Monetary

Highlights Real Rate "Targeting": Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. U.K.: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Japan: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Feature Chart Of The WeekA 'New, New Normal' Of Higher Real Rates? Three major central banks met last week and, surprisingly, the most important message did not come from the Federal Reserve. The Bank of England (BoE) and Bank of Japan (BoJ) both delivered policy decisions that appeared more hawkish on the surface, even though the underlying message was far more mixed. The BoE hiked rates by 25bps, while the BoJ tweaked its yield curve control policy by raising the allowable ceiling for the 10-year Japanese Government Bond (JGB) to 0.2%. Yet both central banks signaled - through published research, commentary and outright forward guidance - that the timing of the next policy move is uncertain. This contrasts with the Fed, who continues to signal a slow-but-steady path of U.S. rate hikes over at least the next year. The BoE and BoJ are dealing with the same issues that all the major developed market central banks are facing now - how to reconcile low unemployment and an apparent dearth of spare economic capacity with only modest upward inflation momentum and real interest rates that appear too low (Chart of the Week). Against that backdrop, the communication of central banker strategies to the public, and to the financial markets, is critical to their success, defined by keeping inflation stable around target levels. The Fed has been a leader in introducing nuance into the execution, and communication, of post-crisis policymaking. First, by focusing more on underutilized capacity in the U.S. labor market to justify keeping the funds rate low despite the headline unemployment rate falling below its estimate of "full" employment. Later, by focusing attention on real interest rates and the possibility that the neutral level of that rate (a.k.a. "r-star") can vary cyclically from levels that would previously have been considered consistent with full employment and stable inflation. In both cases, the Fed has provided a framework that allows some wiggle room as it continues to normalize away from crisis-era policy settings. Passionate advocates of the concept like current New York Fed President John Williams have led the Fed's growing focus on r-star. Yet in its latest Inflation Report published last week, the BoE dedicated five full pages to the topic of estimating r-star in the U.K.1 Other central banks have discussed their own estimates of r-star over the past year, as well.2 This is an important point for global bond markets. If other central banks begin to follow the lead of the Fed and elevate the importance of "real rate targeting" into their inflation targeting frameworks, then real bond yields could have significant upside with policy rates still not above realized inflation in the major developed economies. This will especially be true if factors that have kept r-star cyclically depressed in many countries in the post-crisis era - weak productivity growth, fiscal consolidation, excess capacity in labor markets, household deleveraging, among others - continue to slowly dissipate. At the moment, the most important themes for global financial markets relate to the ongoing Fed tightening cycle, the potential for policy stimulus in China in response to slowing domestic growth, and the slowing growth of central bank balance sheets (Chart 2). All three are bond bearish. We could add a fourth item to that list - U.S. protectionism, which can lead to slowing global through diminished trade activity. While there is evidence from many countries that a more uncertain outlook for global trade has negatively affected business confidence, there is also some tentative evidence that the deceleration in global trade activity may be in the process of stabilizing (Chart 3). Yet even if the U.S. - China trade tensions worsen and industrial activity slows further, tariffs and trade barriers represent a supply shock that could result in higher global inflation and prevent a meaningful decline in bond yields. Summing it all up for our government bond investment strategy, we continue to recommend: a below-benchmark overall portfolio duration stance country allocation (Chart 4) with underweight exposure to countries where central banks can credibly raise interest rates (U.S., Canada) and overweight exposure where rate hikes will be more difficult to deliver (U.K., Japan, Australia) Bottom Line: Global central bankers are increasingly following the Fed's lead by paying more attention to the appropriate level of real interest rates that will keep inflation stable given low unemployment (r-star). This raises a new potentially bearish element for global bond markets through higher real yields. Chart 2The Biggest Market Risks Are Bond Bearish Chart 3Tentative Signs Of Global Trade Stabilization? Chart 4Underweight Countries That Can Credibly ##br##Raise Rates (And Vice Versa) Stay Overweight U.K. Gilts, Even After The BoE Rate Hike The BoE delivered a 25bp rate hike last week, bringing its Bank Rate to 0.75%. The growth and inflation forecasts for the next three years were essentially unchanged, however. The hike was described by BoE Governor Mark Carney as a sign of growing confidence by the Monetary Policy Committee (MPC) in its forecast. Thus, another step towards normalizing the Bank Rate from accommodative levels was appropriate. In the press conference following the MPC meeting, Carney noted that the recent pickup in U.K. wage growth was an important development. Carney said that with the economy at full employment,3 the BoE's job is to "manage demand" to control inflation while nominal wage growth expands. Real wage growth has crept back into positive territory in recent months (Chart 5). Numerous indicators were presented in the August 2018 Inflation Report to suggest that U.K. labor markets are growing increasingly tight - including faster wage growth for those switching jobs than those staying in jobs (bottom panel) and survey data showing greater pay increases in sectors facing recruitment and retention difficulties. The BoE did downplay the recent cooling of realized U.K. inflation, which has been more a product of the stability of the pound than an easing of domestic inflation pressures. While this is true, market-based measures of inflation expectation like CPI swaps have also been following the path of the pound, rather than typical forces like oil prices, since the collapse in the pound after the 2016 Brexit vote (Chart 6). On the margin, however, the more stable pound means that U.K. inflation will be more influenced by domestic factors, like tight labor markets and wage pressures. Chart 5Mixed Signals From The U.K. Labor Market Chart 6U.K. Inflation Following The Pound, Not The Labor Market As discussed earlier, the BoE did devote a significant section of the latest Inflation Report to the topic of the neutral real rate or r-star. The BoE noted that there was a longer-term and shorter-term r-star, and that the latter had to be deeply negative in recent years given the shocks from the 2008 Financial Crisis and recession to the 2016 Brexit vote to the fiscal austerity of recent Conservative governments. As the impacts of those shocks fades, the shorter-term r-star increases, requiring faster BoE rate hikes. Or as it was described in the Inflation Report: "The expected rise in r* over coming years, combined with the absorption of spare capacity over the forecast period, means that - even as inflation is projected to fall back toward 2% - the Bank Rate is likely to need to rise gradually to keep inflation at the target. But the persistence of the fall in the trend real rate means that any rises in the Bank Rate are expected to be limited, and interest rates are likely to need to remain low by historical standards for some time to come." That sounds like the BoE wanting to have its cake and eat it too, talking up rate hikes while making the case for rates to stay low for longer. The longer-run r-star estimates shown in the Inflation Report (between 0.5% and 1.5%) when added to the 2% BoE inflation target, suggests that the neutral nominal Bank Rate is between 2.5% and 3.5%. That does imply that there is a lot of scope for additional BoE rate hikes without even reaching a level that could be considered "'neutral' from a longer-term perspective" (Chart 7). It will be difficult for the BoE to deliver on any additional rate hikes, however, while both the economy and inflation are decelerating. The current pricing in the U.K. Overnight Index Swap (OIS) curve shows that there are only 42bps of hikes discounted by the end of 2020. That represents a very low hurdle to overcome, even if the U.K. economy remains sluggish and the Brexit outcome turns ugly. From a strategy perspective, we think that Gilt yields can rise above the current shallow path of the forward curve over the next 6-12 months, suggesting that a below-benchmark duration stance in the U.K. is appropriate. Yet with U.K. growth slowing and leading indicators suggesting more of that is to come, and with still no resolution to the Brexit negotiations with the March 29, 2019 "Brexit Day" looming in the distance, Gilt yields are likely to stay relatively subdued versus global peers. We continue to recommend an overweight stance on Gilts in hedged global bond portfolios (Chart 8). Chart 7U.K. Real Rates Are WAY Below Longer-Run R-Star Chart 8Stay Overweight U.K. Gilts Bottom Line: The Bank of England hiked rates last week, despite sluggish growth, slowing inflation and elevated Brexit uncertainties. Additional rate hikes will be difficult to deliver, however, without a change in trend for those factors. Stay overweight Gilts in global hedged bond portfolios. Bank of Japan: Zero Pressure On The 0% Target Global bond yields got a bit of a jolt recently from the most unlikely of sources - Japan, the place where bond volatility goes to die. Amid media speculation that the Bank of Japan (BoJ) was considering an upward adjustment to its JGB yield target, the 10-year JGB took several runs at breaching the BoJ's implied pain threshold of 0.10%, resulting in the BoJ intervening with offers of "unlimited" purchases to quell the selloff. Yet at the monetary policy meeting last week, the BoJ only delivered modest changes: The allowable range for the 10-year JGB yield was widened to -0.20% to +0.20% New forward guidance was introduced indicating no rate hikes until at least 2020 A shift in the BoJ's equity ETF purchases to favor ETF's that target a broader index We were not surprised by the outcome, given that there was absolutely no reason why the BoJ should have even considered a change in policy settings. Back in February, we outlined the three things that we believed must ALL occur before the BoJ could plausibly raise its yield target for the 10-year Japanese government bond (JGB).4 Five months later, none of those conditions has been met (Chart 9): 1) The USD/JPY exchange rate must at least get back to the 115-120 range. USD/JPY has struggled to reach even the bottom end of our target range, only getting to an intraday high of 113.17 on July 19th. The starting point for the yen must be weaker than that before the BoJ can deliver any sort of more hawkish policy that would likely send the yen roaring higher. 2) Japanese core CPI inflation and nominal wage inflation must both rise sustainably above 1.5%. The extremely tight Japanese labor market (Chart 10) has finally begun to put upward pressure on wage growth, which now sits at 2.2% on a year-over-year basis. There has been no follow through into core inflation, however, which only got as high at 0.5% in March before sliding back to 0.2% in June. Chart 9None Of Our Conditions For A BoJ Hike Have Been Met Chart 10How Does This Job Market Not Produce Inflation? 3) The 10-year JGB yield must reach an overvalued extreme versus U.S. Treasuries. We judge this by looking at the residual from a fundamental model of the 10-year JGB yield published by the BoJ. The model includes both the 10-year U.S. Treasury yield as the proxy for global yields, and the share of outstanding JGBs owned by the central bank to measure the impact of BoJ buying (Table 1). That model suggests that current JGB yields are only at fair value, and that U.S. Treasury yields have to rise by a lot more (to at least 3.5%) to make the current level of JGB yields look "expensive", thus justifying a higher BoJ yield target (USD/JPY would likely be in the 115-120 range if that happened, as well). Yet despite all these factors arguing against any change in the BoJ's policy settings, the topic was seriously discussed at last week's policy meeting, according to Reuters.5 The renewed weakness of Japanese inflation scuttled any chance that a serious policy change could be delivered. The decision to widen the allowable yield range for the 10-year JGB yield not associated with any signaled change to the 0% yield target. Investors got the hint, and yields have calmed down after the late July turbulence. The BoJ is increasingly backed into a corner with its hyper-easy monetary policy. There is no spare capacity in the economy, with the unemployment rate at a 25-year low of 2.4% and the BoJ estimating that the output gap is closed. Our own Japan Central Bank Monitor is no longer in negative territory, indicating that the next policy move should be a tightening (Chart 11). The BoJ has indeed been "tightening", but only by reducing the pace of its bond buying. BoJ purchases now only matches the pace of new JGB - a far cry from when the BoJ was buying more than all new JGBs issued between 2013 and 2017 (bottom two panels). Table 1JGB Yield Model Chart 11BoJ Has Been Quantitatively Tightening There is a reported disagreement within the BoJ over the impact of the negative interest rate and yield curve control policies on Japanese bank profitability and lending capacity. Yet any sort of rate hike, at either end of the yield curve, would result in a sharp increase in the yen. To have that happen now would harm Japanese exporters' competitiveness at the worst possible time. Economic growth is decelerating in two of Japan's major trading partners, China and South Korea. At the same time, U.S. protectionism risks trade wars that would slow global trade at a time when Japanese export growth, and business confidence, may already be peaking (Chart 12). We continue to recommend an overweight position in Japanese government debt within hedged global government bond portfolios. Admittedly, the idea of overweighting a market where nearly half of all bonds still have a negative yield does not sound like a path to riches. Yet the BoJ stands out as the one major central bank that has virtually no chance at credibly talking about, much less delivering, any sort of monetary tightening with core inflation close to 0%. If non-Japanese yields continue to rise over the next 6-12 months, as we expect, then JGBs will once again be a relative outperformer in a global bond bear market (Chart 13). Chart 12Japan Is Vulnerable To A Global Trade War Chart 13Stay Overweight JGBs In Hedged Global Bond Portfolios Bottom Line: The conditions for a shift higher in the Bank of Japan's bond yield targets - a weaker yen, core inflation at 1.5% and much higher U.S. bond yields - are still not yet in place. Stay overweight JGBs. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The r-star discussion can be found on pages 39-43 of the August 2018 BoE Inflation Report, which can be found here https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2018/august/inflation-report-august-2018.pdf 2 For example, the BoJ's estimates of Japan's r-star can be found here, https://www.boj.or.jp/en/research/wps_rev/wps_2018/data/wp18e06.pdf, while the Bank of Canada's estimates for Canadian r-star can be found here https://www.bankofcanada.ca/wp-content/uploads/2017/11/boc-review-autumn2017-dorich.pdf 3 The BoE estimates full employment to be around the current unemployment rate of 4.25%, which is well below the OECD's estimate of 5.5% shown in the top panel of Chart 5. 4 Please see BCA Global Fixed Income Strategy Special Report "What Would It Take For The Bank Of Japan To Raise Its Yield Target?" dated February 13, 2018, available at gfis.bcaresearch.com 5 https://www.reuters.com/article/us-japan-economy-boj-policy-insight/bojs-architect-of-shock-and-awe-plots-retreat-from-stimulus-idUSKBN1KR0TA Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights U.S. Investment Strategy is getting back to basics: We follow last week's report outlining our stance on interest rates with a review of the credit cycle and its current position. The credit cycle is not just about borrowers: Lender willingness is inversely related to loan performance over a five-year horizon, but it amplifies near-term performance swings. Our bond strategists use three broad indicators to track the credit cycle...: Valuation, monetary conditions and credit quality all offer insight into corporate bond performance. ... and we also consider the fed funds rate cycle: The way that lenders interact with the monetary policy backdrop is discouraging for the course of human evolution, but it follows a well-defined pattern that helps demarcate the credit cycle. The cycle is in its latter stages, and investors should be in the process of dialing down credit exposures: Our bond strategists downgraded spread product to neutral in mid-June, and we won't return to overweight until the next recession is well underway. Feature U.S. Investment Strategy is meant to provide analyses and forecasts of financial markets and the economy for the purpose of helping our clients make asset-allocation decisions. This report continues our focus on going back to the basics of meeting that mandate. Next week's Special Report will present a simple indicator for anticipating the onset of a recession and the end of the equity bull market. After Labor Day, we will publish a Special Report updating, and expanding upon, our work on the fed funds rate cycle. By the unofficial end of the summer, then, we will have outlined our positions on rates, credit, the business cycle, and the state of monetary policy. That will provide us with a framework for evaluating incoming data and engaging in an ongoing investment-focused dialogue. It will also hopefully put us in position to identify the first set of major cyclical inflection points since 2007-8 in a timely fashion. 2019 is shaping up as a pivotal year for asset allocation, and we look forward to navigating it alongside our clients. Lenders Never Learn, Part I: Lending Standards Investors typically think of the credit cycle exclusively in terms of borrower performance. After all, cycle peaks and troughs are defined by default-rate troughs and peaks. There are two parties to every loan, though, and a narrow focus on debtors precludes a full understanding of the landscape. The credit cycle encompasses lender willingness as well as borrower performance. Bad loans are made in good times, just as surely as good loans are made in bad times. Skepticism and gloom carry the day in a recession and its immediate aftermath, and the loans that manage to get made early in the credit cycle are tightly underwritten, insulated with a margin of safety that would warm Benjamin Graham's heart. As the cycle stretches on, however, lenders forget about the trauma of the last downturn and focus more on market share than standards. The fact that standards impact performance with a lag much longer than the annual bonus cycle obscures their importance and helps them persist. Like the rest of us, loan officers and their managers learn best when they receive immediate feedback that clearly results from their decisions. Over the three-decade history of the Federal Reserve's senior loan officer survey the last three cycles, however, it appears that lending standards impact loan performance with as much as a five-year lag. The Chart Of The Week shows the net percentage of loan officers tightening standards for commercial and industrial (C&I) loans to large and mid-sized companies, inverted and advanced by 20 quarters. Easy standards line up with peak defaults, and tight standards align with default troughs. Chart of the WeekLending Standards Are Negatively Correlated With Intermediate-Term Loan Performance ... The lag between loan approval and loan performance is far too long to reinforce learning, however. Over the course of five years, factors that could not have been foreseen at origination may well end up precipitating a default. Lenders' response to that long-term uncertainty may help explain the positive short-term correlation (Chart 2). Partially goaded by pro-cyclical loan-loss reserve standards, lenders react to surging default rates by getting more conservative, nudging default rates higher in a feedback loop that plants the seeds for strong intermediate-term performance. Chart 2... But They March In Lockstep With Loan Performance In The Near Term Bottom Line: 2014's cyclical bottom in standards suggests that rising default rates will not peak until late 2019 or 2020. Increased near-term lender caution will reinforce the upward move. Tracking The Credit Cycle: Default Rates When the economy is expanding, borrowers in the aggregate find it easier to service their debts, just as recessions make debt service more onerous. The pro-cyclicality of inflation, which eases debt burdens, helps reinforce the relationship. There is more to tracking the credit cycle than tracking the business cycle, however. While defaults have peaked within five months after the end of the last three recessions, default-rate troughs have varied wildly, occurring anywhere from six years before the recession to the month it began (Chart 3). Our credit strategists try to identify the point at which defaults begin to take off by tracking lending standards, monetary conditions, and credit quality. None of these factors suggests that default rates can make new lows. The loan officer survey could improve, but tight spreads leave almost no room for the bond market to become more receptive (Chart 4). Monetary conditions are steadily becoming less accommodative, helped along by the rate-hike/dollar-strength loop (Chart 5). Our bond strategists expect that credit quality will weaken as soon as upward wage pressure snuffs out pre-tax corporate profits'1 ability to keep up with double-digit debt growth. It's hard to say just when default rates will begin to erode total returns in a meaningful way, but our bond strategists are of a mind that risk is rapidly catching up with reward. Chart 3The Business Cycle Reliably Calls Peaks,##BR##But It's No Help With Troughs Chart 4Little Room##BR##For Improvement Chart 5Tightening,##BR##But Not Yet Tight Tracking The Credit Cycle: Corporate Spreads Chart 6Spreads Aren't Ready To Blow Out Yet High-yield data only exist for the last two spread-widening episodes, but what they lack in quantity they make up for in consistency. Heading into both the dot-com bust and the financial crisis, spreads did not widen in earnest (Chart 6, top panel) until the Fed had completed its tightening cycle (Chart 6, second panel), BCA's proprietary Corporate Health Monitor (CHM) began to deteriorate (Chart 6, third panel), and lenders tightened their standards (Chart 6, bottom panel). That template suggests that spreads are not poised to blow out anytime soon, as we expect the Fed will not be finished tightening before the end of 2019 (or later), and lenders are still actively easing their standards for commercial borrowers. As noted above, we expect that deterioration in the CHM will pick up again, once runaway profit growth ceases to paper over surging leverage. All in all, our bond strategists do not think it is anywhere near time to panic. As with defaults, they think it is still too soon to expect the beginning of sustained spread widening. On balance, however, the indicators suggest that return expectations should be modest, and limited to coupon yields. It is too late to buy bonds with the expectation of realizing capital gains, and prudent return projections should pencil in some minor capital losses. Lenders Never Learn, Part II: The Fed Funds Rate Cycle The fed funds rate cycle has been a U.S. Investment Strategy pillar, informing many of our views on cycles and asset markets. We will publish a Special Report delving into it more fully the first week of September, but a quick summary is sufficient to illustrate its relevance to the credit cycle. We divide the fed funds rate cycle into four phases based on whether the Fed is hiking rates or cutting them, and whether or not the fed funds exceeds our estimate of the equilibrium rate. Per our stylized representation of the cycle (Chart 7), we are currently in Phase I (the Fed is hiking, but policy remains accommodative) and are likely to remain there until the second half of 2019, when we expect that policy will turn restrictive, ushering in Phase II. While we have found that the level of the fed funds rate trumps its direction when it comes to explaining equity and bond returns, loan growth is more sensitive to the direction of rates. Banks expand their loan books more rapidly when the Fed is tightening than they do when it's easing. The effect is most pronounced for C&I loans, which grow five times faster during rake-hiking campaigns than they do during rate-cutting campaigns (Table 1). The conclusion may seem counter-intuitive on its face, but one must remember that the Fed is charged with leaning against the cycle: it tightens when times are good to keep them from becoming too good, and its eases when times are bad to get the economy back on its feet. Chart 7The Fed Funds Rate Cycle Table 1An Example Of What Not To Do Lenders who take a countercyclical tack operate with the policy wind at their back. Those who follow the cycle are actually fighting the Fed. Most lenders short-sightedly follow the crowd aping the cycle, basing future projections on the most recent data samples and hewing to career incentives that encourage herding. Bankers who load up on loans when the cycle is demonstrably old and approaching its peak make two errors: they ignore a well-established cyclical pattern (tightening leads recessions, which lead defaults and higher losses given default), and they deploy capital when it's widely available in the marketplace, but husband it when it's scarce. Bottom Line: Banks reinforce the credit cycle by avidly deploying capital when conditions are about to take a turn for the worse, and withholding it when they're about to get better. We recommend investors reject their example, and limit their exposure to spread product. Investment Implications If our view that the Fed is going to hike rates more than the consensus expects is correct, all bonds will have to contend with a persistent headwind. Thanks to positive carry, and high-yield bonds' structurally shorter duration, spread product will be less vulnerable than Treasuries. Our bond strategists are nonetheless lukewarm on the risk-reward offered by investment-grade and high-yield bonds. The cycle is clearly in its latter stages and spreads are historically tight. We remain constructive on both the business cycle and the monetary policy cycle, and we are not yet ready to throw in the towel on the equity bull market. Although our equity take is more sanguine than the BCA consensus, our optimism does not extend to the credit cycle, which has clearly passed its peak. While neither modest spread widening nor a mild pickup in defaults is likely to wipe out all of spread product's excess returns, we do not expect that they will be large enough to merit more than benchmark weighting in balanced portfolios. Our sister Global ETF Strategy service's model portfolios hold benchmark spread-product positions (while underweighting Treasuries, maintaining below-benchmark duration across all bond categories, and overweighting cash) and that is the way we intend to be positioned in the small basket of ETFs we will recommend once we've completed our review of the most impactful macro drivers. A Note On Payrolls Friday's Goldilocks employment situation report for July reinforced our views on the economy and rates, but it was mixed enough to have satisfied anyone's preconceived notions. July's net payroll gains fell shy of the consensus expectation, but revisions to May and June pushed the 3-month moving average of net gains to over 224,000, slightly above expectations. Neither hours worked nor average hourly earnings set off any alarm bells, but the "hidden" unemployment rate slid 30 basis points to 7.5%, the lowest level since May 2001. We see the seeds of future inflation pressures in the continued absorption of slack, and believe that the Fed does as well. We continue to expect four hikes this year and next, two more than the money market is currently discounting. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Annualized profit growth calculated with data from the BEA's National Income and Profit Accounts.

Highlights Paradox 1: U.S. growth will slow, and this will force the Fed to raise rates MORE quickly. Paradox 2: China will try to stimulate its economy, and this will HURT commodities and other risk assets. Paradox 3: Global rebalancing will require the euro area and Japan to have LARGER current account surpluses. Feature Faulty Assumptions Investors assume that slower U.S. growth will cause the Fed to turn more dovish; efforts by China to stimulate its economy will boost market sentiment towards risk assets; and global rebalancing requires the euro area and Japan to reduce their bloated current account surpluses. In this week's report, we consider the possibility that all three assumptions are wrong. Let's start with the U.S. growth picture. U.S. Growth About To Slow? The U.S. economy grew by 4.1% in the second quarter, the fastest pace since 2014. The composition of growth was reasonably solid. Net exports boosted real GDP by 1.1 percentage points, but this was largely offset by a 1.0 point drag from a slower pace of inventory accumulation. As a result, domestic final demand increased at a robust rate of 3.9%, led by personal consumption (up 4.0%) and business fixed investment (up 7.3%). Unfortunately, the second quarter is probably as good as it gets for growth. We say this not because we expect aggregate demand growth to falter to any great degree. Quite the contrary. Consumer confidence is high and the labor market is strong, with initial unemployment claims near 49-year lows. The Bureau of Economic Analysis' latest revisions revealed a much higher personal savings rate than had been previously estimated (Chart 1). The savings rate is now well above levels that one would expect based on the ratio of household net worth-to-disposable income (Chart 2). This raises the odds that consumer spending will accelerate. Chart 1Households Are Saving More ##br##Than Previously Thought Chart 2Consumption Could Accelerate ##br##As The Savings Rate Drops Rising consumer demand will prompt businesses to expand capacity (Chart 3). Core capital goods orders surprised on the upside in June, with positive revisions made to past months. Capex intention surveys remain at elevated levels. So far, fears of a trade war have not had a major impact on business investment. Fiscal spending is also set to rise. Federal government expenditures increased by only 3.5% in Q2, far short of the 10%-plus growth rate that some forecasters were projecting. The effect of the tax cuts have also yet to make their way fully through the economy. Supply Matters Considering all these positive drivers of demand, why do we worry that growth could slow meaningfully later this year or in early 2019? The answer is that for the first time in over a decade, demand is no longer the binding constraint to growth - supply is. Today, there are fewer unemployed workers than job vacancies (Chart 4). The number of people outside the labor force who want a job is near all-time lows. Businesses are reporting increasing difficulty in finding qualified labor. Chart 3U.S. Companies Plan To Boost Capex Chart 4Companies Are Struggling To Fill Job Openings New business investment will add to the economy's productive capacity over time, but in the near term, the boost to aggregate demand from new investment spending will easily exceed the contribution to aggregate supply.1 The Congressional Budget Office estimates that potential real GDP growth is running at around 2%. What happens when the output gap is fully eliminated, and aggregate demand growth begins to eclipse supply growth? The answer is that inflation will rise. Instead of more output, we will see higher prices (Chart 5). Chart 5Inflationary Pressures Tend To Increase ##br##When Spare Capacity Is Absorbed Rising inflation will force the Fed to engineer an increase in real interest rates, even in the face of slower GDP growth. Such a stagflationary outcome is not good for equities, which is one reason why we downgraded our cyclical recommendation on risk assets from overweight to neutral in June. Higher-than-expected real interest rates will put upward pressure on the U.S. dollar. A stronger dollar will hurt U.S. companies with significant foreign exposure more than it hurts their domestically-oriented peers. If history is any guide, a resurgent greenback will also cause credit spreads to widen (Chart 6). Chinese Stimulus: Be Careful What You Wish For Chinese stimulus helped reignite global growth after the Global Financial Crisis and again during the 2015-2016 manufacturing downturn. With global growth slowing anew, will China once again come to the rescue? Not quite. China does not want to let its economy falter, but high debt levels, and an overvalued property market plagued by excess capacity, limit what the authorities can do (Chart 7). Chart 6A Stronger Dollar Usually Corresponds ##br##To Wider Corporate Borrowing Spreads Chart 7China: High Debt Levels Make ##br##Credit-Fueled Stimulus A Risky Proposition Granted, the government has loosened monetary policy at the margin and plans to increase fiscal spending. However, our China strategists feel these actions are more consistent with easing off the brake than pressing down on the accelerator.2 They note that the authorities continue to squeeze the shadow banking system, as evidenced by the continued deceleration in money and credit growth, as well as rising onshore spreads for the riskiest corporate bonds (Chart 8). The Specter Of Currency Wars If Chinese growth continues to decelerate, what options do the authorities have? One possibility is to double down on what they are already doing: letting the RMB slide. Chart 9 shows that the Chinese currency has weakened substantially more over the past six weeks than its prior relationship with the dollar would have suggested. Chart 8Chinese Credit Growth Has Been Slowing Chart 9The Yuan Has Weakened More Than Expected ##br##Based On the Broad Dollar Trend Letting the currency weaken is a risky strategy. Global financial markets went into a tizzy the last time China devalued the yuan in August 2015. The devaluation triggered significant capital outflows, arguably only compounding China's problems. This has led some commentators to conclude that the authorities would not make the same mistake again. But what if the real mistake was not that China devalued its currency, but that it did not devalue it by enough? Standard economic theory says that a country should always devalue its currency by enough to flush out expectations of a further decline. Perhaps China was simply too timid? Capital controls are tighter in China today than they were in 2015. This gives the authorities more room for maneuver. China is also waging a trade war with the United States. The U.S. exported only $188 billion of goods and services to China in 2017, a small fraction of the $524 billion in goods and services that China exported to the United States. China simply cannot win a tit-for-tat trade war with the United States. In contrast, China is better positioned to wage a currency war with the United States. The Chinese simply need to step up their purchases of U.S. Treasurys, which would drive up the value of the dollar. Efforts by China to devalue its currency would invite retaliation from the United States. However, since the Trump Administration seems keen on pursuing a protectionist trade agenda no matter what happens, the Chinese may see their decision to weaken the yuan as the least bad of all possible outcomes. Unlike traditional stimulus in the form of additional infrastructure spending and faster credit growth, a currency devaluation would roil financial markets, causing risk asset prices to plunge. Metal prices would take it on the chin, since a weaker RMB would make it more expensive for Chinese businesses to import commodities. China now consumes close to half of the world's supply of copper, zinc, nickel, aluminum, and iron ore (Chart 10). Investors should remain underweight emerging market equities relative to developed markets and shun the currencies of commodity-exporting economies. We are currently short AUD/CAD on the grounds that a China shock would hurt metal prices more than energy prices. The Canadian dollar is highly levered to the latter, while the Aussie dollar is more levered to the former. Global Rebalancing: It's Not About Getting To Zero We have argued before that China's high savings rate explains why the country has maintained a structural current account surplus, despite the economy's rapid GDP growth rate.3 Both the euro area and Japan also have an excessive savings problem, minus the mitigating effect of rapid trend growth. The euro area's excessive savings problem was masked during the nine years following the introduction of the euro by a massive credit boom across much of the region (Chart 11). Germany did not partake in that boom, but it was still able to export its excess savings to the rest of the euro area via a rising current account balance. Chart 10China Is A More Dominant Consumer ##br##Of Metals Than Oil Chart 11Germany Did Not Take Part ##br##In The Credit Boom Germany Needs A Spender Of Last Resort Chart 12 shows that Germany's current account surplus with other euro area members mirrored the country's increasing competitiveness vis-à-vis the rest of the region. In essence, the spending boom in southern Europe sucked in German exports, with German savings financing the periphery's swelling current account deficits. This is the main reason why German banks were hit so hard during the Global Financial Crisis: They were the ones who underwrote the periphery's spendthrift ways. That party ended in 2008. With the periphery no longer the spender of last resort in Europe, Germany had to find a way to export its savings to the rest of the world. But that required a cheaper currency, which Mario Draghi ultimately delivered in 2014 when he set in motion the ECB's own quantitative easing program. So where do we go from here? Germany's excess savings problem is not about to go away anytime soon. The working-age population is set to decline over the next few decades, which means that most domestically oriented businesses will have little incentive to expand capacity (Chart 13). The peripheral countries remain in belt-tightening mode. This will limit demand for German imports. Meanwhile, countries such as Spain have made significant progress in reducing unit labor costs in an effort to improve competitiveness and shift their current account balances back into surplus. Chart 12Competitiveness Gains In The 2000s Allowed ##br##Germany To Increase Its Current Account Surplus Chart 13Germans Need To Have More Children The ECB And The BOJ Can't Afford To Raise Rates The private sector financial balance in the euro area - effectively, the difference between what the private sector earns and spends - now stands near a record high (Chart 14). Fiscal policy also remains fairly tight. The IMF estimates that the euro area's cyclically-adjusted primary budget balance will be in a surplus of 0.9% of GDP in 2018-19, compared to a deficit of 3.8% of GDP in the United States (Chart 15). Chart 14Euro Area: Private Sector ##br##Balance Remains Elevated Chart 15The Euro Area's Fiscal Policy Is Tight If the public sector is unwilling to absorb the private sector's excess savings by running large fiscal deficits, those savings need to be exported abroad in the form of a current account surplus. Failure to do so will result in higher unemployment, and ultimately, further political upheaval. This means that the ECB has no choice other than to keep rates near rock-bottom levels in order to ensure that the euro remains cheap. Japan has been more willing than Europe to maintain large budget deficits, but the problem is that this has resulted in a huge debt-to-GDP ratio. The Japanese would like to tighten fiscal policy, starting with the consumption tax hike scheduled for October 2019. However, this may require the economy to have an even larger current account surplus, which can only be achieved if the yen weakens further. This, in turn, suggests that the Bank of Japan will not abandon its yield curve control policy anytime soon. We were not in the least bit surprised this week when Governor Kuroda poured cold water on the idea that the BoJ was contemplating raising either its short or long-term interest rate targets. The bottom line is that thinking about global imbalances solely in terms of current account positions is not enough. One should also think about the distribution of aggregate demand across the world. Countries with demand to spare such as the United States can afford to run current account deficits, while economies with insufficient demand such as the euro area and Japan should run current account surpluses. The key market implication is that interest rates will remain structurally higher in the United States, which will keep the dollar well bid. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This is partly because it can take a while for additional capital spending to raise aggregate supply. For example, it may take a few years to build an office tower or a new factory. Corporate R&D investment may not generate tangible benefits for a long time, especially in cases where the research is focused on something complicated (i.e., the design of new computer chips or pharmaceuticals). And even if investment spending could be transformed into additional productive capacity instantaneously, aggregate demand would still rise more than aggregate supply, at least temporarily. Here is the reason: The nonresidential private-sector capital stock is about 120% of GDP in the United States. As such, a one percent increase in investment spending would raise the capital stock by four-fifths of a percentage point. Assuming a capital share of income of 40% of national income, a one percent increase in the capital stock would lift output by 0.4%. Thus, a one-dollar increase in business investment would boost aggregate demand by one dollar in the year it is undertaken, while increasing supply by only 4/5*0.4 = roughly 32 cents. 2 Please see China Investment Strategy Weekly Report, "China Is Easing Up On The Brake, Not Pressing The Accelerator," dated July 26, 2018. 3 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights President Trump has expressed dissatisfaction with the Fed's policy tightening. However, we do not think he will be able to influence policy in a dovish fashion this cycle. Trump has suggested that many nations are manipulating their exchange rates to the detriment of the U.S. We do not see the U.S. as having the same capacity to force large exchange rate appreciation for its trading partners as it previously did. We expect instead this rhetoric to result in more favorable trade deals for the U.S. As a result, while we believe Trump's rhetoric was the catalyst for a much-needed correction in the dollar, his utterances do not mark the end of the dollar rally for 2018. We have been hedging the dollar's short-term downside by selling USD/CAD. We do not anticipate the BoJ to tweak its YCC policy next week. As a result, we fade the yen's recent strength against the dollar. However, we do believe the global economic outlook warrants staying long the yen against the euro and the Aussie for the remainder of the year. Feature U.S. President Donald Trump has begun to fight back against the impact of his stimulative fiscal policy. Obviously, it is not that he is displeased with the decent growth and job performance of the U.S. Instead, he is not happy that this increase in economic activity and build-up in inflationary pressures is causing the Federal Reserve to hike interest rates faster than he would like, and the dollar to be stronger as well. Despite President Trump's intentions, it is unlikely that he actually has enough levers to push the Fed to conduct easier monetary policy, and it is even more doubtful that he can push the dollar lower by pressuring the euro area, China, and other trading partners to revalue their currencies. The Fed Is No Pushover While BCA has argued that President Trump is unconstrained when it comes to his international agenda, there are certainly large constraints on his domestic agenda. When it comes to the Fed, this constraint is binding, as the Federal Reserve Act of 1913 clearly states that the U.S. central bank is a creature of Congress. Moreover, historically, the Fed has been a staunch defender of its independence. As Chart I-1 illustrates, through the post-war period, even when we include the 1970s when former U.S. President Richard Nixon's interferences temporarily eroded the Fed's independence, the U.S. central bank has been among the most fiercely independent monetary guardians in the G-10. Chart I-1The Fed Values Its Independence The 1970s offer a counter-argument to the view that the President has little influence on the Fed. However, Nixon chose Arthur Burns as Fed Chair in 1970 with the goal of maintaining very easy policy. Moreover, Burns continued to target full employment as his priority, which meant inflationary pressures only grew larger in response to the 1973 oil shock. This is in sharp contrast with today's Fed. In opposition to the period prior to the 1977 amendment of the Federal Reserve Act, which required the Fed to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," the Fed is now much more focused on controlling inflation - even if this means more frequent large overshoots in unemployment (Chart I-2). Chart I-2Trump's Fed Is Not Nixon's Fed This means that in today's context, the Fed will continue to push rates higher in order to combat inflationary pressures in the U.S. (Chart I-3). Moreover, as Chart I-4 illustrates, our composite capacity utilization measure shows that the U.S. economy is experiencing its tightest conditions since the late 1980s. Historically, such a dearth of economic slack is accompanied by higher interest rates. Chart I-3Upside Risks To U.S. Inflation Budding Price Pressures Chart I-4Maximum Pressure... Capacity Pressures That Is This also means that it is highly unlikely the Fed will sit idly by in front of the large amount of fiscal stimulus implemented in the U.S. while the economy is at full employment (Chart I-5). Not since the late 1960s has the U.S. experienced this kind of a policy mix. While in the late 1960s it took some time for inflationary pressures to emerge, they ultimately did with much vigor by 1968. However, for inflation to become as pernicious a force as it was in the 1970s, the Fed had to maintain too-easy monetary policy. With its dual mandate that includes keeping inflation at bay, we doubt the Fed will allow the 1970s experience to repeat itself.1 Chart I-5Trump Will Push Rates Higher While this means that President Trump is unlikely to be able to affect policy this cycle, it does not mean that he has zero levers. He can ultimately change the Fed leadership to find a great dove; however, this will require that he waits until Fed Chairman Jerome Powell's term ends - something not in sight until 2020. And really, who can he find today that is that dovish; we doubt that Paul Krugman will make any Trump shortlist for Fed leadership anytime soon. In the meantime, we would anticipate President Trump to continue to voice his displeasure with the Fed's policy, as at the very least it will give him a culprit to blame in 2020 if the economy does not perform as he has promised. As a result, we remain confident that the Fed is likely to try to follow the path of rate hikes it currently envisions in its latest set of forecasts. As Chart I-6 illustrates, this path for policy remains above the path currently anticipated in the market. Moreover, we do not believe the Fed will tighten more than it currently anticipates only to assert its own independence. For the Fed to deviate from its current interest rate forecast, economic growth and inflationary pressures will also have to significantly deviate from current expectations, not for Trump to grow louder. Chart I-6U.S. Rate Pricing Has Upside Bottom Line: President Trump may express his unhappiness with the Fed's hiking campaign, but he can do little more than complain. For now, he cannot affect monetary policy directly, as the Fed is very independent and is very set on limiting the long-term upside to inflation. Since the White House's policies are inflationary, we expect the Fed to continue to tighten as per its current intended path. Trump will only be able to affect policy in a dovish fashion once he gets to change the Fed's leadership. In the meantime, blaming the Fed is an insurance policy for 2020: if the economy is not as strong as he promised, someone else will be responsible for it. Currency Manipulators? Another issue raised by President Trump has contributed to the recent decline in the dollar: His assertions that various currencies, including the euro, are being manipulated downward. Is there much to this assertion, and can the White House do anything to generate downward pressure on the dollar? Let's begin with China. We have argued that at the very least, the Chinese authorities are facilitating the recent slide in the RMB. As Chart I-7 illustrates, CNY/USD is much softer than implied by the level of the dollar itself. If we want to stretch the argument that one country is pushing down its currency today, it is China. Can President Trump do much about it? For the time being, we doubt it. The White House has announced a flurry of implemented and proposed tariffs on China (Chart I-8), and in the interim, the CNY has not strengthened; it has only weakened. Instead of letting the U.S. bully them on their exchange rate policy, it seems the Chinese authorities are finding other means to alleviate the pain created by U.S. tariffs. Chart I-7China Is Manipulating Its Currency... Chart I-8... And Is Already Facing An Onslaught Of Tariffs... To begin with, the People's Bank of China has injected RMB502 billion into the banking system in recent weeks in order to put downward pressure on overnight rates. Most importantly, earlier this week, it was revealed that the State Council in Beijing would accelerate the issuance of CNY1.4 trillion in local government bonds to support infrastructure. This significant amount of fiscal stimulus may not be enough to prevent China from slowing in response to its own deleveraging effort, it is nonetheless likely to soften the blow to the Chinese economy created by the Trump tariffs. Essentially, we believe that China wants to avoid the shock Japan suffered in the wake of the 1985 Plaza accord. In the 1980s, U.S. President Ronald Reagan and the American public were fed up with the growing Japanese trade surplus with the U.S. The White House started proposing tariffs on Japanese exports and ultimately got Japan to revalue the yen violently. However, this huge yen rally had massively deflationary consequences for Japan. At first, the Bank of Japan responded by cutting rates, inflating the Japanese bubble in the process. Once the bubble popped and the Japanese private sector debt burden was laid bare, the true deflationary impact of the sudden yen revaluation became evident (Chart I-9). To this day, Japan is still dealing with the consequences of these series of policy mistakes. Chart I-9... But It First And Foremost ##br##Wants To Avoid Japan's Fate Today, Chinese policymakers not only benefit from the insight of Japan's disastrous experience, but also they already face an enormous debt problem. China's corporate debt stands at 160% of GDP, versus Japan's corporate debt, which stood at 110% of GDP in 1985 when the yen began appreciating and 135% of GDP in 1989 just before the bubble burst. The deflationary consequences of a large FX revaluation are thus at least as dangerous in China today as they were in Japan in the 1980s. In fact, if China is serious about deleveraging and reforming its economy, it will need a cheap currency to ease the deflationary impact of these domestic economic adjustments. On the political front, the U.S. does not have the same levers on China today as it did on Japan in the 1980s. The U.S. is not a military ally; it does not defend the Middle Kingdom against foreign attacks. However, the U.S. was - and still is - Japan's most important military ally, its protector against the Soviet Union in the 1980s and China today. As a result, while Reagan was able to threaten Tokyo with the removal of the U.S. military umbrella, Trump does not have the same tool when it comes to China. Hence, we continue to expect that the outcome of the China-U.S. trade conflict to more likely result in a renegotiation of bilateral investments, tariffs and quotas than a sharply higher RMB. What about Trump's stance on the euro? After all, the U.S. does remain the EU's most important military ally, and the key financial contributor to NATO. This should count as leverage, no? Politically Europe is not as beholden to the U.S today as it was in the 1980s. As Marko Papic argues in BCA's Geopolitical Strategy service, the international political order has entered a multipolar state, with various regional powers vying for local dominance. In the 1980s, the world had two poles of power: the U.S. and the Soviet Union. Back then, Moscow constituted a real threat to Western Europe, as Warsaw Pact nations had tanks parked at the EUs border. Today, this is no longer the case. Russia has weakened, its army is technologically beleaguered, and, in fact, Russia is more dependent on the EU than a threat. As a result, the support of the U.S. is not as crucial to Europe as it once was. Moreover, as Marko also argues, global trade is not expanding as fast as it once was. This means that the U.S. allies are not as likely to tolerate a higher exchange rate as they once were. Essentially, in the 1970s and 1980s, Europe was willing to pushup its exchange rates and absorb an immediate negative shock in order to reap the benefits of growing trade later. This is not feasible anymore as future export growth will not be large enough to compensate for the immediate cost of a euro revaluation. This will limit the tolerance of Europeans to pushup the euro just because the U.S. asked them to do so.2 Nonetheless, President Trump is correct to insist that the euro is cheap, and that this is contributing to the huge trade surplus that Europe runs with the U.S. (Chart I-10). However, the euro area does not target a lower exchange rate, and the European Central Bank does not actively sell euros in the open market. Instead, the undervaluation of EUR/USD simply reflects the fact that the ECB continues to conduct very stimulative monetary policy, which is dragging European real rates lower versus the U.S. It is because of this domestic imperative that EUR/USD remains cheap (Chart I-11). Chart I-10European Exports Are ##br##Benefiting From A Cheap Euro.. Chart I-11... But This Cheapness Is A Consequence##br## Of Diverging Monetary Policies However, we think Europe does still need much easier monetary policy than the U.S. because: European growth is lagging that of the U.S. (Chart I-12); The European output gap remains negative, while the U.S.'s is now positive; The U.S. will receive a much larger dose of fiscal stimulus than Europe in 2018 and 2019 (Chart I-13). Chart I-12U.S. Growth Still##br## Outperforms Europe's... Chart I-13... And The Relative Fiscal Policy Points##br## To Continued Monetary Divergences This means that we do not expect the euro's long-term undervaluation to get anywhere near corrected this year. In fact, while we have argued that the dollar is likely to experience a correction in the very near term,3 we continue to anticipate that EUR/USD will make deeper lows later in 2018. As we have highlighted, the euro may be cheap on a long-term basis, but it continues to trade at a premium to its short-term drivers (Chart I-14). Moreover, relative inflation between the U.S. and the euro area has been a powerful driver of anticipated monetary policy shifts between these two economies. As a result, relative core inflation has been a good prognosticator of EUR/USD, and currently points to a lower euro (Chart I-15). Therefore, we are not closing our long DXY trade in the face of the dollar's anticipated correction. Instead, we prefer to hedge our risk through this countertrend move by selling USD/CAD. Chart I-14The Euro Is Not A Buy Yet... Chart I-15... And Will Not Become So Until Later This Year Bottom Line: President Trump can call China and Europe currency manipulators if he wants to, but this does not mean he has much leverage over these two economies. China already has a large debt load and is vulnerable to the kind of deflationary shock that Japan endured in the wake of the yen's appreciation following the 1985 Plaza Accord. This limits Beijing's willingness to let the CNY appreciate. Meanwhile, the euro is not manipulated per se; its undervaluation only reflects the fact that Europe needs much easier monetary policy than the U.S. This state of affairs is not changing this year. Thus, only once Europe is ready to withstand higher interest rates will the euro's undervaluation disappear. Japan: The End of YCC? Rumors have been circulating this week that the Bank of Japan may tweak its Yield Curve Control Strategy as soon as next week's Monetary Policy meeting. We are skeptical. First, it is true that Japanese wages have been accelerating in response to the tightest labor market conditions in 30 years (Chart I-16). However, Japanese inflation excluding food and energy has again weakened to 0.3%, pointing to the difficulty the country has in achieving its 2% inflation target. Second, economic numbers have been quite mixed. Japanese Manufacturing PMIs have weakened to 51.6 from as high as 54.8, five months ago. Moreover, industrial production has softened, heeding the message from the sagging shipments-to-inventories ratio (Chart I-17). As a result, capacity utilization will remain too low to be consistent with upward risk to core CPI. Chart I-16Strengthening Japanese ##br##Wages Are Inflationary... Chart I-17... But Capacity Utilization Concerns ##br##Cap The Upside To Inflation Third, money growth has also slowed significantly in Japan, and is now at the low end of the post-Abenomics experience (Chart I-18). This weighs on the outlook for both growth and inflation. Fourth, if there were a valid reason to removed YCC it would be if banks were in danger. After all, low rates and a flat yield curve hurt banks' profitability, potentially creating risks to the financial system. However, as Chart I-19 shows, Japanese regional banks have not experienced any meaningful downward pressure on their profits since YCC has been implemented, and are far from generating aggregate losses. Chart I-18Japanese Money Trends Do Not Justify Tweaking YCC Chart I-19YCC Does Not Yet Threaten Japanese Banks Health Fifth, it is customary in Japan policy circles to float trial balloons to test policy ideas. It is very likely that the recent rumors of a tweak to YCC were such a balloon. However, the market impact of this trial was clear: a rallying yen, rising yields and falling equity prices. All these market moves suggest that if YCC was indeed tweaked next week, Japan would experience a violent tightening in monetary conditions - exactly what the BoJ wants to avoid if it ever wishes to hit its 2% inflation target. Moreover, we do not read much into the decline of JGB purchases by the Japanese central bank. The BoJ does not need to buy many JGBs in order to cap Japanese bond yields. Instead, speculators can force JGB yields towards the BoJ's target, on the expectation that if JGB yields deviate too much from this target, the BoJ will force bond prices back to its objective. We think these dynamics are currently at play, explaining why the BoJ has not been buying JPY80 trillion of JGBs per annum. Instead, we think that the BoJ will stay the course with YCC. While Japanese wages are stronger than they have been for 20 years, they are still not consistent with 2% inflation. As such, the BoJ needs to engineer further labor market tightening for inflation to move to target. Even in the U.S., where the economy is not in the thralls of deep-seated deflationary pressures, the job-hoppers are the ones pocketing the lion's share of accelerating wages - not people staying in their current positions (Chart I-20). Since Japanese workers do not tend to switch jobs, the Japanese labor market needs to become a genuine pressure cooker before inflation can rise meaningfully. The BoJ will thus need to maintain very easy monetary policy. Chart I-20You Need To Leave Your Job To Get A Raise As a result, we are not buying into the current rally in the yen versus the dollar. We do believe the yen can continue to perform well this year versus the euro and the AUD, but this is because we expect the U.S. monetary policy to tighten along with China's efforts to de-lever to continue to weigh on EM asset prices, EM economic activity, and thus global trade. In the short term, the yen could correct against these currencies as we continue to foresee a temporary correction in "growth slowdown" trades. But ultimately we expect the yen to continue to rally against the more pro-cyclical euro and Australian dollar. Bottom Line: The BoJ will not adjust YCC next week. Japanese wages may have picked up, but inflation itself is not only still well below target, it has weakened of late. Additionally, economic growth is not strong enough to justify a removal of monetary accommodation, especially as YCC has not negatively affected the health of regional banks. As a result, we recommend investors fade the recent strength in the yen versus the dollar. The yen still has room to rally further against the EUR and AUD over the course of the next six to nine months, but this is a reflection of our stance on global growth and EM asset prices, not a consequence of any anticipated shift in YCC. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, "Trump: No Nixon Redux", dated December 2, 2016, available at fes.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, "The Dollar May Be Our Currency, But It Is Your Problem", dated July 25, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Reports, "Time To Pause And Breathe" dated July 6, 2018 and "That Sinking Feeling", dated July 13, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Recent data in the U.S. has been mixed: Markit Manufacturing PMI came in at 55.5, outperforming expectations. It also increased from last month's reading. However, both services and composite PMI underperformed expectations, coming in at 56.2 and 55.9 respectively. Finally, existing home sales surprised to the downside, coming in at 5.38 million. This measure also decreased compared to last month's reading. The DXY has declined by roughly 1.3% this week. We are bearish on the dollar on a tactical basis. Stretched positioning in the USD as well as a respite in the global growth slowdown due to Chinese easing will combine to temporarily weigh on the greenback. However, we believe the DXY will resume its uptrend before year-end, as a combination of fed tightening, slower global growth, and positive momentum will help the dollar on a cyclical basis. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Euro Recent data in the Euro area has been mixed: Manufacturing PMI outperformed expectations, coming in at 55.1, and increasing from last month's reading. Moreover the German IFO, also outperformed expectations, coming in at 101.7. However, both Markit Composite PMI and Markit Services PMI underperformed expectations, coming in at 54.3 and 54.4 respectively, while also decreasing from last month's numbers. Finally, Belgian Business confidence showed a deceleration in the month of July. EUR/USD is flat this week, as the surge at the beginning of the week was counteracted by a relatively dovish announcement by the ECB yesterday. On a 6-month basis we are bearish on the euro, given that the cumulative tightening by both the People's Bank of China and the Fed will still combined in a toxic cocktail for global growth, and hence, drag the euro lower in the process. Report Links: Time To Pause And Breathe - July 6, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Yen Recent data in Japan has been mixed: The Nikkei Manufacturing PMI underperformed expectations, coming in at 51.6. It also decreased from last month's reading of 53. However, the All Industry Activity Index month-on-month growth outperformed expectations, coming in at 0.1%. USD/JPY has declined by roughly 1.5%, partly due to the fall in the U.S. dollar, but also because of the newly perceived hawkish tone by the BoJ. On a short-term basis, we continue to be bullish on the yen against the euro and the Aussie, as we expect Chinese deleveraging to add volatility to the markets. On a longer-term basis, however, we are bearish on the yen, as the BoJ will have to remains very accommodative in order to meet its inflation mandate. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 British Pound Recent data in the U.K. has been positive: Public sector net borrowing outperformed expectations, coming in at 4.530 billion pounds. This measure also increased relatively to last month's number. Moreover, mortgage approvals also surprised to the upside, coming in at 40.541 thousand. This measure also increased relatively to last month's number. Finally, the CBI Distributed Trades Survey also surprised positively, coming in at 20%. GBP/USD has risen by nearly 1.5% this week. Overall, we are cyclically bearish on the pound, as the uncertainty of the Brexit negotiations continue to weigh on capital flows into the U.S. Moreover, the rise in the dollar will add further downward pressure to cable. That being said, the pound could have some upside against the euro, given that the U.K. is less exposed to global trade and industrial activity than its continental counterpart. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Australian Dollar Recent data in Australia has been mixed: Headline inflation came in at 2.1%, underperforming expectations. However, this measure increased from 1.9% the month before. Meanwhile, the RBA trimmed mean CPI yearly growth came in at 1.9%, in line with expectations and with the previous' month number. AUD/USD has rallied by roughly 1.7%, in part due to the fall in the dollar, as well as in response to positive news in China concerning the issuance of infrastructure bonds. Despite these temporary positives, we continue to be cyclically bearish on the Aussie, as a slowdown in the Chinese industrial cycle will weigh heavily on this currency, given its high exposure to base metals, and given the continued presence of slack in the Australian labor market. Report Links: What Is Good For China Doesn’t Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 New Zealand Dollar NZD/USD has risen by roughly 1.7% this week, as trade tensions have eased following the announcement by President Trump that the EU and the United States would collaborate to eliminate tariffs between the two economies. Moreover, Chinese authorities have implemented some easing at the margin, which should provide a temporary boost to high beta economies like New Zealand. However, on a cyclical basis, we remain bearish on the kiwi, as the tightening campaign in China is likely to continue. Moreover, a tightening fed will continue to put pressure on EM dollar borrowers, affecting New Zealand in the process, given its high exposure to global growth. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Canadian Dollar Recent data in Canada has been mixed: Headline inflation came in at 2.5%, surprising to the upside. It also increased from last month's reading. Moreover, retail sales and retail sales ex-autos month-on-month growth both outperformed expectations, coming in at 2% and 1.4% respectively. However, core inflation underperformed expectations, coming in at 1.3%. This measure stayed stable compared to last month's reading. USD/CAD has declined by roughly 1.4% this week. In our view, the best cross to play what we believe will be a temporary correction in the greenback is to short USD/CAD, as the Canadian dollar trades at a deep discount to fair value, while short positions are likely overextended. Moreover, the BoC is the only nation among the G10 commodity producers raising rates, adding another boon for the Lonnie. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Rome Is Burning: Is It The End? - June 1, 2018 Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Swiss Franc EUR/CHF is down roughly 0.5% this week, especially after the perceived dovish tone to the ECB's press conference on Thursday. On a short-term basis, we are bearish on this cross, given that tightening by the fed and a sluggish Chinese economy should cause a risk-off period in markets, creating a supportive environment for the franc. On the other hand, we are bullish on this cross on a longer-term basis, given that the SNB will likely continue with its ultra-dovish monetary policy, as well as currency intervention to make sure that an appreciating franc does not derail its campaign to reach its inflation target. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Norwegian Krone USD/NOK is down roughly 0.7% this week. Overall we continue to be bullish on this cross, given that the tightening of the fed should increase the interest rate differential between Norway and the U.S., counteracting any further appreciation in oil prices due to OPEC output cuts. That being said, we are positive on the NOK within the commodity complex, as Norway will likely be less affected than New Zealand or Australia by the tightening campaign in China, given that oil has a lower beta to Chinese growth than other commodities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Swedish Krona EUR/SEK is down by slightly more than 1% this week, falling substantially after the interest rate decision by the ECB. We are bullish on the krona on a long-term basis, as inflationary pressures continue to be strong in Sweden, and the Riksbank has become progressively more hawkish. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights A flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, but several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy. Investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Feature There have been several policy-related announcements over the past month in China. This has led many market participants to question whether China is in the process of entering full-blown stimulus mode, and if we are on the cusp of another upswing in Chinese economic activity. Our answer to both questions is, for now, no. China appears to merely be easing off the brake, rather than pressing hard on the accelerator. Given that export growth will certainly slow to some degree due to the imposition of import tariffs, and that an industrial sector slowdown was already underway in China prior to President Trump's protectionist actions, it is far from clear that any stimulus will be a net positive for the country's "old economy". In other words, stimulus may counteract an upcoming export shock, but we would need to see more evidence before concluding that it will lead to a renewed cyclical uptrend in China's economy. A Flurry Of Policy Announcements... Several policy actions, announcements, and signals have occurred over the past month: The RMB has fallen nearly 6% since mid-June, which we have argued has been at least partially policy-driven. As we highlighted in our June 27 report,1 the decline in CNY/USD has been large, has occurred very rapidly, and cannot be explained by its previous relationship with the U.S. dollar (Chart 1). The PBOC cut its reserve requirement ratio for both big and small banks at the end of June, following the cut in April (Chart 2). It also provided incentives for banks to buy speculative-rated corporate bonds, clarified that its new asset management rules would permit mutual funds to invest in non-standard assets, and recently injected 500 billion RMB of liquidity into the banking system via its medium-term lending facility (MLF). Chart 1An Enormous, At Least Partially Policy-Driven Move Chart 2A Second Cut To Bank Reserve Requirement Ratios The Ministry of Finance (MOF) signaled that it would speed up spending that was planned to occur later in the year, and the State Council signaled that it would accelerate the issuance of 1.4 trillion RMB in local government bonds to support infrastructure investment. It also green-lighted a comparatively small 6.5 billion RMB in tax cuts for corporate R&D. China's legislature released a draft version of proposed tax changes that would cut the rate paid for individuals. The flurry of policy announcements over the past month has given investors the impression that Beijing has turned the policy dial in the direction of supporting growth. We agree that China is easing at the margin, and that these policy announcements are important: without them, the Chinese economy would likely face a substantial deceleration that would risk a serious slowdown in global growth. ...That Will Not Cause A Material Re-Acceleration In The Economy But several observations suggest that the stimulus proposed so far falls short of a "big bang" response that would reverse both the looming export shock as well as the underlying slowdown in China's old economy: Fiscal Stimulus: Chart 3 shows that China's on-budget deficit expanded by 3 percentage points over an 18-month period from 2014 to 2016. An equivalent expansion today would imply a 2.6 trillion RMB rise in the budget deficit, meaning that the local government bond issuance announced on Monday is 40% smaller than the deficit expansion that occurred from 2014 to 2016. If the infrastructure projects financed by these bonds turn out to be multi-year initiatives tied to China's structural reform plans, the intensity of this round of fiscal stimulus will likely turn out to be less than half, or even a fraction, of what occurred previously. Fiscal Vs. Credit Expansion: While an increase in fiscal spending was important in catalyzing an economic recovery in 2014/2016, Chart 4 highlights that the expansion of credit was considerably larger. The chart shows on-budget fiscal spending and the change in adjusted total social financing (TSF) as a percent of GDP, and highlights that the latter dwarfs the former. By our calculations, adjusted TSF accelerated by 5 trillion RMB from 2015 to 2016, which from our perspective could only have been achieved by very aggressive monetary easing. Currency Depreciation: A simple framework that equates the equilibrium/required currency depreciation to the size of the tariffs imposed as a share of total exports to the U.S. suggests that a 6% decline in CNY/USD may be adequate at negating an export shock if the proposed tariffs stop after the recently proposed new round of 10% tariffs on $200 billion worth of goods. But first, this approach suggests that a further 6-7% decline may be needed if President Trump follows through with his threat to impose tariffs on all imports from China. Second, in either case the currency decline merely addresses the prospective export shock, not the underlying slowdown in China's old economy that has been occurring over the past year. Chart 3Bond-Financed Infrastructure Spending Unlikely To Match 2015's Fiscal Expansion Chart 4Three Years Ago, The Expansion In Credit Dwarfed That Of Fiscal Spending From our perspective, China's monetary policy actions have so far been the most convincingly stimulative developments in response to the threat to exports. We downplayed China's most recent reserve requirement ratio cut in our June 27 Weekly Report,1 and we acknowledge that this initial assessment was overly pessimistic. Chart 5 shows that the 3-month repo rate, China's de-facto policy rate, has broken meaningfully below the lower band that had prevailed since the beginning of 2017. This suggests that the targeted addition of liquidity, particularly to China's small banks, was at least somewhat effective at easing financial conditions. Chart 5The PBOC Has Successfully Lowered The 3-Month Repo Rate... Chart 6...But This Is Unlikely to Significantly Drop Average Lending Rates Still, we remain unconvinced that what has been announced so far is likely to generate an acceleration in credit growth even approaching what occurred three years ago. Chart 6 shows the weighted average lending rate in China, alongside a simple regression model for the rate based on the benchmark lending rate and the 3-month interbank repo rate (China's "old" and "de-facto new" policy rates, respectively). The chart highlights the likely minimal impact of the recent decline in the repo rate on the average lending rate. In fact, Chart 6 underscores an important point about China's stimulus in 2014-2016: a good portion of that episode's reflationary impact appears to have been caused by the PBOC's 170 bps cut to its benchmark lending rate, which has so far remained unchanged (without any hint from policymakers that it might be lowered). Finally, we are similarly underwhelmed by the PBOC's incentives to banks to buy "junk" corporate bonds: debt securities are a small (albeit fast growing) portion of China's total nonfinancial credit, and junk-rated bonds are a small fraction of that market. We thus see this announcement as an attempt to provide some marginal liquidity support for issuers of these bonds that have upcoming refinancing requirements, rather than a policy of any true macro significance. Conclusions And Investment Strategy Recommendations Two important insights emerge from our above analysis. The first is that the intensity and timing of the infrastructure projects alluded to by the State Council are important factors in determining the likely impact of increased government spending. We suspect that any boost to the economy over the coming year from infrastructure spending will be relatively small, but this will be an important element to monitor over the coming months. The second insight is that we would become considerably more constructive towards China's economy were the PBOC to cut its benchmark lending rate. This would be clear sign that the China is pressing on the accelerator, rather than attempting to simply "fine tune" the economy in the face of an external economic shock. For now, however, our view is that the stimulative measures that have been announced are not likely to lead to a renewed cyclical uptrend in China's economy. This implies that investors should remain neutrally positioned towards Chinese stocks within a global equity portfolio, and should favor low-beta sectors within the Chinese investable universe. Chart 7 shows that the latter position, which we initiated on June 27, has risen almost 1% in relative terms over the past month, and we expect further gains over the remainder of the year. Finally, we noted in our July 5 Weekly Report that the selloff in Chinese domestic stocks was advanced,2 and that we would consider implementing a long MSCI China A Onshore index / short MSCI China index trade in response to a 5% rally in relative common currency performance. It is conceivable that "easing off the brake" will be enough for A-shares to rally non-trivially relative to investable stocks, given how much they have fallen since the beginning of the year. Chart 8 shows that A-shares have approached this threshold in response to recent stimulus announcements, but have yet to break through. We will be watching relative A-share performance closely over the coming weeks for a green light to initiate the position. Stay tuned! Chart 7Low-Beta Sectors Are Outperforming China's Investable Market Chart 8Conditions May Soon Warrant A Pair Trade Favoring Domestic Stocks Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Pease see China Investment Strategy Weekly Report "Now What?", dated June 27, 2018, available at cis.bcaresearch.com 2 Pease see China Investment Strategy Weekly Report "Standing On One Leg", dated July 5, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Bank Credit Analyst

Highlights President Trump has taken the next step in the trade war by charging some of America's major trading partners with outright currency manipulation. However, we are not headed for Plaza Accord 2.0, because neither the ECB nor the PBOC will re-orient policy until their own economic and inflation dynamics warrant it. Moreover, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. With the labor market showing signs of overheating, the Fed will stick with its current game plan and ignore President Trump's tweets. The worsening trade dispute is the key risk that investors face and there are growing signs that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Risk tolerance should be no more than benchmark. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that most risk assets will outperform bonds and other defensive sectors in the near term. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. The flattening U.S. yield curve is also worrying. We would not ignore the signal if the curve inverts, although there are reasons to believe that it is not as good a recession signal as it has been in the past. We wish to see corroborating evidence from our other favorite indicators before trimming risk asset exposure to underweight. A peak in the S&P 500 operating margin would be a strong sign that the end of the cycle is drawing close. Even if trade tensions soon die down and global growth holds up, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. High-quality bonds will of course outperform in the next recession, but yields are likely to rise in the meantime. We believe that U.S. Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields. We also like Agency CMBS. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. Feature We warned in last month's Overview that investors had not yet seen "peak pessimism" on the global trade front. Right on cue, President Trump raised the stakes again in July by threatening to impose tariffs on virtually all imports of Chinese goods. Congress is pushing the President to be tough on China because American voters have soured on trade. China will not easily back down with the authorities responding in kind to the U.S. President's trade threats. They have also allowed the RMB to depreciate to cushion the trade blow (Chart I-1). It is not clear whether the authorities purposely depressed the RMB or whether they simply failed to lean against market pressures. Either way, it is a dangerous approach because it has clearly raised the U.S. President's ire. Chart I-1RMB Is Much Weaker Across The Board President Trump has taken the next step in the broader trade war by charging some major trading partners with outright currency manipulation. The script appears to be following previous times that the U.S. sought trade adjustment via tariffs and currency re-alignment: the early 1970s and the 1985 Plaza Accord. Adjusting currencies on a sustained basis requires much more than simply "talking down" the dollar. There must be major changes in relative monetary and/or fiscal policies vis-à-vis U.S. trading partners. On the fiscal front, expansionary U.S. policy is working at cross purposes with the desire to have a weaker dollar and a smaller trade gap. We do not foresee the U.S. President having any success in changing the broad thrust of monetary policy either. Europe and Japan enjoyed booming economies in the early 1970s and mid-1980s, and thus had the luxury of placating the U.S. by adjusting monetary policy and thereby appreciating their currencies. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that generates major bull markets in their currencies. Neither the ECB nor the People's Bank of China (PBOC) will re-orient policy until their own economic and inflation dynamics warrant it.1 It is also unlikely that the Bank of Japan will raise the 10-year yield target to either strengthen the yen or to help bank profits. This is not Plaza Accord 2.0. Powell Isn't Arthur Burns As for the Fed, we doubt the FOMC will be bullied into keeping rates lower than policymakers deem appropriate. The Fed is more open and independent today than in the 1970s and 1980s. Even if Fed Chair Powell were amenable, any hint that he is being politically manipulated to change course would result in a bond market riot that would rattle investors to their core. More likely, the Fed will stick with its current game plan and ignore President Trump's tweets. Powell could not be any clearer in his July Congressional Testimony: "With a strong job market, inflation close to our objective, and the risks to the outlook roughly balanced, the FOMC believes that-for now-the best way forward is to keep gradually raising the federal funds rate." Investors should not be fooled by the uptick in the U.S. unemployment rate in June. The rise reflected a pop in the labor force participation rate. However, the labor force figures are volatile and there is no upward trend evident in the participation rate. The real story is that the labor market continues to tighten. The number of people outside the labor force who want a job, as a percentage of the total working-age population, is back to pre-recession lows. The Employment Cost Index for private-sector workers shows that wage growth is accelerating. Moreover, the New York Fed's Underlying Inflation Gauge, which leads core CPI inflation by 18 months, has already jumped to almost 3 ½% (Chart I-2). Small businesses are increasingly able to pass on cost increases to consumers (Chart I-3). Chart I-2U.S. Inflation Is Percolating Chart I-3U.S. Pricing Power On The Rise The Minutes from the mid-June FOMC meeting included a lengthy discussion of the growing signs of inflation pressure and labor shortage. Firms are responding to the lack of qualified labor by offering training, automating, and boosting wages. Anecdotal evidence suggests that bottlenecks and other cost pressures are boiling over in the transportation sector. Despite an acute shortage of truck drivers, the average hourly earnings data do not show any acceleration in their wages (Chart I-4, second panel). However, these data do not include bonuses, which have been on the rise. The PPI for truck transportation services was up 7.7% year-over-year in June, while the Cass Freight Index that tracks full-truckload prices rose 15.9% year-over-year. The latter does not even include fuel costs. These pipeline cost pressures have implications not only for the Fed, but for corporate profit margins as well (see below). Chart I-4U.S. Transportation Is Boiling Over The U.S. Yield Curve: A Red Flag? The FOMC expects that the fed funds rate will continue to rise and will temporarily exceed its 2.9% estimate of the neutral rate. If the true neutral rate is higher than the Fed's estimate, then the FOMC could find itself hiking too slowly and the economy could severely overheat. And vice versa if the true neutral rate is below 2.9%. We are keeping a close eye on the yield curve as an indication of policy tightness. If the curve inverts with a few more Fed rate hikes, it would signal that the market believes that policy is turning restrictive. It is possible that the yield curve is not as good a recession signal as it has been in the past. First, there is a lot of uncertainty regarding the neutral fed funds rate in the post-GFC world. The collective market wisdom on this could be wrong. Indeed, BCA's Chief Global Strategist, Peter Berezin, makes the case that the neutral rate is rising faster than most investors believe.2 Structural factors have depressed the neutral rate, including population aging and low productivity growth. However, these structural tailwinds for bond prices are now slowly turning into headwinds. Moreover, as Peter argues, cyclical pressures are acting to lift the neutral rate. Private credit growth is rising faster than nominal GDP growth again. The same is true for housing and equity wealth, at a time when the personal saving rate is falling. All this implies strong desired spending which, in turn, suggests a higher neutral rate of interest. It will be important to watch the housing market; if it remains healthy in the face of rate hikes, it means that the neutral rate is still north of the actual fed funds rate. Chart I-5 presents today's market expectation for the real fed funds rate, based on the forward OIS curve and the forward CPI swaps curve. Technical issues may be distorting forward rates in 2019, but we are more interested in expectations further into the future. The real fed funds rate is expected to hover in the 55-75 basis point range until 2024. It then rises to about 1%, but not until almost the end of the next decade. This appears overly complacent to us, suggesting that the risks are to the upside for market expectations of the terminal, or neutral, short-term interest rate. If the neutral rate is indeed higher than the market is currently discounting, then an inverted curve may be premature in signaling that policy is too tight and that an economic slowdown is on the horizon. Moreover, the term premium on long-term bonds may still be depressed by asset purchases by the Fed and the other major central banks, again suggesting that the curve will more easily invert than in the past. There is much disagreement on this issue, even among FOMC members and among BCA strategists. This publication is sympathetic to the work done by the Fed Staff which suggests that the term premium has been substantially depressed by quantitative easing. Chart I-6 shows the annual change in the size of G4 central bank balance sheets (inverted), along with an estimate of the term premium in the 10-year government bonds of the major countries. The chart is far from conclusive, but it is consistent with the view that QE has depressed term premia worldwide. Moreover, forward guidance and the low level of inflation since the GFC have undoubtedly dampened interest-rate volatility, which theory suggests is a key driver of the term premium. Chart I-5Policy Rate Expectations Chart I-6Depressed Term Premiums ##br##Distort Yield Curves The factors that have depressed the term premium are beginning to reverse, including G4 central bank balance sheets. Still, the premium will trend higher from a low starting point, suggesting that an inverted curve today may not necessarily signal a recession. That said, it would be wrong to completely dismiss a U.S. curve inversion, given its excellent track record. Historically, the 3-month/10-year Treasury slope has worked better than the 2/10 yield slope in terms of calling recessions. An inversion of the 3-month/10-year curve has successfully heralded all seven recessions in the past 50 years with one false positive signal. Nonetheless, the curve tends to be very early, inverting an average of almost 12 months before the recession. And, given the possible distortion to the term premium, we would want to see corroborating evidence before jumping to the conclusion that an inverted curve is sending a correct recession signal. For example, the U.S. and/or global Leading Economic Indicator would need to turn negative. The bottom line is that a curve inversion would not be enough on its own to further trim risk asset exposure to underweight. Nonetheless, we are not dismissing the message from the yield curve either, especially in the context of a trade war that could prematurely end the expansion. Trade War Hitting Economy? Estimates based on macro models suggest that the damage to global GDP growth from higher tariffs would be quite small. Nonetheless, these models do not incorporate the indirect, or second-round, effects of rising tariff walls. Business leaders abhor uncertainty, and will no doubt hold off on major capital expenditure plans until the trade dust settles. The uncertainty can then ripple through the economy to industries that are not directly affected by the trade action. The extensive use of global supply chains reinforces this ripple effect. Labor is not free to move between countries or between industries to facilitate shifts in production that are required by changing tariffs. Capital is more mobile, but it is still expensive to shift machinery. Some of the world's capital stock could become "stranded", raising the cost of the tariffs to the world economy. Finally, important economies-of-scale are lost when firms no longer have access to a single large global market. This month's Special Report, beginning on page 18, sorts out the U.S. equity sector winners and the losers from a trade war with China. Spoiler alert: there are not many winners! The bottom line is that the trade threat for the global economy and risk assets is far from trivial. The negative trade headlines have not had a meaningful economic impact so far, but there are some worrying signs. A number of indicators suggest that global growth continues to slow, including the BCA Global Leading Economic Indicator diffusion index, the Global ZEW sentiment index and the BCA Global Credit Impulse index (Chart I-7). The softness in these indicators predates the latest flaring of trade tensions. Nonetheless, business confidence outside the U.S. has dipped (fourth panel). Growth in capital goods imports for an aggregate of 20 countries continues to decelerate, along with industrial production for capital goods and machinery & electrical equipment in the major advanced economies (production related to energy, consumer products and IT remain strong; Chart I-8). Chart I-7Global Growth Is Still Moderating... Chart I-8...In Part Due To Capital Spending None of these data are flagging a disaster, but they all support the view that uncertainty regarding the future of the world trade order is dampening animal spirits and global capital spending. Even if trade tensions soon die down, the extended nature of the U.S. economic and profit cycle make asset allocation particularly tricky. Late Cycle Investing Some of our economic and policy analysis over the past year has focused on previous late-cycle periods. Specifically, we analyzed the growth, inflation and policy dynamics after the point when the economy reached full employment (i.e. when the unemployment rate fell below the CBO estimate of full employment). This month we look at asset class returns during late cycle periods. We wanted to use as broad a range of asset classes as possible, although data limitations mean that we can only analyze the late-cycle periods at the end of the 1990s and the mid-2000s (Chart I-9). To refine the analysis, we split the late-cycle periods into two parts: before and after S&P 500 profit margins peak. One could use other signposts to split the period, such as a peak in the ISM manufacturing index. However, using the S&P operating profit margin proved to be a more useful break point across the cycles in terms of timing trend changes in risk assets. Table I-1 presents total returns for the following periods: (1) the full late-cycle period - i.e. from the point at which full employment is reached until the following recession; (2) from the point of full employment to the peak in the S&P margin; (3) from the peak in the margin to the recession; and (4) during the subsequent recession. All returns are annualized for comparison purposes, and the data shown are the average of the late 1990s and mid-2000 late-cycle periods. Chart I-9Margin Peak Signals Very Late Cycle Table I-1Late-Cycle Asset Returns We must be careful in interpreting the results because no two cycles are exactly the same, and we only have two cycles in our sample of data. Nonetheless, we make the following observations: Treasury bond returns are positive across the board, which seems odd at first glance. However, in both cases the selloff occurred before the late-cycle period began. Yields then fluctuated in a range, and then began to fall after margins peaked. Global factors also contributed to Greenspan's "conundrum" of stable bond yields in the years before the Great Recession. We do not expect a replay this time around given the low starting point for real yields and the fact that the Fed is encouraging an overshoot of the inflation target. Bonds are unlikely to provide positive returns on a six month horizon. Similar to Treasurys, investment-grade (IG) corporate bond returns were positive across the board for the same reason. However, IG underperformed Treasurys after margins peaked and into the recession. High-yield bonds followed a similar pattern, but suffered negative absolute returns after margins peaked. U.S. stocks began to sniff out the next recession after margins peaked. Small caps outperformed large caps in the recessions, but relative performance was mixed after margins peaked. We are avoiding small caps at the moment based on poor fundamentals and valuations. Growth stocks had a mixed performance versus value stocks before and after margins peaked, but tended to outperform in the recessions. Dividend Aristocrats performed well relative to the overall equity market after margins peaked and into the recessions on average, but the performance was not consistent across the two late cycles. EM stocks performed well before margins peak, and poorly during the recessions. However, the performance is mixed in the period between the margin peak and the recession. We recommend an underweight allocation because of poor macro fundamentals and tightening financial conditions. In theory, Hedge Funds are supposed to be able to perform well in any environment, but returns were a mixed bag after margins peaked. The return performance of Private Equity, Venture Capital and Distressed Debt were similar to the S&P 500, albeit with more volatility. Avoid them after margins peak. Structured Product is one of the few categories that performed well across all periods and cycles. The index we used includes MBS, CMBS and ABS. Farmland and Timberland returns were attractive across all periods and cycles, except for Timberland during one of the recessions. Oil and non-oil commodities tended to perform poorly during recession, but returns were inconsistent in the other phases shown in the table. Gold was also a mixed bag. The historical return analysis underscores that it is dangerous to remain aggressively positioned late in an economic cycle because risk assets can begin to underperform well before evidence accumulates that the economy has fallen into recession. Using the peak in the S&P 500 operating profit margin as a signal to lighten up appears prudent. Based on this approach, investors should generally remain overweight risk assets generally, including stocks, corporate bonds, hedge funds, private equity and real estate, as long as margins are still rising. Investors should scale back in most of these areas as soon as margins peak. For fixed income, investors should be looking to raise exposure but move up in quality after margins peak. Oil and related plays are not a reliable late-cycle play, but we are bullish because of the favorable supply-demand outlook. However, this does not carry over to base metals, where we are more cautious. There are some assets other than government bonds that generated a positive average return late in the cycle and during the recession periods, suggesting that they are good late-cycle assets to hold. However, this is misleading because in some cases they experienced a significant correction either during or slightly before the recession (see the maximum drawdown columns in Table I-1; blank cells indicate that the asset did not experience a correction). These include IG credit, CMBS, ABS, Gold and Dividend Aristocrats. The only assets in our list that provided both a positive return across all the phases in Table I-1 and avoided a correction during the recessions, were mortgage-backed securities, Timberland and Farmland. A Special Report from BCA's Global Asset Allocation service found that Timberland is a superior inflation hedge to Farmland, but the latter is a superior hedge against recessions and equity bear markets.3 We believe that Agency MBS are unattractively valued, but should remain insulated from negative shocks such as a trade war or higher Treasury yields (as long as the Treasury selloff is not extreme). Our fixed income team also likes Agency CMBS.4 When Will U.S. Margins Peak? It is impressive that S&P 500 after-tax operating margins are extremely elevated and still rising. The trend has been aided by tax cuts, but corporate pricing power has improved and wage growth has not yet accelerated enough to damage margins. Chart I-10 presents some indicators to monitor as we await the cyclical peak in profit margins. These are generally not leading indicators, but they do provide some warning when they roll over late in the cycle. The first is the BCA Margin Proxy, which is the ratio of selling prices for the non-financial corporate sector to unit labor costs. Margins have tended to fall historically when the growth rate of this ratio is below zero. The same is true for nominal GDP growth minus aggregate wages. The aggregate wage bill incorporates both changes in wages/hour and in total hours worked. We are also watching a diffusion index of the changes in margins for the industrial components of the S&P 500, as well as BCA's Corporate Pricing Power indicator. The latter takes into consideration price changes at the detailed industry level. Chart I-10U.S. Profit Margin Indicators To Watch None of these indicators are signaling an imminent top in margins, but all appear to have peaked except the Corporate Pricing Power indicator. An equally-weighted average of these four indicators, labelled the U.S. Composite Margin Indicator in Chart I-10, is falling but is still above the zero line. We would not be surprised to see S&P 500 margins peak for the cycle late early in 2019. Conclusions: The S&P 500 has so far been largely immune to shocking trade headlines with the help of a solid start to the U.S. Q2 earning season. Based on previous late cycle periods, the fact that S&P 500 profit margins are still rising suggests that investors should remain fully-exposed to most risk assets. Nonetheless, timing is always difficult and we have decided to focus on capital preservation given extended valuations and a raft of risks that could cause a premature end to the bull market. These risks include a possible hard economic landing in China, crises in one or more EM countries, and an escalation in the trade war among others. Some investors appear to believe that the U.S. can "win" the trade war, but there are no winners when tariff walls are rising. We are not yet ready to go underweight on risk assets, but risk tolerance should be no more than benchmark. This includes equities, corporate bonds, EM assets and other risky sectors. An inversion of the yield curve could trigger a shift to underweight, although this signal would have to be corroborated by our other favorite U.S. and global indicators. Attractive late-cycle assets to hold include structured product, Timberland and Farmland. The first statements by Jay Powell as FOMC Chair underscored that it is too early to hide in Treasurys. Market expectations for real short-term interest rates are overly benign out to the middle of the next decade. Moreover, the Fed is not in a position to be proactive in leaning against the negative impact of rising tariffs because inflation is near target and the labor market is showing signs of overheating. This means that bond yields are headed higher until economic pain is clearly evident. Keep duration short of benchmark. Long-term rate expectations for the Eurozone appear even more complacent than they do for the U.S. The real ECB policy rate is expected to remain in negative territory until 2028 (Chart I-5)! At some point there will be a convergence of real rate expectations with the U.S., which will boost the value of the euro. Nonetheless, we believe that it is too early to position for rate convergence. Core inflation is still well below target and Eurozone economic growth has softened recently, suggesting that the ECB will be in no hurry to lift rates once asset purchases have ended. ECB policymakers will be disinclined to cater to President's Trump's desire for tighter monetary policy in Europe, which means that the U.S. dollar has more upside versus the euro and in broad trade-weighted terms. An escalation in the trade war would augment upward pressure on the greenback. As the dollar's behavior during the Global Financial Crisis illustrates, even major shocks that originate from the U.S. tend to attract capital inflows into the safe-haven Treasury market. Emerging market assets are particularly vulnerable to another upleg in the dollar because of the high level of U.S. dollar-denominated debt. Favor DM to EM equity markets and currencies. Mark McClellan Senior Vice President The Bank Credit Analyst July 26, 2018 Next Report: August 30, 2018 1 For more information on why a replay of the 1985 Plaza Accord is unlikely, please see BCA Geopolitical Strategy Weekly Report "The Dollar May Be Our Currency, But It Is Your Problem," dated July 25, 2018, available on gps.bcaresearch.com 2 Please see BCA Global Investment Strategy Weekly Report "U.S. Housing Will Drive the Global Business Cycle...Again," dated July 6, 2018, available on gis.bcaresearch.com 3 Please see BCA Global Asset Allocation Service Special Report "U.S. Farmland & Timberland: An Investment Primer," dated October 24, 2017, available on gaa.bcaresearch.com 4 Please see BCA's U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem," dated July 17, 2018, available on usbs.bcaresearch.com II. U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) Table II-3China Tariffs On U.S. Goods What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State Chart II-3Value Of U.S. Products Tariffed By China (By State) Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors Appendix Table II-2 Exports By U.S. Red States Appendix Table II-3 Exports By U.S. Swing States Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs III. Indicators And Reference Charts Our equity-related indicators flashed caution again in July, despite robust U.S. corporate earnings indicators. Forward earnings estimates continued to surge in July. The net revisions ratio and the earnings surprises index remained well above average, suggesting that forward earnings still have upside potential in the coming months. However, several of our indicators suggest that it is getting late in the bull market. Our Monetary Indicator is approaching very low levels by historical standards. Equities are still close to our threshold of overvaluation, at a time when our Composite Technical Indicator appears poised to break down. An overvalued reading is not bearish on its own, but valuation does provide information on the downside risks when the correction finally occurs. Equity sentiment is close to neutral according to our composite indicator, but the low level of implied volatility suggests that investors are somewhat complacent. Our U.S. Willingness-to-Pay (WTP) indicator has fallen significantly this year, and the Japanese WTP appears to be rolling over. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Flows into the U.S. stock market are waning, and those into the Japanese market are wavering. Flows into European stocks have flattened off. Finally, our Revealed Preference Indicator (RPI) for stocks remained on a ‘sell’ signal in July. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. The U.S. 10-year Treasury is slightly on the inexpensive side and our Composite Technical Indicator suggests that the bond has still not worked off oversold conditions. This suggests that the consolidation period has further to run, although we still expect yields to move higher over the remainder of the year. This month’s Overview section discusses the upside potential for the term premium in the yield curve and for market expectations of the terminal fed funds rate. This year’s dollar rally has taken it to very expensive levels according to our purchasing power parity estimate. The long-term trend in the dollar is down, but we still believe it has some upside while market expectations for the terminal fed funds rate adjust upward. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Our forecast of higher geopolitical risk in 2018 is coming to fruition; President Trump's two key policies, economic populism (fiscal stimulus) and mercantilism (trade tariffs), will counteract each other; Stimulus is leading to trade deficits and a stronger dollar, while a stronger dollar encourages trade deficits. This is a problem for Trump in 2020; The administration will seek coordinated international currency moves, but the U.S. has less influence today than it did at the time of key 1971 and 1985 precedents; Favor DM over EM assets; favor U.S. over DM stocks; and expect Trump to threaten tariffs against currency manipulation. Feature "China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars [sic] gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field... The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?" - President Donald Trump, tweet, July 20, 2018 "The dollar may be our currency, but it is your problem." - Treasury Secretary John Connally, 1971, speaking to a group of European officials Chart 1A Fiscal Boost Will Accelerate Inflation In April 2017, BCA's Geopolitical Strategy concluded that "Political Risks Are Overstated In 2017," but also "Understated In 2018."1 At the heart of our forecast was the interplay between three factors: "Domestic Policy Is Bullish USD:" We argued in early 2017 that the political "path of least resistance" would lead to "tax cuts in 2017" and that President Trump's economic policies "will involve greater budget deficits than the current budget law augurs." The conclusion was that "even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows" (Chart 1). "Chinese Growth Scare Is Bullish USD:" We also correctly predicted that "Chinese data is likely to decelerate and induce a growth scare." Even though Chinese data was peachy in early 2017, we pointed out that "Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally in the interbank system." We would go on to produce several in-depth research reports throughout the year that outlined these reform efforts and linked them to President Xi Jinping's reduced political constraints following the nineteenth National Party Congress in October.2 "European Political Risks Are Bullish USD:" Finally, we argued that a combination of political risks - e.g., the 2018 Italian election - and the slowdown in China would reverberate in Europe, forcing "the ECB to be a lot more dovish than the market expects." Our conclusion in April 2017 - quoted verbatim below - was that these three factors would combine to force President Trump to try to talk down the greenback: The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. On July 20, President Trump put a big red bow on our forecast by doing precisely what we expected: talking down the USD by charging the rest of the world with currency manipulation. Speaking with CNBC, Trump pointed out that "in China, their currency is dropping like a rock and our currency is going up, and I have to tell you it puts us at a disadvantage." President Trump is correct: Beijing is definitely manipulating the currency, as we pointed out last week (Chart 2).3 Chart 2The CNY Is Much Weaker Than The DXY Implies Chart 3U.S. Outperformance Should Be Bullish USD But President Trump wants to have his cake and eat it too. His economic stimulus is inevitably leading to a widening trade deficit. With tax cuts and increased capital spending, U.S. demand is growing faster than demand in the rest of the world. This economic outperformance in the context of stalling global growth is leading to the greenback rally that we forecast (Chart 3). When the U.S. economy outperforms the rest of the world, the Fed tends to be in the lead of tightening policy among G10 economies, spurring a rally in the trade-weighted dollar index (Chart 4).4 A rising currency then reinforces the trade deficit. Chart 42018 Rally Is Not Over There is much uncertainty regarding President Trump's true preferences, but we know two things: he is an economic populist and a mercantilist. He has been clear on both fronts throughout his campaign. The problem for President Trump is that the two policies are working against one another. His stimulus has spurred a USD rally that will likely offset the impact of his tariffs, particularly the more modest 10% variety he has said he will impose on all Chinese imports (Chart 5). Chart 5Trump Threatens Tariffs On All ##br##Chinese Imports (And Then Some) The Trump administration is therefore facing a choice: triple-down on tariffs, potentially causing a market and economic calamity in the process; or, use protectionism as a bargaining chip in a bout of orchestrated and negotiated, global, currency manipulation. As we pointed out last April, President Trump would not be the first to face this choice: 1971 Smithsonian Agreement President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."5 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table. Connally also gave us the colorful quote for the title of this report and also famously quipped that "foreigners are out to screw us, our job is to screw them first." The economists in the Nixon cabinet - including Paul Volcker, then the Undersecretary of the Treasury under Connally - opposed the surcharge, fearing retaliation from trade partners, but policymakers like Connally favored brinkmanship. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not by as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination. As such, the U.S. removed the surcharge merely four months later without meeting most of its objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the currency effects dissipated within two years. 1985 Plaza Accord The U.S. reached for the mercantilist playbook once again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 6). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that the U.S. was serious about tariffs and had no problem with protectionism. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 7). Chart 6Dollar Bull Market And Current Account Balance In 1980s-90s Chart 7The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism and currency manipulation in recent history. Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. In fact, Trump's Trade Representative, Robert Lighthizer, is a veteran of the 1985 agreement, having negotiated it for President Ronald Reagan. Should investors get ahead of the Plaza Accord 2.0 by shorting the greenback? The knee-jerk reactions of the market suggest that this is the thinking of the median investor. For instance, the DXY fell by 0.7% on the day of Trump's tweet. We disagree, however, and are sticking with our long DXY position, initiated on January 31, 2018, and up 6.17% since then.6 Why? Because 2018 is neither 1985 nor 1971. President Trump, and America more broadly, is facing several constraints today. As such, we do not expect that he will find eager partners in negotiating a coordinated currency manipulation. Chart 8Globalization Has Reached Its Apex Chart 9Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s, and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China (now in Japan's place) can afford significant monetary policy tightening that would engineer structural bull markets in their currencies. For Europe, the risk is that the peripheral economies may not survive a back-up in yields. For China, if the PBOC engineered a persistently strong CNY/USD, it would tighten financial conditions and hurt the export sector. Apex of Globalization: U.S. policymakers were able to negotiate the 1971 and 1985 currency agreements in part because of the underlying promise of growing trade. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017-18, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 8), average tariffs have bottomed (Chart 9), and the number of preferential trade agreements signed each year has collapsed (Chart 10). Temporary trade barriers have ticked up since 2008 (Chart 11). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Chart 10Low-Hanging Fruit Of Globalization Already Picked Chart 11Temporary Trade Barriers Ticking Up Multipolarity: The U.S. is simply not as powerful - relatively speaking - as it was at the height of the Cold War (Chart 12). As such, it is difficult to see how President Trump can successfully bully major economies into self-defeating currency manipulation. The Cold War gave the U.S. far greater leverage, particularly vis-à-vis Europe and Japan. Today, Trump's threats of pulling out of NATO are merely spurring Europeans to integrate further as Russia is no longer the threat it once was. There are no Soviet tank divisions arrayed across the Fulda Gap in Eastern Germany. In fact, Russia is cutting defense spending and further integrating into the European economy with new pipeline infrastructure (which Trump has pointedly criticized). And China is overtly hostile to the U.S. and thus completely unlike Japan, which huddled under the American nuclear umbrella during the U.S.-Japan trade war. Chart 12The U.S. Has Less Weight To Throw Around Is the Trump administration ignoring these major differences? No. There may be a much simpler explanation for President Trump's dollar bearishness: domestic politics. We only see a probability of around 20% that the U.S. trade deficit will shrink during the course of Trump's first term in office. Most likely, the trade deficit will widen as domestic stimulus supercharges the U.S. economy relative to the rest of the world and the greenback rallies. Economic slowdown in China and EM will likely further expand the U.S. trade deficit as these economies cut interest rates and allow their exchange rates to drop. President Trump therefore has a problem. The only way the trade deficit will shrink by 2020 is if the U.S. enters a recession and domestic demand shrinks - but presidents do not survive re-election during recessions. If a recession does not develop, he will have to explain to voters in early 2020 why the trade deficit actually surged, despite all his tough rhetoric, tariffs, and trade negotiations. The charge of currency manipulation could therefore do the trick, blaming the rest of the world for the USD rally that was largely caused by U.S. stimulus. Bottom Line: We do not expect the Fed to respond to President Trump's rhetoric. The current Powell Fed is not the 1970s Burns Fed. As such, we would fade any upcoming weakness in the USD. We expect the dollar bull market to carry on in 2018 and to continue weighing on global risk assets, namely EM equities and currencies. Investors should remain overweight DM assets relative to EM in terms of broad global asset allocation, and overweight U.S. equities in particular relative to other DM equities. The major risk to our bullish USD view is not a compliant Fed but rather a China that "blinks." Beijing has begun some modest stimulus in the face of the economic slowdown produced by the Xi administration's aforementioned efforts to contain systemic financial risk. Over the next month, we will dive deep into Chinese politics to see if the trade conflict will prompt Xi to reverse his attempt to tighten policy and once again embrace a resurgence in credit growth. In the long term, however, we expect that the Trump administration will grow frustrated with the fact that its two main policies - economic populism at home and mercantilism abroad - will offset each other and that the U.S. trade imbalance will continue to grow apace. At that point, President Trump may decide to reach for two levers: staffing the Fed with über doves and/or ratcheting up tariffs to much higher levels. We expect the latter to be the more likely outcome than the former, and either would result in a serious blowback from the rest of the world that would unsettle markets. More importantly, it would be the death knell of globalization, stranding trillions of dollars of capex behind suddenly very relevant national borders. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, and "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China Down, India Up," dated March 15, 2017, "China: Looking Beyond The Party Congress," dated July 19, 2017, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, "China: Party Congress Ends... So What?" dated November 1, 2017, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Whoever Said Anything About Bluffing?" dated July 18, 2018, available at gps.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The S&P Doesn't Abhor A Strong Dollar," dated July 20, 2018, available at fes.bcaresearch.com. 5 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org; and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936, and 1971," Behl Working Paper Series 11 (2015). 6 Please see BCA Geopolitical Strategy Weekly Report, "America Is Roaring Back! (But Why Is King Dollar Whispering?)," dated January 31, 2018, available at gps.bcaresearch.com.

Special Report

The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 on page 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return & ##br##Fed Funds Rate Surprises (1990 - Present) Chart 3Treasury Index Price Return & ##br##Fed Funds Rate Surprises (1990 - Present) Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. Chart 5The 2017 Example The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. Chart 6Market Has Underestimated ##br##The Fed In Recent Years We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(ΔY2) E(ΔY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.60% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.37%. Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Table 2Treasury Index Total Return Forecasts Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.9%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 8Change In 2-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 9Change In 3-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 10Change In 5-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 11Change In 7-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 12Change In 10-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Chart 13Change In 30-Year Yield Vs. 12-Month ##br##Fed Funds Rate Surprise Appendix B Chart 14Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios

Highlights Global Yields: Flattening government yield curves in the developed world have raised concerns about a potential future growth slowdown. Yet real policy rates will need to move into positive territory before monetary policy becomes truly restrictive and curves invert. This means global bond yields have not yet peaked for this cycle. UST-Bund Spread: The U.S. Treasury-German Bund spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). UST Technicals: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains bearish. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Feature In most years, investment professionals can look forward to taking some well-deserved time off in July to hit the beach and read a good book. This year, those same investors are forced to keep an eye on their Bloombergs while responding to the public musings of Donald Trump. The president made comments late last week that threatened the independence of the Federal Reserve, while also accusing China and Europe of currency manipulation. While those headlines can briefly move markets on a sunny summer day, they represent more Trump-ian bluster than any potential change in the conduct of U.S. monetary or currency policy. Chart of the WeekCan Policy Be Truly "Tight"##BR##With Negative Real Rates? The underlying dynamic remains one of mixed global growth (strong in the U.S., slowing almost everywhere else) but with low unemployment and rising inflation in most major economies. That means that independent, inflation-fighting central bankers must focus on their inflation mandates. In the U.S., that means more Fed rate hikes and a firm U.S. dollar, regardless of the desires of President Trump - the author of the large fiscal stimulus, at full employment, which is forcing the Fed to continue hiking rates. In other countries, however, the economic backdrop is leading to varying degrees of central banker hawkishness. That ranges from actual rate hikes (Canada) to tapering of bond buying (Europe, Japan) to merely talking up the potential for rate increases (U.K., Sweden, Australia). The aggregate monetary policy stance of the major developed market central banks is now tilted more hawkishly. So it is no surprise that global government bond yield curves have been flattening and returns on risk assets have been underwhelming (Chart of the Week). Yet the reality is that all major global curves still have a positive slope, even in the U.S. and Canada where central banks have been most actively tightening, while real policy interest rates remain below zero. It would be highly unusual for yield curves to invert before real rates turned positive, especially if central bankers must move to an outright restrictive stance given tight labor markets and rising realized inflation. This implies that there is more scope for global bond yields to rise over the next 6-12 months. We continue to recommend that investors maintain a defensive overall duration stance ... and to focus more on that good book on the beach and less on Trump's Twitter feed. Where To Next For The Treasury-Bund Spread? Chart 2A Pause In The Rising Yield Trend,##BR##Not A Reversal The rise in bond yields in both the U.S. and euro area seen in the first quarter of 2018 has been partly reversed since then. One of the culprits has been a stalling of the rally in oil markets, which has prompted a pause in the rise of inflation expectations on both sides of the Atlantic (Chart 2). Yet another factor has been the larger decline in real bond yields, which have fallen around 20bps in the both the U.S. and euro area since the peak in mid-May (bottom two panels). A potential driver of those lower real yields is the growing concern over the potential hit to global growth from rising trade tensions between the U.S. and China (and Europe, Canada, Mexico, etc). This comes at a time when China's economic growth was already slowing and acting as a drag on global trade activity and commodity prices. There has been significant weakness in China's currency and equity market of late, which raises the specter of another broader global selloff as occurred during the Chinese turbulence of 2015/16. Yet the declines in industrial metals prices and emerging market corporate debt have been far more modest so far in 2018 (Chart 3). A big reason for that has been the more subdued performance of the U.S. dollar this year, unlike the massive surge in 2015/16 that crushed risk assets worldwide (Chart 4). A more likely driver of the recent drop in real yields in the U.S. and core Europe was the slump in euro area economic data earlier in 2018. That move not only drove yields lower, but also pushed out the market-implied timing of the first ECB rate hike (Chart 5) and drove the spread between U.S. Treasuries and German Bunds to new wides. In our last Weekly Report, we updated our list of indicators in the U.S. and euro area that we have been monitoring to assess if our below-benchmark duration stance was still appropriate.1 The conclusion was that the underlying trends in growth and inflation on both sides of the Atlantic still supported higher bond yields on a cyclical basis, although the pressures were greater in the U.S. Yet at the same time, the gap between U.S. and euro area government bond yields has remained historically wide, with the 10-year Treasury-German Bund spread now sitting at 255bps - the highest level since the late 1980s. Chart 3Slowing Growth##BR##In China... Chart 4...But Not Yet Enough To Threaten##BR##Global Financial Stability Monetary policy differences have historically been the biggest driver of that spread. Today, the Fed is well into an interest rate hiking cycle that began nearly three years ago, and is now in the process of unwinding its balance sheet. Meanwhile, the ECB has been keeping policy rates at or below 0% while engaging in large-scale bond buying (Chart 6). Chart 5A Turn In European Yields##BR##On The Horizon? Chart 6Wide UST-Bund Spread Reflects##BR##Monetary Policy Divergences When looking at more typical fundamental drivers of the Treasury-Bund spread, many of the cross-regional differences are already "in the price". The spread appears to have overshot relative to the three main factors that go into our Treasury-Bund spread valuation model (Chart 7): The gap between Fed and ECB policy rate The ratio of the U.S. unemployment rate to the euro area equivalent The gap between headline inflation in the U.S. and euro area The Fed's rate hikes have now widened the policy rate differential versus the ECB equivalent (the short-term repo rate) to 200bps. At the same time, the rapidly improving situation in the euro area labor market now means that the unemployment ratio has been constant over the past couple of years, while euro area inflation has also caught up a bit toward U.S. levels in recent months. Adding it all up together in our Treasury-Bund valuation model - which also includes the sizes of the Fed and ECB balance sheets to quantify the impact on yields of bond-buying programs - and the conclusion is that the current spread level of 255bps is 50bps above "fair value" (Chart 8). Chart 7UST-Bund Spread Overshooting Fundamentals Chart 8UST-Bund Spread Looks Wide On Our Model Importantly, fair value is still rising, primarily because of the widening policy rate differential. We have consistently argued that the true cyclical peak in the Treasury-Bund spread will occur when the Fed is done with its rate hike cycle. Yet there are opportunities to play that spread more tactically, based on shorter-term indicators. For example, the gap between the data surprise indices for the U.S. and euro area has been a correlated to the momentum of the Treasury-Bund spread, measured as the 13-week change of the level of the spread (Chart 9). Data surprises are now bottoming out in the euro area while they continue to drift lower in the U.S. As a result, the Treasury-Bund spread momentum has begun to fade, right in line with the narrowing of the data surprise differential. Also from a more technical perspective, the deviation of the Treasury-Bund spread from its 200-day moving average is at one of the more stretched levels of the past decade. Combined with the extended spread momentum, this suggests that the Treasury-Bund spread should expect to see a period of consolidation in the next few months (Chart 10). Chart 9Relative Data Surprises No Longer##BR##Support A Wider UST-Bund Spread Chart 10UST-Bund Spread Momentum##BR##Got To Stretched Extremes We have been recommending both a structural short U.S./long core Europe position in our model bond portfolio for over a year now. We also entered into a trade that directly played for a wider 10-year Treasury-Bund spread in our Tactical Trade portfolio. We initiated that recommendation on August 8th, 2017 when the spread was at 162bps. With the spread now at 255bps, we are now closing out that recommendation this week, taking a profit of 7% (inclusive of the gains from hedging the Bund exposure into U.S. dollars).2 At the same time, we feel that it is too early to position for a narrowing of the Treasury-Bund spread. The large U.S. fiscal stimulus will continue to put upward pressure on U.S. bond yields over the next year, both through higher U.S. inflation and the associated need for tighter Fed policy. Already, the Treasury-Bund spread reflects both the relatively larger dearth of spare capacity in the U.S. economy (Chart 11) and the expected widening of the U.S. federal budget deficit compared to reduced deficits in the euro area (Chart 12). Much like the rise in the fair value of the Treasury-Bund spread, this suggests that there is limited downside for the spread on a more medium-term basis. Chart 11UST-Bund Spread Narrowing Will Be##BR##Limited By Faster U.S. Growth... Chart 12...The Result Of Looser##BR##U.S. Fiscal Policy We are taking profits on our tactical spread based on our read of all of our relevant indicators. There is a good chance, however, that we could consider re-entering a spread widening trade on any meaningful narrowing of the spread or adjustment in our indicators. Bottom Line: The fundamental drivers of the 10-year U.S. Treasury-German Bund spread continue to point to the spread staying wide over the next 6-12 months. Yet the spread has overshot our fair value estimates, and relative positive data surprises are turning more in favor of Europe. We are taking profits on our tactical UST-Bund spread widening trade, after a gain of 7% (hedged into U.S. dollars). A Quick Update On U.S. Treasury Market Technicals One of the overriding aspects of the U.S. Treasury market over the past few months has been the stretched technical backdrop. The combination of oversold price momentum, bearish sentiment and aggressive short positioning have helped keep yields in check, even as U.S. growth and inflation accelerate and the Fed continues to signal more future rate hikes. Back in March, we presented a study of previous episodes of an oversold U.S. Treasury market since the year 2000.3 Our goal was to determine how long it typically took for a resolution of oversold Treasury market conditions. Unsurprisingly, we concluded that the longest episodes of oversold Treasuries occurred when U.S. economic growth and core inflation were both accelerating, and vice versa. At the time of that report, all of the technical indicators that we looked at were signaling that Treasury bearishness was deeply entrenched (Chart 13). Now, four months later, there has been some change in those indicators: Chart 13UST Technical Indicators##BR##Are More Mixed Now The 10-year Treasury yield relative to its 200-day moving average: then, +43bps; now, +18bps The trailing 26-week total return of the Bloomberg Barclays U.S. Treasury index: then, -4.3%; now, -0.6% The J.P. Morgan client survey of bond managers and traders: then, very large underweight duration positioning; now, positioning is neutral The Market Vane index of bullish sentiment for Treasuries: then, near the bottom of the range since 2000; now, still near that same level The CFTC data on speculator positioning in 10-year U.S. Treasury futures: then, a large net short of -8% (scaled by open interest); now, still a large net short of -11%. Therefore, the message from the technical indicators is more mixed now than in March. Price momentum and duration positioning is now neutral, while sentiment and speculative positions remain stretched. The former suggests that there is scope for Treasury yields to begin climbing again, while the latter implies that there may still be room for some counter-trend short-covering Treasury rallies in the near term. In our March study, we defined the duration of each episode of an oversold Treasury market by the following conditions: The start date was when the 10-year Treasury yield was trading at least 30bps above its 200-day moving average and the Market Vane Treasury bullish sentiment index dipped below 50; The end-date was when the yield declined below its 200-day moving average. The details of each of those episodes can be found in Table 1. This is the same table that we presented back in March, but we have now added the current episode. At 150 days in length, this is already the fourth longest period of an oversold Treasury market since 2000. Yet perhaps most surprising is the fact that Treasury yields are essentially unchanged since the start date of the current episode (March 20th, 2018). There is no other period in our study that where yields did not decline while the oversold market resolved itself. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market Perhaps this can be interpreted as a sign that there is still scope for a final short-covering Treasury rally before this current oversold episode can truly end. Yet as we concluded in our March study, it took an average of 156 days for an oversold market to be fully corrected if U.S. growth was accelerating (i.e. the ISM manufacturing index was rising) and core PCE inflation were both rising at the same time - as is currently the case (Chart 14). Chart 14U.S. Growth/Inflation Backdrop Points To Yields Consolidating, Not Reversing The longest such episode in 2003/04 lasted for 203 days before the 10-year yield fell below its 200-day moving average. Yet the second longest episode (196 days) occurred in 2013/14, and Treasury yields ended up climbing to a new cyclical high before eventually peaking. Given the underlying positive momentum in both U.S. economic growth and inflation, but with a mixed message from the technical indicators, we suspect that this current oversold episode may have further to run. Yet as we concluded back in March, and still believe today, it will prove difficult to earn meaningful returns betting on a counter-trend decline in yields this time, as any such move will likely be modest in size and lengthy in duration. Bottom Line: Some of the oversold technical conditions in the U.S. Treasury market have turned more neutral, but sentiment remains very bearish and there are large speculative short positions. With both U.S. growth and inflation accelerating, we recommend sticking with a strategic below-benchmark U.S. duration stance rather than playing for a tactical short-covering Treasury rally. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Trendless, Friendless Bond Market", dated July 17th 2018, available at gfis.bcaresearch.com. 2 The return on this trade is calculated using the Bloomberg Barclays 7-10-year government bond indices for the U.S. and Germany, adjusted for duration differences between the indices. The German return is hedged into U.S. dollars, as this trade was done on a currency-hedged basis. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering From Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Many investors remain overweight equities; BCA recommends a neutral stance. Investors should position portfolios for rising rates. Fed Chair Powell weighed in last week on yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. More evidence of trade policy-related uncertainty, rising labor costs and deteriorating margins in the latest Beige Book. Feature The S&P 500 finished the week little changed, as investors braced for a wave of Q2 earnings reports this week and next. The S&P financials sector, which tends to lead the overall market, rose more than 1% last week, as the banks reported healthy Q2 results. The dollar sold off late last week after President Trump grumbled about the Fed's rate policy. BCA's view is that Fed Chair Powell will ignore Trump's comments on monetary policy and adhere to the central bank's mandate of low and stable inflation and full employment. Gold fell 1% on the week. BCA recommends monitoring the price of gold for clues about the neutral rate of interest. Fed Chair Powell's semiannual policy testimony to Congress dominated the headlines last week. Powell discussed trade policy, the yield curve, the neutral rate and financial stability. The week's economic data was robust, suggesting that Q2 GDP will be well above the Fed's view of potential GDP. Housing starts were soft in June, but the weakness was due to supply issues, not tepid demand. Widespread supply constraints were prevalent in the Fed's latest Beige Book. The strong economic data, along with a 23-year high in the number of inflation words in the Beige Book pushed the 10-year Treasury yield up 6 bps to 2.88%. BCA's U.S. Bond Strategy team notes that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%. In late June, BCA downgraded its 12-month recommendation on global equities and credit from overweight to neutral. We still expect that the U.S. stock-to-bond ratio will grind higher in the next year, as U.S. stocks move sideways and Treasury yields climb. We recommend that investors put proceeds from the sale of equity positions into cash. Not all investors are being risk averse. The National Association of Active Investment Managers (NAAIM) says that active managers have increased their equity risk tolerance since the start of the year (Chart 1). At 89%, the average exposure of institutional investors is close to the cycle high reached in March 2017, which was the greatest since the S&P 500 zenith in October 2007. Furthermore, BCA's Equity Speculation Index remains elevated (Chart 2). Moreover, the asset allocation survey from AAII shows that investors' allocation to equites (at 69% in June) are in line with the 2007 market top (Chart 3). However, equity holdings based on this survey were higher before the peak in equity prices in 2000. Moreover, consumers' expectations for stock price returns in the next 12 months remain close to cycle highs (U of Michigan) and near 24-year extremes based on the Conference Board surveys (Chart 4). Despite the optimism, individual sentiment toward equities remains muted in some surveys (Chart 4, panel 3). Chart 1Active Managers Have Increased Equity Exposure This Year Chart 2Equity Speculation##BR##Is Elevated Chart 3Equity Allocations##BR##On The Rise... Chart 4Households Expect Higher Stock##BR##Prices In The Next 12 Months Individuals, banks and other financial institutions hold more equities today than at the height in 2007. However, insurance companies and pension funds' holdings of equites are not as elevated as they were in 2007 (Table 1). Somewhat surprisingly, households' cash positions are below the 2007 level and at a cycle low. However, the cash positions of financial institutions are four times as large as in 2007, partly due to the Fed's vigilance on financial stability. Pension funds and insurance companies have roughly the same allocation to cash today as earlier in the cycle (2012) and in 2007, just before the financial crisis. Table 1Asset Allocation: Comparison With Early 1990s Bottom Line: BCA's view is that the risk/reward balance for holding equities is much less attractive than it was at the start of the bull market in 2009. The economy is in the late stages of an expansion and is running beyond full employment. The Fed is raising rates. Moreover, equity valuations are elevated and forward earnings estimates are at their most optimistic in 20 years (not shown). The good news is already priced into the equity market. If macro developments evolve as expected, then we will shift to an outright bearish stance on risk assets later this year or early in 2019 in anticipation of a global recession in 2020. Absent a recession, we would move to underweight stocks if a wider trade war develops. We would consider temporarily moving our 12-month recommendation back to overweight if global equities sell off by more than 15% in the next few months. This shift would also be favored if our economic indicators remain constructive and the Fed either cuts rates or signals that it is on hold. 10-Year Treasuries: An Update BCA's U.S. Bond Strategy service recommends that investors remain below benchmark in duration. However, at 2.84%, the 10-year Treasury yield is 27 bps below its 2018 zenith of 3.11%, which was reached in mid-May. Chart 5 shows that the drop in yields since that time reflects both slower economic growth prospects and weaker inflation. Investors are concerned about the impact of Trump's trade policies on global growth and those fears have been stoked by the recent run of poor economic data in the U.S. Oil prices and inflation breakevens moved up in tandem earlier this year, and both are currently rolling over (not shown). U.S. inflation is back to the Fed's 2% target and the central bank remains on course to raise rates two more times in 2018 and another four times next year. The market is pricing in only three more hikes in the next 18 months. The economy is at full employment. Moreover, at 3.6%, the average of the New York Fed and Atlanta Fed's Nowcasts for Q2 GDP growth implies that the GDP expanded well above the Fed's projection of potential GDP (1.8%) in the first half of the year (Chart 6). Moreover, the lagged effect of easier financial conditions suggests that GDP growth in the second half of the year will also be far above potential (Chart 7). Chart 5Inflation Breakevens##BR##Rolling Over Again Chart 6U.S. Economy Poised For Above##BR##Potential Growth in 2018 Inflation breakevens (Chart 5) are falling again despite mounting inflation pressures. The New York Fed's Underlying Inflation Gauge (Chart 8, panel 4) climbed to 3.33% in June, its highest point since 2005. Moreover, wage inflation is trending up and the economy is beset with shortages and constraints.1 Chart 7Lagged Effect Of Easier Financial##BR##Conditions Will Boost Growth Chart 8Inflation Is##BR##Accelerating Bottom Line: Investors should position their portfolios for escalating rates. Global growth should bottom in the second half of the year and the U.S. economic activity reports will begin to outpace lower expectations. Moreover, with inflation at the Fed's target and mounting, inflation breakevens will adjust upward. BCA's position is that the Fed's gradual pace of rate hikes toward a 3% equilibrium fed funds rate would be consistent with a cyclical peak in the 10-year Treasury yield between 3.30% and 3.80%, well above current forward rates.2 Leading The Way S&P Financials provide a long lead time for market peaks. Table 2 shows that since the mid-1970s, a peak in the Financials sector relative to the S&P 500 occurs an average of 16 months before a peak in the overall index. The Bank (Industry Group) sector provides a similar warning (18 months), while the Investment Banking index's relative performance peaks 20 months before the S&P 500 tops out (Chart 9). Note that the leads times are slightly shorter in the last 15 years than in the 1976-2000 period (Table 2). Table 2Financial Stocks' Relative Performance Provides Early Warning Of Market Tops Chart 9Financials Lead The Broad Market In a recent report,3 BCA's U.S. Equity Strategy service noted that cyclicals and interest rate-sensitive sectors, including financials, perform well when U.S. fiscal policy is loose and monetary policy is tight. Furthermore, our equity strategists found that rising rates boost top-line growth for banks, while the impact of fiscal stimulus via lower taxes should support business and consumer demand for capital. Moreover, our U.S. Equity Strategy team examined sector performance in late cycles, defined as the period between the peak in the ISM Manufacturing Index and the next recession.4 Financials outperform the S&P 500 in late-cycle environments; in the early stages (peak in the ISM's index to peak in the S&P 500) financials underperform the broad market, but they outperform after the peak in the S&P 500 and the next recession. Bottom Line: Our equity strategists recommend that investors remain overweight financials relative to the S&P 500. The late-cycle environment, along with the favorable regulatory climate, suggest that financials still have some room to run. The implication is that the peak in the overall U.S. equity market is still over a year away. Until then, the Fed will continue to remain vigilant on the financial sector and financial stability. Staying The Course At his semiannual Congressional testimony last week, Fed Chair Powell reaffirmed that the Fed will maintain its gradual pace of rate hikes. Following his presentation, Powell met with legislators and discussed the yield curve, the impact of the Trump administration's trade policies, financial stability and the level of the neutral Fed funds rate. Powell repeated his June statement that the yield curve can be considered an indicator of monetary stance. Like Powell, BCA's position is that a steep curve signals that policy is stimulative and short-term rates will need to climb. The opposite holds if the yield curve inverts. A flat yield curve indicates that the policy stance is neutral. The 2/10-year curve has flattened to about 25 bps. Our view is that if the curve inverts with a few more Fed rate hikes, it would suggest that the neutral rate is lower than what the Fed believes and policy is becoming restrictive. Furthermore, BCA's U.S. Bond Strategy team anticipates that curve flattening will occur as the Fed lifts rates, but some flattening pressure will be mitigated by the re-anchoring of long-dated inflation expectations at a higher level. On tariffs, Powell stated that "in general, countries that have remained open to trade, that haven't erected barriers including tariffs, have grown faster. They've had higher incomes, higher productivity." He added that more and broader tariffs are bad for the economy. Furthermore, Powell said that the FOMC has not yet seen evidence that the trade uncertainty has affected wages, but he noted that the central bank is concerned that capital spending plans may be at risk. The latest Beige Book (see next section of this report) finds that the business community is increasingly apprehensive about trade policy. BCA's Geopolitical Strategy service anticipates that trade-related uncertainty will remain in place at least until the U.S. mid-term elections in November.5 BCA views financial stability as a third mandate for the central bank,6 along with low and stable inflation, and full employment. Powell stated last week that financial stability vulnerabilities were "moderate right now," but he remarked that "we keep our eye on that very carefully after our recent experience." Chart 10 presents several indicators that the FOMC uses to assess financial vulnerabilities. Powell acknowledged the prominent status of financial stability when asked about the Fed's role. The central bank's Monetary Policy Report,7 released on July 13, has an entire section dedicated to financial stability. Powell spoke about the shape of the yield curve, saying it can relay a message about longer run neutral interest rates. BCA also recommends monitoring the price of gold for clues about the neutral rate of interest. Chart 11 shows that when the Fed funds rate is above its neutral or equilibrium rate, the 2/10 curve is flat (panel 3). Moreover, gold tends to appreciate when the stance of monetary policy is more accommodative and then the metal depreciates when the stance becomes more restrictive (panel 4). The steep decline in the gold price between 2013 and 2016 preceded downward revisions to the Fed's estimate of the neutral rate. An upside price breakout would signal that we should bump up our estimate of the neutral rate. Conversely, a large decline in gold prices would imply that monetary policy is turning restrictive. Gold prices recently headed lower. Chart 10FOMC Is Closely Monitoring##BR##Financial Stability Chart 11The 2/10 Curve,##BR##Gold And The Neutral Rate Bottom Line: The Fed will continue with gradual rate hikes until it believes policy has returned to near neutral. The yield curve and gold will help to indicate when that point is reached. Widespread Chart 12Inflation Words At A 23 Year High The Beige Book released last week ahead of the FOMC's Jul 31-August 1 meeting suggested that uncertainty surrounding U.S. trade policy remained an important headwind in June and July. The Fed's business and banking contacts mentioned either tariffs (31) or trade policy (20) a total of 51 times, an increase from 34 in May and 44 in April. In March, as President Trump announced the first round of proposed tariffs, there were only three mentions of trade or tariff-related uncertainty. Moreover, uncertainty arose nine times in July (Chart 12, panel 4); all were related to trade policy. A recent study by the Federal Reserve Bank of St. Louis8 found that GDP per capita, wages and the investment-to-GDP ratio, all decline after tariffs are implemented (Chart 13). The study covered tariffs in 14 countries from 1980 through 2016. Importantly, the researchers noted that while the data showed that past tariff increases are followed by persistent decreases in economic activity, this evidence does not necessarily mean that higher tariffs triggered these changes. It is possible that other economic events may have driven tariff increases and ensuing recessions. Despite the headwind from trade, BCA's quantitative approach to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book, despite the recent rise in the greenback. The report also finds widespread concern about profit margins. Chart 12, panel 2 shows that at 81% in July, BCA's Beige Book Monitor ticked up from May's 67% reading. The July reading was the highest since early 2016. The recent low in November 2017 at 53% was when doubts over the tax bill weighed on business sentiment. The number of weak words in the Beige Book hit an 18 -year low in July. On the other hand, the number of strong words climbed in July to a 30-month high. The 2017 Tax Cut and Jobs Act was noted 5 times in the latest Beige Book, up from 3 in May, but still far below 15 mentions in March and 12 in April. The legislation was cast in a positive light in three of the five mentions. The implication is that most of the good news related to the tax bill has already been discounted by businesses. BCA's stance is that the dollar will move up modestly in 2018. The trade-weighted dollar has climbed by 6% since mid-April, but the elevated value of the greenback is not yet a concern for Beige Book respondents. Furthermore, based on the handful of references to a robust dollar (only eight in the past eight Beige Books), the dollar should not be a meaningful issue for corporate profits in Q2 2018. We will provide an update on Q2 S&P 500 earnings in next week's report. The dearth of recent dollar references is in sharp contrast with a flood of comments during 2015 and early 2016 (Chart 12, panel 3). The last time that eight consecutive Beige Books had so few remarks about a strong dollar was in late 2014. The disagreement on inflation between the Beige Book and the Fed's preferred price metric widened in July as the number of inflation words surged (Chart 12, panel 1). Mentions of inflation in July's Beige Book were the greatest since at least 1995. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that core PCE may still rise. Chart 13The Economic Consequences Of Trade Wars Moreover, July's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Shortages of qualified workers were reported in various specialized trades and occupations, including truck drivers, sales personnel, carpenters, electricians, painters and information technology professionals. Furthermore, several districts stated that a lack of workers was impeding growth. In addition, "widespread", which is part of BCA's inflation word count, was used 14 times in July to describe both labor shortages and swelling input costs, up from 11 times in May. We discussed the impact of escalating labor and input costs on margins in last week's report.9 The Beige Books released this year suggest that concerns about deteriorating margins is more prevalent in 2018 versus 2017. Only 57% of comments about margins in the first five Beige Books of 2017 noted deteriorating margins. In the 2018 Beige Books, 85% of references to margins indicated concern about higher labor, interest and raw materials costs. Bottom Line: July's Beige Book supports our stance that rising inflation pressures will result in at least two more Fed rate hikes by year-end and four next year. Moreover, the Beige Book confirms that labor shortages are restraining output of goods and services in some economic sectors. Furthermore, rising input costs are pervasive and will continue to pressure corporate profit margins. BCA expects both corporate profit growth and margins to peak later this year. The nation's tax policy still gets high marks from the business community, but the impact is fading. Ongoing uncertainty over trade policy will restrain growth. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Aailable at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Bond Bear Still Intact", published June 5, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Special Report "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening", published April 16, 2018. Available at uses.bcaresearch.com. 4 Please see BCA Research's U.S. Equity Strategy Special Report "Portfolio Positioning For A Late Cycle Surge", published May 22, 2018. Available at uses.bcaresearch.com. 5 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," published April 4, 2018. Available at gps.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," published July 24, 2017. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf 8 https://research.stlouisfed.org/publications/economic-synopses/2018/04/18/what-happens-when-countries-increase-tariffs 9 Please see BCA Research's U.S. Investment Strategy Weekly Report "Constrained", published July 16, 2018. Available at usis.bcaresearch.com.