' exports to that country. Table I-2 shows the size of each country's trade balance with the U.S. as a share of its GDP. Table I-1Vulnerability To U.S. Import Tariffs EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism Table I-2Vulnerability To BATs EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism Again, for Mexico, Canada and Malaysia, we exclude the oil trade balance with the U.S. from the calculation. 3. Combined vulnerability ranking. Lack of clarity on trade policy specifics the U.S. is going to adopt means that we may need to synthesize the above analysis, combining the vulnerability ranking on both measures into one. Chart I-2 plots trade balances on the X axis and exports to the U.S. on the Y axis. It appears Malaysia, Mexico, Taiwan and Thailand are the most vulnerable, based on both criteria. Chart I-2Vulnerability To U.S. Import Tariffs And Border Adjustment Taxes EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism Another way to generate a vulnerability ranking is to calculate an aggregate score based on Tables I-1 and I-2 because either import tariffs, a BAT or some combination of the two will be adopted by the U.S. The aggregate vulnerability score is presented in Chart I-3. Chart I-3U.S. Trade Protectionism Vulnerability Ranking EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism According to the overall vulnerability score, Mexico, Malaysia, Taiwan, Thailand and Korea are the most exposed to potential U.S. trade protectionism measures. By contrast, Turkey, Brazil and Chile are the least exposed. Bottom Line: Mexico and China are not the only countries that could suffer from U.S. trade protectionism. Malaysia, Korea, Taiwan and Thailand are also at risk. On the flip side, Turkey and Brazil are the least exposed to a U.S. trade assault. We remain short many EM exchange rates versus the U.S. dollar including the Malaysian, Korean and Colombian currencies, and reiterate these positions today. Traders who are not positioned this way or have been stopped out should consider reinstating these trades (the full list of our currency recommendations). As for the Mexican peso, it has undershot relative to other EM currencies. We have not been bullish on the MXN versus the USD, though in recent months have recommended going long the MXN versus the BRL and ZAR. These trades have so far produced large losses, but we expect the MXN to recover some of those losses on its crosses. Are Trade Barriers Inflationary Or Deflationary? We consider three scenarios: Chart I-4U.S.: Rising Unit Labor Costs ##br##Warrant Higher Core Inflation U.S.: Rising Unit Labor Costs Warrant Higher Core Inflation U.S.: Rising Unit Labor Costs Warrant Higher Core Inflation 1. Without an exchange rate adjustment (U.S. dollar appreciation), import tariffs and BATs will be inflationary for the U.S. and deflationary for the rest of the world. In this scenario, the prices of imported goods will rise in U.S. dollars and U.S. consumers will end up paying for the tariff/border taxes or exporters will see their U.S. dollar revenues plummet or some combination of the two. U.S. manufacturers will become competitive with higher prices of imported goods, and U.S. employment and resource utilization will mount, heightening domestic inflationary pressures. Even though non-energy imports make up only 11% of U.S. GDP, the inflationary impact of trade protectionism will be pervasive. The reason being that it will tighten the resource utilization in the American economy in general, and the labor market in particular. Currently, the U.S. labor market is tight, wages are accelerating and unit labor costs are rising (Chart I-4). Further strength in demand due to potential fiscal stimulus, import substitution, and a further revival of confidence, will lead to even higher wage inflation and an acceleration in unit labor costs. This, along with rising prices for imported goods, will produce higher inflation. That said, it is likely that American consumers cannot handle a drastic price hike in imported goods, so higher selling prices will entail less demand. For the rest of the world, the same scenario will be very deflationary. Countries with large exports to the U.S. will experience a plunge in their shipments to America, income/profit growth will tank, and domestic demand will dwindle. In aggregate, this scenario will be inflationary for the U.S. and deflationary for the rest of the world - there will be meaningful losses in global output. 2. With "full" exchange rate adjustments, the import tariffs and BATs will be neutral for the U.S. and the rest of the world. But for this to occur, the U.S. dollar has to overshoot. Chart I-5Exchange Rates Have##br## Made A Difference Exchange Rates Have Made A Difference Exchange Rates Have Made A Difference In this scenario, imported goods prices in U.S. dollars will remain the same, given tariffs/BATs are entirely offset by a strong dollar. For exporters, their U.S. dollar revenues will plunge but their currency depreciation will restore the value of shipments to the U.S. in local currency terms (Chart I-5). In brief, the "full" currency depreciation will reflate exporter economies in local currency terms. Given that the rate of tariffs or BATs will likely exceed 15-20%, potential U.S. dollar appreciation will need to be dramatic to produce this scenario. In turn, the considerable dollar appreciation will cap inflationary pressures in the U.S. There will be little, if any, impact on global output. 3. With "partial" exchange rate adjustment (moderate dollar appreciation), the impact of tariffs or BATs will be split between U.S. consumers facing somewhat higher prices for imports and exporters who will suffer declines in revenues in local currency terms, though not as much as in the case of no currency deprecation. Consequently, this scenario will be mildly inflationary for the U.S. and modestly deflationary for the rest of the world. Yet, there will also be a small loss of global output - i.e., global GDP growth will be negatively impacted. Odds favor scenarios two and three - i.e., the greenback is set to appreciate, but it is not clear whether it will rise enough to entirely offset the impact of import tariffs or BATs and preclude decline in global growth. Bottom Line: The inflationary versus deflationary impact of U.S. trade protectionism will depend on exchange rate adjustments and their magnitude - i.e., currencies will move to redistribute the inflationary and deflationary impact of U.S. tariffs and BATs. Overall, the U.S. dollar is set to appreciate meaningfully and probably overshoot before topping out. Go Long EM FX Volatility Given central banks outside the U.S. - both in DM ex-U.S. and EM - are attempting to keep interest rates low, odds favor considerable appreciation in the U.S. dollar, or at least a material rise in exchange rate implied volatility. When monetary authorities control interest rates, the entire burden of adjustment falls on exchange rates. In brief, exchange rates have to move a lot - the U.S. dollar would have to overshoot - to prevent a hit to global output. Investors should consider betting on higher exchange rate volatility. In spite of rising odds of U.S. trade protectionism, EM and DM currency volatility has so far remained surprisingly tame (Chart I-6). We feel there is a trade opportunity here, and today we recommend investors go long select EM exchange rate volatilities. Chart I-7 plots the U.S. trade vulnerability score on the X axis, and exchange rate volatility - more specifically, the standardized 3-month implied currency volatility - on the Y axis. According to Chart I-7, it appears that by historical standards, the current level of volatility of MYR, THB and KRW are low when considering these countries' vulnerability to U.S. trade protectionism. Therefore, investors should go long 3-month implied volatility for the KRW, the MYR and the THB. Chart I-6Exchange Rate Volatility In ##br##Historical Perspective Exchange Rate Volatility In Historical Perspective Exchange Rate Volatility In Historical Perspective Chart I-7Go Long Currency VOLs in Korea, ##br##Malaysia, And Thailand EM Vulnerability To U.S. Trade Protectionism EM Vulnerability To U.S. Trade Protectionism In addition, the volatility in these Asian currencies will rise and the RMB depreciate further. Bottom Line: To capitalize on a potential rise in global currency volatility, traders should go long three-month volatility in the KRW, the MYR and the THB. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Taking Profits On Turkish Shorts For Now In our December 7, 2016 Special Report 2 we argued that the odds of the lira being vigorously defended by the authorities or some sort of capital controls being implemented in Turkey would increase as the exchange rate approached USD/TRY 3.9. Given the exchange rate has come close to that level, we recommend that traders book profits on our Turkish short positions. The idea is to protect profits and capital in the case of capital controls. It is impossible to know whether the Turkish authorities will opt for capital controls, as it is a political decision. Yet, the risk is non-trivial. Furthermore, the rhetoric from Turkish President Recep Tayyip Erdogan suggests3 he views foreign investors as the main culprits for the nation's current financial debacle. President Erdogan will not shy away from hurting foreign investors via the introduction of capital controls and create the perception of financial stability. The central bank has been very active in recent weeks. Apart from hiking the overnight lending rate this week, it has recently curtailed liquidity injections into the banking system: Chart II-1Turkey: A Decline in Liquidity Provision Turkey: A Decline in Liquidity Provision Turkey: A Decline in Liquidity Provision On January 10, the Central Bank of Turkey (CBT) announced that it will place borrowing limits of TRY $22 billion in the Interbank Money Market, effectively limiting the volume of liquidity the central bank provides to commercial banks. Given the lira continued to slide, three days later, the CBT decided to move the interbank money market borrowing limit even lower at TRY $11 billion, effective January 16. That said, since January 10, the CBT has injected TRY $9.5 billion, on average per day, via the overnight window, and TRY $27 billion via the late liquidity window, albeit at higher interest rates than at the overnight window. Hence, the CBT has still injected a meaningful amount of liquidity into the banking system, but it has done so at higher interest rates. All in all, the CBT has curtailed liquidity injections in order to avoid further lira depreciation (Chart II-1, top panel). As a result, interest rates have risen sharply (Chart II-1, bottom panel). Yet, it is not certain that the central bank has tightened liquidity enough. Going forward, there are two main risks: either the CBT's liquidity tightening will be too little, and therefore the lira will continue to plunge, or, there will be considerable liquidity tightening, which will stabilize the exchange rate, but cascade the economy into major recession. Both scenarios are bearish for foreign investors holding Turkish stocks and credit. As we have discussed at length in previous reports, monetary authorities can control either the exchange rate or interest rates, but not both simultaneously. The CBT has been trying unsuccessfully to exercise control over both. To stabilize the exchange rate, the CBT has to drastically curtail its injections of local currency liquidity into the system. In such a case, however, interest rates will surge. Continued attempts to cap interest rates entail a further collapse in the lira's value. The only other option is to introduce capital control (i.e. close the capital account) in order to get control over both interest rates and the currency. Higher interest rates are not politically acceptable, as they will push the economy into deep recession. The reason being that domestic credit growth has been enormous in recent years, and higher interest rates will suffocate the economy. Yet not hiking the policy rate, or allowing interbank interest rates to rise, will all but ensure a deeper crash in the exchange rate. With the industrial sector already showing signs of weakness and the consumer sector flat, a decrease in loan growth will send the already weak economy into recession (Chart II-2). Yet, mushrooming money and credit growth, along with very high inflation in Turkey, justify higher interest rates: Local currency money and credit growth is too strong (Chart II-3). Unless these slow down, the lira will continue to decline. Chart II-2Turkey: Economy Is Heading##br## Into Recession Turkey: Economy Is Heading Into Recession Turkey: Economy Is Heading Into Recession Chart II-3Money/Credit Creation ##br##Has Been Too Rampant Money/Credit Creation Has Been Too Rampant Money/Credit Creation Has Been Too Rampant Genuine inflationary pressures are too ubiquitous: manufacturing and service sector wages have grown by about 20% over the past 12 months (Chart II-4). In brief, such genuinely high inflation, coupled with still low rates, are bearish for the currency. Robust credit and income/wage growth are supporting import demand, and the current account deficit is wide. This is another bearish factor for the exchange rate. In short, the lira has further room to fall. Remarkably, according to the real effective exchange rates based on unit labor costs as well as consumer prices, the lira is still not very cheap, making it vulnerable to further depreciation (Chart II-5) Chart II-4Turkey: 20% Wage Inflation Turkey: 20% Wage Inflation Turkey: 20% Wage Inflation Chart II-5The Turkish Lira Can Get Cheaper The Turkish Lira Can Get Cheaper The Turkish Lira Can Get Cheaper Even more surprising, despite a more than 20% depreciation against the U.S. dollar last year, foreign investors' holdings of Turkish equities and government bonds has not dropped significantly (Chart II-6). Finally, bank share prices in local currency terms have risen despite the spike in interest rates (Chart II-7). This entails that this bourse, which is dominated by bank stocks, is not pricing in risks from higher interest rates. Chart II-6Will Foreigners Capitulate On Turkish Assets? Will Foreigners Capitulate On Turkish Assets? Will Foreigners Capitulate On Turkish Assets? Chart II-7Bank Share Prices Have Held Up So Far Bank Share Prices Have Held Up So Far Bank Share Prices Have Held Up So Far Investment Recommendations: Currency and fixed income traders should take profits on our short TRY / long USD trade, as well as our short 2-year Turkish bond trade. These have returned a 24% and a 20%, respectively, since January 17, 2011 and June 1, 2016. That said, investors should consider shorting the lira versus the U.S. dollar again if the exchange rate rebounds to TRY/USD 3.5. We recommend equity traders book profits on our short Turkish banks position, which has registered a return of 60% since June 4, 2013. Dedicated EM equity and fixed income investors (both credit and local-currency bonds) should continue to underweight Turkey. Absolute-return and non-dedicated EM investors should minimize their exposure to Turkish financial markets. Stephan Gabillard, Research Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Global Investment Strategy Special Report, titled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017", dated January 20, 2017, available at www.gis.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report, titled "Turkey: Military Adventurism And Capital Controls", dated December 7, 2016 available at ems.bcaresearch.com 3 President Erdogan, speaking at the 34th meeting with village chiefs at the Presidential Palace in Ankara, said "Everyone already sees and knows the attacks that Turkey has been subjected to also have an economic aspect. There is no difference between a terrorist who has a weapon or bomb in his hand and a terrorist who has dollars, euros and interest in terms of aim. The aim is to bring Turkey to its knees, to take over Turkey and to distance Turkey from its goals. They are using the foreign exchange rate as a weapon". Equity Recommendations Fixed-Income, Credit And Currency Recommendations