Labor Market

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

Highlights Bond Strategy: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Japan Corporates: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Feature "I love it when a plan comes together." - Hannibal Smith, Leader of The A-Team Many investors likely came down with serious case of a sore neck last week, given the head-turning headlines that came out: Chart 1A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' A Pause In The 'Inflation Scare' U.S. President Donald Trump announcing a blanket tariff on metals imports, then exempting some important countries (Canada, Mexico, Australia) only days later. Trump agreeing to an unprecedented meeting with North Korean leader Kim Jong Un on the nuclear issue, only to have the White House press secretary later announce that no meeting would take place without North Korean "concessions". The European Central Bank (ECB) hawkishly altering its forward guidance to markets at the March monetary policy meeting, but then having that immediately followed by dovish comments from ECB President Mario Draghi. The strong headline number on the February U.S. employment report blowing away expectations, but the soft readings on wages suggesting that the Fed will not have to move more aggressively on rate hikes. For bond markets in particular, the ECB announcement and the U.S. Payrolls report were most important. Investors had been growing worried about a more hawkish monetary policy shift in Europe or the U.S. This was especially true in the U.S. after the previous set of employment data was released in early February showing a pickup in wage inflation that could force the Fed to shift to a more hawkish stance. That created a spike in Treasury yields and the VIX and a full-blown equity market correction. Since then, inflation expectations have eased a bit and market pricing of future Fed and ECB moves has stabilized, helping to bring down volatility and supporting some recovery in global equity markets (Chart 1). With all of these "tape bombs" hitting the news wires, investors can be forgiven for re-thinking their medium-term investment strategy in light of the changing events. We think it is more productive to check if the initial expectations on which that strategy was based still make sense. On that note, the developments seen so far this year fit right in with the key themes we outlined in our 2018 Outlook, which we will review in this Weekly Report. The Critical Points From Our Outlook Still Hold Up In a pair of reports published last December, we translated BCA's overall 2018 Outlook into broad investment themes (and strategic implications) for global fixed income markets. We repeat those themes below, with our updated assessment on where we currently stand. Theme #1: A more bearish backdrop for bonds, led by the U.S.: Faster global growth, with rebounding inflation expectations, will trigger tighter overall global monetary policy. This will be led by Fed rate hikes and, later in 2018, ECB tapering. Global bond yields will rise in response, primarily due to higher inflation expectations. ASSESSMENT: UNFOLDING AS PLANNED, BUT WATCH INFLATION EXPECTATIONS. Economic growth is still broadly expanding at a solid pace, as evidenced by the elevated levels of the OECD leading economic indicator and our global manufacturing PMI (Chart 2). The U.S. is clearly exhibiting the strongest growth momentum looking at the individual country PMIs (bottom panel), while there is a more mixed picture in the most recent readings in other countries and regions. Importantly, all of the manufacturing PMIs remain well above the 50 line indicating expanding economic activity. Last week's U.S. Payrolls report for February showed that great American job creation machine can still produce outsized employment gains with only moderate wage inflation pressures, even in an economy that appears to be at "full employment". The +313k increase in jobs, which included upward revisions to both of the previous two months of a combined +54k, generated no change in the U.S. unemployment rate which stayed unchanged at 4.1% with the labor force participation rate increasing modestly (Chart 3). Chart 2U.S. Growth Leading The Way U.S. Growth Leading The Way U.S. Growth Leading The Way Chart 3The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The Fed Can Still Hike Rates Only 'Gradually' The wage data was perhaps the most important part of the report, given that the spike in global market volatility seen last month came on the heels of an upside surprise in U.S. average hourly earnings (AHE) for January. There was no follow through of that acceleration in February, with the year-over-year growth rate of AHE slowing back to 2.6% from 2.9%, reversing the previous month's increase (middle panel). The immediate implication is that the Fed does not have to start raising rates faster or by more than planned. That pullback in U.S. wage growth, combined with the continued sluggishness of inflation in the other developed economies and the sideways price action seen in global oil markets, does suggest that inflation expectations may struggle to be the main driver of higher global bond yields in the near term. Overall nominal bond yields are unlikely to decline, however, as real yields are slowly rising in response to faster global growth and markets pricing in tighter monetary policy in response (Chart 4). Chart 4Real Yields Rising Now,##BR##Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later Real Yields Rising Now, Inflation Expectations Will Rise Again Later We have not seen enough evidence to cause us to change our view on inflation expectations moving higher over the course of 2018, particularly with BCA's commodity strategists now expecting oil prices to trade between $70-$80/bbl in the latter half of 2018.1 One final point: it is far too soon to determine if the protectionist trade leanings of President Trump will alter the current trajectory of global growth and interest rates. The implication is that investors should not change their overall planned investment strategy for this year at this juncture. Theme #2: Growth & policy divergences will create cross-market bond investment opportunities: Global growth in 2018 will become less synchronized compared to 2016 & 2017, as will individual country monetary policies. Government bonds in the U.S. and Canada, where rate hikes will happen, will underperform, while bonds in the U.K. and Australia, where rates will likely be held steady, will outperform. ASSESSMENT: UNFOLDING AS PLANNED. As shown in Chart 2, the big coordinated upward move in global growth seen in 2017 is already starting to become less synchronized in 2018. Recent readings on euro area growth have softened a bit while, more worryingly, a growing list of Japanese data is slowing. U.K. data remains mixed, while the Canadian economy is showing few signs of cooling off. China's growth remains critical for so many countries, including Australia, but so far the Chinese data is showing only some moderation off of last year's pace. Net-net, the data seen so far this year is playing out according to our 2018 Themes - better in the U.S. and Canada, softer in the U.K. and Australia. We are sticking to our view that the rate hikes currently discounted by markets in the U.S. and Canada will be delivered, but that there will be little-to-no monetary tightening in the U.K. and Australia (Chart 5). Theme #3: The most dovish central banks will be forced to turn less dovish: The ECB and Bank of Japan (BoJ) will both slow the pace of their asset purchases in 2018, in response to strong domestic economies and rising inflation. This will lead to bear-steepening of yield curves in Europe, mostly in the latter half of 2018. The BoJ could raise its target on JGB yields, but only modestly, in response to an overall higher level of global bond yields. ASSESSMENT: UNFOLDING AS PLANNED, ALTHOUGH WE NOW EXPECT NO BoJ MOVE TO TAKE PLACE THIS YEAR. Both central banks have already dialed back to pace of the asset purchases in recent months. This is in addition to the Fed beginning its own process of reducing its balance sheet by not rolling over maturing bonds in its portfolio. Growth of the combined balance sheet of the "G-4" central banks (the Fed, ECB, BoJ and Bank of England) has been slowing steadily as a result (Chart 6). The ECB continues to contribute the greatest share of that aggregate "G-4" liquidity expansion, although that is projected to slow over the balance of 2018 as the ECB moves towards a full tapering of its bond buying program by the end of the year (top panel). Chart 5Not Every Central Bank##BR##Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Not Every Central Bank Will Deliver What's Priced Chart 6Risk Assets Are##BR##Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Risk Assets Are Exposed To ECB Tapering Barring a sudden sharp downturn in the euro area economy, the ECB is still on track for that taper. We have been expecting a signaling of the taper sometime in the summer, likely after the ECB gains even greater confidence that its inflation target can be reached within its typical two-year forecasting horizon. That story will not be repeated in Japan, however, where core inflation is still struggling to stay much above 0% and economic data is softening. We see very little chance that the BoJ will make any alterations of its current policy settings - with negative deposit rates and a target of 0% on the 10-year JGB yield - this year, as we discussed in a recent Special Report.2 We continue to expect a diminishing liquidity tailwind for global risk assets over the rest of 2018 (bottom two panels). Theme #4: The low market volatility backdrop will end through higher bond volatility: Incremental tightening by central banks, in response to faster inflation, will raise the volatility of global interest rates. This will eventually weigh on global growth expectations over the course of 2018, and create a more volatile backdrop for risk assets in the latter half of the year. ASSESSMENT: UNFOLDING AS PLANNED. We saw a sneak preview of how this theme would play out during that volatility spike at the beginning of February, triggered by only a brief blip up higher in U.S. wage inflation. With a more sustained increase in realized global inflation likely to develop within the next 3-6 months, a return to that world of high volatility is still set to unfold in the latter half of 2018, in our view. After reviewing our four investment themes for 2018 in light of the latest news, we conclude that the themes are largely playing out. Therefore, we will continue to stick with the investment strategy conclusions for this year that were derived from those themes (Table 1):3 Table 1A Pro-Risk Recommended Portfolio In H1/2018, Looking To Get Defensive Later In The Year Sticking With The Plan Sticking With The Plan 2018 Model Bond Portfolio Positioning: Target a moderate level of portfolio risk, with below-benchmark duration and overweights on corporate credit versus government debt. These allocations will shift later in the year as central banks shift to a more restrictive monetary policy stance and growth expectations for 2018 become more uncertain. Chart 7Tracking Our Recommendations Tracking Our Recommendations Tracking Our Recommendations 2018 Country Allocations: Maintain underweight positions in the U.S., Canada and the Euro Area, keeping a moderate overweight in low-beta Japan, and add small overweights in the U.K. and Australia (where rate hikes are unlikely). The year-to-date performance of the main elements of our model bond portfolio are shown in Chart 7. All returns are shown on a currency-hedged basis in U.S. dollars. Our country underweights are shown in the top panel, our country overweights in the 2nd panel, our credit overweights in the 3rd panel and our credit underweights in the bottom panel. The broad conclusion is that our best performing underweight is the U.S. and best performing overweight is Japan. All other country allocations are essentially flat on the year (in currency-hedged terms). Our call to overweight corporate debt vs. government debt, focused on the U.S., has performed well, but mostly through our overweight stance on U.S. high-yield. Bottom Line: The investment backdrop is broadly evolving the way that we forecasted in our 2018 Outlook, thus we continue to maintain our core strategic recommendations. Maintain below-benchmark portfolio duration and overweight global corporate debt versus government bonds (focused on the U.S.). Look to reverse that positioning sometime during the latter half of 2018 after global inflation increases and central banks tighten policy more aggressively. Introducing The Japan Corporate Health Monitor Japan's relatively small corporate bond market has not provided much excitement for non-Japanese investors over the years. Japanese companies have always been highly cautious when managing leverage on their balance sheets, and have traditionally relied heavily on bank loans, rather than bond issuance, for debt financing. The result is a corporate bond market with far fewer defaults and downgrades compared to other developed economies, with much lower yields and spreads as well. Due to its small size, poor liquidity and low yields/spreads, we have not paid much attention to Japanese corporate debt in the past. Thus, we don't have the same kinds of indicators available to us for Japanese corporate bond analysis as we have in the U.S., euro area or U.K. One such indicator is the Corporate Health Monitor (CHM) to assess the financial health of corporate issuers.4 We are changing that this week by adding a Japan CHM to our global CHM suite of indicators. In other countries, we have both top-down and bottom-up versions of the CHM. The former uses GDP-level data on income statements and balance sheets to determine the individual ratios that go into the CHM (a description of the ratios is shown in Table 2), while the latter uses actual reported financial data at the individual firm level which is aggregated into the CHM. Table 2Definitions Of Ratios##BR##That Go Into The CHM Sticking With The Plan Sticking With The Plan Consistent and timely data availability is an issue for building a top-down CHM, as there is no one source of top-down data on the corporate sector. Some data is available from the BoJ or the Ministry of Finance, or even from international research groups like the OECD, but not all are presented using a consistent methodology. Some data is only available on an annual basis, which significantly diminishes the usefulness of a top-down CHM as a timely indicator for bond investment. Thus, we focused our efforts on only building a bottom-up version of a Japan CHM, using publically available financial information released with higher frequency (quarterly). We focused on non-financial companies (as we do in the CHMs for other countries) and exclude non-Japanese issuers of yen-denominated corporate bonds. In the end, we used data on 43 companies for our bottom-up CHM. By way of comparison, there are only 36 individual issuers in the Bloomberg Barclays Japan Corporate Bond Index that fit the same description of non-financial, non-foreign issuers, highlighting the relatively tiny size of the Japanese corporate bond market. Our new Japan bottom-up CHM is presented in Chart 8. The overall conclusions are the following: Japanese corporate health is in overall excellent shape, with the CHM being in the "improving health" zone for the full decade since the 2008 Financial Crisis. Corporate leverage has steadily declined since 2012, mirroring the rise in company profits and cash balances over the same period. Return on capital is currently back to the pre-2008 highs just below 6%, although operating margins remain two full percentage points below the pre-2008 highs. Interest coverage and the liquidity ratio are both at the highest levels since the mid-2000s, while debt coverage is steadily improving. The overall reading from the CHM is one of solid Japanese creditworthiness and low downgrade and default risks. It is no surprise, then, that corporate bond spreads have traded in a far narrower range than seen in other countries. In Chart 9, we present the yield, spread, return and duration data for the Bloomberg Barclays Japanese Corporate Bond Index. We also show similar data for the Japanese Government Bond Index for comparison. Japanese corporates have a much lower index duration than that of governments, which reflects the greater concentration of corporate issuance at shorter maturities. Chart 8The Japan Corporate Health Monitor The Japan Corporate Health Monitor The Japan Corporate Health Monitor Chart 9The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index The Details Of Japan Corporate Bond Index Japanese corporates currently trade at a relatively modest spread of 36bps over Japanese government debt, although that spread only reached a high of just over 100bps during the 2008 Global Financial Crisis - a much lower spread compared to U.S. and European debt of similar credit quality. That is likely a combination of many factors, including the small size of the Japanese corporate market and the relatively smaller level of interest rate volatility in Japan versus other countries. Given the dearth of available bond alternatives with a positive yield in Japan, the "stretch for yield" dynamic has created a demand/supply balance that is very favorable for valuations - especially given the strong health of Japanese issuers. Chart 10Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen Japan Corporates Do Not Like A Rising Yen It remains to be seen how the market will respond to a future economic slowdown in Japan, which may be starting to unfold given the recent string of sluggish data. On that note, the performance of the Japanese yen bears watching, as the currency has a positive correlation to Japanese corporate spreads (Chart 10). The linkage there could be a typical one of risk-aversion, where the yen goes up as risky assets selloff. Or it could be linked to growth expectations, where markets begin to price in the impact on Japanese growth and corporate profits from a stronger currency. Given our view that the BoJ is highly unlikely to make any changes to its monetary policy settings this year, the latest bout of yen strength may not last for much longer. For now, given the link between the yen and Japanese credit spreads, we would advise looking for signs that the yen is rolling over before considering any allocations to Japanese corporate debt. Bottom Line: Japanese companies are in excellent financial shape, according to our new Japan Corporate Health Monitor. Although softening Japanese growth and a firming yen may prevent an outperformance of Japanese corporate debt in the coming months. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst Ray@bcaresearch.com 1 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Getting Comfortable With Higher Prices", dated February 22nd 2018, available at ces.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, "What Would It Take For The Bank Of Japan To Raise Its Yield Target?", dated February 13th 2018, available at gfis.bcareseach.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Portfolio In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. 4 For a summary of all of our individual country CHMs, including a description of the methodology, please see the BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: No Improvement Despite A Strong Economy", dated November 21st 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Sticking With The Plan Sticking With The Plan Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Fed Governor Lael Brainard stated last week that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. Labor Market: The economy continues to add jobs at a rapid pace, but there is some debate about whether the unemployment rate accurately reflects the amount of slack in the labor market. We find that even using the broadest measures of labor market slack, we should expect to see wages accelerate in the coming months. Credit Cycle: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Feature Chart 1Fed's Current Projections Are Priced In Fed's Current Projections Are Priced In Fed's Current Projections Are Priced In The cyclical bond bear market is at a critical juncture. The yield curve has now largely priced-in the Fed's median fed funds rate projections (Chart 1), and this raises the possibility that the bear market could stall unless the Fed starts to signal a more aggressive path for hikes. With that in mind, last week's speech by Fed Governor Lael Brainard caught our attention.1 As the most dovish member of the Board of Governors, Governor Brainard's speeches are important bellwethers of inflection points in monetary policy. This is particularly true when the speeches convey a more hawkish tone, as was the case last week. Governor Brainard's shift in tone signals that the Fed is poised to adopt a somewhat more aggressive tightening bias. This will likely lead to upward revisions to its interest rate projections and give the green light for the cyclical bond bear market to continue. Brainard On Growth Comparatively weak economic growth outside of the U.S. has been a perennial concern for Governor Brainard, and indeed a key theme in this publication.2 But last week she acknowledged that this dynamic has shifted: Today many economies around the world are experiencing synchronized growth, in contrast to the 2015-16 period when important foreign economies experienced adverse shocks and anemic demand. [...] The upward revisions to the foreign economic outlook are also pulling forward expectations of monetary policy tightening abroad and contributing to an appreciation of foreign currencies and increases in U.S. import prices. By contrast, foreign currencies weakened in the earlier period, pushing the dollar higher and U.S. import prices lower. Chart 2 shows the dramatic shift that has occurred since mid-2016. The Global Manufacturing PMI has soared, and all but one of the 36 countries with available data now have PMIs above the 50 boom/bust line. As a consequence, the U.S. dollar has depreciated and import prices have surged. A more broadly-based global recovery is bearish for U.S. bonds. With less drag from a stronger U.S. dollar, interest rates must rise further to achieve the same amount of monetary tightening. Although we would still characterize the global economic recovery as highly synchronized, we recently flagged some preliminary signals that suggest the breadth of global growth might be deteriorating.3 Specifically, we observe that leading indicators of Chinese economic activity have rolled over, and the outperformance of emerging market currency carry trades has moderated (Chart 2, bottom panel). We will closely monitor both of these indicators during the next few months to see if the weakness persists, or if it starts to bleed into broader global growth aggregates. While the more optimistic assessment of global growth was the starkest change between last week's speech and Governor Brainard's earlier missives, she also noted reasons for optimism on the domestic front. Nonresidential investment is hooking up, and leading indicators point to further gains (Chart 3, panel 1). Financial conditions remain accommodative despite persistent Fed tightening. This differs from the mid-2014 to mid-2016 period when financial conditions tightened even though monetary policy was more accommodative (Chart 3, panel 2). Most importantly, the economy is poised to receive a huge dose of fiscal stimulus during the next two years in the form of a $1.5 trillion tax cut and a $300 billion increase in federal spending (Chart 3, bottom panel). Even our simple tracking estimate for U.S. GDP suggests that growth is shifting into a higher gear. Aggregate hours worked are growing at an annual pace of 2.2%. When coupled with a conservative estimate of 0.8% for productivity growth - the average since 2012 - that translates into real GDP growth of 3%, well above the average pace of 2.2% we've seen since 2010 (Chart 4). With growth that strong we will almost certainly see further tightening of the labor market in 2018. Chart 2Synchronized Growth Is Bond Bearish Synchronized Growth Is Bond Bearish Synchronized Growth Is Bond Bearish Chart 3Domestic Tailwinds Domestic Tailwinds Domestic Tailwinds Chart 4U.S. GDP Tracking At 3% U.S. GDP Tracking At 3% U.S. GDP Tracking At 3% Brainard On The Labor Market A key question for policymakers is how much slack remains in the labor market. If the Fed views the labor market as at full employment, then it necessarily expects inflation to accelerate and should be prepared to tighten policy. Conversely, an economy with significant labor market slack is not expected to generate inflation. Officially, the Fed's most recent Monetary Policy Report to Congress describes the labor market as "near or a little beyond full employment",4 and in last week's speech Governor Brainard gave an excellent summary of the risks surrounding that assessment. First, she noted that "if the unemployment rate were to continue to fall in the coming year at the same pace as in the past couple of years, it would reach levels not seen since the late 1960s" (Chart 5). With growth set to accelerate, we view this as a very likely outcome. In fact, we calculate that, assuming a flat labor force participation rate, the U.S. economy needs to add only 123k jobs each month to keep the unemployment rate under downward pressure. The economy has added an average of 190k jobs per month during the past year, and added a shocking 313k in February (Chart 6). We anticipate it will be some time before job growth falls below the 123k threshold. Chart 5How Much Slack? How Much Slack? How Much Slack? Chart 6Employment Growth Employment Growth Employment Growth However, it is possible that the unemployment rate is masking some hidden slack in the labor market. Governor Brainard noted that "the employment-to-population ratio for prime-age workers remains more than 1 percentage point below its pre-crisis level" (Chart 5, panel 2). "If substantially more workers could be drawn into the labor force, it would be possible for the labor market to firm notably further without generating imbalances." Chart 7Wage Growth Set To Accelerate Brainard Gives The Green Light Brainard Gives The Green Light In other words, if the labor force participation rate increases, then the unemployment rate could level-off even if job growth remains robust. This would keep a lid on inflation for longer than would be the case otherwise. In our view it will be very difficult for the participation rate to rise meaningfully on a cyclical horizon. As Governor Brainard noted in her speech: "declining labor force participation among prime-age workers predates the crisis" (Chart 5, bottom panel). Added to that, now nine years into the economic recovery, it is questionable whether workers that have been out of the labor force for so long are even able to be drawn back in. Our sense is that the unemployment rate will decline further in the coming months, and it will not be long before that translates into upward pressure on wages. It is important to note that whether we use the unemployment rate or the prime-age employment-to-population ratio as our preferred measure of labor market slack, we are very close to levels that have coincided with exponential wage gains in past cycles (Chart 7). Brainard On Inflation As discussed in our report from two weeks ago, our view is that the headwinds that had been working against inflation are set to fade this year.5 While Governor Brainard agrees that "transitory factors no doubt played a role in last year's step-down in core PCE inflation," she remains concerned that inflation's underlying trend may have softened. Brainard's concern relates to various measures of inflation expectations that are still below levels that prevailed prior to the financial crisis (Chart 8). Without expectations adjusting higher it is doubtful whether inflation can sustainably return to the Fed's 2% target. We share this concern, but note that the cost of inflation protection priced into bond yields has surged in recent months. Survey measures take longer to adjust than market prices, but we anticipate that these measures will also rise as inflation recovers in 2018. The further that measures of inflation expectations (both market-based and survey-based) recover, the more Brainard's concerns about a decline in inflation's underlying trend will fade into the background. Bottom Line: Governor Brainard correctly observed that many of the headwinds that held back growth between 2014 and 2016 have faded. This acknowledgement from the most dovish Fed Governor opens the door for a more aggressive pace of Fed rate hikes, and gives the green light to the cyclical bond bear market. How Sustainable Is Corporate Profit Growth? We've been growing more cautious on the outlook for credit spreads during the past few months, principally because the shift toward a less accommodative monetary policy removes an important support for the corporate bond trade. We view the Fed as getting even more hawkish once inflation expectations are re-anchored around pre-crisis levels, and as such we stand ready to reduce exposure to corporate bonds once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5% (Chart 8, panels 1 & 2). At the time of publication the 10-year TIPS breakeven inflation rate was 2.12% and the 5-year/5-year forward rate was 2.14%. But this is only one piece of the puzzle. For a true bear market in corporate bonds to set in we also need to see rising leverage and mounting defaults. At least for now that is not happening. Our measure of gross leverage for the nonfinancial corporate sector - calculated as total debt divided by EBITD - has flattened off during the past year, and the 12-month trailing default rate is in a steady decline (Chart 9). Chart 8The Re-Anchoring Of Inflation Expectations The Re-Anchoring Of Inflation Expectations The Re-Anchoring Of Inflation Expectations Chart 9Wider Spreads Need Rising Leverage Wider Spreads Need Rising Leverage Wider Spreads Need Rising Leverage Chart 9 shows that periods of sustained corporate spread widening almost always coincide with rising gross leverage. Or put differently, for corporate spreads to widen we need to see corporate debt growth consistently exceed profit growth (Chart 9, panel 2). At first blush it is not obvious that profit growth will weaken any time soon. Leading indicators such as total business sales less inventories and the ISM manufacturing index point to a favorable profit outlook (Chart 10). Profit growth should also continue to benefit from dollar weakness for at least the next few months (Chart 10, bottom panel). But there is one leading profit indicator that is starting to flash red. A simple profit margin proxy created by taking the difference between the nonfarm business sector's implicit price deflator and its unit labor costs turned negative in Q4. Chart 11 shows that, although this indicator can be volatile, sustained negative readings almost always foreshadow periods of falling profit growth and corporate bond underperformance. Chart 10Rising Leverage Needs Weaker Profit Growth Rising Leverage Needs Weaker Profit Growth Rising Leverage Needs Weaker Profit Growth Chart 11Watch Unit Labor Costs In 2018 Watch Unit Labor Costs In 2018 Watch Unit Labor Costs In 2018 The Q4 weakness was driven by a big jump in unit labor costs, and with labor markets as tight as they are this is certainly a trend we see continuing. Unless corporate selling prices can keep pace we will see profit growth sustainably fall below debt growth this year, and this will lead to corporate bond underperformance. Bottom Line: Corporate profit growth remains strong for now, but rising unit labor costs will cause profit growth to sustainably fall below debt growth later this year. This will lead to rising corporate leverage and wider bond spreads. We stand ready to reduce exposure to corporate bonds once our inflation targets are met. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20180306a.htm 2 Please see Theme 3 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017" dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/monetarypolicy/files/20180223_mprfullreport.pdf 5 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Dear Client, This Special Report is the full transcript and slides of a presentation I recently gave at the London School of Economics symposium: 'Will I Work For AI, Or Will AI Work For Me?' The presentation pulls together several years of research analyzing the impact of current technological advances on work, the economy and society. I hope you find the presentation insightful and provocative, especially the narrative surrounding Slide 12. Dhaval Joshi Slide 2 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Feature Good afternoon Thank you very much for the invitation to speak here at the London School of Economics. The specific question you asked me was: will we be able to work in the future? (Slide 1). To which my answer is yes, an emphatic yes. I'm very optimistic that we will be able to work in the future. And one reason I'm saying this is, imagine that we had this symposium 100 years ago. I suspect we might have had exactly the same fears that we have right now (Slide 2). Slide 1 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 2 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Specifically, at the start of the 20th century, about 35% of all jobs were on farms and another 6% were domestic servants. At the time, you could probably also have said, "Well, these jobs aren't going to exist." More or less half of the jobs that existed at that time were going to disappear - and disappear they did. So we'd have thought there would be mass unemployment. Of course, there wasn't mass unemployment, because just as jobs were destroyed, we had an equivalent job creation (Slide 3). For example, at the start of the 20th century, less than 5% of people worked in professional and technical jobs. But by the end of the century, these jobs employed a quarter of the workforce. I guess what I'm saying is that we're very conscious of job destruction because we can see existing jobs being destroyed. But we're not very conscious of job creation, because in real time, it's difficult to visualize or imagine where these new jobs will be. In essence, what we saw in the 20th century was one major segment of employment basically collapsed from very significant to insignificant. While another segment surged from insignificant to very significant (Slide 4). Slide 3 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 4 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? As you all know, there is an economic thesis that underlies this. It's called Say's Law, derived by French economist Jean-Baptiste Say in 1803. In simple terms, it says that new supply creates new demand. Think about it like this: why would you replace a human with a machine? You would only do that if it increases your productivity, right? Otherwise, it does not make sense to replace a human with any sort of machine, including AI. But because you have increased productivity, you then have extra income to spend on new goods and services. Now if those goods and services are being supplied by a machine, then you can redeploy humans to satiate new desires, desires that do not even exist at the time. In economic terms, the producer of X - as long as his products are demanded - is able to buy Y (Slide 5). The question is, what is Y? Y is the new product or service. Let me give you some examples (Slide 6). In the 19th century, we had the advent of railways. And then someone thought. "Hang on a minute. We have this way of moving things around much faster, and we've got all these people who live hundreds of miles from the coast who might want to eat fresh fish." So this was the birth of the frozen food industry. But you could not have the frozen food industry without railways. What I'm saying is that entrepreneurs will seize the new technology to satiate a desire. Or even create a new desire because maybe the people in the middle of the country never thought they could eat fresh sea fish. Until someone came along and said, "you can eat fresh fish now." Slide 5 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 6 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Another example is, as technology improved the health and longevity of your teeth someone thought. "Well, hang on a minute. Maybe there's a desire to make teeth look beautiful." And we created this whole new industry called the dental cosmetics industry. We know this because prior to the 1960s, there was no job called dental technician or dental hygienist. A third example is, let's say that we have more advanced healthcare and pharmaceuticals, so humans are living longer and healthier lives. Well, then you can sort of ask. "Hang on a minute. Don't you want your dog to live the same long and healthy life that you're living?" And this is behind the explosion of the pet care industry that we're seeing at the moment. So while one segment of the economy will employ less, a new segment will come along to replace it. In the 20th century we saw farm work disappearing but professional work rising. Today, we are seeing manufacturing and driving jobs disappearing but healthcare work rising (Slide 7). Which does raise a pretty obvious question (Slide 8). Is there anything really different this time around? Slide 7 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 8 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Well, the answer is yes, there is a subtle but crucial difference this time around. To see the difference, we have to look more closely at where jobs are being destroyed, and where they are being created. As you can see, the mega-sectors losing a lot of jobs are manufacturing, the auto industry, and finance (Slide 9). While on the other side of the ledger, we have job creation in health, social work and education. But now, let's look in a little more detail. Where, specifically, are the jobs being created? For this we have to look at the United States data which is much more granular than in Europe. Here are the top five subsectors of job creation this decade (Slide 10). At the top of the list is food services and drinking places, which is just a euphemistic way of describing bartenders, waitresses, and pizza delivery boys. We also have a lot of new administrative jobs and care workers. What is the common link in this job creation? Answer: these are predominantly low-income jobs. Slide 9 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 10 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? So it is true that we have an enormous amount of job creation in the last decade or so, and the policymakers keep boasting about it, they say, "Well look, the unemployment rate in the U.S. is at a record low, the unemployment rate in the UK is at a record low, the unemployment rate in Germany is at a record low. We're creating loads and loads of jobs." The trouble is that these are predominantly low-income jobs. Meanwhile the job destruction is in middle-income jobs in manufacturing and finance. This means what we're seeing in the labour market is called a 'negative composition effect' - a hollowing out of middle incomes. So while we're getting loads and loads of job creation, it is not translating into wage inflation at an aggregate level. I think one of the reasons is a concept called Moravec's paradox. Professor Hans Moravec is an expert in robotics and Artificial Intelligence, and he noticed this paradox (Slide 11). He said, "Look. For AI, the things that we think are difficult are actually easy." By easy, he means they're doable. Let me give you some specific examples. Say someone could speak five languages fluently and translate between them at ease. We would think that person is a genius, a real rare specimen, and the economy would value this person extremely highly, probably pay that person hundreds of thousands of pounds at a minimum. But actually, AI can translate across five languages quite easily, and even something like Google Translate, which we all use, does a reasonably good first stab at translating from one language to another. Slide 11 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Or consider something like insurance underwriting. Pricing an insurance premium from lots of data on a risk. AI can do that extremely well, much better than a human can. Or medical diagnosis. Figuring out what's wrong with a patient from very detailed medical data. Again, AI beats humans hands down on that. What I'm saying is, these skills that we thought were difficult transpired not to be that difficult for AI, because they just amount to narrow-frame pattern recognition and repetition of algorithms. Whereas, the second part of Moravec's paradox is that AI finds the easy things very hard. Things that we think are really innate, we don't even give them a second thought like walking up some stairs, cleaning a table, moving objects around, and cleaning around them. Actually, AI finds these things incredibly difficult, almost impossible. We have a false sense of what is difficult and what is easy. The main reason is that the things that we find innate took millions and millions of years of human brain evolution for us to find them innate. And as AI is in essence trying to replicate the human brain, only now are we recognizing that things that we find innate are actually incredibly complex. If it took millions and millions of years to evolve the sensorimotor skills that allow us to walk up some stairs, recognize subtle emotional signals, and respond appropriately, then obviously AI is going to find it very, very difficult to replicate those innate human skills. Conversely, the brain's ability to do calculus, construct a grammatical structure for a language, or play chess only evolved relatively recently. So AI can do them very easily. Which brings me to quite a profound thought. If there's one thing that I want you to remember from this presentation it is this (Slide 12). Might we have completely misvalued the human brain? Might we have grossly overvalued things that are actually quite easy? And might we have undervalued things which are actually very, very difficult? And what AI is now doing is correcting this huge error. In which case, the next decade could be extremely disruptive as AI corrects this economic misvaluation of our skills. Slide 12 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? This might also explain the mystery as to why there is no wage inflation when the Phillips curve says there should be. The Phillips curve makes a simple relationship between the unemployment rate and wage pressures. And the folks at the Federal Reserve and Bank of England, they're sort of getting really perplexed. They're saying, "Look, unemployment is so low. Where is this wage inflation? It's going to kick in any time now." In fact, there's a bit of a paradox going on. For the people who are continuously employed in the same job, there has been pretty good wage inflation - at sort of three, four percent (Slide 13). But when you take the negative composition effect into account, then suddenly there's this big gap because what's happening is that the well-paid jobs are disappearing to be replaced by lower-paid jobs. So even if you give the bartender making thirty thousand a big pay rise to thirty-five thousand. Even if you hire two of them, but you're losing a finance job paying over a hundred thousand, then at the aggregate level, you won't see much wage inflation. And this problem, I think, continues for the next few years, minimum. It means that you will not get the wage pressures that a lot of economists think you're going to get from the low unemployment rate. Because you have to look at the quality of the jobs as well as the quantity. I think there is another disturbing impact from a societal perspective. Look again at where the jobs are being lost and where they're being created, and look at the percentage of male employees (Slide 14). Job destruction is occurring in sectors that are male-dominated, whereas job creation is occurring in sectors that are female-dominated. Slide 13 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 14 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? AI is good at narrow-frame pattern recognition and repetition of algorithms and functions - jobs like driving, which are typically male-dominated. Whereas jobs that require emotional input, emotional understanding, and empathy in the 'caring sectors' are typically female-dominated. So if you're a male, you're in trouble. You're in a lot of trouble. Obviously, there'll be re-training, so all the guys who were driving trucks will have to retrain as nurses, or as essential carers. But if you're a female, things are looking okay. You can see that in the data (Slide 15). Female labour force participation is in a very clear uptrend. Male participation is flat to down. This varies by country by country, and in the U.S., it's catastrophic for males, especially young males. Young male participation in the U.S. is really falling off a cliff at the moment. I think the other thing to say from a societal perspective is that the so-called 'Superstar Economy' is booming - both superstar individuals and superstar firms. One way of seeing this is in this index called 'the cost of living extremely well' calculated every year by Forbes (Slide 16). Whereas the ordinary CPI includes the cost of bread and milk, the CPI index for the extremely rich includes the cost of Petrossian caviar and Dom Perignon champagne. And a Learjet 70, a Sikorsky S-76D helicopter. I think there's a pedigree racehorse in there too. Anyway, we're seeing the CPI for the extremely rich rising at a dramatically faster pace than the CPI for society as a whole. So it would seem that superstar individuals and superstar firms are really thriving. Slide 15 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 16 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Let's explain this dynamic in terms of a superstar we all recognise - Roger Federer. Roger Federer was unknown initially, but as he went up the tennis rankings and became a superstar, his income grew exponentially. The other aspect is, how long can he stay a superstar? Because all superstars are eventually displaced by a new superstar. So there's two aspects to the dynamics of superstar incomes (Slide 17). First, how exponential is your income growth? And second, how long do you stay a superstar? What I'm saying is that the rise of AI, by hollowing out the middle jobs, actually allows a few superstars to have this exponential rise in their income. Let's think about it in terms of the legal profession. The top lawyer will be in huge demand. Technology really boosts him. Not just AI, but things like the internet, the fact that social media will reinforce his position, whereby everyone will know who he is. Even if he can't service you directly, he will have a team with his brand on it. And he can stay there for longer before he is displaced. So this is the mechanism by which technology can increase income inequality by hollowing out the middle. In the legal profession, the assistant lawyer who just checks a document for simple legal principle, well the machine can do that. But the guy who knows all the oddities, who knows all the loopholes that can win you the case, the machine won't be able to do that. Essentially what I'm saying is that the technological revolution - it's not just AI, it's technology in aggregate, including the internet and social media, and so on - it increases the rate of income growth for a few superstar individuals and firms. And it increases their longevity (Slide 18). And these are the two drivers for the Pareto distribution of incomes. You can actually go through the mathematics of this to show that it does increase the polarization of incomes. Slide 17 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Slide 18 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Let's sum up (Slide 19). First of all, yes, we will be able to work in the future. I don't think there's any doubt about that because there will be new jobs created, the nature of which we can only guess because we're going to get new industries to satiate our new desires. However, in the coming years, middle-income work will suffer high disruption because of Moravec's Paradox. Some things that we thought were difficult are actually quite easy for AI. But things like gardening, plumbing, nursing, and childcare are very difficult for machines to replicate. Which means that low-income work will suffer much less disruption and, of course, low-income work will get paid better over time - though the gap is so large at the moment that it's preventing overall wage inflation from kicking in. And that, I think, will persist for the next few years at a minimum. Slide 19 The Impact Of AI: Will We Be Able To Work In The Future? The Impact Of AI: Will We Be Able To Work In The Future? Men are going to suffer much more disruption than women because of the nature of the job destruction versus the job creation. And the final point is that superstars will thrive. All of this has a lot of implications for how we respond as a society, and maybe we will need some support mechanisms in this period of disruption. I think the most intense disruption will be in the next decade. After that we will reach a new equilibrium once we have actually corrected this misvaluation of the brain, this misvaluation of what it is that makes us truly human. Thank you very much. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com

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

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

Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Robots Are Getting Cheaper Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Global Robot Usage Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) February 2018 February 2018 As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Stock Of Robots By Country (I) Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) February 2018 February 2018 While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots U.S. Investment in Robots U.S. Investment in Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density February 2018 February 2018 Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity February 2018 February 2018 Chart II-10U.S.: Unit Labor Costs Vs. Robot Density February 2018 February 2018 In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density February 2018 February 2018 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed February 2018 February 2018 The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density February 2018 February 2018 The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density February 2018 February 2018 Chart II-16Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood OF Robots? Japan: Where Is The Flood OF Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27.

Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher U.S. Growth Expectations Revised Higher U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Bond Prices Now Tend to Rise When Equity Prices Go Down Bond Prices Now Tend to Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Stripping Out The Term Premium, The Yield Curve Is Not So Flat Stripping Out The Term Premium, The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 9MacroQuant Still Positive##BR##On The Stock Market Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Second Half Of 1990s: When High-Yield Spreads Rose With Stock Prices Second Half Of 1990s: When High-Yield Spreads Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Corporate Health Has Been Deteriorating Corporate Health Has Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building U.S. Inflation Pressure Are Building U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve Don't Fear A Flatter Yield Curve Don't Fear A Flatter Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue Governments Will Want Their Cut: U.S. Seigniorage Revenue Governments Will Want Their Cut: U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Watching The Warning Signals Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Two of the three indicators we have focused on all year as reliable signals of recession (and, therefore, of the timing for reducing exposure to risk assets) have wobbled in the past month. But, for now, we are not too concerned about this, and continue to argue that the current bull market has maybe another year to run, until a possible 2019 recession starts to get priced in. Global growth indicators are showing no signs of slowdown, with the Global Manufacturing PMI at 53.5, and 26 of the 29 markets for which Markit runs its survey returning a PMI above 50 - close to the highest percentage on record (Chart 1). However, the flattening yield curve in the U.S. has raised concerns: the gap between the yield on two-year and 10-year Treasuries has fallen to less than 60 bps (Chart 2). But a flattening yield curve is not unusual when the Fed is tightening policy, and historically the curve has needed to invert before it became a recession signal. Also of concern was a jump in early November in high-yield spreads, which have also been a good lead indicator for recession (Chart 3). The rise was caused by poor earnings from lowly-rated telecoms companies, which triggered a sell-off in junk bond ETFs. But the rise in spreads remains insignificant, and has mostly reversed since. Chart 1Global Growth Looks Fine... Global Growth Looks Fine... Global Growth Looks Fine... Chart 2But Should We Worry About The Yield Curve... But Should We Worry About The Yield Curve... But Should We Worry About The Yield Curve... Chart 3...And Rising Credit Spreads? ...And Rising Credit Spreads? ...And Rising Credit Spreads? BCA's macro view, as laid out in detail in our recent 2018 Outlook,1 is that the strong growth that has been a positive for risk assets this year will slowly become a negative next year as it is increasingly accompanied by rising inflation. Two-thirds of countries globally now have unemployment below the NAIRU (Chart 4). In the U.S., employment has reached a level at which the Philips Curve has historically been "kinky", associated with an acceleration in wage growth (Chart 5). Upside surprises in inflation will mean that the Fed will hike three or four times next year (compared to the market's expectation of only 1½ hikes), 10-year bond yields will rise to above 3%, and the dollar will appreciate. Chart 4Unemployment Is Below Nairu In Most Places Unemployment Is Below Nairu In Most Places Unemployment Is Below Nairu In Most Places Chart 5The 'Kinky' U.S. Philips Curve Monthly Portfolio Update Monthly Portfolio Update What are the implications of this scenario for portfolio construction? We continue to recommend an overweight on risk assets on the 12-month time horizon, as we would expect equities to outperform bonds until Fed policy tightens above the neutral level (which is still about five rate hikes away, as long as core PCE inflation picks up to 2%, as we expect - Chart 6). However, the risks to this scenario are rising. The Fed could stubbornly push ahead with rate hikes even if inflation remains subdued. Chinese growth could slow if the authorities misjudge the timing of structural reforms. Our geopolitical strategists argue that, while investors overestimated political risks at the start of 2017, now they are underestimating the risks (North Korea, NAFTA renegotiation, China trade issues, Italian elections).2 With valuations stretched, small shocks could trigger a disproportionate negative market reaction. More risk-averse investors, therefore, might choose to reduce exposure now, at the risk of leaving some money on the table. Equities: If global equities have further upside, as we believe, higher beta markets such as the euro zone (average beta to global equities over the past 20 years: 1.2) and Japan (beta: 0.9) are likely to continue to outperform. Both have central banks that remain accommodative, our models suggest further upside for earnings growth into next year (Chart 7), and valuations are less stretched than in the U.S. While EM equities are also high beta, we think they are likely to lag next year: higher U.S. interest rates, a stronger U.S. dollar, potential slowdown in China, and sluggish domestic demand in most major emerging economies all represent significant headwinds. Chart 6How Long Until Rates Above Neutral? How Long Until Rates Above Neutral? How Long Until Rates Above Neutral? Chart 7Euro and Japan Earnings Have Upside Monthly Portfolio Update Monthly Portfolio Update Fixed Income: A combination of higher inflation and a more aggressive Fed is not a positive environment for government bonds. We expect the yield curve to steepen over the next six months, as the market prices in higher inflation and fiscal deficits (after the U.S. tax cut), but to resume flattening mid next year, as the Fed pushes ahead with rates hikes, and worries about the risk of a policy error emerge. For now, we remain underweight duration, and prefer inflation-linked over nominal bonds. For spread product, while valuations are stretched, we see some attractiveness. As long as the global expansion continues, U.S. investment grade bonds should see a carry pickup over Treasuries of around 100 bps, and high-yield bonds one of around 250 bps (adjusting for likely defaults) - even if we don't assume further spread contraction. In a world of continuing low rates, that remains alluring. Currencies will continue to be driven by relative monetary policy. While we see the Fed tightening more than the market expects, the ECB will not raise rates until late 2019, since underlying inflationary pressures in the euro zone are much weaker. This is largely in line with what the futures market is pricing in. Interest rate differentials (and an unwind of the current large speculative long-euro positions) should cause some weakness of the euro versus the dollar. We expect the Bank of Japan to stick to its 0% target for 10-year JGBs, which means that the yen will also weaken, to below 120 to the dollar, if U.S. interest rates rise in line with our forecasts (Chart 8). Emerging market currencies have already fallen by 1.3% since early September as U.S. rates rose, and amid signs of economic weakness in some emerging economies. We expect this to continue. Chart 8Yen Is Driven By U.S. Rates Yen Is Driven By U.S. Rates Yen Is Driven By U.S. Rates Chart 9China Is What Matter For Metals Monthly Portfolio Update Monthly Portfolio Update Commodities: Our energy strategists recently raised their target for Brent and WTI crude to an average over the next two years of $65 and $63 respectively, with risk of upside surprises in the event of geopolitical disruptions (Venezuela, Kurdistan etc.). They see the OPEC agreement being extended possibly to December 2018, and argue that backwardation of the oil curve (futures prices lower than spot) and rising extraction costs will delay the response of shale oil producers to the higher price. The outlook for industrial commodities depends, as always, on China, which now comprises greater demand for base metals than the rest of the world put together (Chart 9). The risk of a slowdown in Chinese infrastructure spending next year makes us wary on metals such as iron ore, and markets such as Australia and Brazil. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "2018 Outlook - Policy And The Markets On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated 22 November 2017, available at gps.bcaresearch.com GAA Asset Allocation