Labor Market

Highlights Economic Outlook: Global growth will remain strong over the next 12 months, but will start to slow in the second half of 2018, potentially setting the stage for a recession in 2019. Overall Strategy: Investors should overweight equities and spread product for now. However, be prepared to pare back exposure next summer. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S. Treasurys, stay neutral Europe, and overweight Japan. Equities: Remain overweight developed market equities relative to their EM peers. Within the DM sphere, favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares have significant upside. Currencies: The selloff in the dollar is overdone. The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar, as does the euro. Commodities: Oil will rally over the coming months as global inventories decline. Gold will continue to struggle, before exploding higher towards the end of this decade. Feature I. Global Macro Outlook End Of The Global Manufacturing Recession Global growth estimates have been trending higher over the past 12 months, having bottomed last summer. Ironically, the collapse in oil prices in late 2014 was both the main reason for the deterioration in global growth as well as its subsequent rebound. Plunging oil prices led to a massive decline in capital spending in the energy sector and associated industries. In the U.S., energy capex dropped by 70% between Q2 of 2014 and Q3 of 2016. The economic fallout was even more severe in many other economies, especially emerging markets such as Russia and Brazil. The result was a global manufacturing recession and a pronounced slump in international trade (Chart 1). When thinking about oil and the economy, the distinction between levels and rates of change is important: While rapidly falling oil prices tend to be bad for global growth, lower oil prices are good for it. By the middle of 2016, the damage from the oil crash had largely run its course. What was left was a massive windfall for households, especially poorer ones who spend a disproportionate share of their paychecks at the pump. Industries that use oil as an input also benefited. Simply put, the oil crash went from being a bane to a boon for the global economy. A Solid 12-Month Outlook We expect global growth to remain firm over the next 12 months. Financial conditions in most countries have eased substantially since the start of the year thanks to rising equity prices, lower bond yields, and narrower credit spreads (Chart 2). Our empirical analysis suggests that easier financial conditions tend to lift growth with a lag of 6-to-9 months (Chart 3). This bodes well for activity in the remainder of this year. Chart 1The Manufacturing Recession Has Ended The Manufacturing Recession Has Ended The Manufacturing Recession Has Ended Chart 2Financial Conditions Have Eased Globally Financial Conditions Have Eased Globally Financial Conditions Have Eased Globally A number of "virtuous cycles" should amplify the effects of easier financial conditions. In the U.S., a tight labor market will lead to faster wage growth, helping to spur consumption. Rising household spending, in turn, will lead to lower unemployment and even faster wage growth. Strong consumption growth will also motivate firms to expand capacity, translating into more investment spending. Chart 4 shows that the share of U.S. firms planning to increase capital expenditures has risen to a post-recession high. Chart 3Easier Financial Conditions Will Support Growth Easier Financial Conditions Will Support Growth Easier Financial Conditions Will Support Growth Chart 4U.S. Firms Plan To Boost Capex U.S. Firms Plan To Boost Capex U.S. Firms Plan To Boost Capex The euro area economy continues to chug along. The purchasing manager indices (PMIs) dipped a bit in June, but remain at levels consistent with above-trend growth. The German Ifo business confidence index hit a record high this week. Corporate balance sheets in the euro area are improving and credit growth is accelerating. This is helping to fuel a rebound in business investment (Chart 5). The fact that the ECB has no intention of raising rates anytime soon will only help matters. As inflation expectations begin to recover, short-term real rates will fall. This will lead to a virtuous circle of stronger growth, and even higher inflation expectations. The Japanese economy managed to grow by an annualized 1% in the first quarter. This marked the fifth consecutive quarter of positive sequential growth, the longest streak in 11 years. Exports are recovering and both the manufacturing and non-manufacturing PMIs stand near record-high levels (Chart 6). Chart 5Euro Area Data Remain Upbeat Euro Area Data Remain Upbeat Euro Area Data Remain Upbeat Chart 6Japanese Economy Is Rebounding Japanese Economy Is Rebounding Japanese Economy Is Rebounding Chart 7China: Slight Slowdown, But No Need To Worry China: Slight Slowdown, But No Need To Worry China: Slight Slowdown, But No Need To Worry The Chinese economy has slowed a notch since the start of the year, but remains robust (Chart 7). Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production are rising at a healthy clip. Exports are accelerating thanks to a weaker currency and stronger global growth. Retail sales continue to expand, while the percentage of households that intend to buy a new home has surged to record-high levels. The rebound in Chinese exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 8). A better profit picture should support business capital spending in the coming months. Meanwhile, the Chinese government's "regulatory windstorm" - as the local press has called it - has largely bypassed the real economy. In fact, medium and long-term lending to nonfinancial corporations, a key driver of private-sector capital spending and physical commodity demand, has actually accelerated over the past eight months (Chart 9). Chart 8China: Higher Selling Prices Fueling A Rebound In Profits China: Higher Selling Prices Fueling A Rebound In Profits China: Higher Selling Prices Fueling A Rebound In Profits Chart 9China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating All Good Things Must Come To An End We remain optimistic about global growth over the next 12 months. Unfortunately, things are likely to sour in the second half of 2018, possibly setting the stage for a recession in the U.S. and several other countries in 2019. The odds of a recession rise when economies approach full employment (Chart 10). The U.S. unemployment rate now stands at 4.3% and is on track to break below its 2000 low of 3.8% next summer. A cursory look at the data suggests that the unemployment rate is usually either rising or falling (Chart 11). And once it starts rising, it keeps rising. In fact, there has never been a case in the postwar era where the three-month average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing. Chart 10Recessions Become More Likely When The Labor Market Begins To Overheat Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Chart 11Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Modern economies contain numerous feedback loops. When unemployment starts increasing, this fuels a vicious cycle where rising joblessness saps confidence and incomes, leading to less spending and even higher unemployment. History suggests that it is almost impossible to break this cycle once it starts. The Fed is well aware of the risks of letting the unemployment rate fall to a level where it has nowhere to go but up. Unfortunately, calibrating monetary policy in a way that achieves a soft landing is easier said than done. Changes in monetary conditions affect the economy with a lag of about 12-to-18 months. Once it has become obvious that a central bank has either loosened or tightened monetary policy too much, it is often too late to right the ship. The risks of a policy error are particularly high in today's environment where there is significant uncertainty about the level of the long-term neutral rate. Question marks about the future stance of fiscal policy will also complicate the Fed's job. We expect the Trump administration to succeed in passing legislation that cuts both personal and corporate income taxes later this year or in early 2018. The bill will be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This will generate a modest amount of fiscal stimulus over the next few years. That being said, the proposed changes to health care legislation could more than neutralize the effects of lower tax rates. The Senate bill, as currently worded, would lead to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Our base case is that Republicans in Congress fail to pass a new health care bill, thus leaving the Affordable Care Act largely unscathed. However, if they succeed, the overall stance of federal fiscal policy would likely shift from being somewhat accommodative, on net, to somewhat restrictive. This would expedite the timing of the recession. How Deep A Recession? If the U.S. does succumb to a recession in 2019, how bad will it be? Here, there is both good news and bad news. The good news is that financial and economic imbalances are not as severe today as those that existed in the lead-up to the past few recessions. The Great Recession was preceded by a massive housing bubble, associated with overbuilding and a sharp deterioration in mortgage lending standards (Chart 12). Today, residential investment stands at 3.9% of GDP, compared to a peak of 6.6% of GDP Q1 of 2006. Lending standards, at least judging by FICO scores, have remained fairly high over the course of the recovery. In relation to income and rents, home prices are also much lower today than they were a decade ago. Likewise, the massive capex overhang that preceded the 2001 recession is largely absent at present. Chart 12No New Bubble In The U.S. Housing Sector No New Bubble In The U.S. Housing Sector No New Bubble In The U.S. Housing Sector Chart 13Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... The bad news is that cracks in the economy are starting to form. In contrast to mortgage debt, student debt has gone through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 13). Not surprisingly, this is starting to translate into higher default rates (Chart 14). The fact that this is happening when the unemployment rate is at the lowest level in 16 years is a cause for concern. Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 15). Chart 14...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories Chart 15U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 16). U.S. financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 17). Chart 16Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 17CRE Debt Is Rising CRE Debt Is Rising CRE Debt Is Rising The retail sector is already under intense pressure due to the shift in buying habits towards E-commerce. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 18 and Chart 19). The number of apartment units under construction stands at a four-decade high, despite a structurally subdued pace of household formation (Chart 20). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Vacancies in the office sector are also likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. Chart 18Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 19...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam If vacancy rates across the CRE sector start rising in earnest, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further. Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins late next year when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it would further add to the risks of a recession. Chart 20Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Gauging The Global Spillover Effects What repercussions would a U.S. recession have for the rest of the world? Simply based on trade flows, the answer is "not much." U.S. imports account for less than 5% of global ex-U.S. GDP. Thus, even a significant decline in U.S. spending abroad would not make much of a dent in overseas growth. More worrisome are potential financial spillovers. As the IMF has documented, these have been the dominant drivers of the global business cycle in the modern era.1 Chart 21Global Debt Levels Are Still High Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Correlations across global markets tend to increase when risk sentiment deteriorates. Thus, if U.S. stocks buckle in the face of rising recessionary risks, risk assets in other economies are sure to suffer. The fact that valuations are stretched across so many markets only makes the problem worse. A flight towards safety could trigger a pronounced decline in global equity prices, wider credit spreads, and lower property prices. This, in turn, could lead to a sharp decline in household and corporate net worth, resulting in tighter financial conditions and more stringent lending standards. Elevated debt levels represent another major source of vulnerability. Total debt as a share of GDP is greater now than it was before the Great Recession in both advanced and emerging markets (Chart 21). High debt burdens will prevent governments from loosening fiscal policy in countries that are unable to issue their own currencies. The monetary transmission mechanism also tends to be less effective in the presence of high debt. This is especially the case in today's environment where the zero lower-bound on nominal interest rates remains a formidable challenge. The presence of these fiscal and monetary constraints implies that the severity of the next recession could be somewhat greater than one might expect based solely on the underlying causes of the downturn. II. Financial Markets Overall Strategy The discussion above implies that the investment outlook over the next few years is likely to be of the "one step forward, two steps back" variety. The global economy is entering a blow-off stage where growth will get better before it gets worse. We are bullish on global equities and spread product over the next 12 months, but expect to turn bearish on risk assets next summer. Until then, investors should position for a stronger dollar and higher bond yields. We recommend a slight overweight allocation to developed market equities over their EM peers. Within the DM sphere, we favor the euro area and Japan over the U.S. in local-currency terms. In the EM universe, Chinese H-shares stand out as offering an attractive risk-reward profile. Comparing government bonds, we are underweight U.S. Treasurys, neutral on European bonds, and overweight Japan. These recommendations are broadly in line with the output of our in-house quantitative models (Table 1 and Chart 22). Table 1BCA's Tactical Global Asset Allocation Recommendations* Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Chart 22Message From Our U.S. Stock Market ##br##Timing Model Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Equities Earnings Are Key Earnings have been the main driver of the global equity bull market. In fact, the global forward P/E ratio has actually declined slightly since February, despite a 3.9% gain in equity prices (Chart 23). Strong global growth should continue to boost corporate earnings over the next 12 months. Consensus bottom-up estimates call for global EPS to expand by 14% in 2017 and a further 11% in 2018. The global earnings revision ratio moved into positive territory earlier this year for the first time in six years (Chart 24). Chart 23Earnings Have Been The Main Driver ##br##Of The Global Equity Bull Market Earnings Have Been The Main Driver OfThe Global Equity Bull Market Earnings Have Been The Main Driver OfThe Global Equity Bull Market Chart 24Global Earnings Picture ##br##Looks Solid Global Earnings Picture Looks Solid Global Earnings Picture Looks Solid Global monetary conditions generally remain favorable. Our U.S. Financial Conditions Index has loosened significantly. Historically, this has been a bullish signal for stocks.2 Excess liquidity, which we define as M2 growth less nominal GDP growth, is also still well above the zero line, a threshold that has warned of a downturn in stock prices in the past. Chart 25Individual Investors Are Not Overly Bullish On U.S. Equities But... Individual Investors Are Not Overly Bullish On U.S. Equities But... Individual Investors Are Not Overly Bullish On U.S. Equities But... Sentiment is stretched, but not excessively so. The share of bullish respondents in the AAII's weekly poll of individual investors stood at 29.7% this week (Chart 25). This marked the 18th consecutive week that optimism has been below its long-term average. Market Vane's survey of traders and Yale's Investor Confidence index paint a more complacent picture, as do other measures such as the VIX and margin debt (Chart 26). Nevertheless, as long as earnings continue to grow and monetary policy remains in expansionary territory, sentiment can remain elevated without being a significant threat to stocks. Overweight The Euro Area And Japan Over The U.S. Regionally, earnings revisions have been more positive in Europe and Japan than in the U.S. so far this year. Net profit margins are also lower in Europe and Japan, which gives these two regions more room for catch-up. Moreover, unlike the Fed, neither the ECB nor the BoJ are likely to raise rates anytime soon. As we discuss in greater detail in the currency section of this report, this should lead to a weaker euro and yen, giving European and Japanese exporters a further leg up in competitiveness. Lastly, valuations are more favorable in the euro area and Japan than in the U.S., even if one adjusts for differing sector weights across the three regions (Chart 27). Chart 26...There Are Signs Of Complacency ...There Are Signs Of Complacency ...There Are Signs Of Complacency Chart 27U.S. Valuations Seem Stretched Relative ##br##To Other Bourses Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull Mixed Outlook For EM Earnings growth in emerging markets has accelerated sharply. Bottom-up estimates imply EPS growth of 20% in 2017 and 11% in 2018 for the EM MSCI index. Our EM strategists believe this is too optimistic, given the prospect of a stronger dollar, high debt levels across the EM space, poor corporate governance, and the lack of productivity-enhancing structural reforms. These problems warrant a slight underweight to emerging markets in global equity portfolios. Nevertheless, considering the solid backdrop for global growth, EM stocks should still be able to deliver positive real total returns over the next 12 months. Within the EM space, we favor Russia, central Europe, Korea, Taiwan, India, Thailand, and China. Chinese H-shares, in particular, remain quite attractive, trading at only 7.1-times forward earnings and 1.0-times book value. Favor Cyclicals Over Defensives ... For Now Looking at global equity sectors, upward revisions have been largest for industrials, materials, financials, and real estate. Revisions for energy, health care, and telecom have been negative. We expect cyclical stocks to outperform defensives over the next 12 months. Energy stocks will move from being laggards to leaders, as oil prices rebound. Financials should also do well, as steeper yield curves, increased M&A activity, and falling nonperforming loans bolster profits. Equity Bear Market Will Begin Late Next Year As growth begins to falter in the second half of 2018, stocks will swoon. U.S. equities are likely to fall 20% to 30% peak to trough, marking the first sustained bear market since 2008. Other stock markets will experience similar declines. Global equities will eventually recoup most of their losses at the start of the 2020s, but the recovery will be a lackluster one. As we have argued extensively in the past, global productivity growth is likely to remain weak.3 Population aging will deplete savings, leading to higher real interest rates. The next recession could also propel more populist leaders into power. None of these things would be good for stocks. Against today's backdrop of lofty valuations, global stocks will deliver a total real return in the low single-digit range over the next decade. Fixed Income Bonds Have Overreacted To The Inflation Dip We turned structurally bearish on government bonds on July 5th, 2016. As fate would have it, this was the very same day that the U.S. 10-year Treasury yield dropped to a record closing low of 1.37%. The dramatic bond selloff that followed was too much, too fast. We warned at the start of this year that bond yields were likely to climb down from their highs. At this point, however, the pendulum has swung too far in the direction of lower yields. Chart 28 shows that almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained resilient, suggesting that investors' views of global growth have not changed much. This helps explain why stocks have been able to rally to new highs. The fall in inflation expectations has been largely driven by the decline in commodity prices. Short-term swings in oil prices should not affect long-term inflation expectations, but in practice they do (Chart 29). If oil prices recover in the second half of this year, as we expect, inflation expectations should shift higher as well. This will translate into higher bond yields. Chart 28Inflation Expectations Declined This Year, ##br##But Real Yields Remained Resilient Inflation Expectations Declined This Year, But Real Yields Remained Resilient Inflation Expectations Declined This Year, But Real Yields Remained Resilient Chart 29Low Oil Prices Drag Down##br## Inflation Expectations Low Oil Prices Drag Down Inflation Expectations Low Oil Prices Drag Down Inflation Expectations U.S. Treasurys Are Most Vulnerable Tightening labor markets should also boost inflation expectations. This is particularly the case in the U.S., where the economy is quickly running out of surplus labor. Some commentators have argued that the headline unemployment rate understates the true amount of economic slack. We are skeptical that this is the case. Table 2 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message from the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Table 2Comparing Current Labor Market Slack With Past Cycles 12-MONTH Third Quarter 2017: Aging Bull Third Quarter 2017: Aging Bull If the U.S. has reached full employment, does the absence of wage pressures signal that the Phillips curve is dead? We don't think so. For one thing, wage growth is not that weak. Our wage growth tracker has risen from a low of 1.2% in 2010 to 2.4% at present (Chart 30). In fact, real wages have been rising more quickly than productivity for the past three years (Chart 31). Unit labor cost growth is now just shy of where it was at the peaks of the last two business cycles (Chart 32). Chart 30Stronger Labor Market ##br##Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Chart 31Real Wages Now Increasing Faster##br## Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Chart 32Unit Labor Cost Growth Close ##br##To Previous Two Peaks Unit Labor Cost Growth Close To Previous Two Peaks Unit Labor Cost Growth Close To Previous Two Peaks The evidence generally suggests that the Phillips curve becomes "kinked" when the unemployment rate falls towards 4%. In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 4.5% to 3.5% does. The experience of the 1960s is illustrative in that regard. Chart 33 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation took off. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. The Fed is keen to avoid a repeat of that episode. In a recent speech, New York Fed President and FOMC vice chairman Bill Dudley warned that "If we were not to withdraw accommodation, the risk would be that the economy would crash to a very, very low unemployment rate, and generate inflation ... Then the risk would be that we would have to slam on the brakes and the next stop would be a recession." If U.S. growth remains firm and inflation rebounds in the second half of this year, as we expect, the Fed will get the green light to keep raising rates in line with the "dots." The market is not prepared for that, as evidenced by the fact that it is pricing in only 27 basis points in rate hikes over the next 12 months. We are positioned for higher rate expectations by being short the January 2018 fed funds contract. The ECB And The BoJ Will Not Follow The Fed's Lead Could better growth prospects cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl? We doubt it. Investors are reading too much into Mario Draghi's allegedly more "hawkish" tone. There is a huge difference between removing emergency measures and beginning a full-fledged tightening cycle. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 34). Chart 33Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Chart 34Euro Area: Labor Market Slack##br## Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany At this point, the market is pricing in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 25 months at present (Chart 35). Investors now expect real yields in the U.S. to be only 16 basis points higher than in the euro area in five years' time.4 This is below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 36). Chart 35ECB: Markets Are Pricing In Too Much Tighteninh ECB: Markets Are Pricing In Too Much Tighteninh ECB: Markets Are Pricing In Too Much Tighteninh Chart 36The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area As for Japan, while the unemployment rate has fallen to a 22-year low of 2.8%, this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Bank Of England's Dilemma Gilts are a tougher call. The equilibrium rate is higher in the U.K. than in most other developed economies. Inflation has risen, although that has largely been a function of a weaker currency. Fiscal policy is turning more accommodative, which, all things equal, would warrant a more bearish view on gilts. The big wildcard is Brexit. Chart 37 shows that the U.K. is the only major country where growth has faltered this year. Worries over Britain's future relationship with the EU have likely contributed to the slowdown. Ongoing Brexit angst will keep the Bank of England on hold, justifying a neutral weighting on gilts. Stay Short Duration ... For Now In summary, investors should keep global duration risk below benchmark levels over the next 12 months. Regionally, we recommend underweighting U.S. Treasurys, overweighting Japan, and maintaining a neutral position towards euro area and U.K. government bonds. Reflecting these recommendations, we are closing our short Japanese, German and Swiss 10-year bond trade for a gain of 5.3% and replacing it with a short 30-year U.S. Treasury bond position. As global growth begins to slow in the second half of next year, global bonds will rally. However, as we discussed at length in our Q2 Strategy Outlook, the rally will simply represent a countertrend move in what will turn out to be a structural bear market.5 The 2020s, in short, could end up looking a lot like the 1970s. Spread Product: Still A Bit Of Juice Left While we prefer equities to high-yield credit on a risk-adjusted basis over the coming months, we would still overweight spread product within a global asset allocation framework. The option-adjusted spread of the U.S. high-yield index offers 200 basis points above the Treasury curve after adjusting for expected defaults, roughly in line with the mid-point of the historical data (Chart 38). Corporate defaults are likely to trend lower over the next 12 months, spurred by stronger growth and a rebound in oil prices. Chart 37U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers Chart 38Default-Adjusted Junk Spreads Are At Historical Average Default-Adjusted Junk Spreads Are At Historical Average Default-Adjusted Junk Spreads Are At Historical Average As with all our other views, the picture is likely to change sharply in the second half of next year. At that point, corporate spreads will widen, warranting a much more defensive stance. Currencies And Commodities The Dollar Bull: Down But Not Out Our long-standing dollar bullish view has come under fire over the past few months. The Fed's broad trade-weighted dollar index has fallen 4.6% since December. Momentum in currency markets can be a powerful force, and so we would not be surprised if the dollar remains under pressure over the coming weeks. However, over a 12-month horizon, the greenback will strengthen, as the Fed raises rates more quickly than expected while most other central banks stand pat. When all is said and done, the broad-trade weighted dollar is likely to peak next summer at a level roughly 10% higher than where it is today. That would still leave it substantially below prior peaks in 1985 and 2000 (Chart 39). The U.S. trade deficit has fallen from a peak of nearly 6% of GDP in 2005 to 3% of GDP at present (Chart 40). Rising shale production has reduced the demand for oil imports. A smaller trade deficit diminishes the need to attract foreign capital with a cheaper currency. Chart 39The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks Chart 40The U.S. Trade Deficit Has Halved Since 2005 The U.S. Trade Deficit Has Halved Since 2005 The U.S. Trade Deficit Has Halved Since 2005 Sentiment and speculative positioning towards the dollar have swung from extremely bullish at the start of the year to being more neutral today (Chart 41). In contrast, long euro speculative positions and bullish sentiment have reached the highest levels in three years. Our tactical short euro/long dollar trade was stopped out this week for a loss of 1.6%. However, we continue to expect EUR/USD to fall back towards parity by the end of the year. We also expect the pound to weaken against the dollar, but appreciate slightly against the euro. Now that the Bank of Japan is keeping the 10-year JGB yield pinned to zero, the outlook for the yen will be largely determined by what happens to yields abroad. If we are correct that Treasury yields - and to a lesser extent yields in Europe - rise, the yen will suffer. Commodity Currencies Should Fare Well Higher commodity prices should benefit currencies such as the Canadian and Aussie dollars and the Norwegian krone. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. While shale output continues to rise, this is largely being offset by falling production from conventional oil fields. Consequently, oil inventories should fall in the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 42). Chart 41USD: Sentiment And Positioning ##br##Are Not Lopsided Anymore USD: Sentiment And Positioning Are Not Lopsided Anymore USD: Sentiment And Positioning Are Not Lopsided Anymore Chart 42Falling Oil Inventories Should Lead ##br##To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices The outlook for industrial metals is not as upbeat as for oil, but metal prices should nevertheless rebound over the coming months. We suspect that much of the recent weakness in metal prices can be attributed to the regulatory crackdown on shadow banking activity in China. Many Chinese traders had used commodities as collateral for loans. As their loans were called in, they had no choice but to liquidate their positions. Today, speculative positioning in the commodity pits has returned to more normal levels (Chart 43). This reduces the risk of a further downdraft in commodity prices. BCA's China strategists expect the Chinese authorities to relax some of their tightening measures. This is already being seen in a decline in interbank lending rates and corporate bond yields (Chart 44). Chart 43Commodities: Long Speculative Positions Returning ##br##To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Commodities: Long Speculative Positions Returning To More Normal Levels Chart 44China: Some Relief##br## After Recent Tightening Action? China: Some Relief After Recent Tightening Action? China: Some Relief After Recent Tightening Action? One key reason why the authorities have been able to let interest rates come down is because capital outflows have abated. Compared to late 2015, economic growth is stronger and deflationary pressures have receded. The trade-weighted RMB has also fallen by 7.5% since then, giving the economy a competitive boost. As such, the seeming can't-lose bet on further yuan weakness has disappeared. We still expect the RMB to depreciate against the dollar over the next 12 months, but to strengthen against most other currencies, including the euro and the yen. If the yuan remains resilient, this will limit the downside risk for other EM currencies. Nevertheless, at this point, much of the good news benefiting EM currencies has been priced in. Across the EM universe, in addition to the Chinese yuan, we like the Mexican peso, Taiwan dollar, Indian rupee, Russian ruble, Polish zloty, and Czech koruna. Lastly, a few words on the most timeless of all currencies: gold. We expect bullion to struggle over the next 12 months on the back of a stronger dollar and rising bond yields. However, once the Fed starts cutting rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For example, please see Box 4.1: Financial Linkages and Spillovers in "Spillovers and Cycles in the Global Economy," IMF World Economic Outlook, (April 2007). 2 Please see Global Investment Strategy Weekly Report, "The Message From Our Stock Market Timing Model," dated May 5, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017; Global Investment Strategy - Strategy Outlook, "First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters), First Quarter 2017 From Reflation To Stagflation, (Section: Supply Matters)," dated January 6, 2017; and Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 4 U.S. minus euro area 5-year/5-year forward real bond yields. Real bonds yields are calculated as a difference between nominal yields and the CPI swap rate. Euro area yields refer to a GDP-weighted average of Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain. 5 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The divergence between global bond yields and equity prices is not as puzzling as it may first appear. Thus far, lower inflation has dampened the need for central banks to tighten monetary policy. This has caused bond yields to fall, lifting stocks in the process. Looking out, the combination of faster growth and dwindling spare capacity will cause inflation to rise. This is particularly the case for the U.S., where the economy has already reached full employment. The "blow-off" phase for the U.S. economy is likely to last until mid-2018. The dollar and Treasury yields will move higher over this period. The euro and the yen will suffer the most against a resurgent greenback, the pound less so. China's economy will remain resilient, helping to boost commodity prices. This will support the Canadian and Aussie dollars. Stronger global growth will provide a tailwind to emerging markets. However, at this point, most of the good news is already reflected in EM asset valuations. Feature Stocks And Bonds: A Curious Divergence Chart 1Global Growth: Increasing Optimism Global Growth: Increasing Optimism Global Growth: Increasing Optimism One could be forgiven for thinking that equity and bond investors are living on different planets. Global bond yields have been trending lower thus far this year, while stocks have been setting new highs. Are bonds signaling an imminent slowdown which equity investors are willfully ignoring? Not necessarily. Almost all of the decline in bond yields has been due to falling inflation expectations. Real yields have remained reasonably steady, suggesting that growth worries are not foremost on investors' minds. The fact that consensus global growth estimates for 2017 and 2018 have continued to grind higher is consistent with this observation (Chart 1). A quiescent inflation picture has given investors more confidence that the Fed will not need to raise rates aggressively. This has pushed down bond yields, weakened the dollar, and fueled the rally in stock prices. The decline in headline inflation, in turn, has been largely driven by lower commodity prices. In the U.S., several one-off factors - including Verizon's decision to move to unlimited data plans, a temporary lull in health care inflation, and a drop in airline fares - have helped keep core inflation in check. The U.S. Economy: It Gets Better Before It Gets Worse Looking out, global growth is likely to remain firm. This should ultimately translate into higher inflation, particularly in the U.S., where the economy has already achieved full employment. Granted, as we discussed last week,1 the U.S. business cycle expansion is getting long in the tooth. However, history suggests that the transition between boom and bust is often accompanied by a revelry of sorts where things get better before they get worse. Call it a "blow-off" phase for the business cycle. The example of the late 1990s - the last time the U.S. unemployment rate fell below NAIRU for an extended period of time - comes to mind. Chart 2 shows that final domestic demand accelerated to 8.3% in nominal terms in Q1 of 2000. Personal consumption growth surged, reaching 8.4% in nominal terms and 5.7% in real terms. Obviously, there are many differences between now and then. However, there is at least one critical similarity: The unemployment rate stood at 4.3% in January 1999. This is exactly where it stands today. And if it keeps falling at its current pace, the unemployment rate will dip below its 2000 low of 3.8% by next summer. As was the case in the past, an overheated labor market will lead to faster wage growth. In the U.S., underlying wage growth has accelerated from 1.2% in 2010 to 2.4% at present (Chart 3). Chart 2The Late 1990s: An End-Of-Cycle Blow-Off The Late 1990s: An End-Of-Cycle Blow-Off The Late 1990s: An End-Of-Cycle Blow-Off Chart 3Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Stronger Labor Market Is Leading To Faster Wage Growth Granted, this is still well below the levels seen in 2000 and 2007. However, productivity growth has crumbled over the past decade while long-term inflation expectations have dipped. Real unit labor costs - a measure of compensation which adjusts for shifts in productivity growth and inflation - are rising at a faster rate than in 2007 and close to the pace recorded in 2000 (Chart 4). In fact, real wage growth in the U.S. has eclipsed business productivity growth for three straight years (Chart 5). As a result, labor's share of national income is now increasing. Chart 4Real Unit Labor Cost Growth: Back To Its 2000 Peak Real Unit Labor Cost Growth: Back To Its 2000 Peak Real Unit Labor Cost Growth: Back To Its 2000 Peak Chart 5Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity What happens to aggregate demand when the share of income going to workers rises? The answer is that at least initially, demand goes up. Companies typically spend less of every marginal dollar of income than workers. This is especially the case in today's environment where the distribution of corporate profits has become increasingly tilted towards a few winner-take-all firms which, for the most part, are already flush with cash (Chart 6). Thus, a shift of income towards workers tends to boost overall spending. In addition, an overheated labor market typically generates the biggest gains for workers at the bottom of the income distribution. Wages for U.S. workers without a college degree have been rising more quickly than those with a university education for the past few years (Chart 7). Such workers often live paycheck-to-paycheck and, hence, have a high marginal propensity to consume. Chart 6A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy Chart 7Tighter Labor Market Boosting Wages Of Less Educated Workers Tighter Labor Market Boosting Wages Of Less Educated Workers Tighter Labor Market Boosting Wages Of Less Educated Workers Let's Get This Party Started The discussion above suggests that U.S. aggregate demand could accelerate over the next few quarters. There is some evidence that this is already happening (Chart 8). Despite a moderation in auto purchases, real PCE growth is still tracking at 3.2% in the second quarter according to the Atlanta Fed's GDPNow model. And with the personal saving rate still stuck at an elevated 5.3%, there is scope for consumer spending to grow at a faster rate than disposable income. Chart 9 shows that the current saving rate is well above the level one would expect based on the ratio of household net worth-to-disposable income. Chart 8Solid Near-Term Outlook For U.S. Consumers Solid Near-Term Outlook For U.S. Consumers Solid Near-Term Outlook For U.S. Consumers Chart 9 Financial conditions have eased over the past six months thanks to lower Treasury yields, narrower credit spreads, a weaker dollar, and higher equity prices (Chart 10). Historically, an easing in financial conditions has foreshadowed faster growth (Chart 11). This could make the coming blow-off phase even more explosive than in past business cycles. Some commentators have noted that while financial conditions have eased, bank lending has slowed significantly. If true, this would imply that easier financial conditions are not boosting credit growth in the way one might expect. The problem with this argument is that it takes a far too limited view of the U.S. financial system. Although bank lending to companies has indeed slowed, bond issuance has soared. In fact, total nonfinancial corporate debt rose by $212 billion in the first quarter according to the Fed's Financial Accounts database, the largest increase in history (Chart 12). Chart 10Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Chart 11...Which Will Support Growth ...Which Will Support Growth ...Which Will Support Growth Chart 12Nonfinancial Corporate Debt Surged In Q1 Nonfinancial Corporate Debt Surged In Q1 Nonfinancial Corporate Debt Surged In Q1 All Good Things Must Come To An End Unfortunately, the burst of demand that often occurs in the late stages of business cycle expansions contains the seeds of its own demise. Initially, when consumer spending accelerates, firms tend to react by expanding capacity. This translates into higher investment spending. However, as labor's share of income keeps rising, an increasing number of firms start incurring outright losses. This causes them to dismiss workers and cut back on investment spending. Such a souring in corporate animal spirits is not an immediate risk for the U.S. economy. Hiring intentions remain solid and businesses are still signaling that they expect to increase capital spending over the coming months (Chart 13). Profit margins are also quite high by historic standards, which gives firms greater room for maneuver. This will change over time, however. Margins are already falling in the national accounts data (Chart 14). History suggests that S&P 500 margins will follow suit. This raises the risk that capex and hiring will start to slow late next year, potentially sowing the seeds for a recession in 2019. We remain overweight global equities on a cyclical 12-month horizon, but will be looking to significantly pare back exposure next summer. Chart 13Corporate America Feeling Great Again Corporate America Feeling Great Again Corporate America Feeling Great Again Chart 14Economy-Wide Margins Have Slipped Economy-Wide Margins Have Slipped Economy-Wide Margins Have Slipped The Dollar Bull Market Is Not Over Yet Chart 15Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Historically, A Rising Labor Share Has Pushed Up The Dollar Until U.S. growth does decelerate, the path of least resistance for bond yields and the dollar will be to the upside. Chart 15 shows the strikingly close correlation between labor's share of income and the value of the trade-weighted dollar. As noted above, the initial effect of accelerating wage growth is to put more money into workers' pockets. This results in higher aggregate demand and, against a backdrop of low spare capacity, rising inflation. Historically, such an outcome has prompted the Fed to expedite the pace of rate hikes, leading to a stronger dollar. This time is unlikely to be any different. The market is currently pricing in only 21 basis points in Fed rate hikes over the next 12 months. This seems far too low to us. Other things equal, a stronger dollar implies a weaker euro and yen. Improved export competitiveness will lead to better growth prospects and higher inflation expectations in the euro area and Japan. Unless the ECB and the BoJ respond by tightening monetary policy, short-term real rates will fall. This, in turn, could put further downward pressure on the euro and the yen. The ECB And The BoJ Will Not Follow The Fed's Lead Many commentators have argued that better growth prospects will cause the ECB and the BoJ to follow in the Fed's footsteps and take away the punch bowl. We doubt it. Labor market slack is still considerably higher in the euro area than was the case in 2008. Outside of Germany, the level of unemployment and underemployment in the euro area is about seven points higher than it was before the Great Recession (Chart 16). If anything, the market has priced in too much tightening from the ECB. Our months-to-hike measure has plummeted from a high of 65 months in July 2016 to 28 months at present (Chart 17). Investors now expect real rates in the U.S. to be only 23 basis points higher than in the euro area in five years' time. This is well below the 76 basis-point gap in the equilibrium rate between the two regions that Holston, Laubach, and Williams estimate (Chart 18). Chart 16Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Euro Area: Labor Market Slack Is Still High Outside Of Germany Chart 17ECB: Markets Are Pricing In Too Much Tightening ECB: Markets Are Pricing In Too Much Tightening ECB: Markets Are Pricing In Too Much Tightening Chart 18The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area The Neutral Rate Is Lowest In The Euro Area As for Japan, while it is true that the unemployment rate has fallen to 2.8% - a 22-year low - this understates the true amount of slack in the economy. Output-per-hour in Japan remains 35% below U.S. levels. A key reason for this is that many Japanese companies continue to pad their payrolls with excess labor. This is particularly true in the service sector, which remains largely insulated from foreign competition. In any case, with both actual inflation and inflation expectations in Japan nowhere close to the BoJ's target, this is hardly the time to be worried about an overheated economy. And even if the Japanese authorities were inclined to slow growth, it would be fiscal policy rather than monetary policy that they would tighten first. After all, they have been keen to raise the sales tax for several years now. The Pound Will Rebound Against The Euro, But Weaken Further Against The Dollar Chart 19Pound: Unloved And Underappreciated Pound: Unloved And Underappreciated Pound: Unloved And Underappreciated While we continue to maintain a strong conviction view that the euro and yen will weaken against the dollar, we are more circumspect about other currencies. Bank of England Governor Mark Carney played down speculation this week that the BoE would raise rates later this year, noting in his annual speech at London's Mansion House that "now is not yet the time to begin that adjustment." U.K. growth has been the weakest in the G7 so far in 2017, partly because of growing angst over the forthcoming Brexit negotiations. Nevertheless, U.K. inflation remains elevated and fiscal policy is likely to be eased in the November budget, as Chancellor Hammond confirmed in a BBC interview on Sunday. Sterling is already quite cheap based on our metrics (Chart 19). Our best bet is that the pound will weaken against the dollar over the next 12 months but strengthen against the euro and the yen. We are currently long GBP/JPY. The trade has gained 7.2% since we initiated it in August 2016. CAD Has Upside We went long CAD/EUR in May. Despite the downdraft in oil prices, the trade has managed to gain 2.6% thus far. We are optimistic on the Canadian dollar over the coming months. Our energy strategists remain convinced that crude prices are heading higher. They expect global production to increase by only 0.7 MMB/d in 2017, compared to 1.5 MMB/d growth in consumption. Consequently, oil inventories should fall over the remainder of this year. If history is any guide, this will lead to a rebound in oil prices (Chart 20). The Bank of Canada has also turned more hawkish. Senior Deputy Governor Carolyn Wilkins suggested last week that interest rates are likely to rise later this year. The market is now pricing in a 84% chance of a rate hike in 2017, up from only 18% earlier this month. The Canadian economy continues to perform well (Chart 21). Retail sales are growing briskly, the unemployment rate is close to its lowest level in 40 years, and goods exports are recovering thanks to a weak loonie and stronger growth south of the border. While the bubbly housing market remains a source of concern, this is as much a reason to raise interest rates - to prevent further overheating - as to cut them. Chart 20Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Chart 21Canadian Economy: Chugging Along Canadian Economy: Chugging Along Canadian Economy: Chugging Along China Will Drive The Aussie Dollar And EM Assets After a very strong start to the year, Chinese growth has slipped a notch. Housing starts slowed in May, as did gains in property prices. M2 growth decelerated to 9.6% from a year earlier, the first time broad money growth has fallen into the single-digit range since the government began publishing such statistics in 1986. Still, the economy is far from falling off a cliff, as evidenced by the fact that the IMF upgraded its full-year 2017 GDP growth forecast from 6.6% to 6.7% last week. Real-time measures of industrial activity such as railway freight traffic, excavator sales, and electricity production remain upbeat. Export growth is accelerating thanks to a weaker currency and stronger global growth. The PBoC's trade-weighted RMB basket has fallen by over 8% since it was introduced in December 2015. Retail sales continue to expand at a healthy clip. The percentage of households that intend to buy a new home has also surged to record-high levels. This should limit the fallout from the government's efforts to cool the housing market. The rebound in exports and industrial output is helping to lift producer prices. Higher selling prices, in turn, are fueling a rebound in industrial company profits (Chart 22). A better profit picture should support business capital spending in the coming months. The government also remains cognizant of the risks of tightening policy too aggressively, especially with the National Party Congress slated for this autumn. The PBoC injected 250 billion yuan into the financial system last Friday. This was the single biggest one-day intervention since January, when demand for cash was running high in the lead up to the Chinese New Year celebrations. Fiscal policy has also been eased (Chart 23). So far, the "regulatory windstorm" of measures designed to clamp down on financial speculation has largely bypassed the real economy. Medium and long-term lending to nonfinancial corporations - a key driver of private-sector capital spending - has actually accelerated over the past eight months (Chart 24). Chart 22China: Higher Selling Prices Fuelling A Rebound In Profits China: Higher Selling Prices Fuelling A Rebound In Profits China: Higher Selling Prices Fuelling A Rebound In Profits Chart 23Fiscal Spending Is On The Mend Fiscal Spending Is On The Mend Fiscal Spending Is On The Mend Chart 24China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating China: Credit To The Real Economy Is Accelerating The key takeaway for investors is that Chinese growth is likely to slow over the next few quarters, but not by much. Considering that fund managers surveyed by BofA Merrill Lynch in June cited fears of a hard landing in China as the biggest tail risk facing financial markets for the second month in a row, the bar for positive surprises out of China is comfortably low. If China can clear this bar, as we expect it will, it will be good news for the Aussie dollar and other commodity plays. Strong Chinese growth should provide a tailwind for EM assets. However, EM stocks and currencies have already had a major run, which limits further upside. The fact that serial-defaulter Argentina could issue a 100-year bond this week in an offering that was three times oversubscribed is a testament to that. The fundamental problems plaguing many emerging markets - high debt levels, poor governance, and lackluster productivity growth - remain largely unaddressed. Until they are, the long-term outlook for EM assets will continue to be challenging. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The European Central Bank's ultra-dovish policies have depressed the value of the euro and, by extension, boosted German manufacturing. Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. As a result of this and labor shortages, wages in central Europe are rising rapidly, and inflation is accelerating. The Polish and Czech central banks will be forced to hike rates sooner than later. Hungary's central bank will lag behind. Go long the PLN versus the IDR. Stay long the CZK versus the euro and the PLN against the HUF. Feature Inflation in central Europe is picking up and will continue to rise (Chart I-1). The main driver is surging wage growth in central Europe. Considerable acceleration in wage growth, in Poland, Hungary and the Czech Republic signifies genuine inflationary pressures that could very well spread. Based on this, our primary investment recommendation is to be long the PLN and CZK versus the euro and/or EM currencies. Labor Shortages There is a shortage of labor in the central European manufacturing economies of Poland, Hungary and the Czech Republic. This partially reflects similar trends in Germany and its increased use of outsourcing to central European countries. Escalating wage growth (Chart I-2) in central European economies denotes widening labor shortages. Chart I-1Inflation Is Rising In CE3 Inflation Is Rising In CE3 Inflation Is Rising In CE3 Chart I-2Labor Shortages = Higher Wages Labor Shortages = Higher Wages Labor Shortages = Higher Wages Indeed, our proxy for labor shortages - calculated as the number of job vacancies divided by the number of unemployed looking for a job - has surged of late across all central European countries (Chart I-3). The same measure for Germany is at a 27-year high (Chart I-3, bottom panel). Chart I-4A and Chart I-4B illustrate both components of the ratio: the number of job vacancies has skyrocketed to all-time highs and the number of unemployed people has dropped to multi-decade lows as well. Chart I-3Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Labor Is Scarce In CE3 And Germany Chart I-4AA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Chart I-4BA Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy A Breakdown Of Labor Shortage Proxy Importantly, it is not the case that labor shortages are occurring because people are discouraged and giving up on their search for work. The participation rate for all these countries has risen to its highest level since data have been available. In brief, a rising share of the population in these countries is either working or actively looking for a job. (Chart I-5). Finally, their working age population is shrinking (Chart I-6), with Germany being the exception because of immigration inflows (Chart I-6, bottom panel). Chart I-5Labor Participation Rate Is ##br##High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Labor Participation Rate Is High In CE3 And Germany... Chart I-6...While Working Age ##br##Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 ...While Working Age Population Is Declining In CE3 Robust labor demand has been occurring in central Europe because of the ongoing manufacturing boom in the region. Given central Europe's extensive supply chain linkages to German manufacturing, the artificial cheapness of the euro that the ECB engineered has boosted the German economy and by extension central Europe's manufacturing boom. Germany: A Cheap Currency And Export Boom The ECB's ultra-accommodative policy has suppressed the value of the euro, and caused German exports to mushroom (Chart I-7, top panel). Chart I-7ECB Policies Have Been ##br##A Boon For German Exports ECB Policies Have Been A Boon For German Exports ECB Policies Have Been A Boon For German Exports A cheap common European currency has boosted Germany's manufacturing competitiveness and has led to rising demand for German exports. An overflow of manufacturing orders in Germany in turn has led to labor shortages in central Europe via increased German outsourcing. Currency appreciation is the conventional economic adjustment in a country with a flexible exchange rate and an export boom coupled with a large current account surplus. However, this has not occurred in Germany in recent years. This is because of the ECB's ultra-easy policies. The euro has depreciated even as the German and euro area overall current account has mushroomed (Chart I-7, bottom panel). Since the currency has not been allowed to appreciate in nominal terms, the real effective exchange rate will inevitably appreciate via inflation - rising wages initially and broader inflation increases later. In our opinion, the best currency valuation measure is the real effective exchange rate based on unit labor costs. Our basis is that this measure reflects both changes in productivity and wages - i.e. it reflects genuine competitiveness. Chart I-8 demonstrates Germany's real effective exchange rate based on unit labor costs in absolute terms compared to other advanced manufacturing competitors like the U.S., Japan, Switzerland and Sweden. Based on this measure, it is clear that Germany continues to enjoy a significant comparative advantage on the manufacturing world stage among advanced manufacturing economies. It is only less competitive versus Japan. Chart I-8Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Germany Is Very Competitive Based On Real Effective Exchange Rates Bottom Line: The ECB's ultra-dovish policies have depressed the value of the euro and boosted German manufacturing. This has boosted central European manufacturing and demand for labor. Germany Is Passing The Inflation Baton To Central Europe Despite a historic low in the unemployment rate and ongoing labor shortages, German wages have not risen by much (Chart I-9). Our hunch is that German companies faced with some labor shortages have been increasing their use of outsourcing. Central European economy's export to Germany have boomed, especially after the euro started depreciating circa 2010 (Chart I-10). Chart I-9German Wage Inflation Is Muted German Wage Inflation Is Muted German Wage Inflation Is Muted Chart I-10Growing Dependence On ##br##Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Growing Dependence On Germany For CE3 Growth Being the lower marginal cost producer in the region, central European economies have benefited from German competitiveness and the cheap euro. Outsourcing is economically justified because German wages are still four times higher than in Poland, Hungary and the Czech Republic. (Chart I-11). Even though Germany's productivity is higher than in central Europe, manufacturing wages adjusted for productivity are still higher than in central European economies (Chart I-12). Therefore, it still makes sense for German businesses to outsource more to lower-cost producers in central Europe. Chart I-11CE3 Wage Bill Is Cheaper ##br##Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... CE3 Wage Bill Is Cheaper Than That Of Germany... Chart I-12...Even After Adjusting ##br##For Productivity ...Even After Adjusting For Productivity ...Even After Adjusting For Productivity Faced with strong orders as well as a lack of available labor, businesses in central European countries have been competing for labor by raising wages. Unlike in Germany, manufacturing and overall wages in Poland, Hungary and the Czech Republic have recently surged (Chart I-2 on page 3). Wages are rising more so in Hungary and the Czech Republic since they have smaller labor pools compared to Poland. Notably, wage growth has exceeded productivity growth, and unit labor costs have been rising rather rapidly (Chart I-13). Chart I-13Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Unit Labor Costs Are Rising Rapidly In CE3 Higher unit labor costs amid rising output denote genuine inflationary pressures. Producers faced with rising unit labor costs and shrinking profit margins will attempt to raise prices. Given that income and demand are strong, they will partially succeed - meaning genuine inflationary pressures in central Europe are likely to intensify. Since the beginning of the ECB's accommodative monetary policy, Germany has been able to avoid the fallout of higher wages because it has been able to outsource a portion of its production to other countries, namely central Europe. The problem is that the supply of labor in central Europe is now drying out, so its price will naturally rise. If Germany did not have the labor pool of CE3 available as a resource, German wage inflation would be significantly higher by now because companies would have been forced to employ Germans more rapidly, paying more in labor costs. Bottom Line: Germany has diffused its inflationary pressures by outsourcing jobs and production to central Europe. Overheating In Central Europe Various inflation measures are showing signs that inflation is escalating in CE3. With rising wages and unit labor costs, these trends will continue. Consequently, output gaps in central European economies are closing or have closed, warranting further increases in inflation (Chart I-14). Money and credit growth are booming, which is further facilitating the rise in inflation (Chart I-15). Finally, employment growth is very robust and retail sales are strong (Chart I-16). Chart I-14Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Inflation Will Remain On An Up Trend In CE3 Chart I-15Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Money & Credit Will Facilitate Path To Inflation Chart I-16Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Employment & Retail Sales Growth Is Robust Bottom Line: A cheap euro has supercharged German demand for central European labor at the time when the pool of available labor in CE3 is shrinking. This has generated genuine inflationary pressures in the region. Conclusions And Investment Recommendations 1. The Polish and Czech central banks will hike rates sooner than later. This will boost their currencies. The Hungarian central bank will lag and the HUF will underperform its regional peers. CE3 currencies are set to appreciate, especially the CZK and the PLN: stay long the PLN versus the HUF, and the CZK versus the euro. We recommended going long PLN/HUF and long CZK/EUR on September 28 2016 due to stronger growth and rising inflationary pressures. This week's analysis reinforces our conviction on these trades. In the face of rising inflationary pressures, the Czech National Bank (CNB) and the National Bank of Poland (NBP) will be less reluctant to tighten policy than the National Bank of Hungary (NBH) and the ECB. This will drive the PLN and CZK higher relative to the EUR and HUF. The NBH is unlikely to tighten policy while credit growth is still weak. Given strong political pressure for faster economic growth, our bias is that the NBH is more interested in ending six years of non-existent credit growth rather than containing inflation. The ECB is unlikely to tighten policy either, given the still-poor structural growth outlook among the peripheral European economies. A new currency trade: go long the PLN versus the IDR, while closing our short IDR/long HUF trade with a 9% loss. This is based on our expectations that central European currencies will appreciate versus their EM peers, and the PLN will do better than the HUF. 2. Relative growth trajectory favors Central European economies relative to other EM countries. Such economic outperformance and resulting currency appreciation will be a tailwind to CE3 equity performance versus EM in common currency terms. Continue overweighting CE3 equity markets within the EM benchmark. We recommended equity traders go long CE3 banks / short euro area banks on April 6, 2016. This position has not worked out due to a significant rally in euro area banks since Brexit. However, euro area banks remain less profitable and overleveraged compared to their central European counterparts. As such they will likely underperform in the coming months. 3. In fixed income, we have the following positions: Overweight Hungarian sovereign credit within an EM sovereign credit portfolio. Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. A new trade: Receive 1-year Hungarian swap rates / Pay 10-year swap rates. As structural inflationary pressures become rampant in the Hungarian economy, the market will start pricing in rate hikes further down the curve, and the yield curve will consequently steepen (Chart I-17). Polish and Czech bonds offer better value relative to bunds as investors stand to gain from currency appreciation as well as an attractive spread. (Chart I-18). Chart I-17Bet On Yield Curve ##br##Steepening In Hungary Bet On Yield Curve Steepening In Hungary Bet On Yield Curve Steepening In Hungary Chart I-18Polish & Czech Bond Offer Value ##br##Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Polish & Czech Bond Offer Value Relative To German Bunds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Fed Is Right: Wage growth and inflation increase as growth rebounds in the second half of the year. Treasury yields move higher, the yield curve steepens and TIPS breakevens widen. This is the most likely scenario. The Fed Capitulates: Inflation fails to rebound but the Fed responds by signaling a shallower rate hike path. Increased inflation compensation offsets lower real yields, leaving long-maturity nominal yields unchanged. Meanwhile, wider TIPS breakevens cause the yield curve to steepen. This is the second most likely scenario. Policy Mistake: Inflation fails to rebound and the Fed continues to tighten. Nominal yields move lower and tighter TIPS breakevens cause the yield curve to flatten. This is the least likely scenario. Feature Chart 1Pricing A Policy Mistake Pricing A Policy Mistake Pricing A Policy Mistake Rather than go out of her way to assure markets that the Fed will respond to recent weakness in core inflation, Janet Yellen insisted at last week's post-FOMC press conference that low inflation will prove transitory. The Fed decided to plough ahead with its second rate hike of 2017, while maintaining its median projection for one more before the year is out. The Treasury market remains skeptical. Long-maturity nominal yields continued to decline following the FOMC meeting while short-maturity yields increased (Chart 1). The resultant curve flattening - the 2/10 Treasury slope is back down to 84 basis points - signals that the market is pricing-in an overly aggressive pace of Fed tightening. Consistent with this message, the drop in long-dated yields continues to be concentrated in the inflation component while real yields - which are linked to the expected pace of Fed rate hikes - remain firm (Chart 1, bottom panel). We were surprised by Yellen's reluctance to throw the market a bone, but we actually agree with her assessment of the fundamentals underpinning inflation. Our base case scenario is that inflation will soon resume its gradual uptrend, causing the Treasury curve to bear-steepen and TIPS breakevens to widen. Whether or not this base case scenario plays out, it is clear that the next few inflation prints and how the Fed responds to them will dictate the path for Treasury yields between now and the end of the year. We see three possible scenarios, and this week we examine each in turn, in order of most likely to least likely. Specifically, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a remote tail risk. Scenario 1: The Fed is Right The Fed is taking a gamble betting against the markets, but as we have argued in the past several reports,1 we think this gamble will soon pay off. In fact, it is quite likely that weak core inflation during the past three months is nothing more than a lagged response to last year's deceleration in economic growth. A deceleration that has already reversed. The year-over-year change in core CPI tends to lag year-over-year GDP growth by about 18 months. Meanwhile, GDP growth has already rebounded and leading indicators such as financial conditions, the BCA Beige Book Monitor and the BCA Composite New Orders Indicator, all point to a further acceleration (Chart 2). More importantly, it would be very unusual for core inflation to trend lower while the unemployment rate is falling and wage growth is increasing (Chart 3). This Phillips Curve relationship between the labor market and prices is the basis for the Fed's belief that inflation will resume its uptrend, and it has worked quite well since 1995.2 Chart 2Inflation Set To Rebound Inflation Set To Rebound Inflation Set To Rebound Chart 3Fundamentals Suggest Inflation Will Rise Fundamentals Suggest Inflation Will Rise Fundamentals Suggest Inflation Will Rise Further, our U.S. Investment Strategy3 service has calculated that it does not take much growth for the unemployment rate to continue its descent (Chart 4). Even a monthly increase of 130k in nonfarm payrolls is sufficient to bring the unemployment rate down, assuming the labor force participation rate stays flat. Monthly payroll gains are already averaging 162k so far this year, and our model suggests that number is poised to accelerate (Chart 5). Chart 4The Unemployment Rate Under Various Monthly Job Count Scenarios ##br##The Unemployment Rate Will Keep Falling The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Will Keep Falling The Unemployment Rate Under Various Monthly Job Count Scenarios The Unemployment Rate Will Keep Falling Chart 5BCA Employment##br## Model BCA Employment Model BCA Employment Model What Could Cause Inflation To Fall? A Rising Participation Rate. While labor market fundamentals support gradually rising inflation, it follows that inflation would likely fall if the unemployment rate were to increase. This is not a likely scenario, but it could occur if there is either a severe slowdown in payroll growth, or a surge of re-entrants into the labor market, leading to an increase in the labor force participation rate. The labor force participation rate fell from 65.9% at the end of 2007 to 62.8% in June 2014. As of today it stands at 62.7%, not far off its mid-2014 level (Chart 6). A paper published by the White House's Council of Economic Advisors (CEA) in July 20144 attributed 1.6% of the decline since 2007 to the ageing of the population, another 0.5% of the decline to normal cyclical factors and left the remaining 1% of the drop unexplained. The demographic effect is not about to reverse. Also, normal cyclical variation in the participation rate is linked to changes in the unemployment rate itself (Chart 6, panel 2). With the unemployment rate already low, it is likely that any normal cyclical decline in the participation rate has already been unwound. It is the remaining 1% residual decline in the participation rate that is tougher to pin down. The CEA offers two possible explanations for that residual 1% drop. The first is that it is the result of the downtrend in the prime age (25-54) participation rate that pre-dated the Great Recession (Chart 7). Prior to the recession, this downtrend had been partially offset by increasing participation among those aged 55+, but that latter trend has leveled off since 2010. If the 1% residual is the result of this longer-run trend in prime age participation, a trend possibly driven by technological advancement and the outsourcing of jobs overseas, then it is unlikely to reverse. Chart 6Can The Part Rate ##br##Bounce Back? Can The Part Rate Bounce Back? Can The Part Rate Bounce Back? Chart 7Secular Downtrend In Prime-Age ##br##Participation Secular Downtrend In Prime-Age Participation Secular Downtrend In Prime-Age Participation The second possible explanation is that the extra 1% is accounted for by the large increase in long-term unemployment that followed the Great Recession (Chart 6, bottom 2 panels). There is an observable correlation between the participation rate and the average duration of unemployment. If this correlation holds, and the duration of unemployment falls back to pre-crisis levels, then the participation rate could increase in the near term. However, there is also a school of thought that says the longer a person is out of the labor force the less likely it is they will ever return.5 If this turns out to be an accurate description of the dynamic between long-term unemployment and the participation rate, then it suggests that the permanent damage from the Great Recession has already been done. Even if the average duration of unemployment falls from current levels, its correlation with the participation rate would likely break down. If we assume that the participation rate rises 0.5% during the next year, then it would take payroll gains of more than 200k per month to keep the unemployment rate flat. That is too high a hurdle. While a much higher participation rate is not our base case, mathematically it is possible to envision a scenario where increasing participation causes the unemployment rate to rise, keeping a lid on wage growth and inflation in the process. Bottom Line: Overall, we agree with the Fed that wage growth and inflation will increase as growth rebounds in the second half of the year. This will very likely cause Treasury yields to move higher, the yield curve to steepen and TIPS breakevens to widen. Indications that the average duration of unemployment is rapidly falling and/or that the labor force participation rate is rising could lead us to change our view. Scenario 2: The Fed Capitulates Chart 8A Dovish Fed Can Boost Breakevens A Dovish Fed Can Boost Breakevens A Dovish Fed Can Boost Breakevens Now let's imagine that U.S. growth remains steady, the labor market continues to tighten, yet core PCE inflation is still close to 1.5% by the time the Fed meets in September. In this scenario we would expect the Fed to send a much more dovish message to markets than it did last week. Specifically, we would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. What sort of impact would this have on the yield curve? Long-maturity real yields, which are highly correlated with rate hike expectations, would almost certainly fall. However, if the Fed sends a sufficiently aggressive signal that it is willing to take action to support inflation, then it is conceivable that the long-maturity compensation for inflation protection could rise, offsetting some of the decline in real yields. In last week's report we noted how this exact scenario played out in 2011/12.6 Regression analysis shows that the 10-year real yield has historically moved about half as much as our 24-month Fed Funds Discounter (Chart 8), with the exception of the period surrounding the 2013 taper tantrum. If we assume the historical beta of 0.5 holds, then even if the market starts to discount no Fed rate hikes during the next two years and our discounter falls from its current level of 42 bps to zero, the 10-year real yield would have only 21 bps of downside. The current 10-year TIPS breakeven inflation rate is 1.67%, and would only need to return to 1.88% to completely offset the decline in real yields from the Fed being completely priced out. This does not seem like a high bar (Chart 8, top panel). Bottom Line: If core PCE inflation remains close to 1.5% by the time the Fed meets in September, then we would expect the Fed to respond more aggressively by signaling a shallower path of rate hikes. In this scenario it is likely that wider TIPS breakevens would offset the impact from lower real yields, leaving nominal Treasury yields close to unchanged. Scenario 3: A Policy Mistake A monetary policy mistake in its strongest form would be tightening so aggressively that the slope of the yield curve flattens all the way to zero before inflation has reached the Fed's target. In prior cycles we are used to seeing much higher inflation when the slope of the 2/10 curve is as flat as it is today (Chart 9), which suggests that the market is already starting to discount a premature Fed tightening. If core inflation remains low between now and the September FOMC meeting, and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would go further to price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. We still view this as the least likely scenario. The Fed should be concerned about inflation expectations becoming un-anchored to the downside. As we showed in last week's report,7 it is well documented that when inflation expectations become unmoored, the relationship between prices and the labor market is significantly weakened. Further, the longer that actual inflation deviates from target the more likely it becomes that inflation expectations will become un-anchored to the downside. In last week's press conference Janet Yellen said: It is true that some household surveys of inflation expectations have moved down, but overall I wouldn't say that we've seen a broad undermining of inflation expectations.8 That claim is undoubtedly open for interpretation (Chart 10), but the important point is that the longer inflation stays below target, the more likely a "broad undermining of inflation expectations" becomes. We expect the Fed will heed this message from the markets, but after last week's meeting we cannot completely rule out a policy mistake. Chart 9Curve Is Too Flat Versus Inflation Curve Is Too Flat Versus Inflation Curve Is Too Flat Versus Inflation Chart 10Still Well Anchored? Still Well Anchored? Still Well Anchored? Bottom Line: If inflation stays low between now and September, but the Fed sticks to its current forward rate guidance, then the market will price-in more of a policy mistake scenario. Nominal yields will fall, led by tighter TIPS breakevens, and the yield curve will flatten. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Reports, "Two Challenges For U.S. Policymakers", dated May 23, 207, "The Fed Doctrine", dated May 30, 2017 and "Low Inflation And Rising Debt", dated June 13, 2017, all available at usbs.bcaresearch.com 2 The post-1995 environment has been characterized by stable inflation expectations. It is well documented that the relationship between labor markets and inflation is much weaker when inflation expectations become un-anchored. We discuss this risk in Scenario #3. 3 Please see U.S. Investment Strategy Weekly Report, "Balancing Act", dated June 12, 2017, available at usis.bcaresearch.com 4 https://scholar.harvard.edu/files/stock/files/labor_force_participation.pdf 5 http://www.nber.org/reporter/2015number3/2015number3.pdf 6 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20170614.pdf Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The FOMC statement reaffirmed that the Fed remains in hiking mode. If the Fed keeps raising rates in line with the "dots," monetary policy will move into restrictive territory by early 2019. By then, the unemployment rate will have fallen to a level where it has nowhere to go but up. Unfortunately, history suggests that once unemployment starts rising, it keeps rising. The good news is that today's economic imbalances are not as formidable as those that existed in the lead-up to the past few recessions. The bad news is that cracks are starting to form. We are especially worried about the health of the U.S. commercial real estate sector. Remain overweight global equities for now, but look to significantly pare back exposure next summer. Feature The U.S. Expansion Is Getting Long In The Tooth Chart 1How Low Can It Go? How Low Can It Go? How Low Can It Go? The current U.S. expansion has now reached eight years, making it the third longest in the post-war era. History teaches that expansions do not die of old age. Rather, they are usually murdered by some combination of Fed tightening and the unwinding of the imbalances that were built up during the boom years. Thinking about the present, there is good and bad news on both fronts. Let's start with the Fed. This week's FOMC statement reaffirmed that the Fed remains in hiking mode. The good news is that real rates are still very low by historic standards, suggesting that the economy is unlikely to stall out this year. The bad news is that the Fed has less scope to raise rates than in the past. Chart 1 shows estimates of the real neutral rate developed by Fed researchers Thomas Laubach and Kathryn Holston, along with John Williams, President of the San Francisco Fed and Janet Yellen's close confidante. Their calculations suggest that the real neutral rate has plummeted over the past decade in the U.S. and the euro area, with lesser declines recorded in Canada and the U.K. In the U.S., the real neutral rate currently stands at 0.4%. Assuming the Fed raises interest rates in line with the "dots," rates will move into restrictive territory in early 2019. Given that monetary policy affects the real economy with a lag of 12-to-18 months, the Fed may not realize that it has raised rates too much until it is too late. The Downside Of A Low Unemployment Rate One might argue that this justifies a "go-slow" approach to tightening monetary policy. There is certainly validity to this view, but it is not without its drawbacks. The unemployment rate has now fallen to 4.3%, 0.4 points below the Fed's estimate of NAIRU. As Chart 2 illustrates, the odds of a recession rise when the unemployment rate reaches such low levels. Some commentators have argued that the headline unemployment rate understates the amount of economic slack. We are skeptical that this is the case. Table 1 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message of the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Taken together, these indicators suggest that slack is comparable to what it was in 2007, albeit still above the levels seen in 2000. Chart 2 Table 1Comparing Current Labor Market Slack With Past Cycles The Timing Of The Next Recession The Timing Of The Next Recession As we noted last week, the easing in U.S. financial conditions over the past six months is likely to boost growth in the second half of this year (Chart 3). If growth does accelerate, the unemployment rate - which is already 0.2 points below where the Fed thought it would be at the end of this year when it made its December 2016 projections - will fall below 4%. There is a high probability that this will fuel inflation, reversing the largely technically-driven decline in most core inflation measures over the past few months. Chart 3U.S.: Easy Financial Conditions Will Support Growth In H2 2017 U.S.: Easy Financial Conditions Will Support Growth In H2 2017 U.S.: Easy Financial Conditions Will Support Growth In H2 2017 The market is not pricing this in at all. In fact, 2-year breakeven inflation rates have tumbled by 87 basis points since March. A bit more inflation would be a welcome development. Not only have market-based projections of inflation fallen since the Great Recession, but long-term survey-based measures have dipped as well (Chart 4). Of course, one can have too much of a good thing. The experience of the 1960s is illustrative in that regard. Chart 5 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation soared. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. Chart 4Inflation Could Use A Boost Inflation Could Use A Boost Inflation Could Use A Boost Chart 5Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% If the Fed today wants to avoid the same fate, it will have to take steps to lift the unemployment rate back up to NAIRU. Unfortunately, history suggests that it is difficult to raise the unemployment rate a little bit without inadvertently raising it by a lot. Once unemployment starts to rise, a vicious circle tends to erupt where increasing joblessness leads to slower income growth, falling confidence, and ultimately, less spending and higher unemployment. In fact, there has never been a case in the post-war era where the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 6). Chart 6Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Imbalances Are Growing The vicious circle described above tends to be amplified when there are large imbalances in the economy. The good news is that today's imbalances are not as formidable as those that existed in the lead-up to the past few recessions. The bad news is that cracks are starting to form. The ratio of household debt-to-disposable income is still close to post-recession lows, but this is largely because mortgage debt continues to be weighed down by a depressed homeownership rate (Chart 7). In contrast, consumer credit is rebounding: Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 8). Not surprisingly, this is starting to translate into higher default rates (Chart 9). The fact that this is happening at a time when the unemployment rate is at the lowest level in 16 years is a cause for concern. Chart 7Low Homeownership Rate Keeping A Lid On Mortgage Debt Low Homeownership Rate Keeping A Lid On Mortgage Debt Low Homeownership Rate Keeping A Lid On Mortgage Debt Chart 8Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Consumer Credit: Making A Comeback... Chart 9...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories ...With Defaults Starting To Rise In Some Categories Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 10). Contrary to the widespread notion that "wages aren't rising," real wages are increasing more quickly than corporate productivity (Chart 11). As the labor market continues to tighten, corporate profitability could suffer, setting the stage for rising defaults and increasing layoffs. Chart 10U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit U.S. Corporate Sector Has Been Feasting On Credit Chart 11Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Real Wages Now Increasing Faster Than Productivity Worries About Commercial Real Estate We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 12). Financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 13). Chart 12Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 13CRE Debt Is Rising CRE Debt Is Rising CRE Debt Is Rising Going forward, the fundamental underpinnings for the CRE market are likely to soften. The retail sector is already under intense pressure due to the shift in buying habits towards eCommerce. CMBX spreads in this space are rising. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 14 and Chart 15). The number of apartment units under construction stands at a four-decade high according to Census data, despite a structurally subdued pace of household formation (Chart 16). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Chart 14Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 15...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam ...While Rent Growth Is Losing Steam Chart 16Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? Apartment Supply Is Surging, But Will There Be Enough Demand? There are fewer signs of overbuilding in the office sector. Nevertheless, vacancy rates are likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. The Fed estimates that the U.S. needs to add only 80,000 workers to payrolls every month to keep up with a growing labor force, down from about 150,000 in the two decades preceding the Great Recession.1 The secular shift towards increased office density and teleworking will only further depress office demand over time. Chart 17Tighter Lending Standards Could Lead To Lower CRE Prices Tighter Lending Standards Could Lead To Lower CRE Prices Tighter Lending Standards Could Lead To Lower CRE Prices The one bright spot is industrial real estate. Thanks to a revival in U.S. manufacturing, vacancy rates remain low and rent growth is rising. However, if the U.S. economy does accelerate over the remainder of the year, the dollar is likely to strengthen, putting a dent in the profitability of U.S. manufacturing companies. Standing back, how worried should investors be about the CRE sector? For now, there is limited cause for concern. U.S. financial institutions have been tightening lending standards on CRE loans for seven straight quarters. Consequently, the average loan-to-value ratio for newly securitized loans has fallen about four points to 60% since 2015, and is now down eight points compared to 2007. However, if vacancy rates keep rising, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further (Chart 17). Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins at a time when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it could easily trigger a recession. Fiscal Policy To The Rescue? Could looser fiscal policy delay the day of reckoning? The answer is yes, but much will depend on when the stimulus arrives and what form it takes. The best-case scenario is that fiscal policy is eased just as the economy is beginning to slow of its own accord. A burst of stimulus that arrives on the scene too early would be less desirable, although not necessarily counterproductive, since it would allow the Fed to step up the pace of rate hikes, thereby giving it more scope to cut rates later in response to slower growth. In practice, however, calibrating the amount of monetary tightening that is necessary to offset a given amount of fiscal loosening is difficult to achieve. This is especially the case in today's environment where another fight over the debt ceiling looms large, a new health care bill is making its way through the Senate, and Trump's tax agenda remains heavy on promises but short on specifics. Our expectation is that Congress will pass a "balanced" budget which equates revenues with expenditures over the 10-year budget horizon. How this affects growth is hard to predict with any certainty. On the one hand, spending cuts tend to depress aggregate demand more than tax cuts raise demand. In economic parlance, the fiscal multiplier for government spending is larger than for taxes. On the other hand, the tax cuts are likely to be front-loaded, while the spending cuts will be back-dated. If history is any guide, this means that the latter will never see the light of day. In addition, some of the budgetary impact from cutting statutory tax rates will be paid for through dynamic scoring, the questionable practice of assuming that lower personal and corporate tax rates will significantly spur growth. On balance, we expect fiscal policy to turn modestly stimulative over the next few years. However, given the uncertainty involved, there is a risk that the Fed either raises rates too much - thereby choking off growth - or by not enough, causing the unemployment rate to fall to a level where it has nowhere to go but up. Both outcomes could trigger a recession. Investment Conclusions Right now, our recession timing model, as well as the models maintained by various regional Fed banks, assign a low probability of a severe slowdown in the coming months (See Box 1 for details). These models, however, tend to send reliable signals only over a fairly short horizon. Looking further ahead, we see a heightened probability of weaker growth in the second half of 2018, which could set the stage for a recession in 2019. The good news is that today's economic imbalances are not as daunting as they were in the late innings of many past economic expansions. Thus, the 2019 recession is not likely to be especially severe. The bad news is that valuations across most markets are quite stretched. Thus, like the 2001 recession, the financial market impact could be disproportionally large compared to the economic impact. We are still overweight global equities, but will be looking to significantly reduce exposure by next summer. Once the equity bear market begins - most likely late next year - a 20%-to-30% retracement in U.S. stocks is probable. Given that correlations across stock markets tend to rise when risk sentiment is deteriorating, it is likely that other global bourses will also suffer if U.S. stocks weaken. Indeed, considering that most stock markets have a beta to the S&P 500 that exceeds one, other regions could suffer even more than the U.S. As the U.S. economy falls into recession, the Fed will stop raising rates. This will cause the dollar to weaken, although not before it has appreciated by about 10% in trade-weighted terms from current levels. Thus, while we remain bullish on the dollar over the next 12 months, we are much less sanguine about the greenback over the long haul. As the dollar weakens, the yen and euro will strengthen, imparting deflationary pressures on those economies. If our timing for the next recession proves correct, neither the ECB nor the BoJ will hike rates for the remainder of the decade. The Bank of England is a tougher call. The neutral rate of interest is higher in the U.K. than in continental Europe. Last week's election results represented a clear rejection of fiscal austerity. A more expansionary fiscal stance would give the BoE some scope to raise rates. A weaker pound has also given the economy a much needed competitive boost. With inflation picking up, it is not surprising that the BoE struck a more hawkish tone this week. Nevertheless, Brexit negotiations are liable to drag on for some time, which will constrain the ability of the BoE to tighten monetary policy. Stay long GBP/EUR and GBP/JPY over the next 12 months, but remain short GBP/USD. Housekeeping Note: Closing Our Tactical S&P 500 Short Hedge As noted above, we remain cyclically overweight global equities over a 12-month horizon. However, on occasion, we have put on a tactical hedge whenever equities appeared to be technically overbought. Such a situation arose six weeks ago. While the stock market did dip briefly shortly after we initiated the trade, it subsequently rallied back. At the time of initiation, we indicated that the trade would have a lifespan of six weeks. The clock has now run out, and we are closing the trade for a loss of 2%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Rhys Bidder, Tim Mahedy, and Rob Valletta, "Trend Job Growth: Where's Normal?" FRBSF Economic Letter, 2016-32, Federal Reserve Bank Of San Francisco (October 24,2016), and Daniel Aaronson, "Estimating The Trend In Employment Growth," Chicago Fed Letter, No. 312, Federal Reserve Bank Of Chicago (July 2013). BOX 1 The Message From Our Recession Timing Model Chart Box 18Near-Term Recession Risk Remains Low Near-Term Recession Risk Remains Low Near-Term Recession Risk Remains Low Our recession timing model is based on eight variables: The Conference Board's Leading Economic Indicator, the Coincident Economic Indicator, the fed funds rate, inflation expectations, the unemployment rate, oil prices, credit spreads, and the yield curve. We use a logistic regression framework to model the probability of a recession. Currently, our model shows that the odds of a recession are low (Chart Box 18, panel 1). Only one of the components, namely, a rising fed funds rate, is signaling a risk of a recession. The various models developed by regional Federal Reserve banks also show very low near-term odds of a recession (panels 2 and 3). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, Along with this brief Weekly Report, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. Marko argues that the U.S. is vulnerable to serious socio-political instability by the 2020 election, as a result of the widening gulf between elites and the rest. Trump, thus far, seems unlikely to bridge this gap. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlight U.S. growth will accelerate over the remainder of the year, thanks to easier financial conditions. This will force the Federal Reserve to raise rates more than the market is currently discounting. In contrast, the BoJ and the ECB will remain on hold. The net result would be a stronger dollar. Solid Chinese growth will support commodity prices. Stay overweight global equities over a cyclical horizon of 12 months. Feature U.S. Growth Will Surprise On The Upside I have been meeting clients in Asia over the past week. The ongoing decline in Treasury yields - the 10-year yield hit a 7-month low of 2.14% this week - was a frequent topic of conversation. Investors are becoming increasingly convinced that the U.S. economy is running out of steam. The OIS curve is pricing in only 48 basis points of rate hikes over the next 12 months. Since a June rate increase is now largely seen as a done deal, the market is essentially saying the Fed will abandon its tightening cycle later this year. We think that's too early. The U.S. economy may not be on fire, but it is hardly floundering. The Blue Chip consensus estimate for Q2 growth stands at 3.1%. The Atlanta Fed's GDPNow model is pointing to growth of 3.4%. There is little reason to think that growth will slow substantially later this year. Financial conditions have eased significantly over the past few months thanks to a weaker dollar, falling bond yields, narrower credit spreads, and higher equity prices (Chart 1). Our research has shown that GDP growth tends to react to changes in financial conditions with a lag of around 6-to-9 months (Chart 2). This means demand growth is likely to strengthen, not weaken, over the remainder of the year. Chart 1Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Financial Conditions Have Been Easing... Chart 2...Which Bodes Well For Growth ...Which Bodes Well For Growth ...Which Bodes Well For Growth Running Out Of Slack If demand growth does accelerate, does the U.S. economy have the supply capacity to fully accommodate it? We do not think so. The headline unemployment rate fell to a 16-year low of 4.3% in May. It is now half a percentage point below the Fed's estimate of full employment. The broader U-6 rate, which includes marginally-attached workers and those working part-time purely for economic reasons, dropped to 8.4%, essentially completing the roundtrip to where it was before the recession (Chart 3). Chart 3A Tight Labor Market A Tight Labor Market A Tight Labor Market Chart 4Wage Growth Is In An Uptrend Wage Growth Is In An Uptrend Wage Growth Is In An Uptrend Chart 5Wage Gains Are Broad Based Wage Gains Are Broad Based Wage Gains Are Broad Based Contrary to popular perception, wages are rising. Looking across the various official wage indices that are published on a regular basis, the underlying trend in wage growth has accelerated from 1.2% in 2010 to 2.4% (Chart 4). The acceleration in wage growth has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 5). Wage Growth: No Mystery Here Granted, wage growth is still about a percentage point lower than it was before the recession, but that can be explained by slower productivity growth and lower long-term inflation expectations (Chart 6). Real unit labor costs, which take both factors into account, are rising at a faster pace than in 2007 and close to the pace in 2000 (Chart 7). Chart 6A Secular Downtrend In Productivity Growth ##br##And Inflation Expectations A Secular Downtrend In Productivity Growth And Inflation Expectations A Secular Downtrend In Productivity Growth And Inflation Expectations Chart 7Rising Real Unit Labor Costs: ##br##A Case Of Deja-Vu Rising Real Unit Labor Costs: A Case Of Deja-Vu Rising Real Unit Labor Costs: A Case Of Deja-Vu Looking out, wage growth is likely to accelerate further. The evidence strongly suggests that the Phillips curve has a "kink" at an unemployment rate of around 5% (Chart 8). In plain English, this means that a drop in the unemployment rate from 10% to 8% tends to have little effect on inflation, while a drop from 6% to 4% does. Chart 8 The Cost Of Waiting One might argue that the Fed can afford to take a "wait and see" approach to raising rates. There is some merit to this view, but it can be taken too far. If the Fed is to have any hope of achieving a soft landing for the economy, it needs to stabilize the unemployment rate at a level close to NAIRU. This may be possible if the unemployment rate is near 4%, but it would be difficult to pull off if the rate slips much below that level. Trying to stabilize the unemployment rate when it has already fallen well below its full employment level means accepting a permanently overheated economy. A standard "expectations-augmented" Phillips curve says that this is not possible to accomplish without accepting persistently rising inflation. If the Fed did find itself in a situation where the economy were overheating, it would have no choice but to jack up rates in order push the unemployment rate to a higher level. Unfortunately, the evidence suggests that once the unemployment rate starts rising, it keeps rising. Indeed, there has never been a case in the post-war era where the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 9). Chart 9Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle The inescapable fact is that modern economies contain numerous feedback loops. When unemployment is falling, this generates a virtuous cycle where rising employment boosts income and confidence, leading to more spending and even lower unemployment. The exact opposite happens when unemployment starts rising. History suggests that trying to raise the unemployment rate by just a little bit is like trying to get a little bit pregnant. It's simply impossible to pull off. The implication is that the Fed will not only raise rates in line with the dots, but could actually expedite the pace of rate hikes if aggregate demand accelerates later this year, as we expect. Remember, it wasn't that long ago that a typical tightening cycle entailed eight rate hikes per year. In this context, the market's expectation of less than two hikes over the next 12 months seems implausibly low. No Tightening In Japan Or Europe Chart 10Inflation Is Way Below The BoJ's Target Inflation Is Way Below The BoJ's Target Inflation Is Way Below The BoJ's Target Could other major central banks follow in the Fed's footsteps and tighten monetary policy more aggressively than what the market is currently discounting? We doubt it. Japanese inflation is nowhere close to the BOJ's 2% target (Chart 10). And even if Japanese growth surprises significantly to the upside, the first step the authorities will take is to tighten fiscal policy by raising the sales tax. Monetary tightening remains some ways off. Likewise, while the ECB might remove a few of its emergency measures, it is nowhere close to embarking on a full-fledged tightening cycle. The ECB's own research department recently put out a paper documenting that the combined unemployment and underemployment rate currently stands at 18% of the labor force across the euro area (Chart 11). This is 3.5 points above where it was in 2008. If one excludes Germany from the picture, the level of unemployment and underemployment is seven points higher than it was in 2008. This is not the stuff of which tightening cycles are made. Meanwhile, on the other side of the English Channel, the BoE must contend with the fact that growth remains underwhelming, partly due to ongoing angst about Brexit negotiations (Chart 12). Chart 11 Chart 12U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers U.K. Is Lagging Its Peers EM Outlook Chart 13Positive Signs For The Chinese Housing Market... Positive Signs For The Chinese Housing Market... Positive Signs For The Chinese Housing Market... The outlook for EM currencies is a tougher call. On the one hand, a more hawkish Fed and broad-based dollar strength have usually been bad news for emerging markets, given that 80% of EM foreign-currency debt is denominated in U.S. dollars. On the other hand, stronger global growth should support commodity prices, even if the dollar is strengthening. Our energy strategists remain particularly convinced that oil prices will rise over the remainder of this year due to robust demand growth for crude and continued OPEC discipline. Strong Chinese growth should also boost metals demand, while limiting the need for further RMB weakness. Chart 13 shows that property developers have been snapping up new land at an accelerating pace. The percentage of households who intend to buy a new home has also surged to record high levels. This bodes well for construction, and by extension, commodity demand. The strong pace of growth in excavator sales - a leading indicator for capex - confirms this trend. Meanwhile, real-time measures of Chinese industrial activity such as rail freight traffic and electricity generation remain buoyant (Chart 14). This is helping to lift producer prices, which, in turn, is fueling a rebound in industrial company profits (Chart 15). And for all the talk about the government's crackdown on credit growth, the reality is that medium-to-long term lending to nonfinancial companies has actually picked up (Chart 16). Chart 14... And Positive Signs For Chinese Capex ... And Positive Signs For Chinese Capex ... And Positive Signs For Chinese Capex Chart 15Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Higher Producer Prices Boosting Profits Chart 16A Positive In China's Credit Picture A Positive In China's Credit Picture A Positive In China's Credit Picture Stick With Stocks... For Now In terms of global asset allocation, we continue to recommend a cyclical (12-month) overweight in equities relative to bonds. We have a slight preference for DM over EM stocks, although given some of the positive factors supporting EM economies noted above, we do not regard this as a high-conviction view. Within the DM universe, we favour higher-beta equity markets such Japan and the euro area over the U.S. (currency hedged). In the government bond space, we would underweight U.S. Treasurys, given the likelihood that the Fed will deliver more rate hikes over the coming months than the market is currently discounting. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Will Trump's trade rhetoric damage the U.S. service sector's abilities to generate a trade surplus and create high-paying jobs? Our assessment of the latest Beige Book via the BCA Beige Book Monitor supports the Fed's view that Q1 weakness was an anomaly and inflation is headed higher. This will keep the Fed on track to tighten in June and again later this year. GDP growth in 2017 is poised to exceed the Fed's forecast for the first time in seven years if the recent pattern of 2H GDP beating 1H GDP growth is repeated. Global oil inventories are set to move lower and drive oil prices higher. The odds of a recession remain low even with the economy at full employment. Feature The May employment report fell short of expectations, but the average gain of 121,000 jobs per month over the past 3 months and the drop in the unemployment rate are still enough to tighten the labor market and keep the Fed on track to tighten later this month. The unemployment rate dipped to 4.3% in May and is now 0.4% below the Fed's view of full employment. Wage growth remains stagnant despite the state of health of the labor market, as year-over-year average hourly earnings growth remained at just 2.5% in May (Chart 1). Chart 1Labor Market Still Tightening##BR##Despite Disappointing May Labor Market Still Tightening Despite Disappointing May Labor Market Still Tightening Despite Disappointing May Taking a broader view, the job picture in the service sector remains robust and wages in the export-oriented service industries remain well above wages in the goods sector. In this week's report we examine the impact of trade on the labor market and highlight areas where Trump's rhetoric may hurt trade-related job growth. Trump At Your Service The large trade surplus in the U.S. service sector is a hidden source of strength for the economy and labor market. Trump campaigned on his ability to create high paying manufacturing jobs, but his America First rhetoric is threatening jobs in the high paying service sector. Since the mid-1970s, the U.S. has imported more than it has exported, acting as a drag on GDP growth. The trade gap reflects a large and persistent goods deficit, which more than offsets a growing trade surplus on the service side. U.S. imported goods exceeded exports by $1.3 trillion in 2016. Service exports totaled an all-time high of $778 billion in 2016, $270 billion more than imports. Exports of services have increased by 7% per year on average since 2000, which is nearly twice as fast as nominal GDP (Charts 2A & 2B). Chart 2AThe U.S. Runs Trade##BR##Surplus In Services... The U.S. Runs Trade Surplus In Services... The U.S. Runs Trade Surplus In Services... Chart 2B...But It's Not Large Enough To Offset##BR##The Big Trade Deficit In Goods ...But It's Not Large Enough To Offset The Big Trade Deficit in Goods ...But It's Not Large Enough To Offset The Big Trade Deficit in Goods The trade surplus in services added 0.07% to GDP in Q1 2017, 0.04% in 2016, and has consistently added to GDP growth over the past few decades, although it is swamped by the large drag on GDP as a result of the trade deficit on goods. Industries where the U.S. enjoys a trade surplus have experienced job growth that is more than seven times faster than in industries where the U.S. runs a deficit. In addition, median wages ($29 as of April 2017) among surplus-producing industries are more than 20% higher than in industries in the goods sector ($24) where there is a trade deficit, even though wages are rising quicker in the goods-producing sector in the past year (Chart 3). U.S. service sector exports tend to compete on quality (not on price) and, therefore, will not be as affected as U.S. goods exports if the dollar meets BCA's forecast of a 10% rise in the next 6-12 months (Chart 4). Chart 3Wages In Export Led Service Industries##BR##20% Higher Than In Goods Sector Wages In Export Led Service Industries 20% Higher Than In Goods Sector Wages In Export Led Service Industries 20% Higher Than In Goods Sector Chart 4Service Sector Export Orders##BR##At New High Despite Strong Dollar Service Sector Export Orders At New High Despite Strong Dollar Service Sector Export Orders At New High Despite Strong Dollar However, Trump's trade policies may threaten to reduce the U.S.'s global dominance in services. The U.S. has the largest trade surpluses in travel (which includes education), intellectual property, financial services, and legal, accounting and consulting services (Table 1). The U.S. also runs a large surplus in areas such as intellectual property, software and advertising. In 2015, foreigners spent $92 billion more to travel to, vacation in and be educated in America compared with what U.S. residents spent for those services overseas. Anecdotal reports note that travel to the U.S. is down by as much as 15% since the start of the year, and that 40% of U.S. colleges and universities have seen a decline in foreign applications, putting the nearly $100 billion trade surplus at risk. Other Trump policies, such as the proposed travel ban and some of his "America First" campaign-style rhetoric, could jeopardize the trade surpluses in financial services ($77 billion), software services ($30 billion), TV and film right ($13 billion), architectural services ($10 billion) and advertising ($8) billion. Table 1Key Components Of U.S. Trade Surplus In Services Can The Service Sector Save The Day? Can The Service Sector Save The Day? Trump's trade rhetoric potentially threatens U.S. service exports to NAFTA countries (Canada and Mexico), the Eurozone and the emerging markets. President Trump campaigned on renegotiating NAFTA, supporting Brexit and pulling the U.S. out of the Trans Pacific Partnership (TPP). Trade in services are key to all of those treaties, although trade in goods gets more attention. At $56 billion in 2015, Canada is the U.S.'s second largest service export market, and Mexico is a top 10 destination ($31 billion). Forty percent of U.S. service exports go to Europe, and at $66 billion in 2015, the U.K. is the single largest market for U.S. service exports. The U.S. sends half of its service exports to EM nations, with markets in Asia accounting for just under 30% of all U.S. service exports. Thus investors should carefully monitor the progress of all three of these trade deals to help better assess the impact on U.S. trade and jobs in the service sector. Bottom Line: The U.S.'s large trade surplus in services fosters faster job creation and better pay than in the goods-producing area where the U.S. has a trade deficit. The Trump administration's rhetoric and actions on trade and globalism potentially risks America's dominance in the service sector. In theory, U.S. trade restrictions could add to U.S. GDP growth as long as there is no retaliation from its trading partners (which is unlikely). But any gains on the manufacturing trade front could be largely offset by damage to the U.S. surplus in services trade. Beige Book Backs The Fed For the Fed, policymakers are treating any potential changes to trade and fiscal policy as risks to their outlook. At the moment, they are judging the need for tighter policy based on the evolution of the labor market and inflation. The Beige Book released on May 31 confirmed the FOMC's base-case outlook. It keeps the Fed on track to tighten in June and then again later this year as it begins to trim its balance sheet. Our quantitative assessment of the qualitative Beige Book that we introduced in April 17 found that the economy had rebounded from a weak Q1 and that inflation was in an uptrend despite recent soft readings.1 The dollar seems to have faded as a key concern for small businesses and bankers. Business uncertainty around government policy (fiscal, regulatory and health) remained elevated. Our analysis of the Beige Book also shows that commercial and residential real estate, the former a surprise source of strength in Q1 GDP, remains stout more than halfway through Q2. Chart 5 shows that the BCA Beige Book Monitor ticked up to 71% in May 2017 from 64% in April. The metric is in line with its cycle highs recorded in mid-2014 as oil prices peaked. "Inflation" words in the Beige Book hit a new peak in May and are in sharp contrast to the recent soft readings on CPI and the PCE deflator. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may be turning up soon. Chart 5May Beige Book Points To Solid Growth In Q2 May Beige Book Points To Solid Growth In Q2 May Beige Book Points To Solid Growth In Q2 In Chart 5, panel 4 we track mentions of "strong dollar" in the report. The May Beige Book saw the same number of references to a strong dollar as the May 2016 report. This suggests that the dollar is not as big a concern for business owners as it was from early 2015 through early 2016. Housing added 0.5 percentage points to growth in Q1, and business spending on structures added 0.7 percentage points. The latest Beige Book suggests that both sectors remain robust here in Q2 (Chart not shown). The implication is that the U.S. economy is poised to clear the low hurdle in 2017 set for it by the FOMC in late 2016. The Fed's economic growth target for 2017 (set at the December 2016 FOMC meeting) was just 2.1%, the lowest year ahead forecast since 2009. The projection incorporates the Fed's lowered trajectory for potential output, but may also reflect the fact that actual GDP growth has not exceeded the Fed's forecast every year since 2009 (Chart 6). GDP growth in 1H 2017 is tracking between 2% and 2.5% despite the weak start to the year. In late May, Q1 GDP growth was revised to +1.2% from the 0.7% reading reported in late April. Based on the Atlanta Fed's GDP Now, the NY Fed's Nowcast and readings on ISM, vehicle sales and the Beige Book, GDP in Q2 is tracking to near 3%. If the economy rebounds from the lackluster first quarter as we expect, then real output will be on course to match or exceed the Fed's forecast for the first time since the recession. We expect an acceleration for fundamental reasons and due to poor seasonal adjustment. In 5 of the past 7 years, real GDP growth in Q3 and Q4 was the same or stronger than the pace of expansion in the first half of the year (Table 2). During that period, 2H output growth averaged 2.4%, while 1H growth was an anemic 1.8%. In the years when Q1 GDP was weak,2 as it was this year, real economic output in the second half of the year accelerated from 1H growth nearly every time. Chart 6 Table 2GDP Growth In 2H Has Met Or Exceeded 1H Growth In 5 Of Past 7 Years Can The Service Sector Save The Day? Can The Service Sector Save The Day? Bottom Line: The latest Beige Book (prepared for the June 13-14 FOMC meeting) confirms policymakers' assessment that the weak growth in Q1 was transitory and inflation is in an uptrend. The economy remains on target to hit or exceed the Fed's growth objectives. The FOMC is poised to raise rates in June and one more time by year end. This view is not discounted in the bond market, implying that Treasury yields are too low. Equity prices could be undermined by higher yields and the dollar, but this will be offset by rising growth (and profit) expectations if our base-case view pans out. Oil Prices: Fade The Recent Weakness A pickup in U.S. growth will also be positive for oil prices, although it is OPEC's efforts to curtail excess inventories that is the main driver of our bullish view. Our commodity strategists believe that OPEC 2.0's recent production cut extension will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating).3 Shale production is bouncing back quickly. OPEC's November 2016 agreement signaled to the world that OPEC (and Russia) would abandon Saudi Arabia's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers to pour money into vastly increased drilling programs. Nonetheless, global oil demand continues to grow robustly. Moreover, production is eroding for oil producers outside of (Middle East) OPEC, Russia and U.S. Shale, which collectively supply half the market. The cumulative effects of spending constraints during 2015-18 will result in falling output in the coming years for this group of producers. Adding it all up, we expect demand to exceed supply for the remainder of 2017, which will result in a significant drawdown in oil inventories (Chart 7). Our strategists think the inventory adjustment will push the price of oil up to US$60 by year end. They expect a trading range of US$45-65 to hold between now and 2020. Chart 8 shows a simple model for oil prices, based on global industrial production, oil production, OECD oil inventories and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, the model implies that oil prices will surge by more than US$10! The coefficient on oil inventories in the model is probably overly influenced by the one major swing in inventories we have seen in the last couple of decades, suggesting that we must take the results with a grain of salt. Nonetheless, our point is that oil prices have significant upside potential if the excessive inventory problem is solved. Chart 7Significant Drawdown##BR##In Inventories Is Coming Significant Drawdown In Inventories Is Coming Significant Drawdown In Inventories Is Coming Chart 8Upside Potential For Oil##BR##If Inventory Issue Is Resolved Upside Potential For Oil If Inventory Issue Is Resolved Upside Potential For Oil If Inventory Issue Is Resolved Bottom Line: The extension of OPEC 2.0 production cuts reinforces our bullish view for oil prices. Revisiting The Odds Of A Recession It seems odd at first glance to be discussing recession risks at a time when growth is poised to accelerate. Nonetheless, BCA's Global Investment Strategy service recently noted that investors should be on watch for recession now that the economy has reached full employment.4 Historically, once the unemployment rate reached estimates of full employment, the odds of a recession in the subsequent 12 months increased four-fold. In last week's report, we maintained that the lack of progress on fiscal policy by the Trump administration may actually be positive for risk assets in the medium term because it would stretch out the cycle and thus lower recession risks.5 The economic data have disappointed so far this year, as highlighted by the economic surprise index (Chart 9). Despite this, there is not much talk of recession in the news media and various models also show slim chances of recession this year (Chart 10). Only one of eight components in our BCA model is flashing recession: the three-year moving average of the Fed funds rate is rising because the Fed rate hike cycle began in late 2015. Chart 9Economic Data Still Disappointing, But Does Not Signal A Recession Economic Data Still Disappointing, But Does Not Signal A Recession Economic Data Still Disappointing, But Does Not Signal A Recession Chart 10Odds Of A Recession This Year Remain Low Odds Of A Recession This Year Remain Low Odds Of A Recession This Year Remain Low In a prior report we dismissed the rollover in commodity prices as a recessionary signal and noted that Trump's political woes would only slow the GOP's legislative agenda. Nonetheless, even without fiscal stimulus, the U.S. economy will still grow above its long-term potential, tighten the labor market and push up wages and inflation in the coming quarters. Bottom Line: The odds of recession remain low despite the U.S. economy being at full employment. The delay in Trumponomics' will prolong the expansion and will support risk assets over the next 6-12 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 1 Please see U.S. Investment Strategy Weekly Report, "The Great Debate Continues", dated April 17, 2017, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Growth Inflation And The Fed", dated May 8, 2017, available at usis.bcaresearch.com. 3 Please see Commodity & Energy Strategy Weekly Report "Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories", dated June 1, 2017, available at ces.bcaresearch.com. 4 Please see Global Investment Strategy Weekly Report, "Fiscal Policy In The Spotlight", dated May 26, 2017, available at gis.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Corporate Earnings Versus Trump Turbulence", dated May 29, 2017, available at usis.bcaresearch.com.

Highlights The global economy remains awash in massive amounts of oversupply, reflecting extraordinary levels of capex in emerging markets. This will weigh on global inflation. Thanks to a tighter labor market, the U.S. is likely to suffer less from this force than the euro area or commodity producers. In this context, the tightening in Chinese and U.S. policy could represent a severe blow to the recent improvement in global trade. Continue to hold some yen and some dollars but stay short commodity and European currencies. Feature The U.S. is in its eighth year of recovery, yet core PCE is clocking in at a paltry 1.5% despite the headline unemployment rate standing 0.3% below its long-term equilibrium and despite incredibly low interest rates. The phenomenon is not unique to the U.S., euro area core CPI remains a meager 1% and even Germany, despite experiencing an unemployment at 26 year lows, is incapable of generating core inflation beyond 1.6%. Let us not even broach the topic of Japan... So what lies behind this low inflation environment? Not Enough Capex Or Too Much Capex? Capex in advanced economies has averaged 21% of GDP since 2008, compared to an average of 24% of GDP between 1980 and 2007, suggesting that the supply side of the economy is not expanding as fast as before (Chart I-1). Historically, countries plagued by low investment rates have tended to experience higher inflation. Simply put, these low investment rates mean these economies do not enjoy high labor productivity growth rates, causing severe bottlenecks. When these capacity constraints are hit, inflation emerges. This time around, the low investment rate in advanced economies is not yielding this development. Why? One reason is that demand has been hampered by the rise in savings preferences that emerged following the financial crisis (Chart I-2). But another phenomenon is also at play. Global capex has remained very elevated. Chart I-1Low Investment In DM ##br##Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Low Investment In DM Should Create Bottlenecks Chart I-2Post 2008: ##br##Marked Preference For Savings Post 2008: Marked Preference For Savings Post 2008: Marked Preference For Savings As Chart I-3 illustrates, global capex has averaged 25.2% of world GDP since 2010, well above the international average from 1980 to 2009. This is simply a reflection of the massive amount of capacity expansion that continues to materialize in the EM space, where investment has equaled more than 30% of GDP for eight years in a row. This matters because since the 1990s, the world has experienced a massive outward shift in the aggregate supply curve, resulting in an extended period of falling inflation and then, low inflation, independent of the state of growth or of long-term inflation expectations (Chart I-4). Chart I-3Global Capex Is High Global Capex Is High Global Capex Is High Chart I-437 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance 37 Years Of Inflation History At A Glance In the 1990s, this expansion of global production capacity reflected the addition of billions of potential workers to the international capitalist system, but this phenomenon slowed massively in the 2000s and is now over (Chart I-5). Instead, the driver of the expansion of the global supply curve has since become the rampant investment taking place in developing economies, which has resulted in a massive increase in the capital-to-GDP ratio for the entire planet (Chart I-6). Chart I-5 Chart I-62000s To Present: Capital Drives##br## The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion 2000s To Present: Capital Drives The Supply Expansion In the first decade of the millennium, this massive increase in the level of global capacity was still manageable. Global real GDP growth expressed in purchasing-power parity terms averaged 7% from 2000 to 2008 and was able to absorb some of the productive capacity being added to the world economy. As a result, core inflation average 2% in the OECD while short-term and long-term interest rates averaged 2.9% and 4.1%, respectively. However, since 2009, global GDP growth expressed in purchasing-power parity terms has only averaged 4.6%, despite a continued robust pace of investment globally, suggesting that now, supply growth is outstripping demand growth by a greater margin than in the previous cycle. This means that to achieve an average core inflation rate of 1.8% in the OECD, short-term and long-term interest rates have needed to average 0.7% and 2.4%, respectively. Going forward, the problem is that global excess capacity has not been expunged. With credit growth still limited in the G10 and in a downtrend in China (Chart I-7), deflationary tendencies are likely to remain a prevalent feature of the global economy for the rest of the business cycle. Thus, central banks the world over will find it very difficult to tighten monetary policy by much without re-invigorating downward spirals in inflation. While this problem applies to the Fed - a case cogently described by Lael Brainard this week - this is even truer for many other economies. The global trend in inflation is a function of this global expansion in supply, but domestic dynamics can still affect the dispersion of national inflation rates around this depressed global level. As Chart I-8 shows, countries with an unemployment rate substantially below equilibrium - a negative unemployment gap - do experience higher levels of inflation. Today, this puts the U.S. on a path toward higher inflation relative to the euro area. This suggests that there remains a valid case to expect a tightening of monetary conditions in the U.S. vis-à-vis the euro area. Chart I-7Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Low Credit Growth Harms Demand Growth Chart I-8 In this vein, Japan is an interesting case. Japan does have one of the most negative unemployment gaps among major economies, yet it experiences one of the lowest inflation rates. Japan is such an outlier that if it were excluded from the chart above, the explanatory power of the employment gap on inflation would double. This is because Japan has to grapple with another, even more pernicious problem: chronically depressed inflation expectations. Hence, the BoJ has to commit to an "irresponsibly easy" monetary policy and keep the economy growing above its potential for an extended period of time to genuinely shock inflation expectations upwards if it ever wants to remotely approach its 2% inflation target. Thus, we should remain negative the yen on a cyclical basis, only buying the JPY when asset markets are at risk. Bottom Line: The global economy remains awash in excessive supply. In the 1980s and 1990s, much of the supply expansion reflected an increase in the global labor force; since the turn of the millennium, the global supply expansion has been a function of high investment rates in developing economies. Without credit growth, the global economy will be hostage to deflationary pressures, at least for the rest of this cycle. Despite this picture, among major economies, the U.S. needs the smallest amount of monetary accommodation, supporting a bullish dollar stance. Policy Mistake In The Making? In this context of global overcapacity, low growth and underlying deflationary pressures, deflationary policy mistakes are easy to come by, and the world economy may be facing two such shocks. In and of itself, the U.S. economy may be able to handle higher rates. Even if inflation is likely to remain low by historical standards, a rebound toward 2% could happen later this year. At the very least, our diffusion index of industrial sector activity suggests that the recent inflation deceleration in the U.S. may be over (Chart I-9). However, it remains to be seen if EM economies, which is where the true excess capacity still lies, can actually handle higher global real rates. The rollover in our global leading indicator diffusion index is perplexing and points to a deceleration in global growth, a potential warning sign about the frailty of the global economy (Chart I-10). Additionally, it is true that 1% CPI inflation in China does not necessitate much of a strong policy response by the PBoC. But the vast swathe of cumulative capital investment in China implies that this country could suffer from the greatest amount of excess capacity (Chart I-11). China required a massive amount of stimulus in 2015 and early 2016 to generate a small rebound in growth. Thus, the current tightening in Chinese monetary conditions, as small as it may be, could be enough to prompt another wave of weakness in that country. The recent softness in PMIs - with the Caixin gauge falling below 50 - could be a symptom of this problem. Chart I-9U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... U.S. CPI Deceleration Is Ending... Chart I-10...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating ...But Global Growth Is Deteriorating Chart I-11China Is Oversupplied China Is Oversupplied China Is Oversupplied Making the situation even more precarious is that China stands at the apex of the overcapacity problem, which makes it prone to develop virtuous and vicious cycles. Chinese corporate debt stands at 180% of GDP, heavily concentrated in state-owned enterprises and heavy industries. This means that swings in producer prices can have a deep impact on real rates. Based on a 10 percentage points swing in PPI, Chinese real rates were able to collapse from 10% to -1% in the matter of 12 months last year. The problem is that for this PPI rebound to happen, Chinese monetary conditions had to ease greatly (Chart I-12). Now that Chinese monetary conditions are tightening and now that commodity prices are weakening anew, PPI could once again fall toward 0%, lifting real rates to 4.4% in the process (Chart I-13). Chart I-12Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chinese MCI: From Friend To Foe Chart I-13Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up Real Rates Are Likely To Go Up This means that the already emerging contraction in manufacturing and the recent deceleration in new capex projects could gather further momentum (Chart I-14). As credit flows dry up because of the increasing price of credit in a weakening and over-supplied economy, so will Chinese imports, which are so sensitive to the investment cycle and credit impulse (Chart I-15). This is a problem because the recent bright patch in the global economy was based on this rebound in Chinese demand. In the wake of the Chinese growth acceleration last year, global exports and export prices rebounded sharply (Chart I-16). However, now that China is facing a renewed slowdown, this improvement is likely to dissipate. Chart I-14Problems With Chinese Growth Problems With Chinese Growth Problems With Chinese Growth Chart I-15Slowing Chinese Credit Will Hurt Chinese Imports... bca.fes_wr_2017_06_02_s1_c15 bca.fes_wr_2017_06_02_s1_c15 Chart I-16...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade ...Which Will Weigh On Global Trade This is obviously negative for the commodity currency complex. Not only does this mean that the negative terms of trade shock that is affecting many commodity producers could deepen - for example iron ore futures continue to fall and are now down 39% since mid-march - but also, monetary policy could be eased relative to the U.S. Actually, our monetary stance gauge, based on real short rates and the slope of the yield curve, already highlights potential weaknesses for AUD/USD (Chart I-17). This development is also a problem for Europe. As we have highlighted before, European growth is three times more levered to EM dynamics than the U.S. economy is. Also, employment in the manufacturing sector in the euro area is still five percentage points above that of the U.S., underscoring the euro area's greater exposure to global manufacturing and global trade. This means that if Chinese troubles deepen, the closing of the European unemployment gap might slow, at least relative to the U.S. where the unemployment rate is already below equilibrium. Therefore, the high-time to bet on a tightening of European policy relative to the U.S. could be passing. Already, before the European economy has even been hit by a negative shock from EM, the euro looks vulnerable. Investors are very long the euro, but also EUR/USD has dissociated enough from interest rate fundamentals that it is now expensive on a short-term basis. The relative monetary stance gauge between the euro area and the U.S. is pointing toward trouble ahead (Chart I-18). This trend may be magnified if, as we expect, global goods prices weaken anew. Another problem for the euro is that now that the world has embraced president Macron with a firm handshake, political risk may be once again rearing its ugly head in Europe. The Italicum electoral reform in Italy is progressing and there may be a new prime minister sitting in the Palazzo Chigi in Rome this fall. The problem is that the Italian public remains much more euroskeptic than France and the euro is supported by barely more than 50% of the population (Chart I-19, top panel). With euroskeptic and pro-euro parties standing neck-and-neck in the polls, the risk of a referendum on the euro in the area's third largest economy is becoming increasingly real (Chart I-19, bottom panel). Chart I-17Relative Monetary Conditions ##br##Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Relative Monetary Conditions Point To A Lower AUD Chart I-18Euro At ##br##Risk Euro At Risk Euro At Risk Chart I-19Italy Is Not ##br##France Italy Is Not France Italy Is Not France The yen could benefit if the combined impact of higher U.S. rates and tighter Chinese policy proves to be a mistake. Our composite indicator of global asset market volatility - based on implied volatility in bonds, global stocks, global commodities, and various exchange rates - is near record lows (Chart I-20). Hence, global risk assets - commodity and EM plays in particular - could suffer some damage in the face of a deeper than anticipated global growth slowdown led by China. The recent improvement in Japanese industrial production, which mirrors the improvement in EM trade, may be short-lived. This would depress Japanese inflation expectations and boost Japanese real rates, helping the yen in the process (Chart I-21). Shorting GBP/JPY may be one of the best ways to take advantages of these dynamics (Chart I-22). Chart I-20Global Cross-Asset ##br##Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Global Cross-Asset Volatility Is Too Low Chart I-21If China And EM Slow, Japanese ##br##CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge If China And EM Slow, Japanese CPI Expectations Will Plunge Chart I-22New Downleg In ##br##GBP/JPY? New Downleg In GBP/JPY? New Downleg In GBP/JPY? Bottom Line: An oversupplied global economy could find it difficult to withstand the combined tightening emanating from China and the U.S. The improvement in global trade and global good prices is likely to dissipate in the coming month. The euro and commodity currencies could suffer from this development and the yen could benefit. Concluding Thoughts Global policy makers will ultimately not stand pat in the face of this problem. This may in fact deepen their well-entrenched dovish biases. As a result, while the scenario above sounds dire, it is likely to be transitory. The Chinese authorities will not let growth crater; European and Japanese policymakers will fight deflation; and even the Fed may be forced to leave policy easier than it would like. We will explore this topic in more detail in future publications. A Few Words On The RMB Chart I-23China Has Regained Control ##br##Of Its Capital Account China Has Regained Control Of Its Capital Account China Has Regained Control Of Its Capital Account This week, the RMB has been well bid as the PBoC announced that the currency will increasingly be used as a countercyclical tool. The market has interpreted this move as an attack on speculators betting on a falling RMB. The conditions had become very propitious for this kind of announcement to lift the CNY. On the back of a weaker dollar the trade-weighted RMB had in fact weakened for most of 2017 (Chart I-23, top panel), implying that the RMB has continued to help the Chinese economy. Additionally, capital flight out of China has slowed in response to the enforcement of capital controls, something made clear by the collapse in import over-invoicing (Chart I-23, bottom panel). Going forward, it is not clear whether this announcement is necessarily bullish or bearish. It all depends on the Chinese economy and its deflationary pressures. If we are correct that Chinese deflationary pressures are set to increase in the coming quarters, this could imply that Chinese authorities put downward pressure on the CNY later this year. That being said, we remain reluctant to short the yuan to play Chinese deflationary forces. The capital account is well controlled and the PBoC will continue to aggressively manage the exchange rate. This implies that currencies like the AUD or BRL, which exhibit strong correlations with Chinese imports, could remain the main vehicles to play a Chinese slowdown in the forex space. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback displayed further weakness as FOMC member Brainard shared her opinions questioning the future path of U.S. policy. We consider these remarks as temporary hurdles for the dollar, as fundamentals are still in favor of a stronger dollar, which is something the Fed recognizes. This week, some minor deflationary worries resurfaced as the ISM Prices Paid declined to 60.5 from the previous 68.5. While this is true, the labor market continues to tighten as the ADP survey come in very strong. Additionally, ISM Manufacturing PMI also paints a brighter picture for manufacturing, coming in at 54.9. We believe the Fed will hike this month, and will continue to highlight its tightening path going forward, which will provide a fillip for the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Europe delivered a more negative outlook this week with softer data: Services sentiment, economic sentiment indicator, industrial confidence and business climate all came in less than expected; German CPI disappointed with CPI increasing at a 1.5% rate, less than the expected 2% rate, and the harmonized index also underperformed at 1.4%; European CPI also disappointed at 1.4%, while core CPI also slowed; However, Italian unemployment improved to 11.1% from 11.5%. President Draghi also reiterated his dovish stance in a speech on Monday. While the euro is up this week, elevated short-term valuations warrant a lower euro in coming months. Furthermore, following Draghi's reiteration, rate differentials may continue to move in favor of the dollar. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Upbeat data from Japan has lifted the yen this week: Job/applicants ratio is at 1.48, a level last seen in 1974; Retail trade increased at a 3.2% annual pace, much more than the expected 2.3% rate; Industrial production increased at a 5.7% pace; Housing starts increased at 1 .9%. While data surprises to the upside in Japan, low inflation still remains entrenched in the economy. We believe the BoJ will remain dovish until inflation emerges, which will keep JPY's upside limited. That being said, risk-averse behavior can provide a temporary tailwind for the yen in the upcoming months. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The U.K.'s consumer sector remains mixed, showing a ray of sunshine after batches of poor numbers: Gfk Consumer Confidence came in at -5, better than the expected -8; Consumer credit came in at GBP 1.525 bn,; M4 Money Supply also increased at 8.2% yoy. Mortgage approvals, however, clicked in below estimates, while net lending to individuals was GBP 4.3 billion, less than expected and previously reported. Nevertheless, cable has been relatively strong this week, lifted by the euro. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 There was some negative data out of Australia this week: Building permits are still contracting, now at a 17.2% pace, less than the 19.9% pace last month; Private sector credit is expanding at a slower pace of 4.9%; AiG Performance of Manufacturing Index decreased to 54.8 from 59.2; AUD has been considerably softened recently, as commodity prices weakened. While the Chinese NBS manufacturing PMI marginally beat expectations, the Caixin Manufacturing PMI actually weakened from 50.3 to 49.6, and is now in contraction territory. As China continues to face structural issues, which are now front and center thanks to their most recent debt rating downgrade, AUD could suffer even more. In the G10 space, it is likely it will be one of the worst performing currencies this year. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD has seen a broad-based appreciation across the G10 space in the past 2 weeks due to stronger than expected trade balance and visitor arrivals. Dairy prices annual growth rate also remain robust at 56% this week. Further buoying the NZD was the release of the RNBZ Financial Stability Report, which was upbeat and states that financial risks have subsided in the past 6 months. The RBNZ also highlighted the slowdown in house price growth due to macroprudential measures. Most recently, NZD has been weak against European currencies, as upbeat data and a higher euro drove up these currencies. EUR/NZD is likely to trend downwards as growth differentials could further bifurcate central bank policies, and weigh on this cross. NZD/USD, itself, is unlikely to see much upside if the dollar bull market resumes and EM cracks deepen. However, AUD/NZD should weaken some more. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The CAD has seen downside recently as oil's gains receded after markets seemed disappointed by the OPEC deal. Data further corroborated this negative view, as both industrial and raw material prices increased by less than expected at 0.6% and 1.6% respectively. Additionally, the first quarter current account also faltered into a further deficit of CAD 14.05 bn. However, GDP growth was strong and could improve further. Investors are currently highly bearish on the CAD, with net speculative positions at the lowest level in 10 years, suggesting the bad news is well priced in. Going forward, the BoC continues to argue that the output gap is closing quicker than expected which will warrant higher rates, and help the CAD. While the CAD may not appreciate much against the USD, it will be one nonetheless one of the best performing currencies in the G10 space. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF continues to drift lower as lofty short-term valuations are hurting the euro. As the ECB is likely to remain accommodative, as per Draghi's recent remarks, the recent weakness may only be the beginning of a new trend. Recent data shows that there might be a slight deceleration in the Swiss economy as the KOF leading indicator has slowed down to 101.6. However, with Italian political risks growing faster than anticipated, the CHF could find additional support. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 As oil prices falter after the OPEC deal, the NOK displayed substantial downside against the USD, the EUR, and the CAD. Despite our Commodity and Energy team seeing additional upside for oil prices, the NOK will continue to be pulled down by low rates as the Norges Bank battles against deflationary prices, falling wages, and a weak labor market. Real rate differentials will prompt upside in USD/NOK, as well as CAD/NOK, as both the U.S. and Canada have adopted a hawkish and neutral bias, respectively. Regarding data, retail sales picked up from a meager 0.1% growth rate to a still unimpressive rate of 0.2%. At 5.1%, Norway's credit Indicator also grew less than expected and continues to slowdown. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data this week showed that last quarter, the economy did not perform as well as anticipated, with GDP increasing by 2.2%, lower than the expected 2.9%. However, more recent data shows a pickup in activity, with retail sales increasing at a 4.5% rate. USD/SEK has been weak recently due to the dollar's weakness, which we think is at its tail end. EUR/SEK's recent appreciation is likely to alleviate the Riksbank's deflationary worries. However, downside is possible as the euro may retract some of its gains. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Markets have gone too far in pricing out the Republican's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections. A bill that at least cuts taxes should be forming by year end. The risk is that continued political turbulence, now including the possibility of impeachment, distracts Congress and delays or completely derails tax reform plans. Fortunately for the major global equity markets, corporate profits are providing solid support. We expect U.S. EPS growth to accelerate further into year end, peaking at just under 20%. The projected profit acceleration is even more impressive in the Eurozone and Japan. Corporations are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end that will favor the latter two bourses in local currency terms. EPS growth will fall short of bottom-up estimates for 2017, but what is more important for equity indexes is the direction of 12-month forward EPS expectations, which remain in an uptrend. The positive earnings backdrop means that stocks will outperform bonds for the remainder of the year even if Congress fails to pass any market-friendly legislation. The FOMC is "looking through" the recent soft economic data and slower inflation, and remains on track to deliver two more rate hikes this year. The impact of the Fed's balance sheet runoff on the Treasury market will be limited by several factors, but a shrinking balance sheet and Fed rate hikes will force bond yields to rise faster than is currently discounted. Policy divergence will push the dollar higher. The traditional relationship between the euro/USD and short-term yield differentials should re-establish following the French election. The euro could reach parity before the next move is done. "Dr. Copper" is not signaling that global growth will soften significantly this year. Chinese growth has slowed but the authorities are easing policy, which will stabilize growth and support base metals. That said, we remain more upbeat on oil prices than base metals. Feature Investors have soured on the prospects for U.S. tax reform in recent weeks, but the latest travails in Washington inflicted only fleeting damage on U.S. and global bourses. The S&P 500 appears to have broken above the 2400 technical barrier as we go to press. Market expectations for a more tepid Fed rate hike cycle, lower Treasury yields and related dollar softness undoubtedly provided some support. But, more importantly, corporate profits are positively surprising in the major economies and this is not just an energy story. The good news on company earnings should continue to drive stock prices higher this year in absolute terms and relative to bond prices. It is a tougher call on the dollar and the direction of bond yields. We remain short duration and long the dollar, but much depends on the evolution of U.S. core inflation and fiscal policy. A Death Knell For U.S. Tax Reform? Chart I-1 highlights that the market now sees almost a zero chance that the Republicans will ever be able to deliver any meaningful tax cuts or infrastructure spending. Many believe that mushrooming political scandals encumbering President Trump will distract the GOP and delay or derail tax reform. Indeed, impeachment proceedings would be a major distraction, although this outcome would not necessarily lead to an equity bear market. The historical record shows that the economy is much more important than politics for financial markets. BCA's geopolitical strategists looked at three presidential impeachments, covering the Teapot Dome Scandal (April 1922 to October 1927), Watergate (February 1973 to August 1974) and the President Clinton's Lewinsky Affair (January 1998 to February 1999).1 Watergate was the only episode that coincided with a bear market, but it is difficult to pin the market downturn on Nixon's impeachment since the U.S. economy entered one of the worst post-war recessions in 1973 that was driven by tight Fed policy and an oil shock. Impeachment would require that Trump loses support among the Republican base, which so far has not happened. The President still commands the support of 84% of Republican voters (Chart I-2). Investors should monitor this support level as an indicator of the President's political capital and the risk of impeachment. Chart I-1Fading Hopes For Tax Reform Fading Hopes For Tax Reform Fading Hopes For Tax Reform Chart I-2 We believe that markets have gone too far in pricing out Trump's market-friendly policy agenda. The President desperately needs a win ahead of mid-term elections, and tax reform and deregulation are two key areas where the President and congressional Republicans see eye to eye. The odds are good that an agreement to cut taxes will be formed by year end. Congressional leaders want tax reform to be revenue neutral, but finding sufficient areas to cut spending will be extremely difficult. They may simply require that tax cuts are paid for in a 10-year window. This makes it possible to lower taxes upfront and promise non-specific spending cuts and revenue raising measures down the road. Or, Congress may pass tax reform that is not revenue neutral through the reconciliation process, which would require that tax cuts sunset at some point in the future. Tax cuts would give stocks a temporary boost either way but, as we discuss below, it may be better for corporate profits in the medium term if Congress fails to deliver any fiscal stimulus. Profits, Beats And Misses While economists fret over the soft U.S. economic data so far this year, profit growth is quietly accelerating in the background (Chart I-3). On a 4-quarter moving total basis, S&P 500 earnings-per-share were up by more than 13% in the first quarter (84% reporting). We expect growth to accelerate further into year end, peaking at about 18%, before moderating in 2018. Profit growth is accelerating outside of the energy sector. The projected acceleration in EPS growth is equally impressive in the Eurozone and Japan. The favorable profit picture in the major economies reflects two key factors. First, profits are rebounding from a poor showing in 2015/16, when EPS was dragged down by the collapse in oil prices and a global manufacturing recession. Oil prices have since rebounded and global industrial production is recovering as expected (Chart I-4). Our short-term forecasting models for real GDP, based on a mixture of hard data and surveys, continue to flag a pickup in economic growth in the major economies (Chart I-5). Chart I-3Top-Down Profit Projection Top-Down Profit Projection Top-Down Profit Projection Chart I-4EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production EPS Highly Correlated With Industrial Production Chart I-5GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate GDP Growth Poised To Accelerate The U.S. model's forecast paints an overly rosy picture, but it does support our view that Q1 softness in the hard data reflected temporary factors that will give way to a robust rebound in the second and third quarters. The Eurozone economy is really humming at the moment, as highlighted by our model and recent readings from the IFO and purchasing managers' surveys. Indeed, these indicators are consistent with real GDP growth of nearly 3%! Our GDP models are also constructive for Japan and the U.K., although not nearly as robust as in the U.S. and Eurozone. Chart I-6Profit Margins On The Rise Profit Margins On The Rise Profit Margins On The Rise Second, the corporate sectors in the major economies are still in a sweet spot in which the top line is growing but there is no major wage cost pressure evident yet. This is the case even in the U.S., where labor market slack has largely been absorbed. Indeed, margins rose in Q1 2017 for the third quarter in a row (Chart I-6). Our indicators suggest that the corporate sector has gained some pricing power at a time when wage gains are taking a breather.2 The hiatus of wage pressure may not last long, and we expect the "mean reversion" in profit margins to resume next year. But for now, our short-term EPS growth model remains upbeat for the next 3-6 months (not shown). Profit margins are also on the rise in Japan and the Eurozone. Margins in the latter appear to have the most upside potential of the three major markets, given the fact that current levels are still depressed by historical standards, and that there remains plenty of slack in the European labor market. We are not incorporating any margin expansion in Japan because they are already very high. Nonetheless, we do not expect any "mean reversion" in margins over the next year either, because the business sector is going to great lengths to avoid any increase in the wage bill despite an extremely tight labor market. U.S. EPS growth is well ahead of both Japan and the Eurozone at the moment, but we expect some "catch up" by year end: The U.S. is further ahead in the global profit mini recovery and year-ago EPS comparisons will become more difficult by the end of the year. The drag on corporate profits in 2017 from previous dollar strength will be larger than the currency drag in the Eurozone according to our models, assuming no change in trade-weighted exchange rates in the forecast period (Chart I-7). The pass-through of past yen movements will be a net boost to EPS growth for Japanese companies this year.3 Currency shifts would favor the Japanese and the Eurozone markets versus the U.S. even more if the dollar experiences another upleg. We expect the dollar to appreciate by 10% in trade-weighted terms. A 10% broad-based dollar appreciation would trim EPS growth by 2½ percentage points, although most of this would occur in 2018 due to lags (Chart I-8). Eurozone and Japanese EPS growth would receive a lift of 2 and ½ percentage points, respectively, as their currencies depreciate versus the dollar. Chart I-7Currency Impact On EPS Growth Currency Impact On EPS Growth Currency Impact On EPS Growth Chart I-8A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits A 10% Dollar Rise Would Trim Profits Finally, the fact that profits in Japan and the Eurozone are more leveraged to overall economic growth than in the U.S. gives the former two markets the edge as global industrial production continues to recover this year and into 2018. Japanese and Eurozone equity market indexes also have a higher beta with respect to the global equity index. The implication is that we remain overweight these two markets relative to the U.S. on a currency hedged basis. Lofty Expectations Even though the message from our EPS models is upbeat, our forecasts still fall short of bottom-up estimates for 2017. Is this a risk for the equity market, especially in the U.S. where valuations are stretched? Investors are well aware that bottom-up estimates are perennially optimistic. Table I-1 compares the beginning-of-year EPS growth estimate with the actual end-of-year outcome for 2007-2016. Not surprisingly, bottom-up analysts massively missed the mark in the recession. But even outside of 2008, analysts significantly over-estimated earnings in seven out of nine years. Despite this, the S&P 500 rose sharply in most cases. One exception was 2015, when the S&P 500 fell by 0.7%. Plunging oil and material prices contributed to an EPS growth "miss" of seven percentage points. Chart I-9 highlights that the level of the 12-month forward EPS estimate fell that year, unlike in the other years since the Great Recession. Valuations are more demanding today than in the past, but the message is that attaining bottom-up EPS year-end estimates is less important for the broad market than the trend in 12-month forward estimates (which remains up at the moment). Chart I- Chart I-9S&P 500 Follows ##br##12-month Forward EPS S&P 500 Follows 12-month Forward EPS S&P 500 Follows 12-month Forward EPS The bottom line is that the backdrop is constructive for equities even if the Republicans are unable to push through any fiscal stimulus. In fact, it may be better for the stock market in the medium term if the GOP fails to pass any meaningful legislation. The U.S. economy does not need any demand stimulus at the moment (although measures to boost the supply side of the economy would help lift profits over the long term). The current long-in-the-tooth U.S. expansion is likely to stretch further in the absence of stimulus, extending the moderate growth/low inflation/low interest rate backdrop that has been positive for risk assets in recent years. The Fed's Balance Sheet: It's Diet Time The minutes from the May FOMC meeting reiterated that policymakers plan to begin scaling back on reinvesting the proceeds of its maturing securities of Treasurys and MBS by the end of the year. The Fed is leaning toward a gradual tapering of reinvestment in order to avoid shocking the bond market. Still, investors are rightly concerned about the potential impact of the balance sheet runoff, especially given that memories of the 2013 "taper tantrum" are still fresh. Chart I-10 Chart I-10 presents a forecast for the flow of Treasurys available to the private sector, taking into consideration the supply that is absorbed by foreign official institutions and by the Fed. The bottom panel shows a similar calculation for the aggregate supply of government bonds from the U.S., Japan, the Eurozone and the U.K. While the supply of Treasurys has been positive since 2012, the net flow has been negative for these four economies as a whole because of aggressive quantitative easing programs. This year will see the largest contraction in the supply of government bonds available to the private sector, at US$800 billion. The flow will become less negative in 2018 even if the Fed were to keep its balance sheet unchanged (mostly due to assumed ECB tapering). If the Fed goes ahead with its balance sheet reduction plan, the net supply of government bonds from the major economies will move slightly into positive territory for the first time since 2014. There is disagreement among academics about whether quantitative easing (QE) directly depressed bond yields by restricting the supply of high-quality fixed income assets, or whether the impact on yields was solely via the "signaling effect" for the path of future short rates. Either way, balance sheet runoff will likely have some impact on bond yields. A good starting point is to employ an empirical estimate of the impact of QE. The IMF has modeled long-term Treasury yields based on a number of economic and financial variables and the stock of assets held by the Fed as a share of GDP. Just for exposition purposes, let us take an extreme example and assume that the Fed simply terminates all re-investment as of January 2018 (i.e. the runoff is not tapered). In this case, the amount of bank reserves held at the Fed would likely evaporate by 2021. This represents a contraction of roughly 10 percentage points of GDP (Chart I-11). Applying the IMF interest rate model's coefficient of -0.09, it implies that long-term Treasury yields and mortgage rates would rise by 90 basis points from the "portfolio balance" effect alone. Chart I-11Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario Fed Balance Sheet Runoff Scenario However, it is more complicated than that. The impact on yields is likely to be tempered by two factors: The balance sheet may never fully revert to historic norms relative to GDP. Some academic experts are recommending that the Fed maintain a fairly large balance sheet by historical standards because of the need in financial markets for short-term, risk-free assets that would diminish if there are fewer excess bank reserves available. Banks, for example, are required by regulators to hold more high-quality assets than they did in the pre-Lehman years. As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. Thus, the path of short-term rates is dependent on the dollar and the reaction of the long end of the curve. It is difficult to estimate how it will shake out, but a recent report from the Federal Reserve Bank of Kansas City estimated that a $675 billion reduction in the size of the Fed's balance sheet is equivalent to a 25 basis point increase in the fed funds rate (although the authors admit that the confidence band around this estimate is extremely wide).4 We expect that the impact of runoff alone will be much less than the 90 basis point estimate discussed above. Still, the combination of balance sheet shrinkage and Fed rate hikes will lead to higher bond yields than are currently discounted in the market. Fed Outlook: Mostly About Inflation The May FOMC minutes confirmed that the FOMC is "looking through" the soft economic data in the first quarter, chalking it up to temporary factors such as shifts in inventories. They are also inclined to believe that the moderation in core CPI inflation in recent months is temporary. The message is that policymakers remain on track to deliver two more rate hikes this year, in line with the 'dot plot' forecast. The market is pricing almost a 100% chance of a June rate hike. However, less than two full rate hikes are expected over the next year, which is far too benign in our view. Investors have been quick to conclude that recent economic data have convinced Fed officials to shift from a "gradual" pace of rate hikes to a "glacial" pace. Treasurys rallied on this shift in Fed expectations and a decline in long-term inflation expectations. The 10-year TIPS breakeven inflation rate has dropped to about 1.8%, the lowest level since before the U.S. election. This appears to us that the bond market over-reacted to the drop in core CPI inflation from 2.2% in February to 1.9% in April. The evolution of actual inflation will be critical to the outlook for the Fed and Treasury yields in the coming months. Our U.S. fixed-income strategists have simulated a traditional Phillips Curve model of inflation (Chart I-12).5 The model projects that core PCE inflation will reach 2.1% by December, even assuming no change in the unemployment rate or the trade-weighted dollar. Inflation ends the year not far below the 2% target even in an alternative scenario in which we assume that the dollar appreciates and that the full-employment level of unemployment is lower than the Fed currently assumes. Chart I-12U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% U.S. Inflation Should End Year At 2% Thus, the trend in inflation should reinforce the FOMC's bias to keep tightening policy, forcing the bond market to reassess the pace of rate hikes discounted in the curve. That said, if we are wrong and inflation does not trend higher in the next 3-4 months, then it is the FOMC that will be forced to reassess and our short duration recommendation will probably not pan out on a six month horizon. Longer-term, last month's Special Report highlighted that we have reached an inflection point in some of the structural forces that have depressed bond yields. This month's Special Report, beginning on page 20, builds on that theme with a look at the impact of technological progress on equilibrium bond yields. With respect to credit spreads, the state of nonfinancial corporate sector balance sheets and the overall stance of monetary policy will continue to be the main drivers of the credit cycle. If unwinding the balance sheet leads to a premature tightening of financial conditions, then the Fed will proceed more slowly on rate hikes. The crucial indicator to watch is core PCE inflation. Credit spreads will remain fairly well contained until core PCE inflation reaches the Fed's 2% target. At that point, the pace of monetary normalization will ramp up, putting spreads at risk of widening. Stay overweight corporate bonds within fixed income portfolios for now. While the Fed's balance sheet reduction by itself may not have a big impact on the dollar, we still believe the currency has more upside because of the divergence in the overall monetary policy stance between the U.S. on one side and the ECB and Bank of Japan (BoJ) on the other. The BoJ will hold the 10-year JGB near to zero for quite some time. The ECB will also not be in a position to tighten policy for an extended period, outside of removing negative short rates and tapering QE purchases a bit further in 2018. The euro has appreciated versus the dollar even as two-year real interest rate differentials have moved in favor of the dollar since the end of March. This divergence probably reflects euro short-covering following the market-friendly French election outcome. Next up are the two rounds of French legislative elections in June. Polls support the view that Macron's En Marche and the center-right Les Republicains will capture the vast majority of seats in the legislature. Such an election outcome would make possible the passage of genuine structural reforms that would suppress wage growth and make French exports more competitive. Investors may be shocked into pricing greater odds of Euro Area dissolution when Italy comes back into focus. In the meantime, we do not see any risk factors emanating from the Eurozone that could upset the global equity applecart in the near term. Moreover, the traditional relationship between the euro/USD exchange rate and 2-year real yield differentials should now re-establish. The implication is that the euro could reach parity before the next move is done. Dr. Copper? The recent setback in the commodity pits has added to investor angst regarding global growth momentum. The LMEX base metals index is up almost 25% on a year-ago basis, but has fallen by 5% since February (Chart I-13). From their respective peaks earlier this year, zinc and copper are down about 7-10%, nickel has dropped by 18% and iron ore has lost almost half of its value. Is the venerable "Dr. Copper" sending an important warning about world growth? Chart I-13What Are Commodities Telling Us? What Are Commodities Telling Us? What Are Commodities Telling Us? Some of our global leading economic indicators have edged lower this year, as we have discussed in previous reports. Nonetheless, the decline in base metals prices likely has more to do with other factors, such as an unwinding of the surge in speculative demand that immediately followed the U.S. election last autumn. Speculators may be disappointed by the lack of progress on Republican promises to cut taxes and boost infrastructure spending. The main story for base metals demand and prices, however, is the Chinese real estate sector. China accounts for roughly 50% of world consumption for each of the major metals. The Chinese authorities are trying to cool the property market and transition to a more consumer spending-oriented economy, thereby reducing the dependence on exports, capital spending and real estate as growth drivers. Fiscal policy tightened last year and new regulations were introduced to limit housing speculation. The effect of policy tightening can be seen in our Credit and Fiscal Spending Impulse indicator, which has been softening since mid-2016 (Chart I-14). The economy held up well last year, but the policy adjustment resulted in a peaking of the PMI at year-end. Growth in housing starts also appears to be rolling over. Both the PMI and housing starts are correlated with commodity prices. The good news is that BCA's China Investment Strategy service does not expect a major downshift in Chinese real GDP growth this year, which means that commodity import demand should rebound: The authorities wish to slow credit growth, but there is no incentive for the authorities to crunch the economy given that consumer price inflation is still low and the surge in producer price inflation appears to have peaked. Monetary conditions have tightened a little in recent months, but overall conditions are not restrictive. Both direct fiscal spending and infrastructure investment have picked up noticeably this year (Chart I-15). Finally, the PBoC re-started its Medium-Term Lending Facility and recently made the largest one-day cash injection into the financial system in nearly four months. Chart I-14China Is The Main Story ##br##For Base Metals Demand China Is The Main Story For Base Metals Demand China Is The Main Story For Base Metals Demand Chart I-15Direct Fiscal Spending And ##br##Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Direct Fiscal Spending And Infrastructure Have Picked Up Recently Export growth will continue to accelerate based on our model (not shown). The upturn in the profit cycle and firming output prices should boost capital spending. Robust demand will ensure that housing construction will continue to grow at a healthy pace. Households' home-buying intentions jumped to an all-time high last quarter. Tighter housing policies in major cities will prevent a massive boom, but this will not short-circuit the recovery in housing construction. Fading fears about a China meltdown may give commodities a lift later this year. Our commodity strategists are particularly positive on crude oil, as extended production cuts from OPEC and Russia outweigh the impact of surging shale production, allowing bloated inventories to moderate. In contrast, the backdrop is fairly benign for base metals. Our commodity strategists do not see the conditions for a major bull or bear phase on a 6-12 month horizon. Within commodity portfolios, they recommend a benchmark allocation to base metals, an underweight in agricultural products and an overweight in oil. From a broader perspective, our key message is that "Dr. Copper" is not signaling that global growth will soften significantly this year. Investment Conclusions: Accelerating corporate profit growth in the major advanced economies provides a healthy tailwind and suggests that stocks could perform well under a couple of different scenarios in the second half of 2017. If the rebound in U.S. economic growth from the poor first quarter is unimpressive and it appears that Congress will be sidetracked by political turmoil in the White House, then the S&P 500 should benefit from the 'goldilocks' combination of healthy profit growth, low bond yields, an accommodative Fed and a soft dollar. If, instead, U.S. growth rebounds strongly and Congress makes progress on the broad outline of a tax reform bill over the summer months, then stocks should benefit from the prospect of stronger growth in 2018. Rising bond yields and a firmer dollar would provide some offset for stocks, but would not derail the equity bull market as long as inflation remains below the Fed's target. Our model suggests that U.S. inflation will remain below-target for the next several months, but could be near 2% by year end. This scenario would set the stage for a more aggressive Fed in 2018, a surge in the dollar and possibly a bear market in risk assets next year. We are therefore comfortable in predicting that the stock-to-bond total return ratio will continue to rise for at least the remainder of this year. The tough part relates to bond yields and the dollar, since the above two scenarios have very different implications for these two asset classes. Our base case is closer to the second scenario, such that we remain below benchmark in duration and long the dollar. That said, much depends on the evolution of U.S. core inflation and U.S. politics. Both are particularly difficult to forecast. A failure for core PCE inflation to pick up in the next 3-4 months and/or continuing political scandals in Washington would force us to reconsider our asset allocation. Of course, there are other risks to consider, including growing mercantilism in the U.S., Sino-American tensions and North Korea. At the top of the list are China and Italy. (1) China China remains our geopolitical strategists' top pick as the catalyst most likely to scuttle our upbeat view on global risk assets in 2017.6 Our base case assumption is that policymakers will not enact wide-scale financial sector reform, which would entail a surge in realized non-performing loans and bankruptcies and defaults, ahead of the Fall Party Congress. The regulatory crackdown so far seems merely to keep the financial sector in check for a while. The government has already stepped back somewhat in the face of the liquidity squeeze, and fiscal policy has been loosened (as mentioned above). All of the key Communist Party statements have emphasized that stability remains a priority. Nonetheless, it may be difficult for the authorities to manage the deleveraging process given nose-bleed levels of private-sector leverage. Politicians could misjudge the fragility of the financial system and investors might front-run the reform process, sending asset prices down well in advance of policy implementation. (2) Italy We have flagged the next Italian election as a key risk for markets because of polls showing that voters have become disillusioned with the euro. It appeared that an election would not take place until 2018, and we have downplayed European elections as a risk factor for 2017. However, the 5-Star Movement has now backed a proportional electoral system, which raises the chances of an autumn election in Italy. This would obviously spark turbulence in financial markets in the months leading up to the event. Turning to emerging markets, the pickup in global growth and a modest bounce in commodity prices would support this asset class. However, our view that the dollar is headed higher on the back of Fed rate hikes keeps us from getting too excited about EM stocks, bonds or currencies. Our other recommendations include the following: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. on a currency-hedged basis. Overweight the dollar versus the other major currencies. Overweight small caps stocks versus large in the U.S. market. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst May 31, 2017 Next Report: June 29, 2017 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 7, 2017, available at gps.bcaresearch.com 2 Please see The Bank Credit Analyst, "Overview," April 017, available at bca.bcaresearch.com 3 Currency shifts affect earnings with a lag, which in captured by our models. 4 Forecasting the Stance of Monetary Policy Under Balance Sheet Adjustments. The Macro Bulletin, Federal Reserve Bank of Kansas City. Troy Davig and A. Lee Smith. May 10, 2017. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com 6 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets ," dated May 24, 2017, available at gps.bcaresearch.com II. Is Slow Productivity Growth Good Or Bad For Bonds? This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-3The Shift Towards Software ##br##Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Chart II-4 Chart II-5 Chart II-6 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8 Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14 Chart II-15Aging Will Reduce ##br##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17 Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Chart II-19Falling Capital Goods Prices Have Allowed ##br##Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-20 Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed ##br##Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The breakout in the S&P 500 above 2400 in May has further stretched valuation metrics. Measures such as the Shiller P/E and price/book are elevated relative to past equity cycles. The price/sales ratio is in a steep rise too. However, our U.S. Composite valuation metric, which takes into consideration 11 different measures of value, is still a little below the one sigma level that marks significant overvaluation. This is because our composite indicator includes valuation measures that take into account the low level of interest rates. Of course, these measures will not look as favorable when rates finally rise. Technically, the U.S. equity market has upward momentum. Our Equity Monetary Indicator has remained around the zero line, meaning that it is not particularly bullish or bearish at the moment. Our Speculation Index is high, pointing to froth in the market. The high level of our Composite Sentiment Index and low level of the VIX speaks to the level of investor complacency. The U.S. net revisions ratio jumped higher this month, and it is bullish that the earnings surprise index advanced again. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little "dry powder" left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking forward, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. It is disconcerting that our Europe WTP suffered a pull-back over the past month. Nonetheless, we believe that accelerating corporate profit growth in the major advanced economies provides a strong tailwind and suggests that stocks remain in a window in which they will outperform bonds. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as we have reached an inflection point in some of the structural forces that have depressed bond yields. We also believe that the combination of Fed balance sheet shrinkage and rate hikes will lead to higher bond yields than are currently discounted in the market. Technically, our composite indicator has touched the zero line, clearing the way for the next leg of the bond bear market. The dollar is very expensive on a PPP basis, although it is less so by other measures. Technically, the dollar has shifted down this year, crossing the 200-day moving average. That said, according to our dollar technical indicator, overbought conditions have been totally worked off, suggesting that the currency is clear to move higher if Fed rate expectations shift up as we expect. Moreover, we believe that policy divergence in the overall monetary policy stance between the U.S. on one side and the ECB and BoJ on the other will push the dollar higher. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights On the European side, the key risk to our bullish DXY stance is that European growth is strong, the labor market seems to be tightening, and core CPI has perked up. These risks are real but mitigated by budding signs that European growth is at its best, by the abundance of hidden labor market slack, and by the high chance that the CPI spike was transitory. On the U.S. side of the ledger, the key risks are that wages do not pick up, that credit growth continues to act as a break on activity, and that political risks hamper fiscal dynamics. All would mean a more dovish Fed than we anticipate. These risks are mitigated by the fact that hidden U.S. labor market slack is only now low enough for wages to improve, credit looks set to turn around as financial conditions are supportive, and fiscal policy should surprise to the upside. USD/NOK has upside as Norway experiences declining inflation. Go long CAD/NOK. Feature Last week, we augmented our cyclically dollar bullish view by removing our tactical bearish bias on the USD. In our eyes, the market is underestimating the capacity of the Fed to increase rates and is also overestimating the economic impact of the fiasco surrounding Trump's alleged relationship with Russia. Despite our high conviction view that the dollar can rally 10% or more from current levels, we cannot be blind to the key risks surrounding it. This week, we explore where our stance on Europe and the Fed can go wrong. ECB Tapering = Upcoming Tightening Campaign? The key risk to our negative euro stance is the ECB. The market has moved to discount the first rate hike in Europe to happen in barely two years, an event we judge highly unlikely. However, if the market is right that a tapering of asset purchases in 2018 and a potential increase in the rates on deposit facilities to 0% are the opening salvos of an imminent campaign to push up the repo rate, the EUR/USD rally is only in its early days. Here are the key factors that would support this bullish euro view: The European economy is in a major economic upswing. Not only have PMIs surged, the IFO has hit an all-time high (Chart I-1). If this pace of growth can be maintained for an extended period of time, the European output gap will close faster than we anticipate, providing a stronger basis for the ECB to nudge all rates higher. The euro area labor market is tightening. Euro area unemployment rate is at 9.5%, only 0.7% above the OECD's estimate for NAIRU (Chart I-2). Thus, it would paint a picture where there is little slack in the economy at large and in the labor market in particular. In this environment, a continuation of the elevated growth currently experienced by the euro area could boost wages. Core inflation has picked up to 1.2% (Chart I-3). The ECB has historically displayed a tight reaction function to inflation. In the past, headline CPI mattered, but since Mario Draghi took the helm of this institution, the focus has switched to underlying pricing pressures. Thus, if euro area core inflation continues to move up, especially as U.S. core PCE inflation has weakened to 1.6%, the market will be vindicated and the euro could rebound on a more hawkish ECB. Chart I-1Europe Is Booming Europe Is Booming Europe Is Booming Chart I-2Low Labor Market Slack In Europe Low Labor Market Slack In Europe Low Labor Market Slack In Europe Chart I-3That Should Help The ECB To Hike That Should Help The ECB To Hike That Should Help The ECB To Hike Why Are These Factors Risks And Not Base Cases? To begin with, these factors have been discounted by the markets, a fact highlighted by the 42-month fall in the month-to-hike for the ECB since July 2016 to 24 months today. Also, as the European surprise index has outperformed the U.S. one, EUR/USD has rallied by 6%. In the process, investors have switched from being massively short the euro to being the most aggressively long in three years (Chart I-4). Risk-reversals in EUR/USD options are also at elevated levels, highlighting the potentially too-bullish disposition of investors toward the euro. On the growth front, some factors suggest that European growth may soon peak. The large improvement in the amount of industrial activity and capacity utilization in Europe relative to the U.S. was reflective of the big easing in monetary conditions that followed the collapse of the euro after 2014. But, as Chart I-5 illustrates, European industrial production needed a falling euro to beat that of the U.S., soon after the euro stabilized, the growth outperformance began to recede and is now near inexistent based on this metric. Thus, the euro rebound removes one of the key factors that supported the European economy in the first place. Chart I-4Investors Have Discounted##br## The Good News In Europe Investors Have Discounted The Good News In Europe Investors Have Discounted The Good News In Europe Chart I-5Europe's Growth Outperformance ##br##Was Because Of Policy Europe's Growth Outperformance Was Because Of Policy Europe's Growth Outperformance Was Because Of Policy Additionally, some economic data are showing disturbing signs. While Germany's IFO stands at a record high, Belgian business confidence has rolled over. In fact, export orders have been particularly weak (Chart I-6). This is of importance as Belgium has long been a logistical center for the euro area, and is a small open economy deeply integrated in the European economic infrastructure. This, therefore, portends to emerging risks to the whole euro area. Monetary dynamics too raise questions. European business confidence, a key piece of soft data that has underpinned investors increased bullishness on the euro is led by dynamics in M1 money supply. The roll over in M1 implies that business conditions in Europe are slowly passing their best period (Chart I-7). If euro area growth peaks, this also raises concerns about the state of the labor market. This is especially worrisome as we think the unemployment gap based on the OECD's estimate of NAIRU misses key elements of the European labor market slack. As we wrote last week, the key problem in Europe is labor underutilization; hidden labor market slack remains a serious concern.1 With workers in irregular contracts being a key source of job creation since the end of the 2013 recession, there are plenty of workers willing to change jobs without the incentive of a higher pay, limiting the upside in wages. Without wage growth, it will be difficult for European core inflation to continue its uptrend, especially as there are many signs that the rebound that has excited investors' imagination may have been a transitory event. Worryingly for euro bulls, our Core CPI A/D line for Europe, which tends to lead core CPI itself, rolled over last year and points to lower core CPI.2 Industrial good prices excluding energy have also been weakening for 15 months now, suggesting this inflation rebound may be an aberration (Chart I-8). Chart I-6Where Belgium Goes, ##br##So Does Europe Where Belgium Goes, So Does Europe Where Belgium Goes, So Does Europe Chart I-7Money Trends Point To A Deceleration##br## In European Soft Data Money Trends Point To A Deceleration In European Soft Data Money Trends Point To A Deceleration In European Soft Data Chart I-8Europe Core CPI ##br##Will Roll Over Europe Core CPI Will Roll Over Europe Core CPI Will Roll Over Bottom Line: Investors have become very bullish of the euro based on the fact that the economy has been very strong, the European headline unemployment rate is moving closer to NAIRU, and core inflation has perked up; raising the specter of high rates sooner than we anticipate. These economic developments need to be monitored closely, but the growth impulse in Europe is likely to soon deteriorate, broader measures of labor market slack in the euro area are far from being at full employment, and the tick up in core inflation is likely to prove to have been only a temporary blip. These forces should weigh on the euro for the rest of 2017. Maybe The Fed Will Not Tighten That Much? Meanwhile, in the U.S., investors only expect three rate hikes over the next 24 months. Markets have begun doubting the fed's capacity or resolve to hike interest rates as aggressively as we envision. A slew of disappointing data and political developments have cemented this opinion among investors. Among the most crucial factors are the following: Chart I-9Disappointing U.S. Wages Dissipating U.S. Wages Dissipating U.S. Wages Wage growth in the U.S. remains poor, especially as per average hourly earnings which are still only growing at a disappointing 2.3% rate (Chart I-9). This raises the specter that consumption will remain tepid and that inflationary dynamics will never take hold in the U.S. This risk is perceived as especially salient as core inflation and core PCE have slowed below the 2% objective of the FOMC. Slowing credit growth has also garnered a lot of attention among the public. Credit is the life blood of the economy, and this slowdown has prompted many investors to begin questioning whether or not the U.S. economy would ever be able to take off. This compounded worries around the perennially weak Q1 GDP growth. Finally, the myriad of scandals surrounding Trump and his dealings with Russia have raised much questions about his ability to ever implement fiscal stimulus. Moreover, the punitive terms associated with the repeal of Obamacare and the implementation of the American Health Care Act (AHCA) - which according to the CBO could leave as many as 23 million individuals without health insurance by 2023 and cause sharp increases in insurance premia - may dull any growth boosting impact of potential tax cuts. Thus, the political backdrop may prompt the Fed to be easier than was anticipated as recently as December 2016. Why Are These Factors Risks And Not Base Cases? To begin with, BCA still hold the view that wages in the U.S. are set to accelerate in the coming quarters. The Phillips Curve continues to be a reality, as the Atlanta Fed Wage Tracker still display a tight relationship with the unemployment gap (Chart I-10). Moreover, it is often argued that the problem with today's labor market is that much of the job creation is happening in low-skilled positions. This is true, but historically, low-skilled jobs have tended to experience the most upward pressures when the job market tightens significantly. Instead, the key anchor on average hourly earnings has been the hidden labor market slack. However, today, the U-6 unemployment rate is finally ticking at 8.6%, levels where in previous cycles wage growth accelerated (Chart I-11). A rebound in GDP growth, as highlighted by the Atlanta Fed growth forecast of 4.1% in Q2, would accentuate pressures on the labor market and help realized the underlying wage pressures resulting from the current readings of the U6 unemployment rate. Chart I-10The Phillips Curve: It's Alive The Phillips Curve: It's Alive The Phillips Curve: It's Alive Chart I-11U.S. Wages Will Pick Up U.S. Wages Will Pick Up U.S. Wages Will Pick Up What could support growth? Let's begin with the credit dynamics. As we have argued, credit growth is a lagging indicator of economic activity. The improvement in the ISM through 2016 and early 2017 continues to point to a rebound in C&I loans in the U.S. (Chart I-12). Moreover, aggregate bank credit in the U.S. is already re-accelerating, suggesting that credit will once again add to economic activity, and will stop subtracting from it (Chart I-13). Chart I-12Credit Lags, And It Will Pick Up Credit Lags, And It Will Pick Up Credit Lags, And It Will Pick Up Chart I-13Momentum In U.S. Loans Is Turning Up Momentum In U.S. Loans Is Turning Up Momentum In U.S. Loans Is Turning Up Another positive for the U.S. economy has been the substantial easing in financial conditions resulting from the fall in the dollar and bond yields since the beginning of 2017. This easing should help economic activity over the course of the next quarters (Chart I-14). In its most recent minutes, the Fed has alluded to these forces. The fall in the dollar is already showing signs of helping. The ISM export orders index is currently ticking near 60, suggesting that the fall in the USD has had a stimulative impact on the U.S economy (Chart I-15). This is especially salient when contrasted with the euro area industrial production dynamics described above. Chart I-14U.S. Financial Conditions Will Help Growth U.S. Financial Conditions Will Help Growth U.S. Financial Conditions Will Help Growth Chart I-15The Dollar's Easing Is Evident The Dollar's Easing Is Evident The Dollar's Easing Is Evident Finally, when it comes to fiscal policy, our Geopolitical Strategy team remains adamant that tax cuts will materialize in the coming quarters. It is becoming imperative for congressional Republicans to achieve this as Trump's popularity remains dismal at the national level, which could prompt a serious electoral rout in the 2018 mid-term elections (Chart I-16). This means that fiscal easing is likely to come through, which should have an impact on asset prices and the dollar: The DXY is back to pre-election levels and the relative performance of stocks most sensitive to changes in tax policy is back to January 2016 levels. These price trends indicate that investors have massively curtailed their expectations for governmental support to growth. Chart I-16If Tax Cuts Don't Pass, Republicans Are Heading For A Huge Defeat In 2018 Exploring Risks To Our DXY View Exploring Risks To Our DXY View Moreover, the current format of the AHCA is unlikely to make it through the more moderate U.S. Senate. The loss of coverage and the insurance premia increases implied by the current plan are likely to be electoral poison in 2018, something well understood by key GOP policymakers. An AHCA still up in the air does not preclude tax cuts either. The budget deficit hole created by unfunded tax cuts will likely be patched through aggressive growth assumptions, the magic of dynamic scoring. The recently revealed Trump budget proposal itself is also unlikely to see the light of day in its current form and will evolve toward something more supportive of growth as time and negotiations pass. Bottom Line: Investors have massively curtailed their expectations of Fed tightening over the next two years. This view has been based on the lack of wage acceleration in the U.S., the poor credit growth numbers, and the uncertainty surrounding fiscal policy. These are still important risks to our bullish stance. However, we remain optimist because wage growth is only set to increase now, credit is a lagging indicator that looks about to pick up anew, financial conditions should help future U.S. economic activity, and the potential for tax cuts is far from dead. Stay long DXY. Norway's Passing Inflation Problem It was not long ago when the Norges Bank was facing the daunting task of kick starting a Norwegian economy ravaged by the collapse in oil prices while trying to contain the high inflation brought upon by the sell-off in the krone. However, following the stabilization of the NOK, this dilemma has dissipated as multiple measures of inflation have plunged. The Norges Bank is now free to maintain its dovish bias as the economy remains tired and will require easy monetary to recover going forward. Based on the effect of currency moves, inflation might reach a bottom at the beginning of next year, but it will likely stay below the central bank's target of 2.5 % for the foreseeable future (Chart I-17). Indeed, in spite of the rebound in oil prices, employment is contracting, the output gap is large, and wage growth remains deeply negative (Chart I-18). The Norges Bank is sympathetic to this view, acknowledging in its most recent monetary policy statement that inflation will hover in a 1-2% range in the coming years. Chart I-17A Stable NOK Will Keep Inflation Subdued A Stable NOK Will Keep Inflation Subdued A Stable NOK Will Keep Inflation Subdued Chart I-18No Domestic Inflationary Pressures In Norway No Domestic Inflationary Pressures In Norway No Domestic Inflationary Pressures In Norway Lastly, Norway's bubbly real estate market, the last obstacle to the Norges Bank dovish bias, is finally slowing down. Thanks to changes in regulation on residential mortgage lending at the start of the year, banks are tightening lending standards to households, a precursor to a cooling housing market (Chart I-19). With a Fed looking to increase rates, the real rate differential between the U.S. and Norway should move in favor of USD/NOK. Yet, could rising oil prices deepen the USD/NOK weakness? This seems doubtful as USD/NOK continues to be more correlated with real rate differentials than with the price of oil (Chart I-20). Nevertheless, the outlook of the krone against the AUD and the NZD is much more promising: Chart I-19No Need To Raise Rates To Curb Housing Prices No Need To Raise Rates To Curb Housing Prices No Need To Raise Rates To Curb Housing Prices Chart I-20Real Rates Matter More Than Oil Real Rates Matter More Than Oil Real Rates Matter More Than Oil Yesterday, OPEC Russia agreed to maintain their production cuts in place for the next nine months. This deal should keep the oil market in a deficit, pushing oil prices up and providing a tailwind to the NOK against non-oil commodity currencies. Chart I-21CAD/NOK: A Call On The U.S. Dollar CAD/NOK: A Call On The U.S. Dollar CAD/NOK: A Call On The U.S. Dollar On the other hand, the outlook for industrial metals and other commodities, which are more sensitive to the Chinese economy, continues to be worrying. Monetary conditions are still tightening in China and multiple economic activity indicators have disappointed to the downside. While base metals have already fallen considerably, we believe that additional weakness in the Chinese economy will trigger a selloff in EM assets, bringing the NZD and the AUD down with them. Finally, it may be time to sell the NOK against the CAD. The Bank of Canada struck a hawkish tone on Wednesday, stating that the Canadian economy's adjustment to lower oil prices is largely complete and that consumer spending should be supported by an improving labor market. This change in rhetoric should set the stage for a rally in CAD/NOK. Moreover, our Intermediate-Term Timing Model shows that this cross is 7% cheap, and our bullish USD view implies an outperformance of the loonie versus the krone given the tight correlation between CAD/NOK and the DXY (Chart I-21). Bottom Line: Outperformance of oil in the commodity space will help the krone outpace non-oil commodity currencies. However, the Norges Bank is likely to keep a dovish bias, which should make it difficult for the NOK to rally durably against a cheap U.S. dollar. Go long CAD/NOK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Juan Manuel Correa Research Analyst juanc@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Bloody Potomac", dated May 19, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "The Achilles Heel Of Commodity Currencies", dated May 5, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 The greenback suffered some losses following the release of Fed minutes. Puzzlingly, the rhetoric was not dovish, as markets and news outlets confirmed the prospect for a June rate hike. The result was a dollar selloff and a drop in yields. This easing in financial conditions created an additional fillip for the S&P as it traded at a record high, the opposite of what is expected with a looming rate hike. As new home sales contracted on a monthly basis and the manufacturing PMI disappointed, the U.S. soft patch continues. Nevertheless, our base case remains on par with the Fed's: the weakness in data is temporary and the Fed will hike more than the markets expect. We are already seeing this as continuing and initial jobless claims beat expectations at 1.923 million, and 234,000 respectively, and the greenback has found a footing at the 97.1 level. As this scenario further unfolds, gold will retreat as real returns increase, and the greenback will gain upward momentum. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The euro area continues to surprise with better than expected data: German IFO: Overall Business Climate came in at 114.6 - levels last seen in 1970; Expectations came in better than expected at 106.5; and the Current Assessment also beat expectations of 121.2, coming in at 123.2. Euro area Manufacturing PMI is at 57 for May, beating expectations of 56.5, and the Composite measure also recorded an outperformance, coming in at 56.8. On the consumer side, German Gfk Consumer Confidence Survey came in at 10.4, beating expectations of 10.2. While the euro to be overvalued on short-term metrics, and the euro area is structurally weaker than the U.S., weaker data needs to be seen for the markets to see a correction. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data has been negative in Japan: Manufacturing PMI decreased to 52 in May from 52.7 in April. Exports growth decreased to 7.5%, from 12% the month before and underperforming expectations. Japan's all industry activity Index also underperformed expectations, contracting by 0.6% MoM. We continue to believe that Japanese economic activity will ultimately be determined by the exchange rate. The yen has appreciated since this the start of the year, therefore it is understandable that inflation and economic activity have been subdued. Taking this into account, the BoJ will continue to target a yield of 0% in JGB's, and thus the yen should suffer on a cyclical basis given that real rates differentials with the U.S. will continue to widen. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent British data has been mixed: GDP growth underperformed, coming in at 2%, decreasing from last quarter and underperforming expectations, mostly reflecting poor trade numbers. Meanwhile total business investment grew by 0.8%, outperforming expectations. We are not positive on the pound against the dollar, given that near 1.3 the pound is no longer a bargain tactically. On the other hand we expect more upside against the euro. Powerful inflationary pressures are building in the U.K., and governor Carney, previously concerned about the effects of Brexit in the economy, might be more inclined now to deal with inflation as the U.K. has proved resilient. This will put upward pressure in British rates vis-à-vis European rates. Additionally EUR/GBP has reached overbought levels, indicating it might be a good time to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 As the greenback's descent slowed down, so did the Aussie's ascent. The underlying motives for strength in the antipodean currency are misplaced. As data remains unpromising, this week followed through with further disappointments as overall construction work done contracted by 7.2% on an annual basis, with the engineering component contracting by 13%. Research by the RBA illustrates that construction work has a very close relationship with the national accounts of Australia. This could result in a slowdown in the economy - something which the RBA cannot afford amidst flailing inflationary pressures. On a more optimistic note, the commodity selloff is taking a breather. Most crucially for the AUD, iron ore futures have remained flat for almost a month after a 30% depreciation, and natural gas has been flat for almost a month. These developments have limited the AUD's downside for now. However, looming EM risks and the potential resumption of the dollar bull market represent very real risks for the AUD going forward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The kiwi has appreciated by about 1.5% against the dollar this week. Additionally, recent data has been positive: Visitor Arrivals yearly growth skyrocketed to 21.5% on April. The trade balance outperformed expectations coming in at -3.48 Billion The kiwi economy continues to surge, with 7% growth in nominal GDP and retail sales growth at decade-highs. Additionally, dairy prices continue to surge, and are now growing at a 60% YoY pace. For this reason we are bearish on AUD/NZD, as the Australian economy is not only in a more precarious state, but is also more sensitive to the Chinese industrial cycle. Meanwhile, we continue to be bearish on NZD/USD, as a negative view on EM assets necessarily entails a bearish view on the kiwi. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Following on from the dollar's weakness, the CAD displayed further strength after the BoC's decision statement. While keeping rates unchanged, the bank highlighted that "recent economic data have been encouraging" and that "consumer spending and the housing sector continue to be robust on the back of an improving labor market". Furthermore, the Bank more or less expects these supports to growth to "strengthen and broaden over the projection horizon". While wholesale sales increased by less than expected at 0.9%, the BoC also expects that the "very strong growth in the first quarter will be followed by some moderation in the second quarter". This is likely to keep market expectations anchored and the CAD's value intact. Additionally, oil should pare recent weaknesses as OPEC follows through on its cuts. The CAD is therefore likely to see some strength against other commodity currencies. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has continued to depreciate after coming close to reaching 1.1. We continue to be negative on this cross, as the Euro is likely to have limited upside from current levels. The ECB is unlikely to hike rates any time soon, as wage pressures outside of Germany continue to be muted. Furthermore, this is not likely to change any time soon, as the labor market of the periphery continues to be very rigid. Meanwhile, the SNB is likely to take off the floor from this cross next year, as core inflation and retail sales growth have both returned to positive territory. We will continue to monitor the rhetoric by the SNB to have a more clear understanding of when the removal of the floor might occur. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The krone has rallied this week, thanks to the rise in oil prices. However real rate differentials should continue to move in favor of USD/NOK. While the fed is likely to hike more than what is currently anticipated in the OIS curve, the Norges Bank will stay dovish, given that the Norwegian economy is still too weak to sustain a rise in interest rates. Furthermore, macro prudential measures seem to be helping the Norges bank to slow down the housing market. The NOK is also likely to have downside against the CAD. The dollar bull market should help this cross rally, given the tight correlation between CAD/NOK and the DXY. Furthermore the BoC has struck a more hawkish tone as of late, which should further increase the difference between interest rate expectations in these two countries. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Positive data emerged from Sweden this week as consumer confidence picked up to 105.9 from 103.7, beating expectation of a decline to 103.6. The seasonally-adjusted unemployment rate remains on a structural downtrend, coming in at 6.6% according to Statistics Sweden. In terms of crosses, USD/SEK continues to weaken due to the greenback's instability. EUR/SEK has topped out and is also showing some weakness. Against commodity currencies, the movement is mixed. The SEK has shown the most strength against the AUD, while CAD/SEK and NZD/SEK have been flat, and NOK/SEK has seen considerable strength on the back of robust oil prices. We can see the SEK being weak against oil-based currencies as we expect OPEC to remain focused on cutting global oil inventories, while AUD/SEK could see further downside due to poor fundamentals in Australia. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades