Money/Credit/Debt

Highlights The 10-year Italian BTP yield at 4% yield marks a 'line in the sand' at which the current drama could escalate into something considerably worse. The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stay underweight in the classically cyclical sectors: banks, basic materials and industrials. Prefer France's CAC over Italy's MIB and Spain's IBEX. The equity market's range-bound pattern can continue, as long as the line in the sand isn't breached. It is a good time to own a small portfolio of high-quality 30-year government bonds. It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. Feature Italian politics have blindsided almost everybody, us included. Few anticipated that the unlikely bedfellows 5S and Lega would try and form a 'government of change'. In March we wrote: "The Italian election result is not an investment game changer. The one exception would be if 5S and Lega joined forces to govern, as it could throw EU integration into reverse. But the likelihood of this unholy alliance seems very low." Even fewer anticipated that Italy's President, Sergio Mattarella, would then scupper this government of change by vetoing the proposed Finance Minister. This has cast a new pall of uncertainty over Italian politics and Italian public support for EU rules and institutions. The 10-Year BTP Yield At 4% Marks A 'Line In The Sand' The market's response has been to fear the worst: shoot first, ask questions later. The danger is that this sets off a negative feedback loop. Higher bond yields weaken Italy's still-fragile banks; which threatens Italy's economic recovery; ahead of a possible new election, this increases the support for parties and policies that push back against EU rules; which further lifts bond yields; and then in a vicious circle until the fear of the worst becomes a self-fulfilling prophecy... Chart of the WeekItalian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% The Italian BTP versus German bund yield spread is effectively a fear gauge for Italy's future in the euro (Chart I-2). As these fears increase, and Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Chart I-2The BTP-Bund Yield Spread Is A Fear ##br## Gauge For Italy's Future In The Euro The BTP-Bund Yield Spread Is A Fear Gauge For Italy's Future In The Euro The BTP-Bund Yield Spread Is A Fear Gauge For Italy's Future In The Euro As a rule of thumb, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart I-3). Chart I-3Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By €35Bn Italian Banks' Equity Capital Exceeds Net NPLs By €35Bn It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4%.1 Hence, the 10-year BTP yield at 4% marks a 'line in the sand' at which the current drama could escalate into something considerably worse (Chart of the Week). To short-circuit the negative feedback loop, the financial markets would need to sense a discernible shift in Italian support for its populist parties; or an explicit de-escalation in the populist pushback against the EU. The question is: could this happen quickly enough? Global Growth Is In A Mini-Downswing The market's concerns about Italy come at a time when global growth has in any case been losing momentum. This is one development that did not blindside us, and has unfolded exactly as predicted. In January we wrote: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting." The theory underlying these mini-cycles is an economic model called the Cobweb Theorem.2 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a delay. The delay occurs because credit demand leads credit supply by several months (Chart I-4). Chart I-4Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse Turning Points In The Bond Yield Lead Turning Points In The Credit Impulse As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months, and the regularity creates predictability. Moreover, as most investors are unaware of these cycles, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. The global 6-month credit impulse is now indisputably in a mini-downswing phase, and exactly as predicted in January, the majority of economically sensitive sectors have underperformed. The glaring anomaly is oil, whose supply-side dynamics have dominated price action (Chart I-5). Given oil's major impact on headline inflation, inflation expectations, and on central bank reaction functions, the global bond yield has also disconnected from the mini-cycle - until now. Chart I-5Oil Is The Glaring Anomaly Oil Is The Glaring Anomaly Oil Is The Glaring Anomaly Mini-downswings last six to eight months and the usual release valve is a decline in bond yields. So one concern is that the apparent disconnect between decelerating global activity and slow-to-react bond yields could extend the current mini-downswing phase beyond the summer. How To Invest Right Now From an equity market perspective, the relative performance of the classically cyclical sectors - banks, basic materials and industrials - very closely tracks the phases of the global credit impulse mini-cycle (Chart I-6 and Chart I-7). For example, in all five of the last five mini-downswings, banks have underperformed healthcare, and we are seeing exactly the same in the current mini-cycle. Chart I-6In A Mini-Downswing##br## Banks Underperform In A Mini-Downswing, Banks Underperform In A Mini-Downswing, Banks Underperform Chart I-7In A Mini-Downswing ##br##Basic Materials Underperform In A Mini-Downswing, Basic Materials Underperform In A Mini-Downswing, Basic Materials Underperform For the next few months at least, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. This strategy has worked extremely well since we initiated it at the start of the year, and it should continue to do so. Sector strategy necessarily impacts stock market allocation. Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. The defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks (Chart I-8 and Chart I-9). Irrespective of the political uncertainties, our sector allocation establishes our near-term caution on these two markets. Prefer France's CAC over Italy's MIB and Spain's IBEX. Chart I-8Italy's MIB = Long Banks Italy's MIB = Long Banks Italy's MIB = Long Banks Chart I-9Spain's IBEX = Long Banks Spain's IBEX = Long Banks Spain's IBEX = Long Banks For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the global economy provide a natural cap and a tradeable reversal in yields. Hence, it is a good time to own a portfolio of high-quality 30-year government bonds. Regarding currencies, the recent developments in Italy have hurt our 50:50 combined long position in EUR/USD and SEK/USD; but this has been countered by gains in our short position in EUR/JPY. We have no tactical conviction on any of these crosses, but we will maintain this medium term currency portfolio unless the Italian 10-year BTP yield breaches the 4% line in the sand. Finally, the hardest call to make is on the direction of equity market. This is because a mini-downswing in global growth creates a headwind to earnings expectations; conversely, if bond yields are capped, this will provide some support to equity market valuations. On balance, this suggests that the year-to-date pattern of a range-bound equity market is set to continue. The caveat is that if Italy's line in the sand is breached, it would warrant a substantial de-risking. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model* It was a spectacular week for our fractal trades with four positions hitting their profit targets: long Poland/short Italy; short energy/long basic materials; short Spanish Bonos/long German bunds; and long AUD/NOK. This week, we note that the 65-day fractal dimension of the Polish zloty / U.S. dollar (or inverse) is approaching its lower limit. Go long PLN/USD with a profit target of 3.5% and symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long PLN/USD Long PLN/USD The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Last year's broad-based global growth recovery has given way to slower growth and increasing differentiation in growth rates across economies. The U.S. has gone from laggard to leader in the global growth horse race, helping to drive the dollar to a five-month high. The biggest risk to our cautious view on emerging markets is that China stimulates the economy proactively as an insurance policy against a possible trade war. So far, there is little evidence that this is happening, but we are watching the data closely. The turmoil in Italy's bond markets is a timely reminder that if the European periphery wants more stimulus, this has to happen through a weaker euro rather than through larger budget deficits. Stay short EUR/USD. We expect to take profits at around the 1.15 level. Feature From Convergence To Divergence 2017 was the year of synchronized global growth. For the first time since 2007, all 46 countries tracked by the OECD experienced positive GDP growth. The euro area economy surprised on the upside, recording real GDP growth of 2.3%. This was slightly above U.S. levels, despite the fact that trend growth is about half a percentage point lower in the euro area. Growth in Japan nearly doubled to 1.7% from the prior year. Emerging markets, which succumbed to a broad-based slowdown starting in 2015, came roaring back. The U.S. dollar tends to perform poorly when global growth is accelerating and the composition of that growth is shifting away from the United States. This was precisely the setting that the global economy found itself in last year, which is why the greenback came under pressure. Things are looking sharply different this year. Global growth has cooled, as evidenced by both the PMIs and economic surprise indices (Chart 1). Euro area growth was sliced in half in the first quarter; U.K. growth decelerated further; and Japanese growth fell into negative territory for the first time since 2015. In contrast, the U.S. has held up relatively well. While growth did dip to 2.3% in Q1, the latest tracking estimates suggest a rebound in the second quarter. Retail sales accelerated in April. The Philly Fed PMI also surprised on the upside, with the new orders component reaching the highest level since 1973. The New York's Fed model is pointing to growth of 3.2% in Q2, while the Atlanta Fed's Nowcast is signaling growth of 4.1%. The divergence in growth rates between the U.S. and most major economies has been mirrored in recent inflation prints. U.S. core inflation has moved higher, but has stumbled elsewhere (Chart 2). Chart 1Global Growth Has Cooled With The U.S.##br## Faring Best Global Growth Has Cooled With The U.S. Faring Best Global Growth Has Cooled With The U.S. Faring Best Chart 2Inflation Is Accelerating In The U.S., ##br##Decelerating Elsewhere Inflation Is Accelerating In The U.S., Decelerating Elsewhere Inflation Is Accelerating In The U.S., Decelerating Elsewhere The relatively strong pace of U.S. growth has led to a widening in interest-rate differentials between the United States and its peers. The 10-year U.S. Treasury yield has risen by 95 basis points since its September lows, compared to 20 points for German bunds, 47 points for U.K. gilts, and 4 points for JGBs. With the exception of the U.K., the increase in spreads has been dominated by the real rate component (Chart 3). Chart 3Widening Interest Rate Differentials Between The U.S. And Its Peers ##br##Have Been Driven By The Real Component Desynchronization Is Back Desynchronization Is Back King Dollar Reigns Supreme Conceptually, it is real, rather than nominal, interest rate differentials that ought to move currencies. We noted earlier this year that the dollar's failure to strengthen on the back of rising Treasury yields was an anomaly that was unlikely to persist. Sure enough, the dollar has now begun to recouple with real interest rate differentials (Chart 4). Our sense is that this year's trends can last a while longer. Leading Economic Indicators have continued to move in favor of the U.S., suggesting that U.S. outperformance is not likely to end anytime soon (Chart 5). Fiscal policy should also help prop up U.S. aggregate demand. The U.S. structural budget deficit is set to widen much more than elsewhere over the next few years (Chart 6). Chart 4Dollar Is Recoupling With Rate Differentials Dollar Is Recoupling With Rate Differentials Dollar Is Recoupling With Rate Differentials Chart 5U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers U.S. Is Outshining Its Peers Chart 6U.S. Fiscal Policy Is More Stimulative U.S. Fiscal Policy Is More Stimulative U.S. Fiscal Policy Is More Stimulative The U.S. economy is now back to full employment. For the first time in the 17-year history of the Bureau of Labor Statistics' Job Openings and Labor Turnover Survey (JOLTS), the number of job openings exceeds the number of unemployed workers (Chart 7). Our composite labor survey indicator has continued to move higher (Chart 8). Core PCE inflation has already accelerated to 2.3% on an annualized 6-month basis and 2.6% on a 3-month basis. The New York Fed's Inflation Gauge, which leads inflation by about 18 months, is pointing to higher inflation over the coming quarters (Chart 9). This means that the bar for further gradual rate hikes is quite low. Chart 7There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers There Are Now More Vacancies Than Jobseekers Chart 8U.S. Wage Growth Is Set To Grind Higher U.S. Wage Growth Is Set To Grind Higher U.S. Wage Growth Is Set To Grind Higher Chart 9U.S. Inflation: Upside Risks U.S. Inflation: Upside Risks U.S. Inflation: Upside Risks Recent revelations by Kevin Warsh - who was once the favorite to lead the Federal Reserve - that Trump was dismissive of the Fed's historic independence during their interview, is only likely to strengthen Jay Powell's resolve to avoid being seen as a Trump flunky.1 China: Shifting Into The Slow Lane? Of course, the outlook for the dollar and bond spreads will also hinge on what happens in the rest of the world. We are watching two economies especially closely: China and Italy. The latest data suggest that China has lost some growth momentum. Retail sales and fixed asset investment decelerated in April. Property sales also declined from an elevated level. Sales tend to lead prices. Home prices were flat in most tier 1 cities over the prior year, reflecting elevated inventory levels, tighter lending standards, and stricter administrative controls (Chart 10). Further price weakness is likely, which could dampen construction activity in the months ahead. Industrial production beat expectations in April, but the overall trend in industrial activity remains to the downside. Electricity production, freight traffic, and excavator sales have all been decelerating (Chart 11). Import growth has also come down, which is one reason why GDP growth in the rest of the world has moderated (Chart 12). Chart 10China: Housing Has Cooled China: Housing Has Cooled China: Housing Has Cooled Chart 11China: Industrial Activity Is Slowing China: Industrial Activity Is Slowing China: Industrial Activity Is Slowing Chart 12China: Import Growth Has Decelerated China: Import Growth Has Decelerated China: Import Growth Has Decelerated Trade War Fears: Will China Overcompensate? In addition to the regular cyclical growth risks, concerns about a trade war loom in the background. The Trump Administration's decision last weekend to defer imposing tariffs on China caused investors to breathe a sigh of relief, but much remains unresolved, including ongoing allegations that China is stealing intellectual property from the U.S. and other countries. Trump's decision to pull out of June's summit with North Korea will only strain America's relationship with China. Considering the damage to China that a full-out trade war would cause, it would be sensible for the government to take out some insurance against a possible downturn. Thus far, any evidence that the authorities are trying to stimulate the economy through either fiscal or monetary means is sketchy (Chart 13). Reserve requirements were cut by 100 basis points in April, but corporate borrowing costs remain elevated. Fiscal outlays are growing at broadly the same pace as last year. The trade-weighted RMB has continued to strengthen. Still, it is hard to believe that the government has not put together a contingency plan that it could roll out if circumstances warrant it. The biggest risk to our fairly cautious view on emerging markets is that China launches a stimulus package in response to a trade war that quickly ends in détente. Similar to what occurred in 2008/09, this would leave China with more stimulus than it actually needed. Italy: From Fiscal Austerity To Bunga Bunga Unlike in China, Italy's incoming coalition government - forged through an uneasy alliance between the populist Five Star Movement (M5S) and the right-leaning League - has made no secret about its desire to ease fiscal policy. The M5S wants more social spending while the League has lobbied for a flat tax. These measures, along with a host of others, would add €100 billion, or 6% of GDP, to the budget deficit. Given that the Italian unemployment rate stands at 11% - 5.3 percentage points above its 2007 low - one could make a compelling case that Italy would benefit from temporary fiscal stimulus. However, the proposed policies are being marketed as permanent in nature. Moreover, several policies, such as the proposal to roll back the planned increase in the retirement age, would actually reduce potential GDP by shrinking the size of the labor force. It is no wonder that bond markets are worried (Chart 14). Chart 13China: No Clear Evidence Of Stimulus ... Yet China: No Clear Evidence Of Stimulus ... Yet China: No Clear Evidence Of Stimulus ... Yet Chart 14Mamma Mia! Mamma Mia! Mamma Mia! Propping Up Demand In Italy Much has been written about what Italy should be doing, but the fact is that there are no simple solutions. Italy suffers from a shrinking working-age population and anemic productivity growth, both of which reduce the incentive for firms to expand capacity. Like many other European countries, Italy also suffers from a debt overhang. This is obviously true for government debt but it is also true, to some extent, for private debt. While the ratio of private debt-to-GDP is below the euro area average, it stills stands at 113%, up from 65% in the mid-1990s (Chart 15). The desire to save more in order to pay back debt, coupled with a reluctance to invest in new capacity, has left Italy with what economists call a private-sector financial surplus (Chart 16). Chart 15Italian Private Sector Has Been Taking ##br## On Less Debt Since The Crisis Italian Private Sector Has Been Taking On Less Debt Since The Crisis Italian Private Sector Has Been Taking On Less Debt Since The Crisis Chart 16Italy: The Private Sector Wants To Save Italy: The Private Sector Wants To Save Italy: The Private Sector Wants To Save If the private sector earns more than it spends, the excess savings have to be absorbed either by the government through its own dissaving or by the rest of the world through a current account surplus. Both options are problematic for Italy. Running large budget deficits for a prolonged period of time would take the level of government debt-to-GDP to stratospheric levels. Japan has been able to get away with this strategy because it issues debt in its own currency. This is a luxury that is not at Italy's disposal. Despite Mario Draghi's pledge to do "whatever it takes" to preserve the euro area, it is far from clear that the ECB would keep buying Italian debt if the country began to openly skirt the EU's deficit rules. Absent an effective lender of last resort, the Italian bond market could fall victim to a speculative attack - a process in which higher yields lead to even higher yields, and eventually a default (Chart 17). Chart 17When A Lender Of Last Resort Is Absent, Multiple Equilibria Are Possible Desynchronization Is Back Desynchronization Is Back This just leaves the option of trying to bolster aggregate demand by exporting excess production abroad via a current account surplus. To its credit, Italy has been able to shift its current account balance from a deficit of 1.4% of GDP in 2007 to a projected surplus of 2.6% of GDP this year. However, some of that surplus simply reflects the fact that a weak economy has suppressed imports. Progress in reducing unit labor costs relative to its euro area peers has been painfully slow (Chart 18). Chart 18Italy: More Work To Be Done To Improve Competitiveness Italy: More Work To Be Done To Improve Competitiveness Italy: More Work To Be Done To Improve Competitiveness If Italy had a flexible exchange rate, it could simply devalue its currency to gain competitiveness. Since it does not have one, it has to improve competitiveness by restraining wage growth and implementing productivity-enhancing structural reforms. The former requires the presence of labor market slack, while the latter, even in a best-case scenario, will take substantial time to achieve. And neither option is politically popular. Given the difficulty of raising Italy's competitiveness relative to the rest of the euro area, the only realistic short-term solution is to boost it relative to the rest of the world. That requires a weak euro which, in turn, requires a dovish ECB. Investment Conclusions In our Second Quarter Strategy Outlook, published on March 30th, we predicted that the dollar was poised to experience a violent rally as short sellers rushed to cover their positions. This view has played out in spades. As we go to press, the nominal broad-trade weighted dollar has gained 4% since early April. It is up 30% since bottoming in July 2011 and is only 6% below its December 2016 peak (Chart 19). The dollar rally has brought our views closer in line with the market. Notably, EUR/USD is now less than two percent above our target of $1.15. The dollar is an ultra-high momentum currency. Chart 20 shows that a simple strategy of buying the DXY when it was above its moving average and selling it when it was below its moving average would have delivered a sizable profit over the past two decades (the exact moving average does not matter much, but the 50-day seems to work best). As such, while we intend to turn neutral on the dollar if it gains another few percent or so, an overshoot is quite probable. Chart 19The Dollar Has Bounced Back The Dollar Has Bounced Back The Dollar Has Bounced Back Chart 20The Dollar Trades On Momentum Desynchronization Is Back Desynchronization Is Back About 80% of EM foreign-currency debt is denominated in dollars. In many cases, dollar borrowers have non-dollar revenue streams. Thus, a stronger dollar automatically hurts their businesses. In the past, this has often ignited a feedback loop where a stronger dollar triggers capital outflows from emerging markets, leading to an even stronger dollar. Our EM strategists strongly feel that such a vicious cycle is fast approaching, especially if China's economy continues to slow. In the late 1990s, brewing EM tensions triggered several brutal equity selloffs. For example, the S&P lost 22% between July 20 and October 8, 1998. However, EM stress also restrained the Fed from tightening too quickly. The resulting dose of liquidity set the stage for a massive blow-off rally between the fall of 1998 and the spring of 2000. A similar dynamic could unfold this time around. We remain overweight global equities for now, but are hedging the risk by being short AUD/JPY, a trade that has gained 5% since we initiated it on February 1st. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Ben White, "How Trump could break from the Fed's independence," Politico, May 9, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature The prospect of a 5S-Lega government in Italy is unnerving some analysts and commentators. Italy's sovereign debt-to-GDP ratio is already one of the highest in the world. A seemingly endless economic stagnation is constraining GDP, and now the populists are proposing policies that would increase the deficit, lifting sovereign debt even higher. Feature ChartFiscal Thrust Has Driven Italy's ##br##Growth In Recent Years Fiscal Thrust Has Driven Italy's Growth In Recent Years Fiscal Thrust Has Driven Italy's Growth In Recent Years The suggested cures to Italy's high sovereign debt-to-GDP ratio divide into two opposing camps. One camp - Italy's populists - wants to boost GDP, the ratio's denominator. The other camp - Brussels - wants to rein in sovereign debt, the ratio's numerator. Who's right? It is not a simple choice. Growth and debt are not independent variables. It is impossible to boost growth quickly without a positive credit impulse from some part of the economy. Equally, reducing government borrowing can have a devastating impact on growth (Chart I-2). Therefore, to resolve the conflict between Italy's populists and Brussels, we need to understand the specific relationship in Italy between government debt, GDP, and their interaction: the fiscal multiplier. Chart I-2The Fiscal Multiplier Is High ##br##When The Private Sector Or Banks Are Financially Unhealthy Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? Italy Is Right, Brussels Is Wrong Imagine that government debt starts at 130 and GDP starts at 100. Imagine also that each unit of government borrowing to spend lifts GDP by one unit, meaning the fiscal multiplier equals one. Under these assumptions, three units of fiscal thrust would lift debt to 133 and lift GDP to 103, reducing the debt-to-GDP ratio to 129%. Conversely, three units of fiscal drag would reduce debt to 127 and reduce GDP to 97, paradoxically increasing the debt-to-GDP ratio to 131% and making the austerity strategy entirely counterproductive. Critics will snap back that these two assumptions appear inconsistent. When sovereign indebtedness is already high, at say 130% of GDP, it seems implausible that the fiscal multiplier could also be high: the government has already done its useful borrowing to spend and, at the margin, additional borrowing is likely to be 'fiscally irresponsible'. This criticism would be valid if the government was the only part of the economy that could borrow. But it isn't. Whether the fiscal multiplier is high or low also depends on what is happening in the private sector (Chart I-3). Chart I-3The Fiscal Multiplier Is Low ##br##When The Private Sector And Banks Are Financially Healthy Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? Fiscal multipliers become very high when there is a breakdown in the ability of households and firms to borrow and/or a breakdown in the ability of banks to lend. After such a breakdown, credit flows to the private sector remain depressed however low (or negative) interest rates go. Specifically, this happens after a severe economic trauma when large numbers of households and firms are simultaneously repairing their badly damaged balance sheets and/or when banks are insolvent. If the one and only engine of demand - government spending - then cuts out, the economy can enter a prolonged stagnation. Under such conditions, thrift reinforces thrift: one unit of fiscal drag can trigger an additional private sector spending cut, magnifying the impact of the original cut. In other words, the fiscal multiplier can exceed one and reach a level as high as two according to several academic and empirical studies.1 During and immediately after the global financial crisis, fiscal multipliers surged. Through 2009-12, fiscal thrust had a very strong explanatory power for GDP growth; across 14 major economies, the regression slope of 1.5 confirms a high average fiscal multiplier. In other words, each unit of fiscal thrust boosted GDP by 1.5 units; and each unit of fiscal drag depressed GDP by 1.5 units.2 Another way to see this is to observe that in the global financial crisis the economies that had the largest fiscal thrusts tended to experience the least severe recessions. The annual fiscal thrust in the U.S., U.K. and France equalled 2% of GDP; in Spain it equalled 3%.3 By contrast, Germany and Italy had negligible fiscal thrusts, and they suffered the worst recessions. But by 2012, households and firms around the world were willing to borrow again, and banks were sufficiently recapitalised to lend. Hence, fiscal multipliers slumped: fiscal thrust no longer had any explanatory power for GDP growth (Charts I-4 - I-7). Chart I-4Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.S. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.S. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.S. Chart I-5Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.K. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.K. Post 2012: No Connection Between Fiscal Thrust And Growth In The U.K. Chart I-6Post 2012: No Connection Between ##br##Fiscal Thrust And Growth In The Germany Post 2012: No Connection Between Fiscal Thrust And Growth In The Germany Post 2012: No Connection Between Fiscal Thrust And Growth In The Germany Chart I-7Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The France Post 2012: No Connection Between Fiscal Thrust And Growth In The France Post 2012: No Connection Between Fiscal Thrust And Growth In The France There was one glaring exception to this trend: alas, poor Italy. Trapped in the EU's inflexible and misguided fiscal compact, and without an outright crisis, the Italian government could not recapitalise the dysfunctional banks. Although the solvency of the banks has improved in the past year, the evidence strongly suggests that fiscal thrust remains the main driver of the Italian economy (Feature Chart). On this evidence, the best economic policy for Italy right now is not to adhere slavishly to the misguided one-size-fits-all EU fiscal compact. The best policy is to use fiscal thrust intelligently to boost growth. We conclude that, on this specific point, Italy's populists are right and Brussels is wrong. Italy Needs Growth Italian BTPs offer a yield premium over German bunds as a compensation for two possible risks. One risk is a haircut or, more euphemistically, a 'restructuring'. But the likelihood of such a restructuring is very low. Putting aside the damage it would do to Italy's international standing, the simpler explanation is that it would kill the Italian banking system. As a rule of thumb, a bank's investors start to get nervous about its solvency when equity capital no longer covers its net non-performing loans (NPLs). In this regard, the largest Italian banks now have €165 billion of equity capital against €130 billion of NPLs, implying excess capital of €35 billion. The banks also hold around €350 billion of Italian government bonds (Chart I-8). Chart I-8Italian Banks Own 350 Billion Euro Of Italian Government Bonds Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? So a mere 10% haircut on these BTPs could cripple the banking system and send the economy into a new tailspin. Meaning, it is in nobody's interest to restructure Italian bonds. The more likely risk to BTP holders - albeit still small - is redenomination out of the euro and into a reinstated lira. In which case the yield premium on BTPs ought to equal: (The likely loss on being paid in liras rather than deutschmarks) multiplied by (the annual probability of Italy leaving the euro) The first of these terms captures Italy's competitiveness shortfall versus Germany, which will change quite gradually. The second term captures a political risk, as leaving the euro would require a mandate from the Italian people. This means that the second term is very sensitive (inversely) to the popularity of the euro in Italy. It follows that a policy that kick starts growth and improves living standards - thereby boosting the popularity of the euro amongst the Italian people - is also a good policy for Italian bonds, banks, sustainable growth in Italy, and therefore for the euro itself. Bear in mind that Italy's structural deficit, at just 1%, is nowhere near the double-digit percentage levels that reliably signal the onset of a sovereign debt trap (Table I-1). Table I-1Italy's Structural Deficit Has Almost Disappeared Italy Vs Brussels: Who's Right? Italy Vs Brussels: Who's Right? Given Italy's high fiscal multiplier, we conclude once again that Italy's populists are right and Brussels is wrong. Some Investment Considerations Italian assets rallied strongly at the start of the year and certainly did not discount an election outcome in which the unlikely bedfellows 5S and La Lega formed a government. Therefore, from a technical perspective, the rally was extended and ripe for a pullback. A further consideration for Italy's MIB is that it is over-weighted to banks, so a sustained outperformance from the stock market requires a sustained outperformance from global banks, which we do not expect to start imminently. So in the near term, we prefer France's CAC to Italy's MIB. We have also opened a tactical pair-trade: long Poland's Warsaw General Index, short Italy's MIB. However, later this year, we expect both our credit impulse (cyclical) indicator and fractal dimension (technical) indicator to signal a better entry point into banks, into the Italian equity market and for BTP yield spread compression. Italy's structural deficit, at 1%, is amongst the lowest in the world, so Italy has plenty of 'fiscal space'. Moreover, fiscal stimulus can deliver bang for its buck because Italy appears to have a high fiscal multiplier. This differentiates Italy from other major economies, and makes the EU's one-size-fits-all fiscal compact entirely counterproductive for the euro area's third largest economy. This means that policies that push back against Brussels on this specific point might finally permit Italy to escape its decade-long growth trap. And therefore, somewhat paradoxically, they will enable the yield premium on 10-year Italian BTPs versus 10-year French OATs ultimately to compress. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, please see: When Is The Government Spending Multiplier Large? Christiano, Eichenbaum and Rebelo, Northwestern University. 2 Even removing the outlier data point that is Greece, the best-fit line has a slope of 1.1. And the r-squared explanatory power remains significant at 0.5. 3 Through 2008-9.

Highlights The spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. The 2017 tax bill, rising energy prices, and banks' willingness to lend all suggest strong capital spending this year. Our view is that stagflation is not a near-term threat. Nonetheless, investors are concerned about a return of a period of decelerating growth and rising inflation. We examine the performance of U.S. financials in and out of stagflation. We reexamine the link between inflation, deficits, credit and money supply growth. Feature Chart 11H GDP Tracking Well Above Potential 1H GDP Tracking Well Above Potential 1H GDP Tracking Well Above Potential The VIX moved lower last week even as U.S. bond yields rose. Tensions with North Korea re-escalated, but Trump's trade spat with China eased. On balance, the spike in volatility in early 2018 did not change the trajectory of most of the cross-asset correlations that we track. Economic growth prospects in the U.S. remained upbeat. A series of reports for April and May on housing, consumer spending, manufacturing and capital spending all indicated that real GDP growth in Q2 2018 was tracking to over 4% after a 2.3% gain in Q1, well above the economy's potential growth rate of 1.8% (Chart 1). Capital spending remains poised to lift off in 2018 aided by the supply-side impact of the 2017 tax cut bill and higher oil prices. Despite upbeat economic news in the U.S., there were additional signs last week that growth outside the U.S. was slowing.1 This deceleration, coupled with recent readings on wage and price inflation, suggest that investors may be concerned that stagflation is imminent. BCA's view is that the next bout of stagflation is still several years away. In this week's report, we look at the longer-term relationship between inflation, money supply, credit growth and deficits. Early 2018 Volatility Spike: An Update Surges in volatility do not signal either the end of a business cycle or an equity bear market. Moreover, while there are many examples of shifts in correlation around elevated equity volatility, there is no consistent relationship between the two.2 Nonetheless, 60% of volatility upheavals outside of recessions occurred during the late stages of a business cycle. Thus, the recent jump in volatility is another signal that the economy is in the final stages of expansion. Our November 13, 2017 report discussed financial market volatility and its relationship with the business cycle, monetary policy and economic volatility.3 In that report, we noted that any meaningful pickup in inflation would upset the 'low vol' applecart. Prices of U.S. dollar financial assets have recovered since early February's market turbulence, but are not back to pre-spike levels. Chart 2 shows that at 13.7, the VIX is 63% lower than its early February peak. Neither the stock-to-bond ratio (panel 2) nor the S&P 500 (panel 3) has returned to its late January high, but both have bounced up. Small caps (panel 4) have hit a new record, but emerging market equity prices (in U.S. dollars) have languished. The price of West Texas Intermediate oil reached a fresh cycle high in late March and is now above $70 (Chart 3, panel 2). BCA's Commodity & Energy Strategy service expects West Texas to average $70/bbl this year. Moreover, increasing geopolitical risks to supplies (Venezuela and Iran) raise the chances of WTI prices reaching $80/bbl by the end of the year, with Brent prices threatening $90/bbl.4 Our stance on oil prices this year supports more energy-related capex (see next section). Panel 3 shows that despite higher realized inflation and inflation expectations, gold prices have rolled over since the volatility spike. High-yield spreads briefly returned to their late January lows in mid-April, but are now back to the middle of the range that they have been in since early February (panel 4). The dollar has surged in recent months (panel 5). BCA's view is that the dollar will continue to strengthen as the Fed raises rates more than the market expects and as U.S. economic growth outpaces growth outside the U.S.5 Chart 2The VIX And U.S. Financial Assets... The VIX And U.S. Financial Assets... The VIX And U.S. Financial Assets... Chart 3...Before And After The February Vol Spike ...Before And After The February Vol Spike ...Before And After The February Vol Spike Chart 4 shows three-year rolling correlations between several major U.S. asset classes. The early 2018 volatility spike coincided with a shift in the link between the 10-year Treasury yield and the broad dollar (panel 2). The relationship between Treasury yields and oil troughed prior to the spike and continues to climb (panel 4). Otherwise, the longer-term, cross-asset class correlations in place prior to early February are still in play. Chart 4Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations Spike In Vol Vs. Stock, Bond Dollar, Oil Correlations However, shorter-term correlations within the S&P 500 have shifted (Chart 5). The early February volatility run up marked a bottom in the correlation between sectors, industries and individual S&P 500 stocks. This is consistent with what happened in the wake of volatility spikes in 2010 and 2011, but not following the 2015 episode. Bottom Line: The recent vol spike did not signal the end of the expansion or the bull market. Stay long stocks over bonds. Chart 5Intra-S&P 500 Correlations Shifted After The Vol Spike Intra-S&P 500 Correlations Shifted After The Vol Spike Intra-S&P 500 Correlations Shifted After The Vol Spike Soundings From The Supply Side BCA expects the U.S. economy to grow above its long-term potential this year and into next year, further reducing slack in both the product and labor markets, and ultimately pushing up inflation. We discussed the housing and consumer sectors in early May6 and this week, we assess business capital spending. Our recent reports7 discussed the near-term benefits to the U.S. economy from higher government spending, but there are supply side benefits as well. The Congressional Budget Office (CBO) boosted its estimate of the economy's long-run potential growth rate due to the supply-side benefits of lower taxes on the labor market and the immediate expensing of capital outlays. Faster growth in the long run would reduce the projected cumulative budget deficit from 2018-2027 by $1 trillion. The CBO also expects that labor force growth will pick up as lower personal income tax rates encourage workers to work longer hours.8 BCA's view is that capital spending was on the upswing before the tax bill passed last year (Chart 6). Moreover, our model for business capital spending suggests gains even without higher oil prices (Chart 7). Chart 8 shows that banks are easing their lending standards for C&I loans (panel 1) and that higher rates have not yet increased the cost of funding to restrictive levels (panel 2). However, demand has been tepid, although it is still trending higher (panel 3). The tax repatriation portion of the 2017 tax cut may have temporarily reduced businesses' demand for loans. Chart 6S&P 500 Sensitive To Oil ##br##Prices And Oil Driven Capex S&P 500 Sensitive To Oil Prices And Oil Driven Capex S&P 500 Sensitive To Oil Prices And Oil Driven Capex Chart 7Business Spending Poised To Lift Off Business Spending Poised To Lift Off Business Spending Poised To Lift Off Chart 8Supply And Demand For C&I Loans Supply And Demand For C&I Loans Supply And Demand For C&I Loans Bottom Line: A surge in U.S. capital spending is likely in the second half of 2018 and into 2019. The rising cost of human capital and sagging productivity are additional incentives for firms to spend on labor-saving equipment. Moreover, increased oil prices will drive additional spending in the energy sector. Our U.S. Equity Strategy team recommends an overweight to the Industrials sector.9 While surging capex this year and next will help to boost productivity in the short run, a comprehensive, economy-wide infrastructure package would be helpful in steering the economy away from stagflation in the long run. Stagflation Scenario BCA's 2018 Outlook10 notes that stagflation may be not be present in the U.S. for several more years, likely not until the early 2020s after the next recession. However, BCA's Global Fixed Income Strategy service states that the global economy may be entering a period of mild stagflation characterized by slowing economic growth and rising inflation.11 Nonetheless, some investors are concerned that a prolonged period of stagflation may ensue. We define stagflation as episodes of decelerating real economic growth and accelerating core inflation (Chart 9). Accordingly, stagflation occurred in the 1960s, 1970s and early 1980s. Since then, there have been an additional six episodes, all of them milder than earlier occurrences. The last bout was between July 2015 and October 2016. Chart 9Risk Assets And Stagflation Risk Assets And Stagflation Risk Assets And Stagflation We show the performance of U.S. financial assets, commodities, the dollar and S&P 500 earnings when stagflation was present (Table 1) and when it was not (Table 2). Note that recessions occurred during four of the stagflationary periods (late '60s/early '70s, early-to-mid '70s, late '70s, and late '90s-to-early 2000s). There were two recessions (early 1980s and 2007-2009) when stagflation did not appear. Table 1Risk Assets, Commodities, Gold Oil And The Dollar During Stagflation Too Soon For Stagflation? Too Soon For Stagflation? Table 2Risk Assets, Commodities, Gold Oil And The Dollar When No Stagflation Is Present Too Soon For Stagflation? Too Soon For Stagflation? U.S. stocks, the stock-to-bond ratio, investment-grade credit and high-yield bonds outperform when there is no stagflation. Small cap performance relative to large caps is also better when stagflation is present. Gold (average gain of 85%) and oil (86%) are the standout performers during these cycles. Without stagflation present, gold rises by only 13% on average and oil prices fall by 11%. The dollar climbs by 4% on average without stagflation and declines by 5% when stagflation develops. Restricting our analysis to only the more benign bouts of stagflation in the past 20 years we find similar results; stocks, the stock-to-bond ratio, investment grade and high yield credit perform better when there are bouts of benign stagflation. A notable exception is that there has been little difference in the performance of gold in or out of stagflation in the past two decades. Bottom Line: BCA expects inflation to reach the Fed's 2% target this year and accelerate in 2019, prompting more aggressive central bank actions in mid-2019 through mid-2020 than the market currently prices in. Increased rates will send the economy into recession in 2020. Stagflation will likely take hold as the economy recovers from that recession. Stay overweight stocks versus bonds for now, but look to pare back exposures later this year. Investors with longer time horizons should begin to prepare for lower real returns in the 2020s after the end of the recession early in the decade. Inflation: A Longer-Term View Some investors are concerned that rising deficits will immediately lead to higher inflation. We take a longer-term approach based on our analysis of the link between inflation and federal government interest payments, private credit growth, money supply growth and federal budget deficits. There is only a loose relationship between federal government interest payments as a share of GDP and inflation (Chart 10). For example, interest payments were high relative to GDP in the 1990s, but inflation was low. In the 1970s, inflation was high while interest payments as a share of GDP were not at an extreme. However, there is a strong connection between the growth of private credit and money supply, and inflation. Chart 11 shows that elevated rates for private credit growth are associated with increased inflation and vice versa. High inflation in the 1970s was accompanied by strong credit growth. In this decade, we have experienced meager private credit creation and very low inflation. Chart 12 shows a similar relationship between M2 growth and inflation. Note that strong M2 growth in the 1970s coincided with high inflation, while minimal growth in money supply in the 1930s was accompanied by deflation. On the other hand, there is only a tenuous connection between deficits as a share of GDP and inflation (Chart 13). In the inflationary 1970s, deficits averaged just 2% of GDP. However, the 1950s and 1960s saw both exceedingly low inflation and deficits. So far in the 2010s, deficits have averaged near 5% of GDP, but inflation has been muted at barely over 1%. Chart 10Long Run Relationship Between Federal ##br##Net Interest Payments And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Chart 11Long Run Relationship Between ##br##Private Credit Growth And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Chart 12Long Run Relationship Between ##br##M2 Growth And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Chart 13Long Run Relationship Between Federal ##br##Budget Deficits And Inflation Too Soon For Stagflation? Too Soon For Stagflation? Moreover, the fiscal stimulus put in place late last year and early this year is likely to push inflation higher as it adds to aggregate demand in an economy that is already at full employment. Bottom Line: BCA expects inflation to reach the Fed's 2% target based on the core PCE measure this year, and move above that goal next year, which would drive up both short and long rates. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Serenity Now," published May 15, 2018. Available at gfis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report "Patience Required," published November 13, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Feedback Loop: Spec Positioning & Oil Price Volatility," published May 10, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's Global Investment Strategy Weekly Report "Swan Songs," published May 18, 2018. Available at gis.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Consumer And Housing Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 7 Please see BCA Research's The Bank Credit Analyst, published May 2018 and U.S. Investment Strategy Weekly Report "Late Innings," published February 26, 2018. Available at bca.bcaresearch.com and usis.bcaresearch.com. 8 https://www.cbo.gov/system/files/115th-congress-2017-2018/reports/53651… 9 Please see BCA Research's U.S. Equity Strategy Weekly Report "Earnings Take Center Stage," published October 2, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's The Bank Credit Analyst "2018 Outlook - Policy And The Markets: On A Collision Course," published November 20, 2017. Available at bca.bcaresearch.com. 11 Please see BCA Research's Global Fixed Income Strategy Weekly Report "Stagflation-ish," published April 18, 2018. Available at gfis.bcaresearch.com.

Highlights The labor market continues to tighten and pressure the Fed. Tightening financial conditions suggest more muted returns for U.S. dollar assets and are associated with a peak in cyclical sectors. BCA's proprietary Monetary Indicator (MI) has turned lower, indicating that liquidity is drying up. Assessing performance of financial markets and the economy as financial conditions tighten. Feature Chart 1Oil Prices And Breakevens##BR##Moving In Lock Step Oil Prices And Breakevens Moving In Lock Step Oil Prices And Breakevens Moving In Lock Step Oil prices rose last week, U.S. equity prices climbed and credit spreads narrowed. Energy prices surged in the wake of President Trump's withdrawal from the 2015 JCPOA deal with Iran. BCA's Commodity & Energy Strategy team noted that the decision is unambiguously bullish for oil prices.1 Escalating geopolitical risks2 with Iran will add the potential for oil supply losses down the road and hence, add a premium to prices. Venezuelan oil production has been declining for the past two years, sitting at only 1.5 million b/d. The pace of future declines is unknown, but the potential for another steep contraction is worrisome as Venezuela's economic collapse continues and links in the oil export supply chain are breaking down. In light of these factors, BCA expects oil prices to test $90/bbl by the end of year. Importantly, inflation expectations are escalating along with oil prices (Chart 1). Continued upward pressure will have implications for monetary policy, particularly in the U.S. where inflation is approaching the Fed's target. The bottom panel of Chart 1 shows that the correlation between Brent crude and the 10-year Treasury breakeven swaps is positive and rising. BCA's U.S. Bond Strategy service pegs fair value for the 10-year Treasury yield at 3.28%.3 The Fed is poised to raise rates gradually this year and next as the labor market tightens further, pushing up wage inflation. Fed rate hikes will squeeze financial conditions and ultimately trigger the next recession in early 2020. Tightening financial conditions suggest more muted returns for U.S. dollar assets and are associated with a peak in cyclical sectors of the economy. Meanwhile, liquidity indicators remain generally favorable for financial assets and the U.S. economy. Nonetheless, BCA's proprietary Monetary Indicator (MI) has turned lower, indicating that liquidity is drying up. The March To 3.5% Data from the National Federation of Independent Business (NFIB) in April and the Job Openings and Labor Turnover Survey (JOLTS) in March support our stance that the slack in the U.S. labor market is tightening and will ultimately lead to higher wage inflation. As noted in last week's report,4 the U.S. economy created an average of 208,000 new jobs in the three months ending April and the unemployment rate fell to a new cycle low of 3.9%. Annual wage inflation moderated in April to just 2.6% from a recent high of 2.8% in January. Chart 2 shows that small business owners' compensation plans remained near all-time highs in April. This metric is closely aligned with the wages and salaries component of the Employment Cost Index (ECI) and suggests further acceleration ahead for the ECI (panel 1). Job openings via the JOLTS data also hit a new zenith in March, creating an even wider gap between openings and hires (panel 2). Moreover, quits minus layoffs, another indicator of labor market slack, reached a record high (panel 3). The stout labor market has lifted the prime age (25-54 years) participation rate. BCA expects that the overall participation rate will remain flat in the next year or so. However, we concur with the Congressional Budget Office that due to demographics, the participation rate will drift lower in the next decade.5 Moreover, the robustness of the labor market is widespread. Charts 3A and 3B show the ratio of job openings to the number of unemployed in 10 sectors of the economy. The ratio is at an all-time high in 9 of the 10 sectors. The exception is the information sector, which includes industries such as newspaper and magazine publishing, broadcasting and telecommunications. Chart 2Labor Market Slack Is Disappearing Labor Market Slack Is Disappearing Labor Market Slack Is Disappearing Chart 3AStrength In The Labor Market... Strength In The Labor Market... Strength In The Labor Market... Chart 3B... Is Broad-Based ... Is Broad-Based ... Is Broad-Based Bottom Line: The U.S. labor market continued to tighten as Q2 began. BCA's stance is that the unemployment rate will fall to a 50-year low of 3.5% by mid-2019.6 The FOMC pegs the longer-term unemployment rate at 4.5%.7 The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. However, BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 3.9%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 curve to remain around 50bps until the inflation breakevens are re-anchored between 2.3% and 2.5% as upward pressure on the short end from Fed rate hikes is offset by the upward thrust of the breakevens on the long end.8 Stay underweight duration. How High Is High? Chart 4Cyclical Spending Suggests That##BR##Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative Cyclical Spending Suggests That Monetary Policy Remains Accommodative The uptrend in cyclical spending suggests that U.S. monetary policy remains accommodative for the time being. Chart 4 shows overall cyclical spending as a share of potential GDP (panel 1) and for sectors most sensitive to the business cycle and interest rates: consumer spending on durables (panel 2), capital spending (panels 3 and 4) and housing (panel 4). All of these metrics are in an uptrend, although the rate of increase has declined during the past few quarters because of slightly weaker consumer spending on durables. In last week's report, we noted that rising rates and tighter financial conditions will not impact household and business spending this year.9 Table 1 shows that since 1960 total cyclical spending as a share of potential GDP has peaked six quarters prior to the onset of a recession. Consistent with our prior research,10 housing reached a zenith several quarters before other sectors. On the other hand, business spending on commercial real estate topped out only a year before a recession. Housing also provides the earliest warning in long economic cycles,11 peaking 14 quarters before the end of an expansion. Overall, cyclical sectors in long expansions crest 10 quarters before the onset of a downturn. Bottom Line: The performance of cyclical segments of the economy suggests that monetary policy is still accommodative. A distinct peak in these sectors will signal that Fed policy has turned restrictive and that long-term rates are close to their cyclical highs. Until then, stay long stocks over bonds and underweight duration. Tightening liquidity and financial conditions are associated with peaks in the cyclical sectors of the economy. Table 1Recession Signals From Cyclical Sectors Of The Economy Tightening Up Tightening Up Liquidity And Financial Conditions While liquidity conditions are accommodative, they are not nearly as abundant as prior to the Lehman event. The October 2017 Bank Credit Analyst Special Report on liquidity12 noted that monetary conditions are super easy, while balance sheet and financial market liquidity are reasonably constructive. In contrast, funding liquidity, while vastly improved since the global financial crisis (GFC), is still a long way from the pre-Lehman go-go years, according to several important indicators such as bank leverage. Moreover, the Fed is in the process of unwinding a massive amount of monetary liquidity provided by its quantitative easing program. The gauges of liquidity have turned restrictive in recent months. Chart 5 shows M2 growth less GDP growth (top panel) along with monetary conditions and world reserves ex gold. Furthermore, the gap between nominal GDP growth and short rates has narrowed this year (Chart 6). Still, GDP growth is outpacing short rates, a sign that monetary liquidity is still present. Chart 5Monetary Liquidity Indicators (I) Monetary Liquidity Indicators (I) Monetary Liquidity Indicators (I) Chart 6Monetary Liquidity Indicators (II) Monetary Liquidity Indicators (II) Monetary Liquidity Indicators (II) Balance sheet liquidity for corporations, households and the banking sector remains supportive. The top panel of Chart 7 presents short-term assets-to-total liabilities for the corporate sector. It is a measure of readily available cash or cash-like instruments that make it easier to weather economic downturns and/or credit tightening phases. The non-financial corporate sector is in very good shape from this perspective. The seizure of the commercial paper market during the GFC encouraged firms to hold more liquid assets on their balance sheets. However, the uptrend began in the early 1990s and likely reflects tax avoidance efforts. The impact of the Tax Cut and Jobs Act of 2017 may partially reverse this trend. Households are also very liquid when short-term assets are compared with income (panel 2). Liquidity is low as a share of individuals' total discretionary financial portfolios, but this is not surprising given extraordinarily unattractive interest rates. In the banking sector, short-term assets as a percentage of total bank credit has climbed in the past decade as banks were forced to hold more liquid assets in the wake of the 2007-2009 financial crisis (Chart 8). Chart 7Balance Sheet Liquidity Balance Sheet Liquidity Balance Sheet Liquidity Chart 8Banking Sector Liquidity Banking Sector Liquidity Banking Sector Liquidity Charts 9 and 10 show market liquidity in the U.S. equity and high-yield markets. For the equity market, we present the one-year moving average of trading volume divided by shares outstanding or share turnover to get a sense of relative liquidity between firms (Chart 9). This measure has improved in recent years, but remains compressed vis-a-vis pre-crisis levels. BCA's Equity Trading System favors firms with lower liquidity, since investors pay a premium for liquidity.13 Liquidity in the high-yield market has recovered in recent years, but flows into high-yield bond funds turned negative in mid-2017 (Chart 10, panels 1 and 2). Nonetheless, the default-adjusted junk spread remains below its long-term average (panel 3). BCA's U.S. Bond Strategy service recommends investors overweight high-yield bonds relative to Treasuries.14 Chart 9Equity Market Liquidity Equity Market Liquidity Equity Market Liquidity Chart 10High Yield Bond Market Liquidity High Yield Bond Market Liquidity High Yield Bond Market Liquidity Funding liquidity - as measured by primary dealers' securities lending - has recovered from financial crisis lows, but has not reached pre-crisis highs (Chart 11, panel 1). Primary dealers make loans to other financial institutions with the purpose of buying securities, thereby providing both funding liquidity and market liquidity. The uptrend in margin debt remains in place (panel 2). The steep escalation in this direct measure of funding liquidity is less impressive when compared with the S&P 500's market cap. Bank's lending standards for C&I loans are another measure of funding liquidity (Chart 12). These surveys reflect bank lending standards on loans to the household or corporate sectors. Nonetheless, a financial institution's appetite for lending for the purposes of securities purchases is highly correlated. Lending standards eased in 2017 and in early 2018, but they are not as loose as they were earlier in this cycle or in the pre-crisis period (2005-2007). Chart 11Funding Liquidity:##BR##Securities Lending And Margin Debt bca.usis_wr_2018_05_14_c11 bca.usis_wr_2018_05_14_c11 Chart 12Funding Liquidity:##BR##Bank Lending Standards Funding Liquidity: Bank Lending Standards Funding Liquidity: Bank Lending Standards Perspective On Liquidity And Financial Conditions BCA expects that both monetary and financial conditions will constrict in the next year as inflation moves through the Fed's 2% target and the FOMC gradually boosts rates in the next 12 months. A stronger dollar and higher bond yields will contribute to the tightening, but higher equity prices are an offset. Chart 13, Appendix Chart 1, and Tables 2 and 3 show BCA's MI versus key U.S. financial assets and commodities, and U.S. economic variables. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Moreover, BCA's stocks-to-bonds ratio rises, investment-grade and high-yield corporate bonds outperform Treasuries. However, oil prices struggle in this environment (Chart 13 and Table 2). Chart 13Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Risk Assets When BCA's Proprietary Monetary Indicator Is Below Zero Table 2Performance Of Risk Assets When Monetary Indicator Is Above Zero Tightening Up Tightening Up Table 3Performance Of Risk Assets When Monetary Indicator Is Below Zero Tightening Up Tightening Up When MI is below zero, on the other hand, economic performance is mixed. GDP growth, cyclical spending as a share of GDP, and employment tend to peak when the MI is decelerating, but recessions rarely occur when the MI is negative (Appendix Chart 1, panels 2, 3 and 4). Core inflation often peaks when the MI is above zero (not shown). However, the MI is sending a negative signal because interest rates have increased and credit growth has slowed. Table 3 indicates the performance of U.S. financial assets when the MI is below zero. We used the periods in which the MI was persistently below zero to avoid false signals. Note that the average and median returns for most asset classes in Table 3 (MI below zero) are well below those in Table 2 (MI above zero). Notable exceptions are oil and the dollar, which strengthen when the MI is below zero. S&P 500 earnings growth struggles during this episodes. Chart 14, Appendix Chart 2, and Tables 4 and 5 present financial conditions versus key U.S. financial assets and commodities, and U.S. economic variables. BCA expects the financial conditions index (FCI) to decline further into negative territory in the next few years. U.S. equities and credit tend to perform better when the FCI rises (Table 4) rather than when it falls (Table 5). However, when it does fall, gold and oil are stronger. Chart 14Risk Assets When Financial Conditions Tighten Risk Assets When Financial Conditions Tighten Risk Assets When Financial Conditions Tighten Table 4Performance Of Risk Assets When Financial Conditions Are Easing Tightening Up Tightening Up Table 5Performance Of Risk Assets When Financial Conditions Are Tightening Tightening Up Tightening Up Moreover, we note that GDP growth and cyclical spending as a share of GDP often peak when FCI drops. Employment and inflation are mixed at best when the FCI decelerates (Appendix Chart 2). Bottom Line: The U.S. economy is growing above its long-term potential, the labor market is tightening and inflation is at the Fed's target but poised to move higher next year. The Fed will increase rates to cool the overheating economy. Therefore, liquidity and financial market conditions will deteriorate further in the next year as Treasury yields increase and the dollar climbs in tandem with a more aggressive Fed. Stay overweight stocks versus bonds for now, but look to pare back exposure later this year. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Energy Sector Strategy Weekly Report "Geopolitical Certainty: OPEC Production Risks Are Playing To Shale Producers' Advantage," published May 9, 2018. Available at nrg.bcaresearch.com. 2 Please see BCA Research's Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," published March 28, 2018. Available at gps.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "Coming To Grips With Gradualism," published May 9, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report "Stressing The Housing And Consumer Sectors," published May, 7 2018. Available at usis.bcaresearch.com. 5 https://www.cbo.gov/system/files/115th-congress-2017-2018/workingpaper/53616-wp-laborforceparticipation.pdf 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Waiting...," published March 26, 2018. Available at usis.bcaresearch.com. 7 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf 8 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Back To Basics," published April 17, 2018. Available at usbs.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Stressing The Housing And Consumer Sectors," published May 7, 2018. Available at usis.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Reports, "2018: Synchronized Global Growth," published December 4, 2017, and "Drives U.S. Economy And Markets," published December 4, 2017. Both available at usis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, published November 24, 2016. Available at bca.bcarearch.com. 12 Please see The Bank Credit Analyst Monthly Report, "Liquidity And The Great Balance Sheet Unwind," published October 2017. Available at bca.bcarearch.com. 13 Please see BCA Research's Equity Trading Strategy Special Report, "Introducing ETS: A Top-Down Approach to Bottom-Up Stock Picking," published December 3, 2015. Available at ets.bcaresearch.com. 14 Please see BCA Research's U.S. Bond Strategy Portfolio Allocation Summary "Coming To Grips With Gradualism," published May 8, 2018. Available at usbs.bcaresearch.com. Appendix Appendix Chart 1The Economy When Monetary Indicator Is Below Zero Tightening Up Tightening Up Appendix Chart 2The Economy When Financial Conditions Are Tightening Tightening Up Tightening Up

Highlights The big danger of higher bond yields is to the $380 trillion edifice of global risk-assets, rather than to the global economy per se. Buy a small portfolio of 30-year government bonds, given that higher bond yields are now hurting equities and 30-year yields are close to resistance levels. The ongoing drama of Italian politics is an irritation, rather than an existential risk to the euro area, as long as Italian populists correctly focus their fire on EU fiscal rules rather than the single currency. Nevertheless, we prefer France's CAC over Italy's MIB and Spain's IBEX, given the latter markets' outsize exposure to banks, a sector in which we remain underweight. Feature When travellers from the U.K. find themselves in Continental Europe or the U.S. they frequently make a potentially fatal error. Trying to cross a busy street, they look right instead of left... Your author has made this error several times and lived to tell the tale, but there is an important moral to the story. However carefully you look, you won't spot the oncoming truck if you are looking in the wrong direction! Chart of the WeekEquities And Bonds Are Both Offering A Paltry 2% Equities And Bonds Are Both Offering A Paltry 2% Equities And Bonds Are Both Offering A Paltry 2% Look At the Markets, Not The Economy The global long bond yield is up around 60bps from the lows of last September, and it would be natural to ask if this poses a danger to the economy. Credit sensitive economic sectors are understandably feeling a headwind, and global growth has indisputably decelerated (Chart I-2). Yet there is no sense of an oncoming truck. Chart I-2Credit Sensitive Sectors Are Feeling A Headwind Credit Sensitive Sectors Are Feeling A Headwind Credit Sensitive Sectors Are Feeling A Headwind But are we looking in the wrong direction? While higher bond yields do not yet threaten the global economy, the big danger is to the $380 trillion edifice of global risk-assets.1 In the space of a few weeks, the correlation between bond yields and equities has suddenly and viciously reversed. When the 10-year T-bond yield was below 2.65%, the correlation was a near perfect positive, r = +0.9 (Chart I-3) but above 2.85%, it has flipped to a near perfect negative, r = -0.8 (Chart I-4). Chart I-3Below A 2.65% T-Bond Yield, Equities And##br## Bond Yields Were Positively Correlated The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Chart I-4Above A 2.85% T-Bond Yield, Equities And ##br##Bond Yields Have Been Negatively Correlated The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way In 2000, 2008 and 2011, the right direction to look was at the financial markets. Recall that it was instabilities in the financial markets - the bursting of the dot com bubble, the mispricing of U.S. subprime mortgages, and the widening of euro area sovereign credit spreads - that spilled over into economic downturns. In any case, for investment strategy, whether such financial instabilities do or do not spill over into the real economy is a secondary concern. The primary concern must always be to identify financial market vulnerabilities - and opportunities. Rich Valuations Are In A Precarious Equilibrium The single most important determinant of an investment's long term return is not the investment's cash flows per se, it is the price that you pay for the cash flows. This is the fundamental lesson of investment. An investment's cash flows might be growing strongly, but if you overpay for the cash flows - for example, in a bubble - you will end up with a negative return. Conversely, cash flows might be collapsing, but if you buy them at an overly depressed price, you will end up with a positive return. It turns out that the long term prospective return from most investments is well-defined. For government bonds, it is the yield to maturity;2 for equities and other risk-assets it is empirically well-defined by the starting valuation, which tends to be an excellent predictor of the prospective long term return (Chart I-5). Chart I-5World Equities Are Priced To Generate 2% A Year World Equities Are Priced To Generate 2% A Year World Equities Are Priced To Generate 2% A Year For the long term prospective return from bonds, the main determinant is central bank policy, and specifically the expected path for interest rates. For the long term prospective return from equities, the main determinant is the return that the market demands relative to that on offer from bonds. What establishes this relative return? The answer is relative riskiness, specifically the potential for short term losses versus short term gains, technically known as negative skew. Investors hate negative skew - the potential to experience larger short term losses than gains. Hence, investors demand relative returns that are commensurate with the investments' relative negative skews. This brings us to the crux of the matter. At low bond yields, bonds become much more risky: their returns take on negative skew. Intuitively, this is because the lower bound to interest rates forces a very unattractive asymmetry on bond returns: prices can fall a lot, but they can no longer rise a lot. At a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-6 and Chart I-7). Chart I-6At A 2% Bond Yield, 10-Year Bonds Have##br## The Same Negative Skew As Equities... The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Chart I-7...So At A 2% Bond Yield, Equities ##br##Must Also Offer A 2% Return The Danger Of Looking The Wrong Way The Danger Of Looking The Wrong Way Right now, the negative skews on bonds and equities are roughly the same, so investors are accepting roughly the same long term return from global equities as they can get from global bonds - a paltry 2% (Chart of the Week). This justifies an equity valuation as rich as at the peak of the dot com bubble. The trouble is that the valuation justification for $380 trillion of global risk-assets would crumble if the bond yield were to rise meaningfully. But which bond yield? As asset-classes tend to move as global rather than regional assets, the yield that matters is the global long bond yield. Given the large spread in yields across major bonds, a global yield of 2% equates to around 3% in the U.S. and 1% in Europe. This may explain why these are the yield levels at which the correlation between bond yields and equities has suddenly and viciously reversed. This brings us to the investment opportunity: 30-year government bonds. In recent years, 30-year yields have failed to sustain breaks through upper bounds: 3.2% for T-bonds; 2.0% for U.K. gilts; 1.4% for German bunds; and 0.9% for JGBs. Indeed, looking at these yields since 2015 it is hard to discern a bear market in 30-year government bonds (Charts I-8- I-11). Chart I-8Resistance At 3.2% Resistance At 3.2% Resistance At 3.2% Chart I-9Resistance At 2.0% Resistance At 2.0% Resistance At 2.0% Chart I-10Resistance At 1.4% Resistance At 1.4% Resistance At 1.4% Chart I-11Resistance At 0.9% Resistance At 0.9% Resistance At 0.9% With higher bond yields now hurting equities, and 30-year yields close to resistance levels, it is a good time to buy a small portfolio of 30-year government bonds. What Unites Italy With Japan? Italy and Japan are the only two major economies in which private indebtedness is considerably less than public indebtedness (Chart I-12 and Chart I-13). In the case of Italy, the very low private indebtedness means that its total indebtedness - as a share of GDP - is actually less than that in the U.K., France, Spain and Sweden. Chart I-12Private Indebtedness Is Less Than ##br##Public Indebtedness In Italy... Private Indebtedness Is Less Than Public Indebtedness In Italy... Private Indebtedness Is Less Than Public Indebtedness In Italy... Chart I-13...And In ##br##Japan ...And In Japan ...And In Japan The other thing that unites Italy with Japan is that their banking systems were left undercapitalised and in a 'zombie' state for years. Which, to a large extent, explains why private indebtedness has been declining in both economies. When somebody in the private sector pays down debt, say €100, and the banking system does not reallocate that €100 to a new private sector borrower, aggregate demand will contract by €100. To prevent this demand recession, the government must step in to borrow and spend the €100. Moreover, because the private sector is deleveraging, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. Instead, government borrowing and spending turns out to be a very sensible economic policy. On this basis, Japan countered its aggressive private sector deleveraging with equally aggressive public sector leveraging and thereby kept its economy motoring along. By contrast, Italy had its hands tied by the EU fiscal compact - which mistakenly looks at public indebtedness in isolation rather than in combination with private indebtedness. Hence, the Italian government was prevented from recapitalizing its banking system, and the Italian economy stagnated for a decade (Chart I-14 and Chart I-15). Chart I-14The Italian Government Was Prevented ##br##From Recapitalising The Banks... The Italian Government Was Prevented From Recapitalising The Banks... The Italian Government Was Prevented From Recapitalising The Banks... Chart I-15...And The Italian Economy ##br##Stagnated For A Decade ...And The Italian Economy Stagnated For A Decade ...And The Italian Economy Stagnated For A Decade In this sense, the populist parties in Italy - The League and 5 Star Movement - have correctly identified that Italy's problem is not the euro per se, but the EU's fiscal dogma. Both parties have dropped calls for a referendum on Italy's membership of the euro area, but have doubled down on their intentions to ignore the EU's misguided fiscal rules, such as the 3 per cent limit on budget deficits. As long as Italian populists correctly focus their fire on EU rules rather than the single currency, investors should view the ongoing drama of Italian politics as an irritation, rather than an existential risk to the euro area. Nevertheless, for the time being, we prefer France's CAC over Italy's MIB and Spain's IBEX. This is less a function of politics, and more a function of the latter markets' outsize exposure to banks, a sector in which we remain underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Global equities and high yield and EM debt is worth around $160 trillion and global real estate is worth $220 trillion. 2 Assuming no default risk and no reinvestment risk. Fractal Trading Model* This week, we note that SEK/EUR is at a key technical turning point, and due a countertrend rally. As we already have a long SEK/GBP position open, we are not doubling up with SEK/EUR. In other trades, we are pleased to report that long USD/Chilean peso hit its 2.7% profit target, and is now closed. This leaves us with four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-16 SEK/EUR SEK/EUR The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

There is scant evidence that the character of the equity market advance is changing and the fact that weak balance sheet stocks are no longer outperforming strong balance sheet stocks is giving us pause (Chart 1). Chart 1Time To Pause And Reflect Time To Pause And Reflect Time To Pause And Reflect Using the Goldman Sachs equity baskets - that utilize the 'Altman Z-score' framework to select stocks - via Bloomberg, we find that the weak balance sheet over strong balance sheet share price ratio leads the broad market at both peaks and is coincident at troughs. The most recent peak occurred in early 2017 and it is rather surprising that a proxy for this ratio using the fixed income market, i.e. the total return high yield bond index versus the total return investment grade bond index, is moving in the opposite direction and not confirming the equity market's message (Chart 2). This begs the question: Which market signal is right, stocks or fixed income, and what are the equity sector investment implications? But before trying to answer these questions, we first zoom out and look at the broad U.S. debt picture. How Will It All End? In our travels and conference calls one common question keeps coming up: What will end all this? The short answer is that rising interest rates will eventually deal a blow to the debt overhang and the expansion will give way to a fresh deleveraging cycle. In other words, a whiff of inflation will entice the Fed to keep on raising the fed funds rate to the point where the business cycle turns down. As demand falters, a decreasing cash flow backdrop will not be able to service the debt overload, as both coupon payments and principal repayments will become a big burden. This will ignite a jump in the default rate, a message the yield curve is already sending (Chart 3). Chart 2Which Market Is Right? Which Market Is Right? Which Market Is Right? Chart 3Has The Junk Default Rate Troughed? Has The Junk Default Rate Troughed? Has The Junk Default Rate Troughed? Peering back to the onset of the GFC, a U.S. financial sector debt crisis engulfed the world. Subsequently, this morphed into a government sector debt problem in the Eurozone and more recently into a non-financial corporate sector debt overhang mostly in the commodity complex and the emerging markets. Debt Supercycle Lives On The investment world is obsessed with China's excess debt uptake and that is a valid concern. However, investors should also be aware that U.S. debt has not been fully purged. Rather, it has moved around between different domestic sectors. The debt supercycle lives on.1 The implication is that an interest rate-induced debt bubble pricking would be deflationary, and thus identifying the U.S. domestic sector most exposed to such risk is important. Chart 4 breaks down U.S. total debt into the four largest sectors using flow of funds data. While households and the financial sector have significantly de-levered, the government and the non-financial business sector have been picking up the slack and aggressively re-levering. While the Trump Administration has embarked on a two-year fiscal policy easing period that will add to the government debt profile, the nonfinancial corporate debt overhang is more vulnerable and thus troublesome in our view (fed funds rate shown inverted, Chart 5). Worrisomely, since the GFC, nonfinancial corporates have been issuing debt and partially using this debt to retire equity and pay handsome dividends. According to the flow of funds data, the cumulative nonfinancial net equity retirement figure stands near $4tn over the past decade (middle panel, Chart 6). Undoubtedly, this has been a large contributor to equity market returns (top panel, Chart 6), and will likely gain further momentum this year on the back of the tax repatriation holiday. Some sell side equity retirement estimates for the S&P 500 hover around $800bn for calendar 2018 or roughly twice the past decade's annual average. AAPL's recent announcement of a $100 billion share repurchase program confirms that the buyback bonanza is persevering and will continue to boost equities. Clearly, such breakneck equity retirement pace is unsustainable and will converge down to a lower trend rate in 2019 and beyond, especially given the drying liquidity as the Fed continues to pursue a tighter monetary policy. Chart 4Debt Is Moving Around Debt Is Moving Around Debt Is Moving Around Chart 5Tight Monetary Policy Pricks Bubbles, And... Tight Monetary Policy Pricks Bubbles, And… Tight Monetary Policy Pricks Bubbles, And… Chart 6...Threatens To End The Equity Retirement Binge …Threatens To End The Equity Retirement Binge …Threatens To End The Equity Retirement Binge Introducing BCA's Sector Insolvency Risk Monitor (IRM) The purpose of this Special Report is to identify debt soft spots and outliers in the U.S. GICS1 equity sectors. What follows is a financials statement-heavy analysis of sector indebtedness. We introduce the 'Altman Z-score' sector analysis that gauges sector credit strength, with a rising score indicating improving health and a declining Z-score signifying deteriorating health.2 In absolute terms, a score below 1.8 warns of a possible credit event, whereas any reading above 3 signals that bankruptcy risk is very low (see appendix below). Our analysis includes our flagship Bank Credit Analyst's Corporate Health Monitor framework that breaks down corporate health in the different sectors3 (see appendix below). We also sift through a number of different stock market reported ratios/data to gauge each sector's health, with net debt-to-EBITDA and interest coverage at the forefront of our analysis, and try to identify outliers (see appendix below). Finally, with the invaluable help of BCA's Chief Quantitative Strategist, David Boucher, we created our new insolvency risk monitor (IRM) per U.S. equity sector incorporating the respective 'Altman Z-scores', BCA's corporate health monitor readings and net debt-to-EBITDA ratios. In more detail, we ranked each sector (ex-financials and real estate) on a monthly basis on each of these three measures. Then we used a simple average of the ranked measures per sector to come up with the final sector ranking. We also selected the median sector ranking per measure and used the average of the three metrics as a proxy for the broad market.4 This way we were able to compare each sector IRM to the overall market. Note that the IRMs are designed so that a higher IRM ranking means better solvency. Charts 7 & 8 summarize the results and showcase this new all-inclusive relative ranking alongside relative share price performance. Chart 7Unsustainable... Unsustainable… Unsustainable… Chart 8...Divergences ...Divergences ...Divergences Sector Outliers Consumer discretionary stocks are the clearest outliers and the message from the relative IRM is to expect a significant underperformance phase in the coming quarters (top panel, Chart 7). AMZN's juggernaut is blurring the discretionary landscape given its 20% index weight, and artificially boosting relative share prices. Ex-AMZN, this early cyclical sector is behaving similar to previous episodes when the Fed embarked on a tightening interest rate cycle. We reiterate our recent downgrade to a below benchmark allocation.5 Consumer staples equities are steeply deviating from their increasing relative IRM score, underscoring that investors are unduly punishing staples stocks (second panel, Chart 8). We maintain our overweight stance and treat this sector as a small portfolio hedge to our otherwise general dislike of defensives (as a reminder we are underweight both the S&P health care and the S&P telecom services sectors). Chart 9Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand The utilities share price ratio is also deviating from the IRM relative reading (fourth panel, Chart 8). The implication is that extreme bearishness toward the sector is overdone and we reiterate our mid-February upgrade to a neutral stance.6 Energy stocks have fallen behind the energy IRM rebound reading (top panel, Chart 8). We expect a catch up phase on the back of the global capex upcycle, still improving debt profile, favorable underlying commodity supply/demand dynamics and firming oil prices. The S&P energy sector remains a high-conviction overweight. The niche materials sector is also trailing the sector's slingshot IRM recovery. Keep in mind that, as expected, the materials IRM is one of the most volatile series (second panel, Chart 8). Materials manufacturers are capital intensive and high operating leverage businesses and despite the debt dynamic betterment since the recent global manufacturing recession, this sector is still saddled with a large amount of debt that makes it extremely sensitive to the ebbs and flows of global economic growth. We continue to recommend a benchmark allocation. The remaining sectors' (tech, health care, telecom services and industrials) relative share prices are moving in tandem with their respective IRM readings (Charts 7 & 8). In addition, we have complied all the cyclical and defensive IRMs in two distinct series and the relative IRM ratio is giving the all-clear sign to continue to prefer cyclicals over defensives on a 9-12 month time horizon (Chart 9). So What? In sum, the IRM is one new additional metric we are using to gauge the validity of our sector positioning and should not be used in isolation. To answer our original question, while the weak balance sheet versus strong balance sheet stock underperformance is alarming and we will continue to closely monitor this stock price ratio, it is premature to change our constructive overall equity market view on a 9-12 month horizon. We therefore continue to recommend a cyclical over defensive portfolio bent. Finally, for completion purposes, the appendix below shows a number of debt-related indicators we track, including the absolute 'Altman Z-score' and corporate health monitor readings, in two charts per sector along with the cyclicals over defensives compilation and the overall market (ex-financials). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 For a primer on the debt super cycle please refer to Box 1 in the BCA Special Year End Issue: "Outlook 2013: Fewer Storms, More Sunny Breaks," dated December 19, 2012, available at bca.bcaresearch.com. 2 Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E. Where: A = working capital / total assets, B = retained earnings / total assets, C = earnings before interest and tax / total assets, D = market value of equity / total liabilities and E = sales / total assets. Source: https://www.investopedia.com/terms/a/altman.asp 3 Please see BCA The Bank Credit Analyst Report, "U.S. Corporate Health Gets A Failing Grade," dated January 28, 2016, available at bca.bcaresearch.com. 4 We refrained from using the top down computed S&P 500 'Altman Z-Score' and net debt-to-EBITDA as the financials sector really skewed the results and therefore opted to use the median sector 'Altman Z-score' and net debt-to-EBITDA as a proxy for the broad market because using the mean also skewed the results largely because of the tech sector. Staying consistent in our analysis, we also used the median sector BCA corporate health monitor to proxy the broad market. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Appendix U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market II U.S. Non-Financial Broad Market II U.S. Non-Financial Broad Market II U.S. S&P Industrials I U.S. S&P Industrials I U.S. S&P Industrials I U.S. S&P Industrials II U.S. S&P Industrials II U.S. S&P Industrials II U.S. S&P Energy I U.S. S&P Energy I U.S. S&P Energy I U.S. S&P Energy II U.S. S&P Energy II U.S. S&P Energy II U.S. S&P Consumer Staples I U.S. S&P Consumer Staples I U.S. S&P Consumer Staples I U.S. S&P Consumer Staples II U.S. S&P Consumer Staples II U.S. S&P Consumer Staples II U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Utilities I U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Materials I U.S. S&P Materials I U.S. S&P Materials I U.S. S&P Materials II U.S. S&P Materials II U.S. S&P Materials II U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary II U.S. S&P Consumer Discretionary II U.S. S&P Consumer Discretionary II U.S. S&P Telecom Services I U.S. S&P Telecom Services I U.S. S&P Telecom Services I U.S. S&P Telecom Services II U.S. S&P Telecom Services II U.S. S&P Telecom Services II U.S. S&P Health Care I U.S. S&P Health Care I U.S. S&P Health Care I U.S. S&P Health Care II U.S. S&P Health Care II U.S. S&P Health Care II U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives II U.S. S&P Cyclicals Vs. Defensives II U.S. S&P Cyclicals Vs. Defensives II

Highlights The global 6-month credit impulse is now indisputably in a mini-downswing phase. Stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since the start of the year, and it is too early to exit. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a tradeable reversal in yields. The trade-weighted euro has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. We have a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Feature Entering the fifth month of the year, one puzzle for investors is the conflicting messages coming from banks and bonds. While banks' relative performance is close to its 2018 low, bond yields are not far from their year-to-date high (Chart of the Week). Chart of the WeekBanks Or Bonds: Which One Is Right? Banks or Bonds: Which One Is Right? Banks or Bonds: Which One Is Right? This poses a puzzle because the performances of banks and bond yields are usually joined at the hip. The underperformance of the economically sensitive banks would suggest that global growth is decelerating, whereas the performance of bond yields would suggest that global activity is holding up well. Which one is right? The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Looking at the other classically cyclical sectors, the mystery seems to deepen. Industrials and basic materials are also in very clear downtrends this year, which corroborates the message from the banks. But the oil and gas sector is close to a year high, which corroborates the message from bond yields (Charts I-2-I-4). Chart I-2Industrials Have Underperformed... Industrials Have Underperformed... Industrials Have Underperformed... Chart I-3...And Basic Materials Have Underperformed ...And Basic Materials Have Underperformed ...And Basic Materials Have Underperformed Chart I-4...But Oil And Gas Has Outperformed... ...But Oil And Gas Has Outperformed... ...But Oil And Gas Has Outperformed... The conflicting messages from banks, basic materials and industrials on one side and bond yields and oil and gas equities on the other side reflect the disconnect between non-oil commodity prices which have drifted lower this year and oil prices which have moved sharply higher (Chart I-5). This disconnect, resulting from differing supply dynamics in the different commodity markets, points us to a likely solution to our puzzle. Chart I-5...Because Oil Has Disconnected ##br##From Other Commodities ...Because Oil Has Disconnected From Other Commodities ...Because Oil Has Disconnected From Other Commodities The classically cyclical sectors are taking their cue from global growth and industrial activity, which does appear to be losing momentum. The global 6-month credit impulse is now indisputably in a mini-downswing phase. In contrast, bond yields are taking their cue from the oil price, given its major impact on headline inflation, inflation expectations, and thereby on central bank reaction functions. Based on previous mini-cycles, we can confidently say that mini-downswing phases last at least six to eight months and that the usual release valve is a decline in bond yields. In this regard, the apparent disconnect between decelerating activity and un-budging bond yields risks extending this mini-downswing phase. Therefore, for the next few months, it is appropriate to stick with underweights in the classically cyclical sectors: banks, basic materials and industrials. The strategy has worked well since we initiated it at the start of the year, and it is too early to exit. This sector strategy necessarily impacts regional allocation as explained in the next section. For bonds, the implication is that yields can move only slightly higher before stronger headwinds to risk-assets and/or the economy provide a natural cap and a tradeable reversal in yields. Even More Investment Reductionism Imagine a world in which all the global commodity firms decided to get their stock market listings in London; all the global financials decided to list on euro area bourses; all the major tech companies listed in New York; and all the industrials listed in Tokyo. Clearly, each major stock market would just be a play on its underlying global sector and nothing more. Our imagined world is an exaggeration, but it does illustrate an important truth. A quarter of the market capitalisation of each major stock market is in one dominant sector, and this gives each equity index its defining fingerprint: for the FTSE100 it is commodity firms; for the Eurostoxx50 it is financials; for the S&P500 it is technology; and for the Nikkei225 it is industrials (Table I-1). Table I-1Each Major Stock Market Has A Defining Fingerprint Banks Or Bonds: Which One Is Right? Banks Or Bonds: Which One Is Right? There is another important factor to consider: the currency. A global oil company like BP receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In this sense, BP's global business is currency neutral. But BP's stock price is quoted in pounds. This means that if the pound strengthens, the company's multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. So the currency is the channel through which the domestic economy can impact its stock market, albeit it is an inverse relationship: a strong currency hinders the stock market; a weak currency helps it. The upshot is that the defining fingerprints for the major indexes turn out to be: FTSE100: global commodity shares expressed in pounds. Eurostoxx50: global banks expressed in euros. S&P500: global technology expressed in dollars. Nikkei225: global industrials expressed in yen. And that's pretty much all you need to know for regional equity allocation! The charts in this report should leave you in no doubt. True to our Investment Reductionism philosophy, the relative performance of the regional equity indexes just reduces to their defining fingerprints: FTSE100 versus S&P500 reduces to global commodity companies in pounds versus global tech companies in dollars, Eurostoxx50 versus Nikkei225 reduces to global banks in euros versus global industrials in yen. And so on (Charts I-6-I-11). Chart I-6FTSE 100 Vs. S&P 500 = Global Commodity##br## Equities In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Commodity Equities In Pounds Vs. Global Tech In Dollars FTSE 100 Vs. S&P 500 = Global Commodity Equities In Pounds Vs. Global Tech In Dollars Chart I-7FTSE 100 Vs. Nikkei 225 = Global Commodity ##br##Equities In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Commodity Equities In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Commodity Equities In Pounds Vs. Global Industrials In Yen Chart I-8FTSE 100 Vs. Euro Stoxx 50 = Global Commodity##br## Equities In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Commodity Equities In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Commodity Equities In Pounds Vs. Global Banks In Euros Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In ##br##Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Tech In Dollars Chart I-10Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In##br## Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Chart I-11S&P 500 Vs. Nikkei 225 = Global Tech In ##br##Dollars Vs. Global Industrials In Yen S&P 500 Vs. Nikkei 225 = Global Tech In Dollars Vs. Global Industrials In Yen S&P 500 Vs. Nikkei 225 = Global Tech In Dollars Vs. Global Industrials In Yen The Right Way To Invest In The 21st Century One important implication of Investment Reductionism is that the head-to-head comparison of stock market valuations is a meaningless and potentially dangerous exercise. Two sectors with vastly different structural growth prospects - say, banks and technology - must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Another implication is that simple 'value' indexes may not actually offer better value! In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. Some people suggest comparing a valuation with its own history, and assessing how many 'standard deviations' it is above or below its norm. The problem is that the whole concept of standard deviation assumes 'stationarity' - meaning, no step changes in a sector's valuation through time. Unfortunately, sector valuations are 'non-stationary': they undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange. Pulling together these complexities of sector effects, currency effects, and step changes in sector valuations, we offer some strong advice on how to sequence the investment process: 1. Make your asset class decision at a global level. This is because asset classes tend to move as global entities, not regional entities. And also because at a global level, asset class valuation comparisons are less distorted by sector and currency effects. 2. Make your sector decisions. Given that the companies that dominate European (and all major) indexes are multinationals, the sector decision should be based on the direction of the global economy. 3. Make your currency decisions. 4. You do not need to make any more major decisions! The main regional equity allocation, country allocation and value/growth allocation just drop out from the sector and currency decision. With the global 6-month credit impulse now indisputably in a mini-downswing phase (Chart I-12), the classically cyclical sectors are likely to continue underperforming for the next few months; the rise in bond yields faces resistance; and the euro - at least on a trade-weighted basis - has some support given that the BoE and/or the Fed have tightening expectations that can be priced out, while the ECB doesn't. Chart I-12The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing The Global 6-Month Credit Impulse Is Indisputably In A Mini-Downswing Finally, in terms of regional equity allocation, Investment Reductionism implies a slight preference for the FTSE100 and S&P500 over the Eurostoxx50. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* In addition to the fundamental arguments in the main body of this report, fractal analysis finds that the outperformance of Oil and Gas relative to other commodity equities is technically extended. Hence, this week's trade recommendation is to underweight euro area Oil and Gas versus global Basic Materials. Set a profit target of 5%, with a symmetrical stop-loss. In other trades, we are pleased to report that long USD/ZAR hit its 6% profit target, and is now closed. This leaves us with five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Short Euro Area Energy Vs. Global Basic Materials Short Euro Area Energy Vs. Global Basic Materials The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Both the euro's undervaluation and the euro area's massive trade surplus constitute disequilibria, which cannot persist in the long term. Hence, the trade-weighted euro will structurally appreciate... ...and euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Banks are not a sector to buy and hold for the long term, but rather a sector to own for periodic cyclical rallies. We anticipate the next such cyclical opportunity will arise later this year. Feature Yanis Varoufakis, the former Finance Minister of Greece, recently highlighted EU institutions' obsession with protecting their credibility at all costs. Once set on a course, EU institutions tend to suffer a blinkered tunnel-vision. A big fan of Shakespeare, Varoufakis likened this resistance to change course - no matter the repercussions - to Lady Macbeth's declaration that "what's done cannot be undone."1 As Mario Draghi prepares to take the stage again, we recall the final line of his last performance on March 8 as an echo of Lady Macbeth. Asked to justify the ECB's obsession with the 2 per cent inflation point-target, Draghi declared that "there are serious costs about changing course on credibility". We fully understand the ECB's desire to protect its credibility. The trouble is that it is set on a course that is incredibly difficult to accomplish: a single mandate to sustain a 2 per cent inflation point-target, based on a consumer price basket that omits one of the largest items of household expenditure - housing itself. Chart of the WeekAs The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Euro Area Inflation Is Running Higher Than The HICP Suggests Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses. Which makes the omission of this cost from the euro area Harmonized Index of Consumer Prices (HICP) completely ludicrous. Using the experience of U.S. inflation which does include owner occupiers' housing costs, we estimate that a price basket that correctly included home maintenance costs would outperform the HICP by an average of 0.5 percentage points a year (Chart I-2). Chart I-2Including Owner Occupiers' Housing Costs ##br##Adds 0.5% To Inflation Including Owner Occupiers' Housing Costs Adds 0.5% To Inflation Including Owner Occupiers' Housing Costs Adds 0.5% To Inflation Recognizing this error, the U.K.'s Office For National Statistics recently changed its main inflation index from the Consumer Prices Index (CPI) to the Consumer Prices Index including owner occupiers' housing costs (CPIH), acknowledging that "the costs of housing services associated with owning, maintaining and living in one's home are an important component of household expenditure that are not included in the CPI... Therefore the CPIH is the most comprehensive measure of inflation." We expect the BoE's target for 2 per cent inflation to switch eventually to the CPIH too, albeit it remains the CPI for the time being. However, a 1 to 3 per cent 'variation band' around the CPI inflation target does give the BoE considerable breathing space. By comparison, the ECB's target for 2 per cent inflation excluding owner occupiers' housing costs and excluding a variation band gives it a significantly more difficult task than its peer central banks. The crucial point is that the ECB's ultra-loose policy is to a large extent a function of a tunnel-vision pursuit of an HICP inflation rate which significantly understates true inflation. As true inflation is higher than suggested, it means that true real interest rates are lower than suggested. And as currency markets feel true real interest rate differentials - rather than those derived from the faultily constructed HICP - it means that markets have undervalued the euro. This has resulted in an over-competitive euro area, and a massive trade surplus (Chart I-3). Chart I-3The Euro Area Trade Surplus Is A Mirror-Image ##br##Of The Undervalued Euro The Euro Area Trade Surplus Is A Mirror-Image Of The Undervalued Euro The Euro Area Trade Surplus Is A Mirror-Image Of The Undervalued Euro Both the currency undervaluation and the associated trade surplus constitute disequilibria, which cannot persist in the long term. We have no strong conviction for the very near term move in the euro, but there are two longer term implications: the trade-weighted euro will structurally appreciate by about 10%; and euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart of the Week). Japanese Lessons For Europeans: The Homework A few weeks ago in Japanese Lessons For Europeans we made some counterintuitive observations about Japan's post-bubble economic experience.2 Most notably, we showed that on a real GDP per head basis, Japan has outperformed every other major economy over the past twenty years. Our finding was based on real GDP divided by working age (15-64) population because we wanted to capture real productivity gains - which rely mainly on the productive population. The counterintuitive finding elicited a couple of questions. One question was whether the result changes if we were to divide by the total population rather than the working age population. The answer is, not really. Dividing by total population, Japan would no longer be top of the leader board, but the broad result would still hold. Japan has performed impressively, and we fail to see the so-called 'lost decades' (Chart I-4 and Chart I-5). Chart I-4Japan Has Performed Impressively On ##br##Real GDP Per Working Age Population... Japan Has Performed Impressively On Real GDP Per Working Age Population... Japan Has Performed Impressively On Real GDP Per Working Age Population... Chart I-5...And Real GDP Per##br## Total Population ...And Real GDP Per Total Population ...And Real GDP Per Total Population Still, some people pointed out that Japan's public indebtedness now equals 210% of its GDP, up from 120% at the start of the century. So a second question was whether Japan's impressive performance is entirely due to its fiscal largesse. The answer is, not exactly. What matters is the change in total indebtedness - public plus private. As a share of GDP, public indebtedness is up by 90% but private indebtedness is down by 40%. So total indebtedness is up by 50% of GDP, considerably less than the increases elsewhere in the developed world. For example, over the same period, the U.K.'s total indebtedness is up by 100% of GDP. Moreover, even the level of Japan's total indebtedness as a share of GDP - at 370% - is not that different to other major economies. In Belgium, it is 340%; in France it is 305%; in Canada it is approaching 300% (Charts I-6-Chart I-17). Chart I-6Japan: Total Debt Up From 315% ##br##To 370% Of GDP Japan: Total Debt Up From 315% To 370% Of GDP Japan: Total Debt Up From 315% To 370% Of GDP Chart I-7U.S.: Total Debt Up From 185% ##br##To 250% Of GDP U.S.: Total Debt Up From 185% To 250% Of GDP U.S.: Total Debt Up From 185% To 250% Of GDP Chart I-8Canada: Total Debt Up From 225%##br## To 290% Of GDP Canada: Total Debt Up From 225% To 290% Of GDP Canada: Total Debt Up From 225% To 290% Of GDP Chart I-9Australia: Total Debt Up From 150% ##br##To 235% Of GDP Australia: Total Debt Up From 150% To 235% Of GDP Australia: Total Debt Up From 150% To 235% Of GDP Chart I-10U.K.: Total Debt Up From 180%##br## To 280% Of GDP U.K.: Total Debt Up From 180% To 280% Of GDP U.K.: Total Debt Up From 180% To 280% Of GDP Chart I-11Switzerland: Total Debt Up From 245%##br## To 270% Of GDP Switzerland: Total Debt Up From 245% To 270% Of GDP Switzerland: Total Debt Up From 245% To 270% Of GDP Chart I-12Germany: Total Debt Down From 185%##br## To 180% Of GDP Germany: Total Debt DOWN From 185% To 180% Of GDP Germany: Total Debt DOWN From 185% To 180% Of GDP Chart I-13France: Total Debt Up From 190%##br## To 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP Chart I-14Italy: Total Debt Up From 195%##br## To 265% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Chart I-15Spain: Total Debt Up From 165% ##br##To 270% Of GDP Spain: Total Debt Up From 165% To 270% Of GDP Spain: Total Debt Up From 165% To 270% Of GDP Chart I-16Belgium: Total Debt Up From 260% ##br## To 340% Of GDP The ECB's Shakespearean Act Continues... The ECB's Shakespearean Act Continues... Chart I-17Sweden: Total Debt Up From 210% ##br##To 275% Of GDP Sweden: Total Debt Up From 210% To 275% Of GDP Sweden: Total Debt Up From 210% To 275% Of GDP Public Sector Leveraging Must Counterbalance Private Sector Deleveraging People who take on debt tend to be young, while those who pay down debt tend to be older. As population pyramids in developed economies shift to older cohorts, there are fewer people who wish to take on debt and more people who wish to pay it down. Specifically, the 50-70 age cohort tends to use pre-retirement income and retirement lump-sum payments to extinguish any outstanding mortgage debts. Consider an older person with an income of €1000 who wishes to pay down €100 of debt. It follows that the person will spend €900. Ordinarily, the banking sector will then reallocate the paid-down €100 to, say, a younger person who wants to borrow it. When the borrower spends the €100, aggregate expenditure totals €1000, which equals the original income. And all is well and good. However, in a world where there is an excess of people who wish to pay down debt versus those that wish to borrow, it might not be possible to reallocate the paid-down €100 to a new borrower in the private sector, even with interest rates at ultra-low levels. In this case, the only way to prevent a contraction in expenditure - a recession - is if the government steps in to borrow and spend the aforementioned €100 to keep the economy's expenditures at €1000. Moreover, because the private sector is paying down debt, what seems to be fiscal largesse does not lead to crowding out, inflation, or surging interest rates. The above illustration describes the structural situation in many developed economies at the moment. And it explains why we should not look at the evolution of indebtedness in the public sector and the private sector separately, but rather in combination. This is another important Japanese lesson for Europeans. A final observation is that if the private sector is deleveraging, private indebtedness as a share of GDP tends to drift lower. This necessarily means that banks total assets' are growing slower than overall sales in the economy. As banks' asset growth is their main driver of long-term profit growth, it also means that banks struggle to outperform the market on a sustained basis. This has been the experience in Japan since 1990 and in the euro area since 2008 (Chart I-18). Chart I-18When The Private Sector Pays Down Debt, Banks Structurally Underperform When The Private Sector Pays Down Debt, Banks Structurally Underperform When The Private Sector Pays Down Debt, Banks Structurally Underperform With private indebtedness declining as a share of GDP in many major economies, we conclude that banks are not a sector to buy and hold for the long term, but rather a sector to own for periodic cyclical rallies. We anticipate the next such cyclical opportunity will arise later this year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 From Yanis Varoufakis's 2018 Rose Shakespeare Lecture. 2 Please see the European Investment Strategy Weekly Report "Japanese Lessons For Europeans" April 5, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a mixed week for our trades. Long USD/ZAR is approaching the end of its 3 month maximum holding period comfortably in profit. Against this, the recent intense volatility in the metals market closed the pair-trade long lead/short nickel at its stop-loss. We are not initiating any new trades this week. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-19 USD/ZAR USD/ZAR The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Slower nominal GDP growth explains virtually all of the increase in China's debt-to-GDP ratio over the past ten years. The authorities were unwilling to restrain debt growth as it became obvious that nominal income was decelerating because this would have only exacerbated the economic downturn. Excess private-sector savings forced the Chinese government to rely on debt-financed investment by state-owned companies (SOE) and local governments in order to keep aggregate demand elevated. Financial deregulation also encouraged debt accumulation. Debt growth linked to speculative activity can be curbed without endangering the economy, but a lasting solution to the surplus savings problem will require consumers to spend more. This will take a while. At some point over the next few years, the central government will transfer a large fraction of SOE and local government debt onto its own balance sheet. The risk to investors is that this "debt nationalization" happens reactively rather than proactively. Feature If there are too many pro-cyclical factors in the economy, cyclical fluctuations are magnified and there is excessive optimism during the period, accumulating contradictions that could lead to the so-called Minsky Moment. - Zhou Xiaochuan, Former Governor of the People's Bank of China, October 19, 2017 The Calm Before The Storm? Stability begets instability. That is the nature of business cycles, Hyman Minsky famously argued. Rising confidence leads to excessive risk-taking, higher asset prices, and mounting economic imbalances. Eventually the mood sours. Like Wile E. Coyote running off a cliff, investors look down and see that there is nothing but thin air between them and the ground below. Panic ensues. Is China on the verge of its own Minsky Moment? A glance at the evolution of its debt-to-GDP ratio would certainly say so. But before running towards the exit door, consider the following: People have been fretting about spiraling Japanese government debt levels for over twenty years now. And yet, interest rates remain at rock-bottom levels in Japan. China's Savings Glut In many respects, China finds itself facing similar problems to those that have haunted Japan. The simultaneous bust in equity and real estate prices in 1990 sent Japan's private sector into a prolonged deleveraging cycle (Chart 1). In order to prop up demand, the Japanese government was forced to run large budget deficits. In effect, the government had to absorb the excess savings of the private sector with its own dissavings. The abundance of domestic private-sector savings forestalled a financial crisis, but it also led to today's gross government debt-to-GDP ratio of 240%. Like Japan, China suffers from a dearth of spending, or equivalently, an abundance of savings. The IMF estimates that Chinese gross national savings reached 46% of GDP in 2017. While this is down from a peak of 52% of GDP in 2008, it is still abnormally high for any major economy, even by emerging market standards (Chart 2). Chart 1 Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Japan Relied On Large Fiscal Deficits And Current Account Surpluses To Offset The Rise In Private-Sector Savings Chart 2China's Savings Rate Stands Out Even By EM Standards China's Savings Rate Stands Out Even By EM Standards China's Savings Rate Stands Out Even By EM Standards By definition, whatever a country saves must either be invested domestically or channeled abroad via a current account surplus. China's savings rate has edged lower over the past ten years, but its current account surplus has dropped even more, falling from nearly 10% of GDP in 2007 to 1.4% of GDP at present. As a result, investment as a share of GDP has actually risen to 44%, a three-point increase since 2007 (Chart 3). The decline in China's current account surplus was inevitable (Chart 4). In 2007, China accounted for 6% of global GDP in dollar terms. Today it accounts for 15%. Having a massively undervalued currency, as China had in 2007, is just not politically tenable anymore, especially with Donald Trump in the White House. Simply put, China has become too big to continue exporting its way out of its problems. Chart 3Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Since The Great Financial Crisis, Chinese Savings Have Been Channeled Into Domestic Investment, Not Funneled Abroad Chart 4Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Undervalued Currency And Massive Current Account Surplus: Modus Operandi Of The Past Debt As The Conduit Between Savings And Investment How does a country transform savings into investment? In an economy like China where the stock market at times appears to be little more than a casino, the answer is that credit markets must play the dominant role. Households or firms with surplus savings park their funds in banks or other financial institutions. These institutions channel the savings to willing borrowers. Debt ends up being the natural byproduct of surplus savings. China is still a relatively poor country with a lot of catch-up potential. Capital-per-worker is a fraction of what it is among advanced economies (Chart 5). Even with its bleak demographics, China would need to grow by around 6% per year over the next few years just to converge with South Korea in output-per-worker by 2050 (Chart 6). All this means that China needs to invest more than most other economies, which is only possible if it saves more than other economies. Chart 5China Has More Catching Up To Do (1) Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Chart 6China Has More Catching Up To Do (2) China Has More Catching Up To Do (2) China Has More Catching Up To Do (2) Unfortunately, one can have too much of a good thing. The fact that China's capital stock-to-output ratio has risen dramatically in recent years means that the economy is already investing too much. And the optimal amount of investment will only fall over time as potential GDP growth continues to decelerate. Unless savings come down, China will find itself increasingly awash in excess capacity. Chart 7If Only GDP Growth Did Not ##br## Decelerate Over The Past Ten Years Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Slower trend growth will also make deleveraging more difficult to achieve. The overall stock of nonfinancial debt grew at an annualized rate of 18.8% between 2008 and 2017. Notably, this growth rate was not much higher than the one of 16.5% between 2003 and 2007 - a period when the debt-to-GDP ratio was broadly stable. The main difference between the two periods lies in the denominator of the debt-to-GDP ratio, not in the numerator: Nominal GDP expanded at an annualized rate of 11.2% between 2008 and 2017, a sizable retreat from the pace of 18.4% between 2003 and 2007. Chart 7 shows that the debt-to-GDP ratio today would be virtually identical to its end-2007 level had nominal GDP continued to grow at its 2003-2007 pace over the past ten years. Financial Deregulation Has Exacerbated The Debt Problem The Chinese government's reluctance to crack down on credit growth was motivated by the desire to support aggregate demand. However, in turning a blind eye to what was happening in credit markets, a lot of debt was generated that was not directly tied to the intermediation of savings into investment. Chart 8Debt And Capital Accumulation Went Hand In Hand Debt And Capital Accumulation Went Hand In Hand Debt And Capital Accumulation Went Hand In Hand Debt can be created when someone borrows money to finance the purchase of goods or services. Debt can also be created when someone borrows money to finance the purchase of pre-existing assets. Crucially, while the former typically requires additional "savings" (i.e., someone needs to reduce their spending relative to their income), the latter does not.1 Granted, savings can still play an indirect role in facilitating debt-financed asset purchases. Financial assets are typically backed by something of value. A mortgage is backed by a piece of property. A corporate bond is backed by both the tangible and intangible capital that a firm possesses. The more a country has been able to save over time, the larger its capital stock will be. China, of course, has been saving like crazy for years. It is thus no surprise that its debt-to-GDP ratio has soared as its capital stock has expanded (Chart 8). Financial deregulation in China has allowed a large share of its capital stock to repeatedly shift hands. Debt has often been created in the process. The problem is that debt-financed asset purchases drive up asset prices, sometimes to unsustainable levels. And the higher the price of the asset, the greater the risk that it will not yield enough income to cover the borrowing costs. When asset prices are rising, borrowers and lenders are apt to disregard this risk, figuring that they can always sell the asset at a high enough price to pay back the loan. But once prices start falling, reality sets in very quickly. Stability begets instability. Consumers Need To Step Up The authorities are keenly aware of the risks discussed above. This is the key reason why they are clamping down on the shadow banking system, which has increasingly become the main source of speculative lending in China. We expect the pressure on shadow banks to persist in 2018. This will continue to weigh on credit growth. The more vexing challenge is how to reduce excessive household savings. The government's current strategy of cramming down the capital stock by taking out excess capacity from sectors such as steel, coal, and solar may be better than nothing, but it still pales in comparison to a strategy of encouraging consumer spending. Higher consumer spending would obviate the need for state-owned companies and local governments to keep people employed in make-work projects. The good news is that there are plenty of ways that China can boost household consumption. Government spending on education, health care, and pensions as a share of GDP is close to half of the OECD average (Chart 9). Increasing social transfer payments would give households the wherewithal to spend more. Unlike in most countries, the poor in China are net savers (Chart 10). Expanding the social safety net would discourage precautionary savings. Chart 9Chinese Social Welfare Spending ##br##Is Lagging The OECD Average Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Chart 10Low Income Households Are Net ##br##Savers In China Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? The Chinese income tax structure is fairly regressive. Poor households face an effective income tax rate exceeding 40%. This is well above OECD norms (Chart 11).2 A more progressive tax system would boost spending among poorer households. It would also curb inequality, which has increased sharply over the past few decades (Chart 12). The saving rate among the richest 10% of Chinese earners is close to 50%. Policies that shift income from the rich to the poor would reduce overall household savings. Chart 11High Tax Burden For ##br##Low Income Households In China Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Chart 12Shifting Income To Poorer Households Would Reduce ##br##China's Household Savings Rate Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Debt Nationalization Is Inevitable Chart 13Ratio Of Workers-To-Consumers Is Peaking,##br## And China Is No Exception Ratio Of Workers-To-Consumers Is Peaking, And China Is No Exception Ratio Of Workers-To-Consumers Is Peaking, And China Is No Exception Realistically, reforms aimed at encouraging consumption will take a while to implement. In the meantime, debt levels are likely to keep rising. Much of China's debt burden remains on the books of state-owned companies and local governments. At some point over the next few years, the central government will transfer a large fraction of this debt onto its own balance sheet. This would ease concerns about a mass wave of defaults. The key question for investors is whether this de facto "debt nationalization" is done proactively or reactively in response to a crisis. If the latter occurs, investors should steer clear of Chinese assets, as well as China-related plays such as commodities and commodity currencies. If the former pans out, global risk assets could rally. While the truth will fall somewhere between those two extremes, our bet is that the proactive view will prove closer to the mark, at least relative to market expectations (keep in mind that Chinese banks are trading below book value, so a lot of bad news has already been priced in). The Chinese authorities talk a lot about the importance of reducing moral hazard, but in practice, they have shown very little tolerance for defaults. Just as they did in the early 2000s, government leaders could commission state-owned asset management companies to purchase distressed debt from banks and other lenders at inflated prices. Chinese financials, which are nearly 70% of the H-share index, will benefit. Will investors balk at the prospect of the Chinese government blowing out the budget deficit in order to rescue insolvent borrowers? There might be some short-term panic, but as has been the case with Japan, as long as there are plenty of excess domestic savings to go around, the risk of a debt crisis will remain minimal. Indeed, the issuance of more government debt would help alleviate what has become a critical problem for Chinese savers: The lack of safe, liquid domestic assets available for purchase. What is true, from a longer-term perspective, is that the combination of higher debt and slower growth will eventually create a strong incentive for the Chinese government to inflate away debt. As in many other countries, China's "support ratio" -- broadly defined as the ratio of workers-to-consumers -- has peaked (Chart 13). As the growth of output and income falls behind consumption growth, China's savings glut will become a thing of the past. Rather than raising rates, the PBOC will just let the economy overheat. Such a day of reckoning is probably still at least five years away, but eventually inflation will return to China. Concluding Thoughts On The Current Market Environment A true "Minsky moment" in China - one where the financial sector seizes up due to spiraling fears of bankruptcies and defaults - is not in the cards. Nevertheless, China's economy is slowing, and growth is likely to decelerate further over the next few quarters as the authorities restrain credit growth and the property market continues to cool. The slowdown in Chinese growth is occurring at the same time as the economic data has been deteriorating around the world. The equity component of our MacroQuant model - which is highly sensitive to changes in the direction of growth - has been in bearish territory for two straight months (Chart 14). Our base case remains that global growth will stabilize over the next few months at an above-trend pace. Global bond yields are still near record-low levels and fiscal policy is moving in a more stimulative direction (Chart 15). It would be odd for the global economy to deteriorate sharply in such an environment. Chart 14MacroQuant Model Suggests Caution Is Warranted Is China Heading For A Minsky Moment? Is China Heading For A Minsky Moment? Trade protectionism is an obvious risk to this sanguine cyclical view. BCA has long argued that globalization is under threat from the combination of rising populism and the end of America's role as the world's sole superpower. However, the retreat from globalization will occur in fits and starts. Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now. Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade. President Trump has been able to shrug off the decline in equities because his approval rating has actually risen during the selloff (Chart 16). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks continue to fall - Trump will change his tune. Chart 15Global Economy Buttressed By ##br##Accommodative Fiscal And Monetary Policy Global Economy Buttressed By Accommodative Fiscal And Monetary Policy Global Economy Buttressed By Accommodative Fiscal And Monetary Policy Chart 16Trump's Approval Rating Has ##br##Actually Risen During Equity Selloff Trump's Approval Rating Has Actually Risen During Equity Selloff Trump's Approval Rating Has Actually Risen During Equity Selloff For its part, the Chinese government is also looking to strike a deal. The U.S. exported only $131 billion in goods to China last year. This is already less than the $150 billion in Chinese goods that Trump has targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Bottom Line: The near-term picture for global equities and other risk assets is murky, but the 12-month cyclical outlook is still reasonably upbeat. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 For instance, if someone buys stock on margin or takes out a second mortgage on their house, new debt is created without anyone having to cut back on spending. In the context of China, imagine a financial institution which funds the purchase of a building by issuing a certificate of deposit or by selling a "wealth management" product. Both the asset and liability side of the financial institution's balance sheet go up (i.e., new debt is created). Suppose further that the company that sold the building puts the proceeds into a certificate of deposit or wealth management product. The entire transaction is self-financing. The example above illustrates that debt can go up in some situations even if everyone's spending habits remain the same. The need to intermediate savings is one source of debt growth, but it does not have to be the only one. 2 Please see "People's Republic Of China: Selected Issues," IMF Country Report, dated August 15, 2017.