Labor Market

Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Patience Required Patience Required Chart 1Managements Focused On The Message##BR##Not The Man In DC Managements Focused On The Message Not The Man In DC Managements Focused On The Message Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Strong EPS Growth Ahead, Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global Growth Estimates Accelerating Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Global LEI's Pointing Higher Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Supports For Global Growth In Place Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe Patience Required Patience Required While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators China: Healthy Growth Indicators China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet NAIRU is Not Dead Yet NAIRU is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag Patience Required Patience Required The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation In the 80s And 90s Wage Growth Did Not Provide And Early Warning On Inflation In the 80s And 90s Wage Growth Did Not Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Patience Is Required On Inflation In Long Cycles Patience Is Required On Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Labor Market Is Tight Enough To Push Up Inflation Labor Market Is Tight Enough To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU 70%+ Of States Have Unemployment Rates Below NAIRU 70%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Wage Pressures Mounting Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Return Of The Great Moderation? Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! The Great Moderation: A Global Phenomenon Too! The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks Back To Low Correlations Among Stocks Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Broad-Based Growth Lowers Implied Volatility Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Patience Required Patience Required Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.

Highlights The so-called 'Silver Tsunami' of retiring baby boomers will continue to be a drag on aggregate wage growth for some time. We would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. Overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The global inflation mini-cycle will turn down in early 2018. Approaching the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Feature Last week, the Bank of England pointed out that "some of the softness in recent pay outturns had related to the composition of employment, with the number of low-paid jobs growing disproportionately."1 Separately, a recent study by the Federal Reserve Bank of San Francisco described the exact same phenomenon in the United States. "The drag on wage growth reflects changes in workforce composition."2 The San Francisco Fed study highlighted two paradoxes. The first paradox is that for continuously full-time employed workers, wages are actually rising quite strongly. For the continuously employed, pay is growing close to the rate seen at the previous economic peak in 2007 (Chart I-2). Chart of the WeekThe Inflation Mini-Cycle Will Turn Down In Early 2018 Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-2Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up However, the entry of new and returning workers to full-time employment continues to depress aggregate wage growth - because new entrants generally earn less than workers who are leaving full-time employment. This creates the second paradox. Strong job growth can actually pull down average wages in the economy and slow the pace of aggregate wage growth. Solving The Wage Puzzle According to the San Francisco Fed, this 'composition effect' is exceptionally pronounced right now because of the large-scale exit of higher-paid baby boomers from the labour force. This has depressed aggregate wage growth by 2 percentage points, a sizeable effect relative to the normal expected wage gains. Furthermore, with so many of the baby boomer generation still approaching retirement, "the so-called Silver Tsunami will continue to be a drag on aggregate wage growth for some time." A second very important factor is at play. The current wave of technological progress is having its most disruptive impact on middle-income jobs. As we explained in Why Robots Will Kill Middle Incomes,3 "high-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources." The upshot is that when baby boomers retire, automation and Artificial Intelligence (AI) are replacing many of the jobs that the boomers occupied in high-income and middle-income sectors such as Finance and Manufacturing, rather than opening up these formerly lucrative career paths to new entrants. Therefore, new entrants are flooding into industry sectors which AI cannot yet disrupt but which are traditionally much lower paid with limited prospects for advancement - sectors like Food Services and Drinking Places and Administrative and Support Services (Table I-1). Table I-1Which Sectors Are Creating The Most Jobs? Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up In summary, for the continuously employed, wages are rising healthily. But for aggregate wage growth, the composition effect from retirements and new entrants is an exceptionally strong headwind. What does this mean for overall inflation? The study concludes that as long as the economy can keep its wage bill low by replacing retiring staff with AI and with lower-paid workers, "labour cost pressures for higher price inflation could remain muted for some time." Given that the next wave of AI is just about to hit us, we expect these conditions to hold true in all developed economies for at least the next five years. Solving The U.K. Productivity Puzzle Chart I-3Since The Global Financial Crisis U.K. ##br##Productivity Has Stagnated Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up But the San Francisco Fed study does also carry a warning about a latent inflationary threat. If productivity growth is slowing, "continued increases in unit labour costs could be hiding behind low readings on measures of aggregate wage growth." This seems to be a particular worry in the U.K. Since the global financial crisis, serial disappointments in productivity growth have concerned the Bank of England (Chart I-3). However, the Bank need not worry. We would like to present a very simple explanation for the U.K.'s so-called 'productivity puzzle'. Big clues come from comparing and contrasting the economic recoveries of 1993-2000 with 2009-17. At the very beginning of the two recoveries, productivity growth evolved in the same way. But then it took drastically different paths. Through the late 1990s, productivity growth accelerated, whereas through the 2010s productivity has stagnated. Why? A plausible explanation comes from the mirror-image patterns in self-employment. At the very beginning of the two recoveries, self-employment evolved in the same way. But through the late 1990s self-employment fell by 300,000, whereas through the 2010s self-employment has increased by a million, accounting for 30% of all jobs created (Chart I-4, Chart I-5, Chart I-6, Chart I-7). Furthermore, there is a tell-tale pattern. Whenever self-employment has picked up most sharply - for example, 2011-13 and 2015 - productivity growth has taken a big hit. Chart I-41990s Recovery: ##br##Self-Employment Fell Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-52010s Recovery: Self-Employment ##br##Has Risen Sharply Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-6Compare And Contrast: ##br##The Pattern of Self-Employment... Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart I-7...And Productivity...##br##Are Mirror-Images Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up What's going on? Contrary to popular belief, the self-employed are not innovative entrepreneurs, who might typically boost productivity. The Office for National Statistics itself has poured cold water on the increased innovation thesis, claiming that "while there has been an increase in the number of people who are self-employed there has been a reduction in the number of employees who work for the self-employed." Given that these new self-employed work for themselves with no employees of their own, the idea that they are innovative entrepreneurs is a long way from the truth. In reality, the new model army of self-employed consists of former employees in sectors like journalism, media and technology who are now freelancing. And this provides a simple explanation for the productivity puzzle. Job creation that is skewed to self-employment depresses productivity growth. The reason is that the army of self-employed have to carry out tasks in which they have no specialism, and in which they are therefore much less productive. For example, a freelance journalist must spend time managing her IT gremlins, accounts, sales pitches, and so on, rather than focussing entirely on her special skill of writing powerful news stories. This makes her much less productive as a freelancer than as an employee. However, this hit to productivity eventually abates in one of two ways: freelancers gradually become more adept at the new tasks they must undertake; or more likely, they switch back to employee jobs in which they are much more productive. Combining the messages from the first two sections, the Bank of England need not fear labour cost pressures for higher price inflation. Furthermore, with Brexit negotiations progressing at a snail's pace, U.K. based companies are getting increasingly nervous about what their future international trading relationships will look like. So we would strongly bet against the two further rate hikes that the Bank of England has flagged for this tightening cycle. The investment conclusion is to overweight U.K. 10-year gilts versus German 10-year bunds; and underweight GBP/EUR. The Inflation Mini-Cycle Will Turn Down In Early 2018 Last week, we reviewed our mini-cycle framework for the global economy. To recap, the acceleration and deceleration of global bank credit flows - as measured in the global credit impulse - exhibits a remarkably regular wave like pattern with each half-cycle lasting about 8 months. As the current mini-upswing started in May, we are likely more than half way through the mini-upswing - with an expected end around January/February 2018. At which point, the cycle will enter a mini-downswing. The mini-cycle framework is so powerful that it also perfectly explains the mini-cycles in commodity price inflation - specifically, metals - and unsurprisingly, in overall inflation too. To anybody who still doubts the existence of these remarkably regular mini-cycles, the Chart of the Week and Chart I-8 should put the doubts to rest once and for all. Chart I-8Metal Price Inflation Also Exhibits Remarkably Regular Mini-Cycles Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Make no mistake. The mini-cycle in commodity prices and overall inflation will turn down in early 2018. So as we approach the year end, use technical opportunities to trim exposure to commodities, commodity equities and commodity currencies. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From the Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on November 1, 2017. 2 From the SF Fed blog 'The Good News on Wage Growth' August 14. 2017. 3 Please see the European Investment Strategy Special Report 'Why Robots Will Kill Middle Incomes' August 10, 2017 available at eis.bcaresearch.com. Fractal Trading Model* The near 20% rally in Japan's Nikkei 225 since early September has taken its 65-day fractal dimension to its lower bound, suggesting a likelihood of a trend-change. So our recommended trade this week is short Nikkei 225 / long Eurostoxx50 with a profit target / stop loss set at 3%. We now have six open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-2Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-3Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-4Indicators To Watch - Bond Yields Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-6Indicators To Watch -##br## Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-7Indicators To Watch -##br## Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up Chart II-8Indicators To Watch - ##br##Interest Rate Expectations Will The Real Wage Inflation Please Stand Up Will The Real Wage Inflation Please Stand Up

Highlights The macro environment remains positive for risk assets. Nonetheless, the shadow of the '87 stock market crash is a reminder that major market corrections can occur even when the earnings and economic growth backdrop is upbeat. Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of easier financial conditions and the likelihood of some fiscal stimulus next year. Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should overweight Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments). High-yield relative value is decent after accounting for the favorable default outlook. It is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late cycle phase. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. The risk of disappointment is therefore elevated. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons and provide dry powder to boost exposure after the correction. Feature The October anniversary of the '87 stock market crash was a reminder to investors that major market corrections can arrive out of the blue. With hindsight, there were some warning signs evident before the crash. Nonetheless, the speed and viciousness of the correction caught the vast majority of investors by surprise, in large part because the economy was performing well (outside of some yawning imbalances such as the U.S. current account deficit). Many worried that the 20% drop in the S&P 500 would trigger a recession, but the economy did not skip a beat and it was not long before the equity market recouped the losses. We view the '87 crash as a correction rather than a bear market. BCA's definition of a bear market is a combination of magnitude (at least a 15% decline) and duration (lasting at least for six months). Bear markets are usually associated with economic recessions. Corrections tend to be short-lived because they are not associated with an economic downturn. None of our forward-looking indicators suggest that a recession is in the cards in the near term for any of the major economies. Even the risk of a financial accident or economic pothole in China has diminished in our view. As discussed below, the global economy is firing on almost all cylinders. Chart I-1Valuation Today Is Very Stretched Vs. 1987 Valuation Today Is Very Stretched Vs. 1987 Valuation Today Is Very Stretched Vs. 1987 Nonetheless, there are some parallels today with the mid-1980s. A Special Report sent to all BCA clients in October provides a retrospective on the '87 crash.1 One concern is that the proliferation of financial computer algorithms and derivatives is a parallel to the popularity of portfolio insurance in the 1980s, which was blamed for turbocharging the selling pressure when the market downturn gathered pace in October. My colleague Doug Peta downplays the risks inherent in the ETF market in the Special Report, but argues that automatic selling will again reinforce the fall in prices once it starts. It is also worrying that equity valuation is much more stretched than was the case in the summer of 1987 based on the cyclically-adjusted P/E ratio (CAPE, Chart I-1). The CAPE is currently at levels only previously reached ahead of the 1929 and 2000 peaks. In contrast, the CAPE was close to its long-term average in 1987. Quantitative easing and extremely low interest rates have pulled forward much of the bond and stock markets' future returns. It has also contributed to today's extremely low readings on implied volatility. The fact that the Fed is slowly taking away the punchbowl and that the ECB is dialing back its asset purchase program only add to the risk of a sharp correction. The Good News For now though, investors are focusing on the improving global growth backdrop and the still-solid earnings picture. While the S&P 500 again made new highs in October, it was the Nikkei that stole the show among the major countries. Impressively, the surge in the Japanese stock market was not on the back of a significantly weaker yen. As we highlighted last month, risk assets are being supported by the three legged stool of robust earnings growth, low volatility and yield levels in government bonds, and the view that inflation will remain quiescent for the foreseeable future. The fact that the global growth impulse is broadly-based is icing on the cake because it reduces lingering fears of secular stagnation. Even emerging economies have joined the growth party, while a weak U.S. dollar has tempered fears of a financial accident in this space. Our forward-looking growth indicators are upbeat (Chart I-2). Our demand indicators in the major economies remain quite bullish, especially for capital spending (not shown). Animal spirits are beginning to stir. Moreover, financial conditions remain growth-friendly, especially in the U.S., and subdued inflation is allowing central banks to proceed cautiously for those that are tightening or tapering. The global PMI broke to a new high in October, and the economic surprise index for the major economies has surged in recent months. Our global LEI remains in a strong uptrend and its diffusion index shifted back into positive territory, having experiencing a worrisome dip into negative territory earlier this year. We expect the global growth upturn will persist for at least the next year. The U.S. will be the first major economy to enter the next recession, although this should not occur until 2019. It is thus too early to expect the equity market to begin to anticipate the associated downturn in profit growth. Earnings: Japan A Star Performer It is still early days in the Q3 earnings season, but the mini cyclical rebound from the 2015/16 profit recession in the major economies is still playing out. The bright spots at the global level outside of energy are industrials, materials, technology and consumer staples (Chart I-3). All four are benefitting from strengthening top line growth and rising operating margins. Chart I-2Upbeat Global Economic Indicators Upbeat Global Economic Indicators Upbeat Global Economic Indicators Chart I-3Global Earnings By Sector Global Earnings By Sector Global Earnings By Sector The U.S. is further advanced in the mini-cycle and EPS growth is near its peak on a 4-quarter moving total basis. The expected topping out in profit growth is more a reflection of challenging year-on-year comparisons than a deterioration in the underlying fundamentals. The hurricanes will take a bite out of third quarter earnings, but this effect will be temporary. Moreover, oil prices are turbocharging earnings in the energy patch and we expect this to continue. Our commodity strategists recently lifted their 2018 target price for both Brent and WTI to $65/bbl and $63/bbl, respectively. The global uptick in GDP growth, along with continued production discipline from OPEC 2.0 are the principal drivers of our revised outlook. We expect the fortuitous combination of fundamentals to accelerate the drawdown in oil inventories globally, which also will be supportive for prices. While U.S. financials stocks have cheered the prospects that Congress may pass a tax bill sometime in early 2018, sell-side analysts have been brutally downgrading financial sector EPS estimates. This has dealt a blow to net earnings revisions in the sector. Expected hurricane-related losses are probably the main culprit, especially in the insurance sector. Nonetheless, our equity sector strategists argue that such indiscriminate downgrades are unwarranted, and we would lean against such pessimism.2 Recent profit results corroborate our positive sector bias, although we are still early in the earnings season. European profits will suffer to some extent in the third quarter due to the lagged effects of previous euro strength. The same will be true in the fourth quarter, although we expect this headwind to diminish early in 2018. That leaves Japan as the star profit performer among the majors in the near term. The recent surge in foreign flows into the Japanese market suggests that global investors are beginning to embrace the upbeat EPS story. Abe's election win in October means that the current monetary stance will remain in place. The ruling LDP's shift away from austerity (e.g. abandoning the primary balance target) may also be lifting growth expectations. A Return To The Great Moderation? Chart I-4Market Correlation And The ERP bca.bca_mp_2017_11_01_s1_c4 bca.bca_mp_2017_11_01_s1_c4 A lot of the good news is already discounted in equity prices. The depressed level of the VIX and the drop in risk asset correlations this year signal significant complacency. Large institutional investors are reportedly selling volatility and thus dampening vol across asset classes. But there is surely more to it. It appears that investors believe we have returned to the pre-Lehman period between 1995 and 2006 when the Great Moderation in macro volatility contributed to low correlations among stocks within the equity market (Chart I-4). The idea is that low perceived macroeconomic volatility during that period had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. Of course, the Great Recession and financial market crisis brought the Great Moderation to a crashing end. Correlations rocketed up and investors demanded a higher equity risk premium to hold stocks. Today, dispersion in the outlooks for growth and interest rates have fallen back to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart I-5). Some of this can be justified by fundamentals. The onset of a broadly-based global expansion phase has likely calmed lingering fears that the global economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has moderated as well (bottom panel). Historically, implied volatility tended to fall during previous periods when global industrial production was strong and global earnings were rising across a broad swath of countries (Chart I-6). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to fall as earnings fundamentals become more important performance drivers and sector differentiation generates alpha, as the broad market enters the last stage of the bull market. Similarly, the VIX can fluctuate at low levels for an extended period when global growth is broadly based. Chart I-5A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? A Less Uncertain Macro Outlook? Chart I-6Broad-Based Growth Lower Implied Volatility Broad-Based Growth Lower Implied Volatility Broad-Based Growth Lower Implied Volatility Still, current levels of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table I-1 shows the drop in the S&P 500 index during non-recession periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during the nine episodes, with a range of -3.6 to -18.1%. Table I-1Episodes When VIX Spiked November 2017 November 2017 The Equity Risk Premium Chart I-7Still Some Value In High-Yield Still Some Value In High-Yield Still Some Value In High-Yield On a positive note, the equity risk premium (ERP) is not overly depressed. There are many ways to define the ERP, but we present it as the 12-month forward earnings yield minus the 10-year Treasury yield in Chart I-4. It has fallen from about 760 basis points in 2011 to 310 basis points today. We do not believe that the ERP can return to the extremely low levels of 1990-2000. At best, the ERP may converge with the level that prevailed during the last equity bull market, from 2003-2007 (about 200 basis points). The current forward earnings yield is 550 basis points and the 10-year Treasury yield is 2.4%. The ERP would need to fall by 110 basis points to get back to the 2% equilibrium. This convergence can occur through some combination of a lower earnings yield or higher bond yield. If the 10-year yield is assumed to peak in this cycle at about 3% (our base case), then this leaves room for the earnings yield to fall by 50 basis points. This would boost the forward earnings multiple from 18 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We are not betting on any further multiple expansion but the point is that stocks at least have some padding in the event that bond yields adjust higher in a gradual way. It is the same story for speculative-grade bonds, which are not as expensive as they seem on the surface. The average index OAS is currently 326 bps, only about 100 bps above its all-time low. However, junk value appears much more attractive once the low default rate is taken into account. Chart I-7 presents the ex-post default-adjusted spreads, along with our forecast based on unchanged spreads and our projection for net default losses over the next year. The spread padding offered by the high-yield sector is actually reasonably good by historical standards, assuming there is no recession over the next year. We are not banking on much spread tightening from here, which means that high-yield is largely a carry trade now. Nonetheless, given a forecast for the default and recovery rate, we expect U.S. high-yield excess returns to be in the range of 2% and 5% (annualized) over the next 6-12 months. The bottom line is that the positive growth backdrop does not rule out a correction in risk assets, especially given rich valuations. But at least the profit, default and growth figures will remain a tailwind in the near term. The main risk is a breakout in inflation, which financial markets are not priced for. Inflation And Hidden Slack The September CPI report did little to buttress the FOMC's view that this year's inflation pullback is temporary. The report disappointed expectations again with core CPI rising only 0.13% month-over-month. For context, an environment where inflation is well anchored around the Fed's target would be consistent with core CPI prints of 0.2% every month, roughly 2.4% annualized. The inflation debate continues to rage inside and outside the Fed as to whether the previous relationship between inflation and growth have permanently changed, whether low inflation simply reflects long lags, or whether it will require tighter labor markets in this business cycle to fuel wage and price pressures. We back the latter two of these three explanations but, admittedly, predicting exactly when inflation will pick up is extremely difficult and we must keep an open mind. A Special Report in the October IMF World Economic Outlook sheds some light on this vexing issue.3 Their work suggests that the deceleration in wage growth in the post-Lehman period in the OECD countries can largely be explained by traditional macro factors: weak productivity growth, lower inflation expectations and labor market slack. The disappointing productivity figures alone account for two-thirds of the drop in wage growth. However, a key point of the research is that the headline unemployment figures are not as good a measure of labor market slack as they once were. This is because declining unemployment rates partly reflect workers that have been forced into part-time jobs, referred to as involuntary part-time employment (IPT). The rise in IPT employment could be associated with automation, the growing importance of the service sector, and a diminished and more uncertain growth outlook that is keeping firms cautious. The IMF's statistical analysis suggests that the number of involuntary part-time workers as a share of total employment (IPT ratio) is an important measure of slack that adds information when explaining the decline in wage growth. Historically, each one percentage point rise in the IPT ratio trimmed wage growth by 0.3 percentage points. Chart I-8 and Chart I-9 compare the unemployment rate gap (unemployment rate less the full-employment estimate) with the deviation in the IPT ratio from its 2007 level. The fact that the IPT ratio has had an upward trend since 2000 in many countries makes it difficult to identify a level that is consistent with full employment. Nonetheless, the change in this ratio since 2007 provides a sense of how much "hidden slack" the Great Recession generated due to forced part-time employment. Chart I-8Measures Of Labor Market Slack (I) Measures Of Labor Market Slack (I) Measures Of Labor Market Slack (I) Chart I-9Measures Of Labor Market Slack (II) Measures Of Labor Market Slack (II) Measures Of Labor Market Slack (II) For the OECD as a whole, labor market slack has been fully absorbed based on the unemployment gap. However, the IPT ratio was still elevated at the end of 2016 (latest data available), helping to explain why wage growth has remained so depressed across most countries. The IPT ratio is still above its 2007 level in three-quarters of the OECD countries. Of course, there is dispersion across countries. Japan has no labor market slack by either measure. In the U.S., the unemployment gap has fallen into negative territory, but only about half of the post-2007 rise in the IPT ratio has been unwound. For the Eurozone, the U.K. and Canada, the unemployment gap is close to zero (or well into negative territory in the U.K.). Nonetheless, little of the under-employment problem in these economies has been absorbed based on the IPT ratio. Our discussion in last month's report highlighted the importance of the global output gap in driving inflation in individual countries. Consistent with this, the IMF finds that there have been important spillover effects related to labor market slack, especially since 2007. This means that wage growth can be held down even in countries where slack has disappeared because of the existence of a surplus of available labor in their trading partners. Phillips Curve Is Not Dead That said, we still believe that the U.S. is at a point in the cycle when inflationary pressures should begin to build, even in the face of persisting labor market slack at the global level. Chart I-10 shows the ECI and the Atlanta Fed wage tracker, which are the best measures of wages because they are less affected by composition effects. Both have moved higher along with measures of labor market tightness. Wage and consumer price inflation have ebbed this year, but when we step back and look at it over a longer timeframe, the Phillips curve still appears to be broadly operating. Moreover, inflation is a lagging indicator. Table I-2 splits the post-war U.S. business cycles into short, medium, and long buckets based on the length of the expansion phase. It presents the number of months from when full employment was reached to the turning point for consumer price inflation in each expansion. There was a wide variation in this lag in the short- and medium-length expansions, but the lags were short on average. Chart I-10Phillips Curve Still (Weakly) Operating Phillips Curve Still (Weakly) Operating Phillips Curve Still (Weakly) Operating Table I-2Inflation Reacts With A Lag November 2017 November 2017 It is a different story for long expansions, where the lag averaged more than two years. We have pointed out in the past that it takes longer for inflation pressures to reveal themselves when the economy approaches full employment gradually, in contrast to shorter expansions when momentum is so strong the demand crashes into supply constraints. The fact that U.S. unemployment rate has only been below the estimate of full employment for eight months in this expansion suggests that perhaps we and the Fed are just being too impatient in waiting for the inflection point. Turning to Europe, the IPT ratio confirms the ECB's view that there is an abundance of under-employment, despite the relatively low unemployment rate. This suggests that the Eurozone remains behind the U.S. in the economic cycle. As expected, the ECB announced a tapering in its asset purchase program to take place next year. While policymakers are backing away from QE in the face of healthy growth and a shrinking pool of bonds to purchase, they will continue to emphasize that rate hikes are a long way off in order to avoid a surge in the euro and an associated tightening in financial conditions. U.S./Eurozone bond yield spreads are still quite wide by historical standards and thus it is popular to bet on spread narrowing and a stronger euro/weaker dollar. However, some narrowing in short-term rate spreads is already discounted based on the OIS forward curve (Chart I-11). The real 5-year, 5-year forward OIS spread - the market's expectation of how much higher U.S. real 5-year rates will be in five years' time relative to the euro area - stands at about 70 basis points. This spread is not wide by historical standards, and thus has room to widen again if market expectations for the fed funds rate moves up toward the Fed's 'dot plot' over the next 6-12 months. While market pricing for the ECB policy rate path appears about right in our view, market expectations for rate hikes in the U.S. are too complacent. This implies that long-term spreads could widen in favor of the U.S. dollar over the coming months, especially if U.S. growth accelerates while euro area growth cools off a bit. The fact the U.S. economic surprise index has turned positive is early evidence that this process may have already begun. Moreover, the starting point is that the dollar has been weaker than interest rate differentials warrant, such that there is some room for the dollar to 'catch up', even if interest rate differentials do not move (Chart I-12). We see EUR/USD falling to 1.15 by the end of the year. Chart I-11Room For U.S./Eurozone Spreads To Widen... Room For U.S./Eurozone Spreads To Widen... Room For U.S./Eurozone Spreads To Widen... Chart I-12...Giving The Dollar A Lift ...Giving The Dollar A Lift ...Giving The Dollar A Lift A New Fed Chair? Our forecast for yield spreads and currencies is not overly affected by the choice of Fed Chair for next year. President Trump's meeting with academic John Taylor reportedly went well, but we think the President will prefer someone with a less hawkish bent. Keeping Chair Yellen is an option, but she has strong views on financial sector regulation that Trump does not like. The prevailing wisdom is that Jerome Powell is a moderate who is only slightly more hawkish than Yellen. But the truth is that we don't really know where he stands because he has no academic publication record and has generally steered clear of taking bold views on monetary policy. In any event, the organizational structure of the Fed makes it impossible for the chair to run roughshod over other FOMC members. This suggests that no matter who is selected, the general thrust of monetary policy will not change radically next year. As discussed above, uncertainty is elevated, but our base case sees inflation rising enough in the coming months for the Fed to maintain their 'dot plot' forecast. The market and the Fed are correct to 'look through' the near-term growth hit from the hurricanes, to the rebound that always follows the destruction. The U.S. housing sector is a little more worrying because some softness was evident even before the hurricanes hit. Since the early 1960s, a crest in housing led the broader economic downturn by an average of seven quarters. Nonetheless, we continue to expect that the housing soft patch does not represent a peak for this cycle. Residential investment should provide fuel to the economy for at least the next two years as pent up demand is worked off, related to depressed household formation since the 2008 financial crisis. Affordability will still be favorable even if mortgage rates were to rise by another 100 basis points (Chart I-13). Robust sentiment in the homebuilder sector in October confirms that the hurricane setback in housing starts is temporary. China And Base Metals Turning to China, economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic are all growing at double-digit rates, albeit down from recent peak levels (Chart I-14). Various price indexes also reveal a fairly broadly-based inflation pickup to levels that will unnerve the authorities. Growth will likely slow in 2018 as policymakers continue to pare back stimulus. We do not foresee a substantial growth dip next year, but it could be hard on base metals prices. Chart I-13Housing Affordability Outlook Housing ##br##Affordability Under Various Rate Assumptions Housing Affordability Outlook Housing Affordability Under Various Rate Assumptions Housing Affordability Outlook Housing Affordability Under Various Rate Assumptions Chart I-14China: Healthy ##br##Growth Indicators China: Healthy Growth Indicators China: Healthy Growth Indicators Policy shifts discussed in Chinese President Xi's speech in October to the Party Congress are also negative for metals prices in the medium term. The speech provided a broad outline of goals to be followed by concrete policy initiatives at the National People's Congress (NPC) in March 2018. He emphasized that policy will tackle inequality, high debt levels, overcapacity and pollution. Globalization will also remain a priority of the government. The supply side reforms required to meet these goals will be positive in the long run, but negative for growth in the short run. Restructuring industry, deleveraging the financial sector and fighting smog will all have growth ramifications. The government could use fiscal stimulus to offset the short-term hit to growth. However, while overall growth may not slow much, the shift away from an investment-heavy, deeply polluting growth model, will undermine the demand for base metals. Our commodity strategists also highlight the supply backdrop for most base metals is not supportive of an extended rally in prices. The implication is that investors who are long base metals should treat it as a trade rather than a strategic position. Despite our expectation that policy will continue to tighten, we believe that investors should overweight Chinese stocks relative to other EM markets. Investment Conclusions: Our base case remains that global growth will stay reasonably firm in 2018, although the composition of that growth will shift towards the U.S. thanks to the lagged effects of the easing in U.S. financial conditions that has taken place this year and the likelihood of some fiscal stimulus next year. The U.S. Congress has drawn closer to approving a budget resolution for fiscal 2018 that would pave the way for tax legislation to reach President Donald Trump's desk by the end of the first quarter of next year. Surveys show that investors have all but given up on the prospect of tax cuts, which means that it will be a positive surprise if it finally arrives (as we expect). Positive U.S. economic growth surprises and the disappearing output gap will allow the Fed to raise rates more than is discounted by the markets, providing a lift to the dollar and widening U.S. yield spreads relative to its trading partners. The momentum in profit growth, however, will favor Japan relative to the U.S. and Europe. Investors should favor Japanese equities and hedge the currency risk. There is still more upside for oil prices, but we are not playing the rally in base metals. The Chinese economy is performing well at the moment, but ample base metal supply and a rising dollar argue against a substantial price rise from current levels. Emerging market equities should underperform the developed markets due to a rising U.S. dollar and the largely sideways path for base metals. Our macro and profit views are consistent with cyclicals outperforming defensive stocks. Investors should also continue to bet on higher inflation expectations and be overweight corporate bonds (relative to governments) in the major developed fixed-income markets. Our base-case outlook implies that it is too early to fully retreat from risk assets and prepare for the next recession. Nonetheless, the market has entered a late-cycle phase. Calm macro readings and still-easy monetary policy have generated signs of froth. Investors appear to have shed fears of secular stagnation, and have embraced a return to a lackluster-growth version of the Great Moderation. Low levels of market correlation and implied volatility can perhaps be justified, but only if there are no financial accidents on the horizon and any rise in inflation is gradual enough to keep the bond vigilantes at bay. Upside inflation surprises would destabilize the three-legged stool supporting risk assets, especially at a time when the Fed is shrinking its balance sheet. Black Monday is a reminder that major market pullbacks can occur even when the economic outlook is bright. Thus, investors with less tolerance for risk should maintain an extra cash buffer to protect against swoons, and to ensure that they have dry powder to exploit them when they materialize. Mark McClellan Senior Vice President The Bank Credit Analyst October 26, 2017 Next Report: November 20, 2017 1 Please see BCA Special Report, "Black Monday, Thirty Years On: Revisiting The First Modern Global Financial Crisis," October 19, 2017, available at bca.bcaresearch.com 2 Please see BCA U.S. Equity Strategy Weekly Report, "Banks Hold The Key," October 24, 2017, available at uses.bcaresearch.com 3 Recent Wage Dynamics In Advanced Economies: Drivers And Implications. Chapter 2, IMF World Economic Outlook. October 2017. II. Three Demographic Megatrends Dear Client, This month's Special Report is written by my colleague, Peter Berezin, Chief Global Strategist. Peter highlights three key demographic trends that will shape financial markets in the coming decades. His non-consensus conclusions include the idea that demographic trends will be negative for both bonds and equities over the long haul, in part because the trends are inflationary. Moreover, continuing social fragmentation will not be good for business. Mark McClellan Megatrend #1: Population Aging. Aging has been deflationary over the past few decades, but will become inflationary over the coming years. Megatrend #2: Global Migration. International migration has the potential to lift millions out of poverty while boosting global productivity. However, if left unmanaged, it poses serious risks to economic stability. Megatrend #3: Social Fragmentation. Rising inequality, cultural self-segregation, and political polarization are imperilling democracy and threatening free-market institutions. On balance, these trends are likely to be negative for both bonds and equities over the long haul. In today's increasingly short-term oriented world, it is easy to lose track of megatrends that are slowly shifting the ground under investors' feet. In this report, we tackle three key social/demographic trends. Chart II-1Our Aging World Our Aging World Our Aging World Megatrend #1: Population Aging Fertility rates have fallen below replacement levels across much of the planet. This has resulted in aging populations and slower labor force growth (Chart II-1). In the standard neoclassical growth model, a decline in labor force growth pushes down the real neutral rate of interest, r*. This happens because slower labor force growth causes the capital stock to increase relative to the number of workers, resulting in a lower rate of return on capital.1 The problem with this model is that it treats the saving rate as fixed.2 In reality, the saving rate is likely to adjust to changes in the age composition of the workforce. Initially, as the median age of the population rises, aggregate savings will increase as more people move into their peak saving years (ages 30 to 50). This will put even further downward pressure on the neutral rate of interest. Eventually, however, savings will fall as these very same people enter retirement. This, in turn, will lead to a higher neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in r*, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up, leading to higher long-term nominal bond yields. Contrary to popular belief, spending actually increases later in life once health care costs are included in the tally (Chart II-2). And despite all the happy talk about how people will work much longer in the future, the unfortunate fact is that the percentage of American 65 year-olds who are unable to lead active lives because of health care problems has risen from 8.8% to 12.5% over the past 10 years (Chart II-3). Cognitive skills among 65 year-olds have also declined over this period. We are approaching the inflection point where demographic trends will morph from being deflationary to being inflationary. Globally, the ratio of workers-to-consumers - the so-called "support ratio" - has peaked after a forty-year ascent (Chart II-4). As the support ratio declines, global savings will fall. To say that global saving rates will decline is the same as saying that there will be more spending for every dollar of income. Since global income must sum to global GDP, this implies that global spending will rise relative to production. That is likely to be inflationary. Chart II-2Savings Over The Life Cycle Savings Over The Life Cycle Savings Over The Life Cycle Chart II-3Climbing Those Stairs Is ##br##Getting More And More Difficult November 2017 November 2017 Chart II-4The Ratio Of Workers To ##br##Consumers Has Peaked The Ratio Of Workers To Consumers Has Peaked The Ratio Of Workers To Consumers Has Peaked The projected evolution of support ratios varies across countries. The most dramatic change will happen in China. China's support ratio peaked a few years ago and will fall sharply during the coming decade. Nearly one billion Chinese workers entered the global labor force during the 1980s and 1990s as the country opened up to the rest of the world. According to the UN, China will lose over 400 million workers over the remainder of the century (Chart II-5). If the addition of millions of Chinese workers to the global labor force was deflationary in the past, their withdrawal will be inflationary in the future. The fabled "Chinese savings glut" will eventually dry up. Chart II-5China On Course To Lose More ##br##Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers Rising female labor force participation rates have blunted the effect of population aging in Europe and Japan. This has allowed the share of the population that is employed to increase over the past few decades. However, as female participation stabilizes and more people enter retirement, both regions will also see a rapid decline in saving rates. This could lead to a deterioration in their current account balances, with potential negative implications for the yen and the euro. Population aging is generally bad news for equities. The slower expansion in the labor force will reduce the trend GDP growth. This will curb revenue growth, and by extension, earnings growth. To make matter worse, to the extent that lower savings rates lead to higher real interest rates, population aging could reduce the price-earnings multiple at which stocks trade. This could be further exacerbated by the need for households to run down their wealth as they age, which presumably would include the sale of equities. Megatrend #2: Global Migration Economist Michael Clemens once characterized the free movement of people across national boundaries as a "trillion-dollar bill" just waiting to be picked up from the sidewalk.3 Millions of workers toil away in poor countries where corruption is rife and opportunities for gainful employment are limited. Global productivity levels would rise if they could move to rich countries where they could better utilize their talents. Academic studies suggest that less restrictive immigration policies would do much more to raise global output than freer trade policies. In fact, several studies have concluded that the removal of all barriers to labor mobility would more than double global GDP (Table II-1). The problem is that many migrants today are poorly skilled. While they can produce more in rich countries than they can back home, they still tend to be less productive than the average native-born worker. This can be especially detrimental to less-skilled workers in rich countries who have to face greater competition - and ultimately, lower wages - for their labor. Chart II-6 shows that the share of U.S. income accruing to the top one percent of households has closely tracked the foreign-born share of the population. Table II-1Economic Benefits Of Open Borders November 2017 November 2017 Chart II-6Immigration Versus Income Distribution Immigration Versus Income Distribution Immigration Versus Income Distribution Low-skilled migration can also place significant strains on social safety nets. These concerns are especially pronounced in Europe. The employment rate among immigrants in a number of European countries is substantially lower than for the native-born population (Chart II-7). For example, in Sweden, the employment rate for immigrant men is about 10 percentage points lower than for native-born men. For women, the gap is 17 points. The OECD reckons that a typical 21-year old immigrant to Europe will contribute €87,000 less to public coffers in the form of lower taxes and higher welfare benefits than a non-immigrant of the same age (Chart II-8). Chart II-7Low Levels Of Immigrant Labor Participation In Parts Of Europe November 2017 November 2017 Chart II-8Immigration Is Straining Generous ##br##European Welfare States November 2017 November 2017 All of this would matter little if the children of today's immigrants converged towards the national average in terms of income and educational attainment, as has usually occurred with past immigration waves. However, the evidence that this is happening is mixed. While there is a huge amount of variation within specific immigrant communities, on average, some groups have fared better than others. The children of Asian immigrants to the U.S. have tended to excel in school, whereas college completion rates among third-generation-and-higher, self-identified Hispanics are still only half that of native-born non-Hispanic whites (Chart II-9). Across the OECD, second generation immigrant children tend to lag behind non-immigrant students, often by substantial margins (Chart II-10). Chart II-9Hispanic Educational Attainment Lags Behind November 2017 November 2017 Chart II-10Worries About Immigrant Assimilation November 2017 November 2017 Immigration policies that place emphasis on attracting skilled migrants would mitigate these concerns. While such policies have been adopted in a number of countries, they have often been opposed by right-leaning business groups that benefit from cheap and abundant labor and left-leaning political parties that want the votes that immigrants and their descendants provide. Humanitarian concerns also make it difficult to curtail migration, especially when it is coming from war-torn regions. Chart II-11The Projected Expansion ##br##In Sub-Saharan Population The Projected Expansion In Sub-Saharan Population The Projected Expansion In Sub-Saharan Population Europe's migration crisis has ebbed in recent months but could flare up at any time. In 2004, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2017 revision, the UN doubled its projection to 4 billion. Nigeria's population is expected to rise to nearly 800 million by 2100; Congo's will soar to 370 million; Ethiopia's will hit 250 million (Chart II-11). And even that may be too conservative because the UN assumes that the average number of births per woman in sub-Saharan Africa will fall from 5.1 to 2.2 over this period. For investors, the possibility that migration flows could become disorderly raises significant risks. For one, low-skill migration could also cause fiscal balances to deteriorate, leading to higher interest rates. Moreover, as we discuss in greater detail below, it could propel more populist parties into power. This is a particularly significant worry for Europe, where populist parties have often pursued business-sceptic, anti-EU agendas. Megatrend #3: Social Fragmentation In his book "Bowling Alone," Harvard sociologist Robert Putnam documented the breakdown of social capital across America, famously exemplified by the decline in bowling leagues.4 There is no single explanation for why communal ties appear to be fraying. Those on the left cite rising income and wealth inequality. Those on the right blame the welfare state and government policies that prioritize multiculturalism over assimilation. Conservative commentators also argue that today's cultural elites are no longer interested in instilling the rest of society with middle-class values. As a result, behaviours that were once only associated with the underclass have gone mainstream.5 Technological trends are exacerbating social fragmentation. Instead of bringing people together, the internet has allowed like-minded people to self-segregate into echo chambers where members of the community simply reinforce what others already believe. It is thus no surprise that political polarization has grown by leaps and bounds (Chart II-12). When people can no longer see eye to eye, established institutions lose legitimacy. Chart II-13 shows that trust in the media has collapsed, especially among right-leaning voters. Perhaps most worrying, support for democracy itself has dwindled around the world (Chart II-14). Chart II-12U.S. Political Polarization: Growing Apart November 2017 November 2017 Chart II-13The Erosion Of Trust In Media November 2017 November 2017 It would be naïve to think that the public's rejection of the political establishment will not be mirrored in a loss of support for the business establishment. The Democrats "Better Deal" moves the party to the left on many economic issues. Nearly three-quarters of Democratic voters believe that corporations make "too much profit," up from about 60% in the 1990s (Chart II-15). Chart II-14Who Needs Democracy When You Have Tinder? November 2017 November 2017 Chart II-15People Versus Companies November 2017 November 2017 The share of Republican voters who think corporations are undertaxed has stayed stable in the low-40s, but this may not last much longer. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to lean liberal on social issues and conservative on economic ones - the exact opposite of a typical Trump voter. If Trump voters abandon corporate America, this will leave the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. The fact that social fragmentation is on the rise casts doubt on much of the boilerplate, feel-good commentary written about the "sharing economy." For starters, the term is absurd. Uber drivers are not sharing their vehicles. They are using them to make money. Both passengers and drivers can see one another's ratings before they meet. This reduces the need for trust. As trust falls, crime rises. The U.S. homicide rate surged by 20% between 2014 and 2016 according to a recent FBI report.6 In Chicago, the murder rate jumped by 86%. In Baltimore, it spiked by 52%. Chart II-16 shows that violent crime in Baltimore has remained elevated ever since riots gripped the city in April 2015. The number of homicides in New York, whose residents tend to support more liberal policing standards for cities other than their own, has remained flat, but that is unlikely to stay the case if crime is rising elsewhere. The multi-century decline in European homicide rates also appears to have ended (Table II-2). Much has been written about how millennials are flocking to cities to enjoy the benefits of urban life. But this trend emerged during a period when urban crime rates were falling. If that era has ended, urban real estate prices could suffer tremendously. It is perhaps not surprising that the increase in crime rates starting in the 1960s was mirrored in rising inflation (Chart II-17). If governments cannot even maintain law and order, how can they be trusted to do what it takes to preserve the value of fiat money? The implication is that greater social instability in the future is likely to lead to lower bond prices and a higher equity risk premium. Chart II-16Do You Still Want To Move Downtown? November 2017 November 2017 Table II-2Crime Rates Are Creeping Higher In Europe November 2017 November 2017 Chart II-17Homicides And Inflation Homicides And Inflation Homicides And Inflation Peter Berezin Chief Global Strategist Global Investment Strategy November 2017 November 2017 2 Another problem with the neoclassical model is that it assumes perfectly flexible wages and prices. This ensures that the economy is always at full employment. Thus, if the saving rate rises, investment is assumed to increase to fully fill the void left by the decline in consumption. In the real world, the opposite tends to happen: When households reduce consumption, firms invest less, not more, in new capacity. One of the advantages of the traditional Keynesian framework is that it captures this reality. And interestingly, it also predicts that aging will be deflationary at first, but will eventually become inflationary. Initially, slower population growth reduces the need for firm to expand capacity, causing investment demand to fall. Aggregate savings also rises, as more people move into their peak saving years. Globally, savings must equal investment. If desired investment falls and desired savings rises, real rates will increase. At the margin, higher real rates will discourage investment and encourage saving, thus ensuring that the global savings-investment identity is satisfied. As savings ultimately begins to decline as more people retire, the equilibrium real rate of interest will rise again. 3 Michael A. Clemens, "Economics and Emigration: Trillion-Dollar Bills on the Sidewalk?" Journal of Economic Perspectives Vol. 25, no.3, pp. 83-106 (Summer 2011). 4 Robert D. Putnam, "Bowling Alone: The Collapse And Revival Of American Community," Simon and Schuster, 2001. 5 Charles Murray has been a leading proponent of this argument. Please see "Coming Apart: The State Of White America, 1960-2010," Three Rivers Press, 2013. 6 Federal Bureau of Investigation, "Crime In The United States 2016" (Accessed October 25, 2017). III. Indicators And Reference Charts Global equity markets partied in October on solid earnings and economic growth figures, and the rising chances of a tax cut in the U.S. among other bullish developments. The Nikkei has been particularly strong in local currency terms following the re-election of Abe. Our equity indicators remain upbeat on the whole, although the rally is looking stretched by some measures. The BCA monetary indicator is hovering at a benign level. Implied equity volatility is very low, investor sentiment is frothy and our Speculation Indicator is elevated. These suggest that a lot of good news is already discounted. Our valuation indicator is also closing in on the threshold of overvaluation at one standard deviation. Our technical indicator is rolling over, although it needs to fall below the zero line to send a 'sell' signal. On a constructive note, the solid rise in earnings-per-share is likely to continue in the near term, based on positive earnings surprises and the net revisions ratio. Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in September for the third consecutive month. We introduced the RPI in the July report. It combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The U.S. and European WTPs rose in October after a brief sideways move in previous months, suggesting that equity flows have turned more constructive. But the Japanese WTP is outshining the others. Given that the Japanese WTP is rising from a low level, it suggests that there is more 'dry powder' available to purchase Japanese stocks, especially relative to the U.S. market. We favor Japanese stocks relative to the other two markets in local currency terms, as highlighted in the Overview section. Oversold conditions for the U.S. dollar have now been absorbed based on our technical indicator, but there is plenty of upside for the currency before technical headwinds begin to bite. The greenback looks expensive based on PPP, but is less so on other measures. We are positive in the near term. Our composite technical indicator for U.S. Treasurys has moved above the zero line, but has not reached oversold territory. Bond valuation is close to fair value based on our long-standing valuation model. These factors suggest that yields have more upside potential before meeting resistance. Other models that specifically incorporate global economic factors suggest that the 10-year Treasury is still about 20 basis points on the expensive side. Stay below benchmark in duration. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Revisiting the shadow banking system 10 years later. The September CPI data is unlikely to resolve the inflation debate at the Fed. How to invest in a late cycle environment. Wage Inflation was on the rise even before the hurricanes. Feature Chart 1September CPI And Retail Sales Keep##BR##The Fed On Track To Tighten September CPI And Retail Sales Keep The Fed On Track To Tighten September CPI And Retail Sales Keep The Fed On Track To Tighten The state of the U.S. business cycle, and what could end it, were key topics of conversation at BCA's semi-annual Research Advisory Board meeting in early October. Most participants agreed with the BCA view that the economy is in the late stages of the economic cycle, and a few suggested that another bubble in the shadow banking sector may end the expansion. With those discussions in mind, we review the state of the shadow banking in the first section of this report and then examine how key aspects of the economy and U.S. asset classes behave while the U.S. economy is in the final stages of an expansion. In the final section, we take another look at wage inflation signals from the hurricane impacted September jobs report, and conclude that wage growth has accelerated even excluding the effect of the storms. The September CPI and retail sales data were also impacted by the storm, but the message is that the underlying economy is strong enough to generate some inflation (Chart 1), although the September CPI is unlikely to resolve the inflation debate at the Fed. The minutes of last month's FOMC meeting (released last week) indicate that the upcoming inflation data could be pivotal to whether the Fed delivers another rate hike in December. There are two more CPI reports ahead of the December FOMC meeting (with the second release coming on the day of the policy announcement). While the September CPI data was hard to interpret due to the storms, the next few data prints need to affirm the Fed's forecast that core inflation is indeed recovering from the "transitory weakness" seen earlier this year. BCA's U.S. bond strategists believe that inflation will be strong enough for the Fed to justify a hike in December and recommend below-benchmark duration for fixed income portfolios. Shadow Banking Update At current levels, shadow banking activity in the U.S. is not a threat to the economic expansion. The ratio of financial sector debt to non-financial sector debt is a rough proxy of how the system can leverage existing debt into new securities and boost credit creation (Chart 2). As financial innovation and deregulation boosted system liquidity, outstanding financial debt as a percentage of non-financial debt climbed from 10% in the mid-1970s to over 50% in 2008. In Q2 2017, the shadow banking proxy stands at only 33%, because the global financial crisis and subsequent reregulation of the financial sector have reigned in excesses. The last time that the ratio was this low was in the late 1990s. Bank lending standards highlight key differences between the backdrop in the mid-2000s and today (Chart 3). In the mid-2000s, even as the Fed had boosted rates by 425 basis points, lending standards were easy and loosening. In contrast, the 100 bps increase in the Fed funds rate since late 2015 was accompanied by a tightening of lending requirements. Moreover, lending criteria were already tight when the Fed began its latest rate hikes. Chart 2The Shrinking Shadow##BR##Banking Sector The Shrinking Shadow Banking Sector The Shrinking Shadow Banking Sector Chart 3Bank Lending Standards Tighter##BR##Today Than In Mid '00s Bank Lending Standards Tighter Today Than in Mid '00s Bank Lending Standards Tighter Today Than in Mid '00s The Fed and other regulators are more attuned to financial excesses than they were a decade ago. The central bank under Yellen has raised the profile of financial stability.1 BCA views "financial stability" as a third mandate for the central bank, along with low and stable inflation, and full employment. That said, the Fed did not assess financial stability at the September FOMC meeting and the topic was only briefly mentioned by Fed staff and FOMC participants. At the July 2017 meeting, the central bank's staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance. BCA expects that the Fed will return to the topic at either one or both remaining FOMC meetings in 2017. The October 2017 Bank Credit Analyst Monthly Report2 provided a checklist of liquidity measures to watch as the U.S. economy enters the end of an elongated expansion. In view of these indicators, we would describe liquidity conditions in the U.S. as fairly accommodative, although not nearly as abundant as prior to the Lehman event in 2008. Monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis, is still a long way from the pre-Lehman go-go years (as per indicators such as bank leverage). The Fed is set to begin the process of unwinding the massive amount of monetary liquidity created by its quantitative easing program. This has the potential to undermine other types of liquidity in the financial system, leading to a correction in risk assets. However, the BCA Special Report argues that the reaction of the bond market is more important for risk assets than the balance sheet adjustment itself. If inflation only edges higher and market expectations for the upward path of the Fed funds rate remain gentle, then risk assets should take the balance sheet unwind in stride. An abrupt upward shift in inflation would be an altogether different story. Bottom Line: The U.S. expansion entered a late-cycle environment near the close of 2016 as the unemployment rate dipped below NAIRU. Nonetheless, none of our recession-timing indicators warns that a downtown is imminent3 and the financial excesses in the end stage of the 2001-2007 economic expansion are not present today. If the next recession begins in the second half of 2019, then global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities may decline by 20% to 30% peak-to-trough. Stay overweight equities for now. The time to trim exposure could come in mid-2018. Late-Cycle Playbook Chart 4Easier Financial Conditions##BR##Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easing financial conditions will lead to faster U.S. GDP growth in the next few quarters. Financial conditions have eased sharply this year due to a strengthening stock market, narrower credit spreads and a weaker dollar. Changes in financial conditions lead growth by about 6 to 9 months, implying that U.S. growth could reach 3% early next year (Chart 4). This could drop the unemployment rate to 3.5% by end-2018, more than one point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. Rising inflation will compel the Fed to lift rates aggressively next year to cool the economy and push the unemployment rate back above NAIRU. The U.S. has never averted a recession in the post-war era when the unemployment rate has increased by more than one-third of a percentage point. BCA's stance is that the U.S. economy enters the expansion's final stage when the unemployment rate dips below NAIRU. Chart 5 shows that the unemployment rate moved below NAIRU in November 2016. In the past 45 years, the economy has spent an average of 33 months in late-cycle mode ahead of 5 recessions. The exception was 1981-82 when the unemployment rate did not dip below NAIRU ahead of the recession; we treated the separate 1980 and 1981-82 recessions as one episode. Note that several of these late-cycle intervals overlap with recessions (vertical lines on Charts 5, 6 and 7 indicate the start of recessions). Chart 5Late Cycle Performance Of Stocks, Bonds, & Commodities Late Cycle Performance Of Stocks, Bonds, & Commodities Late Cycle Performance Of Stocks, Bonds, & Commodities The late-cycle environment favors equities over Treasuries, gold and oil, but other risk assets (small caps, investment-grade and high-yield corporates) underperform (Table 1). The dollar drops by an average of 5% in late cycles and it moved lower in 4 of the 5 previous episodes. Oil is a consistent late-cycle performer, climbing in all the stages in our analysis. The average returns across all assets classes are similar, even excluding the 1973 OPEC oil embargo and the 1987 stock market crash. Nonetheless, asset class returns in the current environment have mostly run counter to history. Table 1Late Cycle Performance Of Stocks, Bonds, & Commodities The Late-Cycle View The Late-Cycle View In typical late-cycle performance, U.S. stocks have outperformed Treasuries since November 2016, the dollar has weakened and oil is up, though by far less than in an average late cycle. However, both investment-grade and high-yield corporate bonds have outpaced Treasuries, and small caps have beaten large caps. Moreover, gold prices have dropped. However, the current late-cycle period has been in place for only 10 months, which is more than two years short of the 33-month average of late cycles since 1972 (Table 1). Furthermore, the level of S&P 500 earnings, both trailing and forward, also rise uniformly in late cycles. That said, earnings growth tends to peak about halfway through each cycle, but we note that we have only forward EPS data for three of the five episodes in our analysis. Profit margins take the same course as earnings and earnings growth (Chart 6). The late-cycle climb in wages and labor compensation impacts margins. Additionally, inflation tends to escalate during late cycles (Chart 7). Chart 6S&P 500 Earnings And Margins In Late Cycle S&P 500 Earnings And Margins In Late Cycle S&P 500 Earnings And Margins In Late Cycle Chart 7Inflation And Interest Rates During Late Cycles Inflation And Interest Rates During Late Cycles Inflation And Interest Rates During Late Cycles Bottom Line: The late-cycle environment may persist for another two years or so, favoring stocks over bonds, a weaker dollar and higher oil prices. Although we are overweight both investment-grade and high-yield corporate bonds, these two asset classes tend to underperform Treasuries as the business cycle fades. We also expect wages and inflation to continue to mount, suggesting that duration should be kept short. The late-cycle pattern is at odds with BCA's view that the dollar will appreciate modestly in the next 12 months. However, the dollar's trajectory depends both on Fed policy and the direction of rates in the economies of the major U.S. trading partners. The Bank of Canada will be lifting rates in the coming quarters, but policy rates will be flat for some time in the Eurozone and Japan, such that interest rate differentials will shift in favor of the dollar on a multi-lateral basis. Another Look At Wage Inflation In last week's report4 we indicated that the September jobs report was difficult to interpret due to the impacts of Hurricanes Harvey and Irma. Specifically, we stated that the unexpected 0.5% month-over-month gain in average hourly earnings should be discounted. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. These wages will correct lower as these workers return to their jobs post-hurricane recovery. A closer look at the wage data, however, suggests that the acceleration in wage growth in September 2017 to 2.9% from 2.7% in August and a recent low of 1.9% in 2014, has been in place for some time. Admittedly, the 2.9% year-over-year reading on wage inflation, may have overstated labor costs in September. That said, at 56% in August, the percentage of U.S. states where the year-over-year percentage change in average hourly earnings is rising has been on the upswing since mid-2014. The August reading was the highest since 2012 (Chart 8). In Chart 9, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. Chart 10 updates research by the Kansas City Fed5 that found only a few industries (mostly in the goods-producing sector) account for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have increased faster than in the goods-producing sector. Chart 856% Of States Have Seen##BR##Higher Wage Inflation 56% Of States Have Seen Higher Wage Inflation 56% Of States Have Seen Higher Wage Inflation Chart 9Compositional Effects Do Not##BR##Explain Recent Wage Weakness Compositional Effects Do Not Explain Recent Wage Weakness Compositional Effects Do Not Explain Recent Wage Weakness Chart 10Acceleration In Hours Worked##BR##Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Acceleration In Hours Worked Should Lead To Faster Wage Growth Moreover, the August JOLTS data also provides evidence that the labor market began to tighten before the effects of Harvey and Irma. The quit rate matched a 15-year high in August, and job openings were at an all-time high. Job openings in the leisure and hospitality sector were at all-time highs in August, and the quit rate in that storm-impacted industry stood at 4.2% (Chart 11). Even excluding the leisure and hospitality industry from the average hourly earnings data, wage growth has unambiguously climbed in the past 1- and 3- months (Chart 12). Chart 11Overall Job Openings And Quit Rates##BR##Vs. Leisure And Hospitality Overall Job Openings And Quit Rates Vs. Leisure And Hospitality Overall Job Openings And Quit Rates Vs. Leisure And Hospitality Chart 12Wage Acceleration Evident Even##BR##Excluding Leisure And Hospitality Wage Acceleration Evident Even Excluding Leisure And Hospitality Wage Acceleration Evident Even Excluding Leisure And Hospitality Bottom Line: Wage inflation was on the upswing even before the hurricanes hit in late August and September. Persistent wage inflation will allow the Fed to raise rates again in December and three or four times next year. This supports BCA's underweight stance on duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 2 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," October 2017. Available at bca.bcaresearch.com. 3 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Small Cap Surge," October 9, 2017. Available at usis.bcaresearch.com. 5 "Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings," Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.

Highlights It's ok to ignore the September jobs report. Is the small cap comeback sustainable? Assessing the threat to the consumer from higher rates and oil prices. The ISM is over 60, now what? Feature Risk assets outperformed again last week, as the S&P 500, the dollar, and the 10 year- Treasury yield all moved higher. Oil was an exception, as WTI dipped back below $50 per barrel, but BCA's Commodity & Energy Strategy service expects WTI to end the year over $55/bbl. Small-cap stocks outperformed as well and conditions are in place for the rise in small caps to continue. The rise in risk assets in recent weeks occurred alongside a marked improvement in the Citi Economic Surprise Index (Chart 1), which moved into positive territory last week for the first time since April, despite the impacts of Hurricanes Harvey and Irma. Chart 1S&P And 10 Year Treasury Yield Tracks Economic Surprise S&P And 10 Year Treasury Yield Tracks Economic Surprise S&P And 10 Year Treasury Yield Tracks Economic Surprise The lack of impact from the hurricanes on the economic data is surprising. Before Hurricane Harvey made landfall, the Atlanta Fed GDP Now reading for Q3 was 3.4%, but moved as low as 2.1% in late September as the August economic data was reported. The most recent Atlanta Fed forecast pegged Q3 GDP at 2.5%. The 60+ readings on September's manufacturing ISM composite and 70+ reading on prices were notably strong, as was the 18.6 million reading on September vehicle sales, the strongest in 12 years. That said, the impact of the storms was evident in the employment data released last week (See below). U.S. Jobs Report: All Noise, No Signal U.S. nonfarm payrolls fell 33,000 in September, which was entirely due to the hurricanes. According to the BLS, 1.47 million workers could not show up for their jobs due to the weather. Because this data series is not seasonally adjusted, one cannot simply add it back to the headline payrolls number. Unfortunately, the separate household survey does not help to shed any better light on the state of the labor market. The household survey is known to be much more volatile than the establishment survey. This was quite apparent with the 906,000 surge in jobs, which followed a 74,000 decline in the previous month. The outsized and unbelievable surge in household employment was the main reason for the decline in the jobless rate to 4.2% from 4.4%. The labor force actually grew by a hefty 575,000 and the participation rate rose to 63.1%, the highest since March 2014 (Chart 2). The 0.5% m/m gain in average hourly earnings needs to be discounted as well. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. As these workers return to their jobs, average hourly wages will correct lower. Bottom Line: Investors should ignore the September jobs report. The 3-month average of payrolls growth from June to August was 172K. This is probably the best gauge of underlying jobs growth and this pace is above the trend growth in the labor force. To the extent that the Fed believes the tightening labor market will push inflation to its 2% target, the calculus for the December FOMC should not change after today's report. Small Caps Make A Comeback Rising prospects for tax cuts have lifted the Trump trades, including small-cap equities. We first initiated an overweight to small caps on November 14, 20161 (Chart 3). Since then, small caps have underperformed large by 162 bps, but not uniformly. The trade was successful from the start through to late January, but faded by late summer along with the prospects for Trump's tax cuts. Starting in mid-August, small cap made a comeback as odds of the tax cut troughed. Chart 2The September Jobs Report Is More Noise Than Signal The September Jobs Report Is More Noise Than Signal The September Jobs Report Is More Noise Than Signal Chart 3The Trump Trades Are Back On The Trump Trades Are Back On The Trump Trades Are Back On Several factors support our overweight view. According to BCA's U.S. Equity Strategy service S&P 600 valuation indicator, small caps are even more undervalued today than when we last discussed them in June2 (Chart 4). Moreover, the Cyclical Capitalization Indicator (CCI) moved sharply into positive territory following the U.S. election despite a modest dip in subsequent months (Chart 5). In addition, small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (Chart 5, panel 2). That characteristic of small caps argues for a bullish stance given our upbeat view on growth and our overweight positions in U.S. equities versus bonds. BCA's outlook for regulation, inflation, the dollar, the Fed and the consumer also favor small over large caps. Trump has already made significant progress in slowing the pace of new regulations,3 which has long been a concern for small businesses. We expect inflation to move back to 2% in the coming quarters and then begin to climb higher in 2018. Chart 6 shows that small caps often thrive when inflation accelerates. BCA's outlook is that the dollar will see modest appreciation over the next 12 months. Small-cap stocks are less sensitive to dollar movements than large caps. Gradually rising rates will not impede small caps and credit conditions remain favorable. Finally, small caps are more closely linked to the consumer than the S&P 500, and BCA's view on household spending remains upbeat. Chart 4Small Caps Are Cheap, But Not Historically Cheap Small Caps Are Cheap, But Not Historically Cheap Small Caps Are Cheap, But Not Historically Cheap Chart 5Our CCI Supports Small Caps Our CCI Supports Small Caps Our CCI Supports Small Caps Chart 6Accelerating Inflation Usually Supports Small Caps Accelerating Inflation Usually Supports Small Caps Accelerating Inflation Usually Supports Small Caps Despite the upbeat prospects for small caps, some risks linger. Tighter credit conditions for consumers and businesses, an abrupt pullback in housing that would trigger a consumer retrenchment, persistent weakness in the dollar, and a "risk off" environment would see small caps underperform large caps. Bottom Line: It is too early to abandon our bullish bias toward small caps. Conditions remain in place for small caps to outpace large caps. Favorable valuation and encouraging prospects for Trump's pro-small business platform are key to BCA's view, as our favorable outlook for the U.S. consumer. Will Higher Rates And Oil Prices Crush The Consumer? Supports remain in place for continued strength in U.S. consumer spending despite rising interest rates and oil prices. That support was confirmed by September's reports on employment and vehicle sales, and August's personal income and spending data, all released in the past two weeks. However, investors should be aware of hurricane-related distortions in the August and September figures.4 Moreover, BCA's position is reinforced by elevated readings on consumer confidence and booming household net worth statistics, and record high FICO scores (Chart 7). The conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 8 shows that at 41%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by 1.3 percentage points since 2012. In contrast, spending on necessities rose by a record 3.5% in the five years ending in 2008, matching the bruising impact of higher rates, surging inflation and soaring oil prices seen by the end of 1980. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of the consumer.5 Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will provide a boost to disposable income. Personal tax cuts as part of the plan Trump proposed last month would also enhance incomes. Chart 7Plenty Of Support For The Consumer Plenty Of Support For The Consumer Plenty Of Support For The Consumer Chart 8Consumer In Good Shape Despite Rise In Oil, Rates Consumer In Good Shape Despite Rise In Oil, Rates Consumer In Good Shape Despite Rise In Oil, Rates BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. The latest reading on the manufacturing ISM composite and the 60+ readings on the new orders component of ISM since February suggest that managements are starting to note the robust pace of consumer spending. Signals From Elevated ISM Readings September's numbers on the ISM manufacturing index support BCA's case for accelerating corporate profits in the coming quarters. The ISM is a good proxy for industrial production, which in turn tracks S&P 500 sales. The recent strong data on ISM suggests that IP should pick up in the next six months (Chart 9). A rollover in the 12-month change in IP would challenge our constructive stance on earnings. While a decline is possible given that the index is already lofty, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 10). Chart 9Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Chart 10ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate Some investors question how long the composite and new orders indices will remain beyond 60 and what that will mean for risk assets. Additionally, the second 70+ reading on the ISM Prices index this year challenges the notion that inflation is dormant. Other investors are concerned about what will happen after these ISM components are so elevated. Others may fear that the index will soon fall below 50. We analyze the historical periods when the ISM and its sub-indexes were above the 60 threshold, and then what happens to the returns of risk assets 12 months after they fall below the 60 threshold (Chart 11A, Chart 11B and Chart 11C). Chart 11AComposite ISM And Risk Assets Composite ISM And Risk Assets Composite ISM And Risk Assets Chart 11BISM New Orders And Risk Assets ISM New Orders And Risk Assets ISM New Orders And Risk Assets Chart 11CISM Prices And Risk Assets ISM Prices And Risk Assets ISM Prices And Risk Assets Historically, the relative performance of large cap equities to Treasuries is typically poor when the ISM Manufacturing Composite Index is over 60, but investment-grade credit outperforms and both gold and oil usually gain. The performance of these assets is similar even excluding the period around the 1973 OPEC oil embargo and the 1987 stock market crash (Chart 11A and Appendix Table 1). The ISM Manufacturing Composite Index ticked up to 60.8 in September, the first 60+ reading since 2004. The indicator also reached 60 three times in the 1970s and twice in the 1980s, and it stayed above 60 on average for 8 months. The last time it breached 60, it remained at that level for 6 months (December 2003 through June 2004). That interval, along with most of the others, was accompanied by tightening monetary policy and accelerating inflation late in the latter half of economic cycles. Gold and oil perform strongly in the 12 months after ISM Composite Index goes below 60, large-cap equities barely do better than Treasuries, while investment-grade credit underperforms. Surprisingly, high-yield bonds and small-cap stocks outperform 12 months after the ISM falls back below 60, although the sample size is limited. In 1974-1975, the economy was in recession. In all but one other instance (the mid- 1980s), the economy was in a late stage of the cycle, nearing full employment and inflation was on the rise. Risk assets also are strong performers when the New Orders component of the ISM exceeds the 60 threshold (Chart 11B and Appendix Table 2). Moreover, the episodes are more numerous (14 since 1971 versus only 6 for the composite) but, on average, they persist as long as the signal from the ISM Composite. New Orders have been above 60 since February 2017 (7 months), just shy of the 46-year average (8 months). Large cap equities and credit (both investment-grade and high-yield) have outperformed Treasuries, and gold has climbed since February. This performance matches the historical pattern when the New Orders index exceeds 60. In the past 8 months, the underperformance of small caps and the drop in oil prices in that span runs counter to history. The performance of risk assets in the year after the new orders index moves below 60 is mixed, at best. In these periods, while the S&P 500 outperforms Treasuries on average, and small caps outperform large caps, credit underperforms. The big winners when the New Orders index is falling from over 60 are gold (average 14% gain) and oil (22%). Chart 11C and Appendix Table 3 shows the performance of risk assets when the ISM Prices index is greater than 70 and then 12 months after the index crosses below 70. Gold and oil are standouts in the first case, and small cap tends to outperform large. Note that 3 of these 11 episodes coincided with recessions (early 1970s, 1980 and 2008) and 1 occurred during the 1987 stock market crash. Small-cap equities continue to outperform as the Prices index fades, and returns on gold and oil are muted. High-yield bonds underperform Treasuries when the ISM Prices index dips back below 70, and the total return on investment-grade corporate struggles, but it beats Treasuries. Moreover, 3 of these 11 occurred during recessions (early 1980s, 2001, 2008-2009). Separately, there has been a tight relationship between the 12-month change in the 10-year Treasury yield and both the overall ISM, the New Orders and Prices component of the ISM in the past 25 years (Chart 12). Nonetheless, the relationship between the ISM Prices component and the 10-year Treasury has broken down since oil prices peaked in 2014. The 12-month jump in ISM Prices surge in 2016 was met with a decline in Treasury yields. Prior to that, a rise in Prices index was almost always accompanied by a move higher in bond yields. BCA's view is that the ISM manufacturing Composite will remain elevated (although not necessarily more than 60 in the months ahead), supporting our bullish stance on corporate sales and earnings. However, if we are wrong and the ISM dips below 60 and then down to 50, would that signal a downturn and concomitant selloff in risk assets? The ISM has a mixed track record as a leading indicator of recessions (Chart 13). Since 1948, the ISM has provided 9 false signals, using 3 consecutive months below 50 as the indication of an economic decline. Furthermore, 5 of the 9 examples occurred since 1985, as the U.S. economy became less reliant on manufacturing. In the 6 instances that the ISM warned of contractions, the average lead time was 4 months. In the 4 other economic slumps, the ISM moved and stayed below 50 for 3 consecutive months only after the start of recession. The lag averaged 4 months. This was the case in the 2007-2009 episode when the ISM did not send a recession signal until May 2008, 5 months after the official start of the downturn. Chart 1210 Year Treasury Vs. ISM 10 Year Treasury Vs. ISM 10 Year Treasury Vs. ISM Chart 13The Rocky Relationship Between ISM And Recessions The Rocky Relationship Between ISM And Recessions The Rocky Relationship Between ISM And Recessions Bottom Line: Elevated readings on ISM support BCA's view that profit growth will accelerate for a few more quarters while the recent rise in the ISM Prices index confirms the move higher in Treasury yields. Stay overweight stocks versus bonds and underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," November 14, 2016. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Waiting For The Turn," June 26, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still Waiting for Inflation, "August 14, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From the Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Monthly Report, "Global Debt Titanic Collides With Fed Iceberg?," February 2017. Available at bca.bcaresearch.com. Appendix: Table 1 Small Cap Surge Small Cap Surge Table 2 Small Cap Surge Small Cap Surge Table 3 Small Cap Surge Small Cap Surge

Dear Client, I had the pleasure of speaking at BCA's Annual New York conference on Monday, where I offered the following trade recommendations. This week's report is a summary of my remarks. Please note we will be publishing our Q4 Strategy Outlook and monthly tactical asset allocation recommendation table next Wednesday. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Go short the December 2018 fed funds futures contract. Go long global industrial stocks versus utilities. Go short 20-year JGBs relative to their 5-year counterparts. Feature Trade #1: Go Short The December 2018 Fed Funds Futures Contract The hurricanes are likely to dent activity in the third quarter, but leading economic indicators are pointing to faster growth starting in Q4. This can be seen in a variety of measures, including the Conference Board's LEI (Chart 1). U.S. financial conditions have eased sharply this year, thanks to a decline in government bond yields, narrower credit spreads, a weaker dollar, and rising equity prices. Changes in our FCI lead growth by about 6-to-9 months. If history is any guide, U.S. growth will rise to about 3% in the first half of 2018 (Chart 2). Growth could even temporarily rise above that level if Congress enacts significant unfunded tax cuts, as we expect it will. Chart 1U.S. Leading Economic Indicator Pointing Higher U.S. Leading Economic Indicator Pointing Higher U.S. Leading Economic Indicator Pointing Higher Chart 2Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Contrary to popular belief, the Phillips curve is far from dead. It has just been dormant for the better part of 30 years because the unemployment rate has hovered along the flat side of the curve. The closest the economy came to overheating was in the late 1990s, but any inflationary pressures back then were choked off by turmoil in emerging markets, a surging dollar, and collapsing commodity prices.1 If U.S. growth accelerates over the next few quarters, the unemployment rate is likely to fall to 3.5% by the end of next year - well below the Fed's end-2018 projection of 4.1%, and even below the low of 3.8% reached in 2000. At that point, the U.S. economy will find itself on the steep side of the Phillips curve (Chart 3). Chart 3U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Three Tantalizing Trades Three Tantalizing Trades As Chart 4 illustrates, our wage survey indicator - a propriety measures that combines the results of 13 separate employer surveys - is pointing to faster wage growth. Rising wages should boost consumer spending. With the output gap all but extinguished, faster demand growth will lead to higher inflation. This is already being telegraphed by the ISM manufacturing index (Chart 5). Chart 4Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Survey Data Point To Higher Wage Growth Ahead Chart 5Strong ISM Signaling A Rise In Inflation Strong ISM Signaling A Rise In Inflation Strong ISM Signaling A Rise In Inflation If inflation accelerates, there is little reason why the Fed would not continue raising rates in line with the dots, which call for one more hike in December and three hikes in 2018. That's 100 basis points of hikes between now and the end of next year, considerably more than the 40 bps that the market is currently discounting. We went short the December 2018 fed funds futures contract three weeks ago. The trade has gained 20 basis points so far, but my discussion this morning suggests that it has plenty of juice left. Trade #2: Go Long Global Industrial Stocks Versus Utilities Economists are a bit like stock market analysts - they are generally too optimistic. As a result, they usually end up having to revise their growth estimates down over time. That has not been the case this year: Global growth estimates have been marching higher (Chart 6). Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. We are starting to see that now. A variety of indicators - including capital goods orders and capex intention surveys - are pointing to further gains in business spending. This is captured in our model estimates, which project that global capex will grow at the fastest pace in six years (Chart 7). Chart 6Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global Growth Estimates Accelerating Despite Stalled U.S. Growth Chart 7Global Capex On The Upswing Global Capex On The Upswing Global Capex On The Upswing A burst of capital spending should benefit global industrial stocks. Conversely, rising global yields will hurt rate-sensitive utilities (Chart 8). Industrials are no longer cheap, but relative to utilities, valuations do not seem especially stretched, implying further room for re-rating (Chart 9). Chart 8Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Chart 9Relative Valuations Are Not Stretched Relative Valuations Are Not Stretched Relative Valuations Are Not Stretched Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The deflationary mindset remains firmly entrenched in Japan. CPI swaps are pricing in inflation of only 0.5% over the next twenty years (Chart 10). Not only do investors expect the Bank of Japan to continue to miss its 2% target, they don't even think that inflation will rise from today's miserly levels. They could be in for a big surprise. Many of the structural drivers of deflation in Japan are fading. Land prices have stopped falling for the first time in 25 years, and bank balance sheets are in good shape (Chart 11). Goods prices are also rising again, thanks in part to a cheaper yen (Chart 12). Profit margins have soared, giving firms the wherewithal to pay their workers more. Chart 10Deflationary Mindset Remains Deeply Entrenched... Deflationary Mindset Remains Deeply Entrenched... Deflationary Mindset Remains Deeply Entrenched... Chart 11A...But Deflationary Pressures Are Abating ...But Deflationary Pressures Are Abating ...But Deflationary Pressures Are Abating Chart 11B ...But Deflationary Pressures Are Abating ...But Deflationary Pressures Are Abating Chart 12ACorporate Pricing Power Has Improved Corporate Pricing Power Has Improved Corporate Pricing Power Has Improved Chart 12B Corporate Pricing Power Has Improved Corporate Pricing Power Has Improved Companies have been reluctant to raise wages, but that may be starting to change. Our wage trend indicator is showing signs of life (Chart 13). As in the U.S., the Phillips curve in Japan tends to become kinked at very low levels of unemployment. Japan's unemployment rate now stands at 2.8%, almost a full percentage point below 2007 levels. As the labor market heats up, companies will have to compete more intensively for a shrinking pool of available workers. This could spark a tit-for-tat cycle where wage hikes by one company lead to hikes by others. Chart 13ATentative Signs of Wage Growth Three Tantalizing Trades Three Tantalizing Trades Chart 13B Three Tantalizing Trades Three Tantalizing Trades Chart 14Demographic Inflection Point? Demographic Inflection Point? Demographic Inflection Point? The government has been hoping for such a bidding war to break out. It will get its wish. The ratio of job openings-to-applicants has soared, and is now even higher than at the peak of the bubble in 1990 (Chart 14). Amazingly, Japan's labor market has tightened over the past few years despite tepid GDP growth and a steady influx of women into the labor force. However, now that female participation in Japan exceeds U.S. levels, this tailwind to labor supply will dissipate. Meanwhile, the retirement of aging Japanese baby boomers will accelerate. The largest number of births in Japan occurred between 1947 and 1949. These workers will reach 70 over the next two years, the age at which most Japanese retire. How should investors play this theme? Considering that inflation is still far from the Bank of Japan's 2% target, it is doubtful that the BoJ will abandon its yield curve targeting regime any time soon. But as inflation expectations begin to rise, ultra long-term yields - which are not subject to the BOJ's cap - will increase. This suggests that shorting 20-year JGBs relative to their 5-year counterparts will pay off in spades. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights French labor reforms stack up well against German and Spanish predecessors; We remain bullish on French industrials versus German industrials; Populism is overrated in Germany - European integration may not accelerate, but it will continue; The U.K.'s position remains weak in Brexit talks ... don't expect much from sterling. Feature On recent travels across Asia Pacific, the U.K., and the U.S., Europe has rarely featured in our conversations with clients. We proclaimed European politics a "trophy red herring" in our annual Strategic Outlook.1 Following the defeat of populists in Austria, the Netherlands, Spain, and particularly France, the market now agrees with us (Chart 1). Chart 1European Political Risk Was Overstated European Political Risk Was Overstated European Political Risk Was Overstated In this report, we ask whether there is anything left to say about Europe. First, we provide an update on French structural reforms, which we predicted with enthusiasm in February.2 Second, we give a post-mortem of the German election. Third, we dissect U.K. Prime Minister Theresa May's speech in Florence. We remain positive on near-term and mid-term prospects for European assets. We have recently closed our unhedged long Euro Area equities trade for a 7.88% gain (open from January 25 to September 6). We have reopened the position on September 6 with a currency hedge given our view that there is some downside risk for the euro in the near term. We also remain long French industrials / short German industrials, with gains of 9.30% since February 3. The French Revolution Continues President Emmanuel Macron has ignored tepid union protests and signed five decrees overhauling French labor rules on September 22. While there is more to be done, Macron's swift action just five months after assuming office justifies our optimism about France earlier this year. As we posited in February, investors are surprised every decade by a developed market that defies all stereotypes and catches the markets off guard with ambitious, pro-market and pro-business structural reforms. Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s. Sweden surprised the world in the 1990s. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own "socialist" label and moved the country to the right of the economic spectrum. Finally, the past decade's reform surprise came from Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. How do French labor reforms stack up against the German and Spanish efforts? Table 1 surveys the measures and classifies them into three categories. On unemployment benefits, Macron's effort falls short of the considerable cuts implemented as part of the Hartz reforms in Germany. However, while benefits will still be generous, France's unemployed will now be cut off if they refuse job offers that pay within 25% of the salary they previously held. On increasing labor market flexibility, we give France high marks. Reforms will simplify the termination process for economic reasons and cap damages that can be awarded to employees, in line with the Spanish experience. Macron has also managed to neuter the power of national unions by allowing firm-level collective bargaining to take precedence. France's labor bargaining reform is also a carbon copy of the Spanish effort and both are attempts to create a more German-like management-employee context. Table 1Measuring French Reforms Against German And Spanish Reforms Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? What should investors expect as a result? Spain is instructive. While its unemployment rate remains 5.8% above the Italian rate and 7.3% above the French rate, it still fell from a high of 26.3% in 2013 to 17.1% today. Meanwhile, Italian and French unemployment rates remain stubbornly high (Chart 2). In addition, Spain's export competitiveness has had one of the sharpest recoveries in Europe since 2008, whereas Italy and France continue to languish (Chart 3). Spain accomplished this feat via a considerable reduction in labor costs relative to peers (Chart 4). Chart 2Italy, France: Unemployment Still High Italy, France: Unemployment Still High Italy, France: Unemployment Still High Chart 3Spain Regained Competitiveness Spain Regained Competitiveness Spain Regained Competitiveness Chart 4Spain Cut Labor Costs Spain Cut Labor Costs Spain Cut Labor Costs The key pillar of Prime Minister Mariano Rajoy's reforms was to create a more flexible labor market so as to restore competitiveness to the economy by aligning labor costs with productivity. Reforms, passed in February 2012, removed stringent collective bargaining agreements and replaced them with firm-level agreements. This has made it easier for firms to negotiate their own labor conditions, including reducing wages as an alternative to termination of employment. France is now on the path to do the same. True, it is difficult to establish a clear causal connection between Rajoy's structural reforms and Spain's economic performance since 2008. Nevertheless, reforms also work as a signaling mechanism, encouraging investment and unleashing animal spirits by affirming the government's commitment to a pro-business agenda. Under Rajoy's leadership, Spain has moved from 62nd in the World Bank "Ease of Doing Business" survey in 2009 to 32nd in 2017, 18 spots above Italy. Given the speed and commitment of the Macron administration, we would expect an even stronger signaling effect in France. German Hartz reforms are easier to assess because more time has passed since 2005 (when the final stage, Hartz IV, was implemented). Prior to the reforms, Germany's GDP growth rate was falling and unemployment was rising (Chart 5). At least on these two broad measures, it appears that reforms were positive. Chart 5Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Hartz Reforms Marked Turning Point In Germany Chart 6German Long-Term Unemployment Benefits Were Cut Down To OECD Average Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Germany's problem prior to the Hartz reforms was that generous unemployment benefits discouraged unemployed workers from finding employment. Long-term benefits could be as high as 53% of the terminated salary and eligible for indefinite renewal! The Hartz IV reforms specifically targeted these benefits, with the intention of forcing the unemployed to get back to work. Germany brought these benefits into line with the OECD average (Chart 6). The long-term impact of the Hartz reforms was a dramatic decline in the unemployment rate from a bottom of 9.2% in 2001 to the still falling 3.7% of today! Reforms have also seen a steady increase in wage growth, despite the conventional view saying the opposite. Wages have been steadily rising since implementation in 2005, only slowing down during the global financial crisis and the subsequent European debt crisis (Chart 7). This does not mean that labor reforms failed. The intention of the Hartz reforms was to push people back into the labor force, not necessarily suppress their wages. Chart 8 shows the effect on the hours worked in the economy, with a clear uptrend after the reform was enacted. Chart 7German Wages Recovered... German Wages Recovered... German Wages Recovered... Chart 8...While Working Hours Increased ...While Working Hours Increased ...While Working Hours Increased In line with the previous labor reform efforts in Europe, we think that investors should expect three broad developments from French labor reforms: Competitiveness: As Chart 3 suggests, Spain and Germany have had the best export performance in Europe. By allowing companies some flexibility in setting costs, these economies were able to regain export competitiveness. As a play on this theme, we are long French industrials relative to German peers. Unemployment: Forcing the unemployed back to the labor market by ending their unemployment benefits if they refuse a job offer within 25% of the previous income level should encourage workers to get back to the labor force. Confidence: Macron's labor reforms are only the beginning of a packed agenda that also includes reducing the size of the public sector, reducing the wealth tax on productive assets, and cutting corporate taxes significantly. What of the opposition to the reform effort? What if the French leadership backs down in the face of protest? First, we must ask, what protest? The labor union response has been underwhelming. In part, this is because Macron's reforms are packed with pro-union clauses. The intention is to empower union activity at the firm level in order to neuter its activity at the national level. Second, Macron's electoral victory was overwhelming, both the presidential and legislative. Yes, turnout was low. And yes, many voted for Macron just so that Marine Le Pen would not become president. But the fact remains that 85% of the seats in the National Assembly are held by pro-reform parties, including the pro-business, right-wing Les Républicains, who want even stricter reforms. Bottom Line: Our clients, colleagues, friends, and family all tell us that France will not reform. But we have seen this film before, with Germany in the 2000s and Spain in the 2010s. One day, investors will wake up and France will be more competitive. Fin. A German Election Post-Mortem The media narrative before and after the German election tells of the rise of Alternative für Deutschland (AfD), a far-right party that campaigned on an anti-EU and anti-immigration platform. Indeed, the performance of the center-right Christian Democratic Union (CDU) and center-left Social-Democratic Party (SPD), which have dominated German politics since the Second World War, was historically poor (Chart 9). Chart 9Germany's Dominant Parties Underperformed... Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Despite the media hysterics, there were no surprises this year. The AfD performed in line with its polls, only outperforming their long-term polling average by around 2%. Meanwhile, the historic underperformance of the CDU and SPD was also due to the solid performance of the other two establishment parties, the liberal Free Democratic Party (FDP) and the center-left Greens (Chart 10). The FDP stormed back into the Bundestag by more than doubling their performance from 2013, while the Greens maintained their roughly 9% performance. Die Linke, a left-wing party whose Euroskeptic tendencies have dissipated, also gained around 9% of the vote. From a historical perspective, the combined CDU and SPD performance was bad, but roughly in line with their 2009 election result. Chart 10... While Minor Parties Outperformed Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? That said, there was no once-in-a-lifetime global recession this time around to excuse the poor performance of the two establishment parties. German GDP growth is set to be 2.1% in 2017 and the unemployment rate is at a historic 3.7%. Meanwhile, support for the euro is at 81% (Chart 11), which begs the question of why 12.6% voters decided to entrust AfD with their votes. Chart 11Germans Love The Euro Germans Love The Euro Germans Love The Euro The simple answer is immigration and the 2015 asylum crisis. The more complex answer is that AfD's performance was particularly strong in East Germany, where the party is now the second largest after the CDU. The same forces that fueled the Brexit referendum and the election of President Donald Trump are at work in Germany. Voters who feel left behind by the transition to a globalized, service-oriented economy have rebelled against a system that favors the educated and mobile voters. In Germany, the angst is particularly notable in the East, where economic progress has lagged that of the rest of the country. On the other hand, it is ludicrous to compare AfD to Brexit and Trump. After all, AfD received only 12% of the vote. This is in line with, or slightly trails, the performance of other right-wing parties in Europe (Chart 12). Yes, it is disturbing to see a far-right party back in the Bundestag, but it was also naïve to believe that Germany could remain a European outlier forever. In fact, like other right-wing parties in Europe, the party is beset with internal rivalries. Party chairwoman Frauke Petry, who represents the moderate wing of the party, decided to quit one day after the election.3 We would suspect that the party will struggle going forward, particularly now that the influx of asylum seekers has trickled down to insignificance (Chart 13). Chart 12German Far Right Performed In Line With Other European Anti-Establishment Parties Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Chart 13Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Refugee Crisis Is Over In Germany And Europe Going forward, Chancellor Angela Merkel will retain her hold on power. However, she will likely have to do so via a "Jamaica coalition" with the FDP and the Greens.4 Forming such a challenging coalition could take until the New Year. Particularly problematic are the positions of the FDP and the Greens on Europe. The former are mildly Euroskeptic, the latter are rabidly Europhile. Merkel's 2009-13 coalition with the FDP was similarly challenging. The FDP moved towards soft Euroskepticism after the Great Financial Crisis. It combined with CDU's Bavarian sister party - the Christian Social Union (CSU)5 - to vote against a number of European rescue efforts and institutional changes (Chart 14). Merkel had to rely on the opposition SPD, which is staunchly Europhile, to push several European reforms through the Bundestag. More broadly, both the FDP and the CSU were a brake on Merkel during this period, leading to Berlin's halting response to the Euro Area crisis. Chart 14The FDP Hampered German Rescue Efforts Amid Euro Crisis Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Going forward, a Jamaica coalition is investment-relevant for three reasons: First, it would likely pour cold water on recent enthusiasm about accelerated European integration spurred by the election of President Emmanuel Macron in France. But investors should not read too much into it. As Chart 11 clearly illustrates, Germans are not Euroskeptic. The Euro Area works for Germany. If there is a future crisis, Germany will react to it in an integrationist fashion, shoving aside any coalition agreements to the contrary. And if Merkel has to rely on opposition SPD votes to push through the evolving European agenda, she will do so, regardless of what is said between now and December. Second, Merkel will have to respond to the poor performance of her party. She has to give in to the right wing on illegal immigration. Investors should expect to see tighter border enforcement on Europe's external borders. More relevant to the markets, we expect mildly Euroskeptics critics in her own party, as well as in the FDP and CSU, to be satisfied by officially pushing for Jens Weidmann's presidency at the ECB. Weidmann has recently toned down his criticism of ECB policies - publically defending low interest rates - which is likely a strategy to make himself palatable as the next president. Third, it is widely being discussed that the FDP will demand the finance ministry from Merkel, replacing Wolfgang Schäuble. This would definitely complicate any future efforts to deal with Euro Area sovereign debt crises, were they to emerge. However, the FDP is making a mistake. If they take the finance portfolio, they will be signing off on bailouts in the future. That is a guarantee. Europe is full of moderately Euroskepic finance ministers who have done the same (see: Austria, Finland, and the Netherlands in particular). Finally, the election was a clear failure by Merkel to defend her brand. While she has not signaled a willingness to resign, it is highly likely that she will try to groom her successor over the next four years. The 63 year-old has been in power since 2005. At the moment, the list of potential names for CDU leadership is long, but devoid of star power (Box 1). The one quality of all the potential candidates, however, is that they are pro-Europe. Bottom Line: In the short term, markets have read German elections overly negatively. The euro reacted on the news as if the currency bloc breakup risk premium had risen. It hasn't. In fact, the election could prove to be a long-term bullish euro outcome, given that Merkel will likely have to acquiesce to Jens Weidmann's candidacy for the ECB presidency. The German Bundestag remains overwhelmingly pro-Europe. The now-in-opposition SPD is pro-integration, as are the likely new coalition members, the Greens. Die Linke has evolved from anti-capitalist, soft Euroskeptics to left-of-SPD Europhiles. While FDP remains committed to a mildly Euroskeptic line (pro-Europe, but opposed to further integration), its members will likely have to sacrifice this position in order to be in government in the long term. They won't say that they are doing that, but trust us, they are. The performance of Germany's populist right wing is largely in line with that of other European countries. As such, it signals that Germany is a "normal country," not that there is something particularly disturbing going on. Box 1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Ursula von der Leyen (CDU): Leyen, who has served most recently as defense minister, is often cited as a likely replacement for Merkel. However, she is not seen favorably by most of the population: she has not won first place in her district in any of the past three general elections. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has argued that the European refugee crisis and debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. The markets and pro-EU elites in Europe would love Leyen, who handled U.S. President Trump's statements on Germany, Europe, Russia and NATO with notable tact. Thomas De Maizière (CDU): Maizière, who has served as minister of interior and minister of defense, is a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could become a compromise candidate between the Europhiles and Eurohawks within CDU ranks. Though he has been implicated in scandals as defense minister, he has remained popular by drawing a relatively hard line on immigration policy and internal security. Julia Klöckner (CDU): A CDU deputy chairwoman from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel and a hence a likely candidate to replace her. While remaining loyal to Merkel, she has taken a more right-wing stance on the immigration crisis. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist," though she has insisted that AfD voters are not all "Nazis" but are mostly in the middle of the political spectrum and need to be won back by the CDU. We think that she would be a very pro-market choice as she combines a popular, market-irrelevant wariness about immigration with a market-relevant centrism that favors further European integration. Hermann Gröhe (CDU): Gröhe last served as minister of health and is a former CDU secretary general. He is very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Gröhe, although they may take some time to get to know who he is! Volker Bouffier (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier is in a position to capitalize on Brexit. He is a heavyweight within the CDU's leadership and a staunch Europhile. He has already declared he will run for the top state office again in 2018, though he will be 67 years old by then. The U.K.: Fall In Florence Prime Minister Theresa May tried to reset Brexit negotiations with the EU recently by giving a speech in Florence. We were told by clients and colleagues that it would be an important event, so we tuned in and listened. The speech was largely a dud. It confirmed to us the constraints on London's negotiating position as well as the challenges that Brexit poses to the British economy. May's team is struggling to navigate both. There are three things that investors should take from the speech - most which we have been emphasizing for over a year: The EU exit bill: The U.K. will pay. The one concrete point that Prime Minister May agreed with, for the first time ever, is that London will continue to pay into the current EU seven-year budget period (2014-2020). This should never have been in doubt. Britain's refusing to pay would be the equivalent of a tenant giving notice that he is ending his lease in 24 months, then refusing to pay in the interim. What May did not say is whether the U.K. would pay anything beyond its share of contribution to the EU budget. At the moment, the answer appears to be no, but we don't expect that to be the final word. Services really (really) matter: The U.K. has a competitive advantage in services. This is why May has tried to signal that she wants the broadest trade deal possible, since regular free trade agreements (FTAs) do not provide for deep integration in services. What will the U.K. give in return? May appears to want a Norway-type EU trade agreement with Canada-type liabilities. This won't fly in Brussels. The transition deal will last two years at minimum: This was never in doubt. But due to domestic political pressures, May was afraid of voicing it in public until today. Below we provide excerpts of the most relevant (or irrelevant, but comical) parts of May's speech.6 Our running commentary is in brackets. Theresa May's Florence Speech On Brexit, September 2017: A Reinterpretation By GPS It's good to be here in this great city of Florence today at a critical time in the evolution of the relationship between the United Kingdom and the European Union. It was here, more than anywhere else, that the Renaissance began - a period of history that inspired centuries of creativity and critical thought across our continent and which in many ways defined what it meant to be European. [GPS: Strong opening by May. Odd location for the speech, however. Unless she was looking to ingratiate herself with Matteo Renzi, former mayor of Florence, former prime minister of Italy, and current leader of the ruling Democratic Party]. * * * The British people have decided to leave the EU; and to be a global, free-trading nation, able to chart our own way in the world. For many, this is an exciting time, full of promise; for others it is a worrying one. I look ahead with optimism, believing that if we use this moment to change not just our relationship with Europe, but also the way we do things at home, this will be a defining moment in the history of our nation. [GPS: This is a crucial argument by proponents of Brexit, that leaving the EU is not just about leaving the bloc's oversight, but also about domestic renewal. At the heart of this view is the belief that the EU has shackled the U.K.'s potential economic output with its regulatory oversight and protectionist trade policies. For this to be true, the U.K. has to replace significance labor force growth - from the EU Labor Market - with even greater productivity growth. If the U.K. fails to do this, its potential GDP growth rate will be substantively lower in the future. We do not buy the optimism. For one, the EU has not been a drag on the U.K.'s World Bank Ease Of Doing Businness rankings, where the country ranks seventh. Second, several other EU member states are in the top 20, including Sweden, Estonia, Finland, Latvia, Germany, Ireland and Austria. Third, developed economies have been dealing with sub-standard productivity growth for over a decade, both EU members and non-members. As such, we are pretty certain that the U.K.'s potential GDP growth rate will be lower over the next decade, not higher.] And it is an exciting time for many in Europe too. The European Union is beginning a new chapter in the story of its development. Just last week, President Juncker set out his ambitions for the future of the European Union. [GPS: A nod to the reality that without the U.K. stalling its integration, Europe is now better able to build its "ever closer union." May is essentially conceding here to Charles de Gaulle's argument, articulated in the 1960s, that letting Britain into the club would ultimately be a mistake.]7 There is a vibrant debate going on about the shape of the EU's institutions and the direction of the Union in the years ahead. We don't want to stand in the way of that. [GPS: Reality check: it has literally been the foreign policy of the U.K. to "stand in the way of" of a united Europe for at least six hundred years ...] * * * Our decision to leave the European Union is in no way a repudiation of this longstanding commitment. We may be leaving the European Union, but we are not leaving Europe. Our resolve to draw on the full weight of our military, intelligence, diplomatic and development resources to lead international action, with our partners, on the issues that affect the security and prosperity of our peoples is unchanged. Our commitment to the defence - and indeed the advance - of our shared values is undimmed. Our determination to defend the stability, security and prosperity of our European neighbours and friends remains steadfast. [GPS: As we have argued repeatedly, the U.K. and EU share crucial geopolitical and economic links. As such, it is difficult to see negotiations devolving into the sort of acrimony that many have expected. May understands this and is reminding Europe of how important the U.K. role is, and will continue to be, geopolitically for Europe.] * * * The strength of feeling that the British people have about this need for control and the direct accountability of their politicians is one reason why, throughout its membership, the United Kingdom has never totally felt at home being in the European Union. [GPS: A not-so-slight dig at Europe. Basically, May is saying that U.K. voters live in a democracy. EU voters live in something else.] And perhaps because of our history and geography, the European Union never felt to us like an integral part of our national story in the way it does to so many elsewhere in Europe. [GPS: This is true and can be empirically measured (Chart 15).] Chart 15Brits Have A Strong Sense Of National Identity Brits And Only Brits Brits And Only Brits * * * For while the UK's departure from the EU is inevitably a difficult process, it is in all of our interests for our negotiations to succeed. If we were to fail, or be divided, the only beneficiaries would be those who reject our values and oppose our interests. [GPS: This is all true and very well put. But it also appears to be a line of argument designed to tug at Europe's emotional strings. Like a husband asking his wife to take it easy on him in a divorce "for the sake of the children."] So I believe we share a profound sense of responsibility to make this change work smoothly and sensibly, not just for people today but for the next generation who will inherit the world we leave them. [GPS: Literally the line about the kids followed immediately!] * * * But I know there are concerns that over time the rights of EU citizens in the UK and UK citizens overseas will diverge. I want to incorporate our agreement fully into UK law and make sure the UK courts can refer directly to it. Where there is uncertainty around underlying EU law, I want the UK courts to be able to take into account the judgments of the European Court of Justice with a view to ensuring consistent interpretation. On this basis, I hope our teams can reach firm agreement quickly. [GPS: An important concession - the first in the speech so far, and we are more than halfway through: London will apparently take into account ECJ rulings when dealing with EU citizens living in the U.K. That is a huge concession to Europe and an arrangement unlike anywhere else in the world.] * * * The United Kingdom is leaving the European Union. We will no longer be members of its single market or its customs union. For we understand that the single market's four freedoms are indivisible for our European friends. We recognise that the single market is built on a balance of rights and obligations. And we do not pretend that you can have all the benefits of membership of the single market without its obligations. [GPS: As we have said in the past, May's decision to concede this point in January was a major concession to the EU and is the reason that the negotiations are not and will not be acrimonious. If the U.K. demanded access to the Common Market without accepting the "four freedoms," it would have received an acrimonious response, given that its request would have been construed as "special treatment."] So our task is to find a new framework that allows for a close economic partnership but holds those rights and obligations in a new and different balance. But as we work out together how to do so, we do not start with a blank sheet of paper, like other external partners negotiating a free trade deal from scratch have done. In fact, we start from an unprecedented position. For we have the same rules and regulations as the EU - and our EU Withdrawal Bill will ensure they are carried over into our domestic law at the moment we leave the EU. [GPS: May is correct. The EU-U.K. trade negotiations should be relatively smooth given that the U.K. is not starting from scratch in negotiating the relationship. The Canada-EU FTA took seven years because they were starting from scratch.] So the question for us now in building a new economic partnership is not how we bring our rules and regulations closer together, but what we do when one of us wants to make changes. One way of approaching this question is to put forward a stark and unimaginative choice between two models: either something based on European Economic Area membership; or a traditional Free Trade Agreement, such as that the EU has recently negotiated with Canada. I don't believe either of these options would be best for the UK or best for the European Union. European Economic Area membership would mean the UK having to adopt at home - automatically and in their entirety - new EU rules. Rules over which, in future, we will have little influence and no vote. [GPS: We pointed out why such an arrangement would be illogical in March 2016. Essentially, the U.K. would leave the EU due to its onerous regulation and infringement on sovereignty only to accept the onerous regulation as a fait accompli with no room for British sovereignty (Diagram 1)!] Diagram 1The Central Paradox Of Brexit Is There Anything Left To Say About Europe? Is There Anything Left To Say About Europe? Such a loss of democratic control could not work for the British people. I fear it would inevitably lead to friction and then a damaging re-opening of the nature of our relationship in the near future: the very last thing that anyone on either side of the Channel wants. As for a Canadian style free trade agreement, we should recognise that this is the most advanced free trade agreement the EU has yet concluded and a breakthrough in trade between Canada and the EU. But compared with what exists between Britain and the EU today, it would nevertheless represent such a restriction on our mutual market access that it would benefit neither of our economies. [GPS: This is, by far, the most critical part of May's speech. She is essentially saying that a Canadian FTA deal would benefit the EU more than it benefits the U.K., a point we have made for nearly two years now. This is true. The U.K. needs access to the EU services market, where British exporters have a comparative advantage. Were they to secure an FTA deal with the EU instead, they would be giving Europe a massive advantage, given the bloc's comparative advantage in tradable goods (Chart 16). However, this takes us back to Diagram 1. What kind of a relationship does May expect to get from the EU when she is unwilling to accept any of the liabilities inherent in such a deep trade deal? That is precisely what the Common Market is for.] Chart 16Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Brexit Hinders U.K.'s Comparative Advantage Bottom Line: Prime Minister May's Florence speech has shown the limits of the U.K.'s negotiating position. May set a friendly tone with Europe, but she has nothing to bargain with. Much of the speech reiterated British commitment to Europe's security and its capacity to defend the continent from external threats. In exchange, May argues, the U.K. ought to receive the deepest and most expansive access to the EU Common Market without any of the liabilities that go with it. In particular, she wants access to the EU's services market, where U.K. exporters have a comparative advantage. The problem with the tradeoff between U.K. geopolitical benefits and EU economic benefits is that it suggests that London has an alternative to being a geopolitical ally to Europe! As if it could suddenly shift its geopolitical, military, and diplomatic focus elsewhere. Berlin, Brussels, and Paris will call London's bluff. The U.K. is not in North America, it is in Europe. As such, Europe's problems are the U.K.'s problems, and the U.K. must defend against them even if it receives little in return. We expect the U.K. to succumb to the reality that the EU holds most of the cards in the negotiations. The U.K. will have a lower potential GDP growth rate after Brexit. But before Brexit is solidified, we expect considerable domestic political upheaval. In the short term, there is some upside for the pound. In the long term, it is a sell. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 3 Although she has herself played a role in kicking out the original, even more moderate, founders of the party. 4 The CDU, FDP, and Greens coalition is dubbed the "Jamaica coalition" because of their traditional colors - black, yellow, and green - which combine to make the colors of the Jamaican flag. 5 The CSU does not directly compete against the CDU on the federal level. It only fields candidates in Bavaria, where the CDU does not compete. 6 For the full transcript, please see "Theresa May's Florence speech on Brexit, full text," The Spectator, September 22, 2017, available at blogs.spectator.co.uk. 7 In turn, this will allow the EU to build up its power, develop a navy, and finally conquer the British Isles with a new armada somewhere around 2066! Geopolitical Calendar