Money/Credit/Debt

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. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Trade wars have captured investors' imaginations, but slowing global growth is a more immediate risk for both asset prices and exchange rates. As reflationary forces ebb, slow global growth will help the dollar stage a rally. EUR/USD and GBP/USD could decline over the next two quarters. We are selling EUR/CHF. The AUD has more downside. It is too early to close short AUD/NZD or AUD/JPY. Short EUR/CAD with a first target at 1.44. Feature The growing trade skirmish between China and the U.S. has been blamed for much of the movements in risk assets this year. We do not deny that this has been a very important factor determining the price action of all assets globally; after all, market participants are trying to price in the probability that global supply chains as we currently know them will be forever impaired. If this were to happen, global growth and profits would suffer considerably. This warrants a risk premium, one that is currently being estimated by the market.1 As we have written in recent weeks, this will be a stop-and-go pattern, and behind-the-scene negotiations between China and the U.S. will remain intense until June, when the U.S. tariffs are in fact implemented. However, trade wars are not the only force impacting asset returns today. Global asset prices are also slowly adjusting to a world where reflation is ebbing and where growth may be dipping from its heightened state. This week, we examine the role of liquidity and how it is affecting growth,2 and the implications for various currency pairs. From Reflation To Less Growth Through most of 2016 and 2017, risk assets, EM plays, commodity prices and growth greatly benefited from a wave of global reflation implemented by monetary and fiscal authorities around the world in the wake of a market meltdown that culminated in January 2016. A great victim of this reflationary effort was the U.S. dollar. Once global growth and inflation perked up, the dollar sold off. The U.S. economy is not as levered to global growth as the rest of the world is, thus investors were attracted by greater shift in expected returns outside the U.S. than in the U.S. But how is this reflation story faring today? Global monetary policy is not as supportive as it once was as central banks are not adding to global base money as forcefully as before. For example, the Federal Reserve has begun the rundown of its balance sheet, and the real fed funds rate is closing in on the Laubach-Williams estimate of the neutral rate; the European Central Bank has begun tapering it asset purchases, the European shadow policy rate has increased by 400 basis points; and the Bank of Japan has not hit its JGB target of JPY80 trillion of purchases since mid-2016. Even the Swiss National Bank has not seen any increase in its sight deposits since mid-2017. We like to use excess money growth to measure the impact of these changes in base money growth. Excess money supply growth is measured as the difference between broad money supply growth and money demand as approximated by loan growth. As base money and deposits become scarcer in the banking system relative to the pool of existing loans, the liquidity position of commercial banks deteriorates. This deprives them of the necessary fuel to generate further loan growth down the road. Chart I-1 not only shows that excess money in the U.S., euro area and Japan has been decelerating sharply in recent months, but also that this decline points toward slowing global industrial activity, widening junk spreads and decline EM stock prices. Beyond quantity-based measures of liquidity, price-based measures are sending a similar signal. The widening in the LIBOR-OIS spread has now been well documented. It is true that technical factors such as the issuance of T-bills by the Treasury and the progressive move away from LIBOR as a key benchmark for the pricing of loans partly explain this phenomenon. However, this development is now spreading outside the U.S., with Australia in particular experiencing some especially sharp widening in the spread between deposit rates and the OIS. In fact, the LIBOR-OIS spread for the G-10 as a whole is now at its widest since 2012 (Chart I-2). This also portends a situation where liquidity is becoming scarcer than it once was. Chart I-1Deteriorating Liquidity Conditions Deteriorating Liquidity Conditions Deteriorating Liquidity Conditions Chart I-2Price Of Liquidity Is Increasing Price Of Liquidity Is Increasing Price Of Liquidity Is Increasing Growth is responding to these dynamics, and the softening in PMIs around the world was in full display this week. Interestingly, two bellwethers of global growth are showing especially clear signs of a slowing.3 In Korea, exports have greatly decelerated, industrial production is contracting and PMIs are well below 50 (Chart I-3). Taiwan is also showing some signs of weakness, as exports and export orders are both slowing sharply (Chart I-4). Chart I-3Korea: A Key Global Bellweather Is Slowing Korea: A Key Global Bellweather Is Slowing Korea: A Key Global Bellweather Is Slowing Chart I-4Taiwan Echoes Korea's Message Taiwan Echoes Korea's Message Taiwan Echoes Korea's Message This message is also being relayed by the Japanese economy. Japan's exports to Asia have been slowing sharply as well. As Chart I-5 illustrates, weak Japanese shipments to Asia correlate closely with a weak AUD/JPY, weak EM stock prices and widening junk spreads, suggesting that these specific shipments capture systematic developments behind global growth. Key growth-sensitive currencies are flashing a similar signal. As the top panel of Chart I-6 shows, NZD/JPY has historically rolled over and declined ahead of recessions, growth slowdowns or EM crashes. It has clearly weakened for eight months now. Meanwhile, the bottom panel of Chart I-6 shows the Swedish krona versus the euro. This cross is also a good leading indicator of global growth, and it is clearly pointing south. Chart I-5Japanese Exports Point To A Malaise Japanese Exports Point To A Malaise Japanese Exports Point To A Malaise Chart I-6NZD/JPY And EUR/SEK: Confirming The Risks NZD/JPY And EUR/SEK: Confirming The Risks NZD/JPY And EUR/SEK: Confirming The Risks Finally, one of our favorite gauges to measure the impact of reflation has substantially weakened: the combination of global growth and inflation surprises. This indicator clearly shows that after a massive upsurge in reflationary forces over the past two years, reflation is now waning (Chart I-7). Chart I-7Economic Surprises Are Declining The Reflation Trade In One Chart Economic Surprises Are Declining The Reflation Trade In One Chart Economic Surprises Are Declining If reflation is about pushing growth and prices upward, removing stimulus could have the opposite impact. While it is clear that global growth is slowing, what about inflation? We do not think that global inflation is set to slow significantly: global growth is unlikely to move back below trend, and the U.S. is experiencing increasingly potent domestic inflationary pressures supercharged by fiscal profligacy. That being said, the uptrend in global inflation is nonetheless set to flatten for now as our Global Inflation Diffusion Index based on consumer and producer prices across 27 economies has begun to fall, which normally points to lower global headline and core consumer prices (Chart I-8). Bottom Line: The market's attention has been captured by the dramatic flare-up in trade tensions between the U.S. and China, but a more imminent risk has been garnering less press: the decline of reflation. China sent the first salvo on this front; DM central banks have also slowly been either tightening outright or not expanding monetary aggregates as aggressively as before. As a result, global liquidity is tightening and global growth is slowing. Global inflation is also set to decelerate as well, suggesting the decline in economic activity will not be a real phenomenon only, but a nominal one as well. Key Currency Market Implications One of the key implications of lower global growth and ebbing inflationary pressures is likely to be a stronger dollar. As Chart I-9 illustrates, when our Global Inflation Diffusion Index declines and global inflationary pressures ebb, the dollar tends to strengthen. This makes sense: the dollar does best when global growth weakens, inflation slows and commodity prices soften. This time around, the case for a few quarters of dollar strength may be even better defined. U.S. inflation is unlikely to decelerate as much as non-U.S. inflation as U.S. capacity utilization is tighter, the U.S. labor market is at full employment and America is receiving an extraordinarily large amount of fiscal stimulus at this late stage of the business cycle. Chart I-8No Acceleration For Now In Global Inflation No Acceleration For Now In Global Inflation No Acceleration For Now In Global Inflation Chart I-9Ebbing Inflationary Pressures Will Help The Dollar Ebbing Inflationary Pressures Will Help The Dollar Ebbing Inflationary Pressures Will Help The Dollar Technical considerations suggest the dollar is well placed to take advantage of these dynamics. On a short-term basis, both our intermediate-term oscillator and 13-week rate-of-change measures have formed positive divergences with the DXY itself (Chart I-10). While the pattern does not look as bullish as the one registered in 2014, it evokes deep similarities with the 2011 formation. On a longer-term basis, the dollar is massively oversold, as measured by the 52-week rate of change measure. It is true that it managed to stay at similarly oversold levels for nearly a year in 2003, but back then the dollar was much more expensive than today: the U.S. current account deficit was 4.4% of GDP versus 2.4% today and the basic balance of payments deficit was at 3% of GDP versus 2% today (Chart I-11). It is reasonable that with these stronger fundamentals, the dollar will not need to hit as oversold levels as back then before staging a significant rebound. Chart I-10Positive Divergences For The Greenback Positive Divergences For The Greenback Positive Divergences For The Greenback Chart I-11Dollar Technicals And Valuations: 2003 Vs. Today Dollar Technicals And Valuations: 2003 Vs. Today Dollar Technicals And Valuations: 2003 Vs. Today With global growth slowing, especially in Asia, it is easy to paint a picture where the dollar only strengthens against EM and commodity currencies - the currencies most exposed to both global growth and this specific geographic area. However, while we do see downside in USD/JPY, we expect the greenback to rally against the euro toward EUR/USD 1.15. Our model for EUR/USD shows that the euro is trading 10% above its fair value determined by real rate differentials, the relative slope of yield curves and the price of copper relative to lumber (Chart I-12). In fact, since Europe is more levered to global economic activity than the U.S., these drivers are likely to deteriorate a bit further for the remainder of 2018. Chart I-12EUR/USD Is Vulnerable EUR/USD Is Vulnerable EUR/USD Is Vulnerable GBP/USD also looks set to experience a period of weakness against the greenback. Historically, GBP/USD and EUR/USD have been correlated. This is a simple reflection of the fact that the U.K. has a deeper economic relationship with the euro area than the U.S., and thus benefits from the same economic impulses as the eurozone. Chart I-13GBP/USD: ##br##Extremely Overbought GBP/USD: Extremely Overbought GBP/USD: Extremely Overbought Some pound-specific factors will also play against GBP/USD. As we argued last week, the British domestic economy is rather weak; this week's construction PMI confirmed this assessment.4 Additionally, the British basic balance of payments is in deficit anew. This is not only a reflection of the U.K.'s current account deficit of 4% of GDP, it also reflects the fact that FDI into the U.K. has been melting in response to uncertainty surrounding Brexit. This means the U.K. is dependent upon global liquidity to finance this large deficit. An environment where global growth is set to decelerate and where global liquidity is tightening will make it more expensive to finance this large hole. The fastest means to increase expected returns on British assets to attract foreigners' funds is to depreciate the pound today. Finally, the GBP's annual momentum has hit levels consistent with a reversal in cable (Chart I-13). Staying in Europe, another pair is currently interesting and devoid of taking on any USD risk: EUR/CHF. While we think EUR/CHF has more upside over the remainder of the economic cycle,5 this is unlikely to be the case in the second and third quarters of 2018. The Swiss franc tends to outperform the euro when reflationary forces retreat, when global growth slows and when FX volatility increases - all views we espouse for the coming quarters. Moreover, Switzerland's current account and basic balance-of-payment surpluses are 6.5% of GDP and 11.5% of GDP greater than that of the euro area, providing further attraction in a growth soft spot. Finally, EUR/CHF is massively overbought right now, pointing to heightened vulnerability to the economic risks highlighted above (Chart I-14). We are opening a short EUR/CHF trade this week. In the same vein, we remain bearish EUR/JPY. Finally, in previous reports, we highlighted the AUD as being the currency most at risk from any downshift in global growth.6 Despite its recent weakness, we think the AUD is likely to remain very vulnerable. We have been short AUD/NZD since last October, and we do believe this pair will retest 1.04 before forming a base. Australia is experiencing even less inflationary pressures than New Zealand, and is more exposed to slower global industrial production than its neighbor. Technically, AUD/NZD still has some downside. As Chart I-15 illustrates, the 13-week rate of change measure for AUD/NZD has not yet hit the kind of depressed levels associated with complete capitulation. In fact, the recent breakdown in momentum points toward such capitulation as being imminent. AUD/JPY too is not yet oversold enough to be a buy, especially in the context of slowing global growth. Thus, we continue to recommend investors stay short this pair. Chart I-14Technical Indicators Confirm ##br##The Fundamental Vulnerability Of EUR/CHF Technical Indicators Confirm The Fundamental Vulnerability Of EUR/CHF Technical Indicators Confirm The Fundamental Vulnerability Of EUR/CHF Chart I-15AUD/NZD Has A Little Bit More Downside AUD/NZD Has A Little Bit More Downside AUD/NZD Has A Little Bit More Downside Bottom Line: Ebbing reflationary forces suggest the trade-weighted dollar is likely to rally over the coming months. We do see upside for the USD against EM and commodity currencies, but against European currencies as well. Only the yen is anticipated to buck this trend. Within the commodity-currency complex, we foresee that the AUD will suffer the most, and the CAD the least. Within the European currency complex, we are selling EUR/CHF. We are not selling EUR/USD as we are already long the DXY. A Cyclical Opportunity To Sell EUR/CAD This trade is an attractive means to bet on global growth slowing, especially relative to the U.S. As we have argued, U.S. financial conditions have eased relative to the rest of the world, the U.S. is enjoying large injections of fiscal stimulus and it is less exposed to declining global growth. As a result, we anticipate the outperformance of the U.S. ISM to continue relative to global PMIs. Historically, this is an environment where EUR/CAD tends to depreciate (Chart I-16). This is because while 75% of Canadian exports go to the U.S., only 13% of euro area exports end up there. Thus, Canada is much more exposed to the U.S. business cycle than Europe, who is exposed to the rest of the world's. Domestic factor also argues in favor of shorting EUR/CAD. Canadian core inflation is in an uptrend, and at 2% is at the Bank of Canada's target. European core inflation meanwhile only stands at 1%. Moreover, Canada's unemployment's rate is already 0.5% below equilibrium, while the euro area's is 0.4% above such equilibrium (Chart I-17). Thus, European wages and service sector inflation is likely to continue to lag behind Canada's. As a result, we continue to expect the BoC to keep hiking in line with the Fed, or another three times this year. The same cannot be said for the ECB. Chart I-16EUR/CAD: A Play Global Vs. U.S. Growth EUR/CAD: A Play Global Vs. U.S. Growth EUR/CAD: A Play Global Vs. U.S. Growth Chart I-17No Slack In Canada, Plenty In Europe No Slack In Canada, Plenty In Europe No Slack In Canada, Plenty In Europe Making the trade even more attractive, EUR/CAD is currently trading at a premium on many metrics. First, our augmented interest rate parity models show that the EUR/CAD trades anywhere between 10-15% above fair value (Chart I-18).7 Relative productivity trends have been a reliable long-term indicator of the path for EUR/CAD. On this metric as well, EUR/CAD is trading at a significant 9% premium (Chart I-19). Finally, EUR/CAD has tended to trend in an inverse relationship with oil prices. Today, it is well above levels implied by various oil prices (Chart I-20). Chart I-18EUR/CAD Trades At A Premium To Rate Differentials... EUR/CAD Trades At A Premium To Rate Differentials... EUR/CAD Trades At A Premium To Rate Differentials... Chart I-19...At A Premium To Relative Productivity... ...At A Premium To Relative Productivity... ...At A Premium To Relative Productivity... In our view, a key factor explains these discounts: Fears regarding the future of the North American Free Trade Agreement. An abandonment of NAFTA would hurt Canadian growth and prompt the BoC to be much more dovish than we anticipate. However, while there will be some small tweaks to NAFTA, the probability of a major overhaul that deeply affects the North American supply chain has declined, as Canada and Mexico are being exempted from steel and aluminum tariffs and as the White House has softened its stance on the U.S. content of Canadian auto exports back to the U.S. Our Geopolitical team assesses that the probability of a major NAFTA overhaul has declined from 50% to less than 20%, especially as Trump now has bigger fish to fry with China. As a result of these improvements in negotiations, EUR/CAD is potentially set to decline toward 1.44 over the rest of 2018, especially as our oil strategists continue to expect Brent prices to average US$74/bbl this year. Meanwhile, the ratio of copper prices to oil prices, which has been a decent early directional indicator for this cross, suggests the timing is ripe to bet against euro/CAD (Chart I-21), especially as slowing global growth will further weigh on copper relative to oil. Chart I-20...And A Premium To Oil ...And A Premium To Oil ...And A Premium To Oil Chart I-21Where Copper-To-Oil Goes, So Does EUR/CAD Where Copper-To-Oil Goes, So Does EUR/CAD Where Copper-To-Oil Goes, So Does EUR/CAD Bottom Line: An attractive means to bet on slowing global growth while benefiting from the impact of the U.S.'s fiscal stimulus is to short EUR/CAD. Not only is this cross a play on the differential between international and U.S. growth, it is also currently trading at a large premium on various metrics. Dissipating risks that NAFTA will be abrogated in a major way are providing an attractive cyclical entry point to short EUR/CAD, with an initial target of 1.44. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Analyst haarisa@bcaresearch.com 1 For more analysis on trade wars and the current China/U.S. spat, please see Foreign Exchange Strategy Weekly Report, "Are Tariffs Good or Bad For The Dollar?" dated March 9, 2018, available at fes.bcaresearch.com as well as the Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 2 We have already gone over the role of China at length to explain the global growth slowdown. For detailed discussions on the topic, Please see Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility", dated March 16, 2018, available at fes.bcaresearch.com. 3 For more indicators pointing toward slower global growth, Please see Foreign Exchange Strategy Weekly Report, "Canaries In the Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017 and "Canaries In the Coal Mine Alert 2: More On EM Carry Trades And Global Growth", dated December 15, 2017, available at fes.bcaresearch.com. 4 Please see Foreign Exchange Strategy Weekly Report, "Do not Get Flat-Footed By Politics", dated March 30, 2018, available at fes.bcaresearch.com. 5 Please see Foreign Exchange Strategy Special Report, "The SNB Doesn't Want Switzerland To Become Japan", dated March 23, 2018, available at fes.bcaresearch.com. 6 Please see Foreign Exchange Strategy Weekly Report, "From Davos To Sydney, With a Pit Stop in Frankfurt", dated January 26, 2018, available at fes.bcaresearch.com. 7 EUR/CAD trades 15% above a fair value model, that does not encapsulate the trend in the cross. If the recent cross is taken into account through a model that incorporates mean-reversion, EUR/CAD trades at a more modest 10% above its fair value. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: ISM Manufacturing came in slightly weaker than expected at 59.3; However, ISM Prices Paid was a very strong number, 78.1, up from the previous 74.2; Services PMI and Non-Manufacturing ISM also disappointed expectations; The trade balance in February fell to US$ -57.6 bn; Initial jobless claims, however, came in much higher than expected at 242,000. The dollar is now up more than 2% from its February lows. This has been driven by slowing global growth, particularly in Korean and Taiwanese trade data. The greenback should fare well in this environment. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Are Tariffs Good Or Bad For The Dollar? - March 9, 2018 The Dollar Deserves Some Real Appreciation - March 2, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 European data was mixed: German retail sales disappointed, growing at a 0.7% monthly pace and a 1.3% annual pace; German Manufacturing PMI came in slightly lower than expected at 58.2; European unemployment dropped to 8.5% as expected; Headline inflation improved to 1.4% also as expected, but core inflation came in weaker than expected at 1%. The euro is set to experience a period of correction as inflation in the Eurozone remains weak and global growth is slowing, as Asian economic data increasingly shows. Report Links: Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Housing starts yearly growth outperformed despite coming in at -2.6%. The Nikkei manufacturing PMI surprised on the strong side, coming in at 53.1 However, the Markit Services PMI underperformed expectations coming in at 50.9. USD/JPY has been relatively flat this week. Overall, we expect that the yen will continue to strengthen, given that the market will continue to be rattled by the increasing a weakening in global growth. This risk off environment should benefit the yen. However, given the slowdown in Japanese economic data, the BoJ will eventually have to intervene to make sure that the rise in the yen does not derail the economic recovery and particularly, its inflation objective. Report Links: The Yen's Mighty Rise Continues... For Now - February 16, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Markit Manufacturing PMI outperformed expectations, coming in at 55.1. It also increased slightly from last month's reading. However PMI construction underperformed expectations substantially, coming in at 47. This is the lowest level in more than 2 years. GBP/USD has been relatively flat this week. Overall the latest construction PMI number confirms our analysis: the uncertainty caused by Brexit is weighing heavily on Britain's housing market. This weakness in the housing sector, coupled with a strong pound, will likely limit how high British interest rates can go. Therefore GBP/USD has downside on a tactical basis. Report Links: Do Not Get Flat-Footed By Politics - March 30, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was weak: The RBA's Commodity Index in SDR terms contracted by 2.1% annually, much more than the expected 0.1% contraction; Building permits contracted on a monthly basis at a rate of 6.2%, while also contracting at a 3.1% pace in annual terms; However, retail sales did pick up in monthly terms at a rate of 0.6%. At the monetary policy meeting on Tuesday, Governor Philip Lowe referenced the increase in short-term funding costs that have spilled over from the U.S. into foreign markets owing to higher volatility, particularly in Australia. An escalation of a trade war will also prove to be very damaging for the Australian economy, which is a large export-based and commodity-dependent nation. Report Links: Who Hikes Again? - February 9, 2018 From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has been flat this week. Overall we expect this cross to weaken going forward, given that New Zealand is one of the most open economies in the G10, and thus, it stands to risks the most from both an increasing risk of trade wars and slowing global growth. Moreover, there are also some negative aspects of New Zealand on a more structural basis, as the neutral rate is set to be lowered. This is because the populist government is looking to lower immigration while also implementing a dual mandate for the central bank. All of these factors will cause the kiwi to suffer on a long term basis. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Data out of Canada was mixed: Manufacturing PMI came in line with expectations of 55.7; Exports and Imports for February came in at CAD 45.94 bn and CAD 48.63 bn, respectively, sinking the trade balance to CAD -2.69 bn. The CAD received a fillip on Tuesday as President Trump hopes to conclude preliminary negotiations for NAFTA by the end of next week. While the outcome for these negotiations remains uncertain, the Canadian economy is still in great shape, with a tight labor market, high wage growth and a closing output gap. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation outperformed expectations, coming in at 0.8%. Real retail sales yearly growth outperformed expectations, coming in at -0.2%. However, the SVME PMI underperformed expectations, coming in at 60.3. EUR/CHF has been relatively flat this week. Overall, we expect EUR/CHF to have further upside on a long-term basis. The Swiss economy is still weak and inflationary pressures are tepid. This means that any further appreciation by the franc will weigh heavily on the SNB's goals. While for now EUR/CHF could suffer as global growth declines, the SNB will fight this trend in order for them to achieve their inflation target. Thus, any rally in the CHF will prove temporary. Report Links: The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has been relatively flat this week. Overall, the krone should outperform most other commodity currencies given that oil should perform better than the rest of the commodity complex in the current environment. While all commodities would be affected by a possible slowdown in global growth and Chinese industrial production, oil will probably hold up the best given that advanced economies consume a greater proportion of oil than they do of other commodities, making oil less sensitive to gyrations in global industrial activity than metals. Moreover, the supply backdrop for oil remains more favorable than that of other commodities thanks to OPEC and Russia's production restrains. All of these developments should help the NOK outperform currencies like the NZD and the AUD. Report Links: Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish data was disappointing: Manufacturing PM came in at 55.9, below last month's 59.9; New Orders increased annually only by 1.3% compared to 8.7% in January; Industrial production contracted in monthly terms by 0.5%, and grew annually by 5.7%, but it was still a deceleration relative to the previous 7.7% reading. The SEK has been weakening because of three factors: the talk of trade wars, the slowdown in the global manufacturing sector, and Sweden's housing bubble. While these risks are very real, Sweden's favorable macro backdrop of a cheap currency, a high basic balance of payments surplus and an economy operating above capacity mean that inflation will pick up meaningfully. This will prompt the SEK to rally once global growth can find its floor. Report Links: Who Hikes Again? - February 9, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is highly concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely elevated debt service ratio. Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the current message from our DRM is that the odds of a deleveraging event over the coming year are low. Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Feature Hong Kong has appeared in the headlines of the financial press for two reasons over the past few months. The first is due to the recent weakness in the Hong Kong dollar (HKD), a topic that we addressed last week.1 The second was prompted by the BIS' March 2018 Quarterly Review, which noted that mainland China, Hong Kong, and Canada stood out among 26 jurisdictions as being the most vulnerable to a banking crisis according to their research. The BIS's warning is rooted in the fact that Hong Kong is a highly leveraged economy, but there are two additional reasons for investors to be cautious about the region: China's industrial sector is slowing, and monetary policy is tightening due to the region's direct link to U.S. interest rates. While Hong Kong has avoided the full brunt of rising U.S. rates over the past year thanks to plentiful interbank liquidity (which has limited the rise in 3-month HIBOR), we noted in last week's report that the weakness in the HKD likely means that gap between interbank rates and the base rate cannot get much wider. This means that further Fed rate hikes over the coming year are likely to feed more fully into tighter Hong Kong monetary conditions. In this report we review the extent and disposition of Hong Kong's indebtedness, and develop an indicator for investors to monitor in order to gauge the risk of a serious private sector deleveraging event. We conclude that while it is too early to position aggressively against Hong Kong stocks, the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn. For now, however, that appears to be a story for another day, and as we explain below, potentially a distant one. Breaking Down Hong Kong's Debt Chart 1 presents the basis for concern about Hong Kong's debt. The chart shows the BIS' nonfinancial private sector debt service ratio ("DSR", which includes both households and nonfinancial corporations) for the G10 countries alongside that of China, Hong Kong, and Canada. The chart shows that Hong Kong's DSR has risen nearly to 26%, a full 10 percentage points higher than the G10 average, and is now the highest among the 32 economies that the BIS has debt service data for. One important point to note is that among the three countries that the BIS recently singled out for concern, the disposition of Hong Kong's private sector debt is more similar to that of China than Canada. Chart 2 highlights that the private sector debt in China and Hong Kong is predominantly owed by the nonfinancial corporate sector, whereas in Canada the debt is more equally split among the two sectors, with households owing more in total. Chart 1Hong Kong's Debt Burden Hits##br## A New High Hong Kong's Debt Burden Hits A New High Hong Kong's Debt Burden Hits A New High Chart 2Unlike In Canada, Hong Kong's Leverage##br## Is A Corporate Sector Problem Unlike In Canada, Hong Kong's Leverage Is A Corporate Sector Problem Unlike In Canada, Hong Kong's Leverage Is A Corporate Sector Problem Normally we would be inclined to suggest that the skew in Hong Kong's debt towards the corporate sector makes it less risky than in other jurisdictions where elevated leverage is a household sector problem. The rationale is that while corporations can (and often do) misallocate their capital, firm borrowing is usually employed to acquire income-producing assets, with problems arising only when the value of those assets (or their potential to generate income) declines sharply. Household leverage problems, on the other hand, are almost always the result of a sharp rise in residential mortgage credit, and our view is that the purchase of residential property is fundamentally an act of consumption rather than a true investment. In addition, the past experiences of several countries have shown that housing-related leverage busts are particularly pernicious, in that the resulting recessions tend to be followed by long periods of subpar economic growth. But unlike in China where the majority of nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong's corporate debt does not have de-facto state backing and appears to be enormously concentrated in the real estate and financial sector. Over 80% of Hong Kong's total nonfinancial sector debt (which includes households) is provided by domestic banks, and Chart 3 shows that among bank loans to firms, 35% have been granted to property building & construction companies and another 22% to "financial concerns" and stockbrokers. This high concentration of corporate sector debt in the real estate sector means that investors should be legitimately concerned over Hong Kong's extremely high DSR. On the household side, we have made the case in a previous report that a replay of another spectacular housing bust (similar to what occurred in 1997) is highly unlikely despite the fact that Hong Kong house prices have vastly outstripped income over the past decade2 (Chart 4). Chart 3Loans To Businesses Are Highly Concentrated ##br##And Exposed To Property Loans To Businesses Are Highly Concentrated And Exposed To Property Loans To Businesses Are Highly Concentrated And Exposed To Property Chart 4Lofty House Prices Are A Red Herring: ##br##The Risk Is On The Business Side Lofty House Prices Are A Red Herring: The Risk Is On The Business Side Lofty House Prices Are A Red Herring: The Risk Is On The Business Side This suggests that, despite extremely elevated residential property prices, investors should be more concerned about a shock that will destabilize the commercial real estate market. Hong Kong households would not likely escape the impact of such a shock, since commercial and residential real estate prices move strongly in tandem (Chart 5). But in terms of watching for a "tipping point" that could push Hong Kong's private sector into a balance sheet recession, the trigger seems more likely to occur in the market for the former, rather than the latter. Bottom Line: Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is extremely concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely high debt service ratio. Chart 5Still, Households Will Be Hurt##br## If CRE Prices Fall Still, Households Will Be Hurt If CRE Prices Fall Still, Households Will Be Hurt If CRE Prices Fall Chart 6The BIS' Warning Thresholds ##br##Don't Seem To Apply To Hong Kong The BIS' Warning Thresholds Don't Seem To Apply To Hong Kong The BIS' Warning Thresholds Don't Seem To Apply To Hong Kong Timing The Onset Of A Balance Sheet Recession Our analysis above supports the recent warnings from the BIS that the risk of a banking crisis / private sector deleveraging event in Hong Kong is nontrivial. This raises the obvious question of how to gauge the timing of such an event in order for investors to properly position their exposure towards Hong Kong's financial markets. The BIS has itself investigated this question, and has published several reports on its "Early Warning Indicator" (EWI) approach.3 Table 1 presents a list of these indicators for several countries, and highlights that the two of the most informative measures (the credit-to-GDP gap4 and the overall debt service ratio) are flashing red for Hong Kong. In fact, Table 1 served as the basis for the BIS' warning in their most recent Quarterly Review that we noted above. The BIS' EWI research has focused on identifying thresholds for these measures that can predict a banking crisis within a three-year window based on the historical record. But in the case of Hong Kong, it is not clear that these thresholds apply. Chart 6 shows the credit-to-GDP gap and overall private sector DSR along with the more stringent BIS threshold noted in Table 1, and highlights that these measures have been flashing red for 4-8 years. Based on this approach, Hong Kong should have experienced a banking crisis long ago. Table 1BIS Early Warning Indicators For Stress In Domestic Banking Systems Hong Kong's Private Sector Debt: There Will Be Blood, But Not Today Hong Kong's Private Sector Debt: There Will Be Blood, But Not Today Rather than relying on the BIS' framework, we have instead constructed our own private-sector debt risk monitor for Hong Kong. In contrast to the BIS' measures, which have been specifically constructed to predict a banking crisis, the goal of our indicator is to help predict a serious credit-driven downturn regardless of its character (i.e. we abstract from whether the result of the downturn is a full-blown financial crisis or simply a prolonged period of economic stagnation). Chart 7Low Risk Of A Serious Credit-Driven ##br##Downturn, For Now Low Risk Of A Serious Credit-Driven Downturn, For Now Low Risk Of A Serious Credit-Driven Downturn, For Now Chart 7 presents our BCA Hong Kong Debt Risk Monitor (DRM) and its five equally-weighted components, a summary of which is provided below. All series have been scaled such that an increase in the DRM represents higher risk. Alpha: We have highlighted the importance of examining the alpha as well as the beta of regional equity returns in a previous report,5 and we include a composite indicator of Hong Kong's rolling alpha versus the global benchmark as a measure of Hong Kong-specific stock performance that adjusts for Hong Kong's riskiness. While this component of our DRM was quite elevated in early-2016 (signaling weak Hong Kong stock performance), it is presently in line with its historical average, and thus is not flashing a warning sign. Property Prices: Given the high concentration of Hong Kong's corporate sector debt in the real estate sector, our DRM includes the deviation of office & retail property prices from their 9-month moving average. Similar to the first component of our indicator, Hong Kong property prices are roughly in line with their trend and are not signaling serious economic weakness. Credit Impulse: The third component of our DRM is a simple bank credit impulse, calculated as the flow of credit over the past year as a percent of GDP. While this component has fallen well into "low risk" territory, over the past year, there are some tentative signs of a reversal that investors should monitor. Monetary Policy Stance: The fourth component of our DRM is a structural variable that attempts to measure whether U.S. (and thus Hong Kong) interest rates are either consistent or out of alignment with economic conditions in Hong Kong. This component is an average of two measures of the stance of monetary policy: 1) the difference between U.S. 10-year government bond yields and Hong Kong nominal GDP growth, and 2) the difference between the base rate and a Taylor Rule estimate for the region (with the latter acting purely as an estimate of the cyclical equilibrium interest rate).6 The chart shows that despite the onset of tighter monetary policy in the U.S. over the past few years, our gauge of Hong Kong's policy stance suggests that conditions are still easy, and that material further increases would likely be required in order to see this component rise to +1 sigma territory. Debt Service Ratio: The final component of our DRM is the BIS' total private sector DSR shown in Chart 6, acting as a second structural variable that captures the underlying debt servicing risk that the BIS has warned about. We extent the BIS' series back to the early-1990s on a best efforts basis, by adjusting the product of Hong Kong's prime rate and the total private sector debt-to-GDP ratio to best align with the official DSR series over the course of its history. Our extended series suggests that Hong Kong's debt servicing burden is indeed the highest that it has been over the past three decades, underscoring that our DRM is likely to rise materially if the cyclical factors included in the indicator deteriorate. The overall message of our DRM is that a threat to Hong Kong's economy from excessive debt does not appear to be imminent, despite the underlying risks highlighted by the BIS. While the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn, the odds of this occurring over the coming 6-12 months appear to be low. Bottom Line: Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the message from our DRM is that the odds of a deleveraging event over the coming year are low. The Spooky Implications Of The Natural Interest Rate Gap Interestingly, at least part of the benign reading of our DRM is due to the fourth component of the indicator, our gauge of Hong Kong's monetary policy stance, which suggests that there is ample room for further rate increases. In fact, in our view this observation carries much deeper significance than many may initially perceive, as it may explain why the BIS' early warning indicator thresholds have not worked in the case of Hong Kong, and why the region may avoid a debt crisis for a further significant period (but ultimately experience a much more painful collapse when it finally arrives). At root, the reason that U.S. 10-year Treasury yields remain exceedingly low relative to U.S. nominal GDP growth is because investors believe that real U.S. policy rates are likely to be much lower on average over the next 10-years than they have been historically (Chart 8). Abstracting from calendar-based cyclical considerations (such at the timing of the next U.S. recession), this fundamentally reflects the prevalent view among fixed-income investors that the U.S. natural rate of interest (or "r-star") has likely permanently declined. If true, this is of enormous importance for Hong Kong, as it suggests that the region will permanently "enjoy" easy monetary policy. This is because the substantial leveraging that has occurred in Hong Kong in response to low interest rates implies that there has been no impairment (yet) to Hong Kong's natural rate of interest (Chart 9). Chart 8A Low Estimate Of R-Star Has Depressed##br## U.S. Bond Yields A Low Estimate Of R-Star Has Depressed U.S. Bond Yields A Low Estimate Of R-Star Has Depressed U.S. Bond Yields Chart 9No Evidence Of A Low R-Star##br## In Hong Kong No Evidence Of A Low R-Star In Hong Kong No Evidence Of A Low R-Star In Hong Kong In some ways the dynamic we are describing is not new: the importation of easy monetary policy from the U.S. via competitive currency devaluation over the past decade has been a well-known phenomenon that was quite prominent during the early phase of the global economic recovery. But the fixed exchange rate regime in Hong Kong means that this process cannot be avoided without abandoning the peg, an event that itself could trigger a deleveraging event via a sharp decline in asset prices. The key point for investors is that if the U.S. natural rate of interest has indeed fallen materially and permanently below potential GDP growth, then Hong Kong will not experience tight monetary conditions even once the Fed has normalized short-term interest rates, unless it raises them well above equilibrium levels. This suggests that Hong Kong's private sector may perpetually leverage itself until debt service burdens reach some, as yet, unknown maximum level, precipitating what would likely become a cataclysmic recession. The fact that no crisis erupted in late-2015/early-2016 when the cyclical components of our DRM deteriorated significantly suggests that this level may be materially higher than is presently the case. Bottom Line: Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Investment Implications: Stay Neutral, For Now Chart 10Room For A Rise In Relative Earnings Momentum Room For A Rise In Relative Earnings Momentum Room For A Rise In Relative Earnings Momentum The picture painted by our above analysis suggests that a benign cyclical outlook for Hong Kong is arrayed against a negative (and potentially horrific) structural outlook. How should investors position towards Hong Kong equities in response? First, as noted above, our Debt Risk Monitor does not signal that there is an imminent threat facing the Hong Kong economy that would herald the potential for a major deleveraging event over the near-term. Second, while Hong Kong's earnings momentum is stretched in absolute terms, Chart 10 highlights there is room for a catchup versus global stocks, which could boost relative performance over the coming year. Third, relative valuation and technical conditions are at neutral levels (Chart 11), and thus do not provide any compelling basis to avoid Hong Kong stocks. But to us, the weight of this modestly positive assessment over the coming year is overshadowed by the structural outlook, meaning that we continue to recommend a neutral allocation towards Hong Kong stocks over the coming 6-12 months. The most investment-relevant conclusion from our analysis is that investors will one day be able to earn significant risk-adjusted returns from underweighting / shorting Hong Kong stocks once a serious credit-driven downturn begins. As an example, Chart 12 shows the impact of the Asian financial crisis on Hong Kong's relative performance, a period where our DRM rose sharply and persistently into "high risk territory". It took 12½ years for Hong Kong to rise to a new high in relative total return terms, and it has yet to do so in price terms. Chart 11Neutral Relative Valuation And ##br##Technical Conditions Neutral Relative Valuation And Technical Conditions Neutral Relative Valuation And Technical Conditions Chart 12One Day, Shorting Hong Kong Stocks##br## Will Be Enormously Profitable One Day, Shorting Hong Kong Stocks Will Be Enormously Profitable One Day, Shorting Hong Kong Stocks Will Be Enormously Profitable So while the economic and financial market conditions are not yet in place to act on a bearish structural view, we will be closely watching our Debt Risk Monitor over the coming months and years for signs of a significant deterioration, as it will likely provide a major opportunity for investors to earn outsized returns. Stay tuned! Bottom Line: Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Hong Kong Housing Bubble: A Replay Of 1997?", dated June 29, 2017, available at cis.bcaresearch.com. 3 For example, please see "Evaluating early warning indicators of banking crises: Satisfying policy requirements" by Mathias Drehmann and Mikael Juselius, BIS Working Paper No. 421, August 2013. 4 The BIS defines the credit-to-GDP gap as the difference between the credit-to-GDP ratio and its long-run trend, derived using a one-sided (i.e. backward-looking) Hodrick-Prescott (HP) filter. 5 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 6 Our Taylor Rule estimate for Hong Kong is constructed in a fashion similar to what we showed for China in our January 18 Weekly Report, using a neutral policy rate estimate of 5%. Cyclical Investment Stance Equity Sector Recommendations

Highlights Continue to underweight the most cyclical sectors - Banks, Basic Materials, and Energy. As predicted, global growth is losing steam. This implies that the Eurostoxx50 will struggle to outperform the S&P500. Continue with a currency pecking order of "yen first, euro second, pound third, dollar fourth." The sell-off in bonds is due a retracement, or at least a respite. Stock markets' rich valuations are contingent on low bond yields. Feature The views in this report do not necessarily align with the BCA House View Matrix. Chart I-2Cyclicals Were Underperforming##br## Long Before The Trade Skirmishes Cyclicals Were Underperforming Long Before The Trade Skirmishes Cyclicals Were Underperforming Long Before The Trade Skirmishes Stock markets have experienced turbulence this year, and it would be very simple to blame the first skirmishes of a global trade war. It would also be simplistic. The sharp underperformance of cyclical stocks started in January, well before any inkling of the Trump tariffs (Chart I-2). The trade skirmishes have merely accelerated a process that was already underway. In this week's report, we make sense of the market turbulence from three broad perspectives: the global economic mini-cycle; market technicals; and valuation. The Economic Mini-Cycle Has Likely Turned Down When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but this headwind is felt with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but the tailwind is felt with a delay. This delay occurs because credit supply lags credit demand by several months. But if credit supply lags demand, an economic theory called the Cobweb Theorem1 points out that both the quantity of credit supplied and its price (the bond yield) must undergo 'mini-cycle' oscillations. The theory is supported by compelling empirical evidence (Chart I-3). Furthermore, as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same mini-cycle oscillations (Chart I-4). Chart I-3Compelling Evidence For Mini-Cycles In##br## Credit Supply And The Bond Yield... Compelling Evidence For Mini-Cycles In Credit Supply And The Bond Yield... Compelling Evidence For Mini-Cycles In Credit Supply And The Bond Yield... Chart I-4...And ##br##Economic Activity ...And Economic Activity ...And Economic Activity These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months. Their regularity creates predictability. And as most investors are unaware of these cycles, the next turn is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. Mini half-cycles average eight months, and the latest mini-upswing started last April. Hence, on January 4 we predicted that "contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018." The predicted deceleration is precisely what we are now witnessing, and we expect this to continue through the summer months. From an equity sector perspective, the relative performance of the most cyclical sectors - Banks, Basic Materials, and Energy - very closely tracks the regular mini-cycles in global growth. In a mini-downswing these cyclical sectors always underperform (Chart of the week). Accordingly, continue to underweight these sectors through the summer months. Chart of the weekCyclicals Always Underperform In An Economic Mini-Downswing Cyclicals Always Underperform In An Economic Mini-Downswing Cyclicals Always Underperform In An Economic Mini-Downswing For the time being, this implies that the Eurostoxx50 will struggle to outperform the S&P500 - because euro area bourses have an outsize exposure to the most cyclical sectors. From a currency perspective, the stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. In essence, as the ECB and BoJ are at the realistic limit of ultra-loose policy, long-term expectations for their policy rates possess an asymmetry: they cannot go significantly lower, but they can go significantly higher. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they can go either way, lower or higher. Hence, on January 18 we advised a currency pecking order of "yen first, euro second, pound third, dollar fourth." This currency pecking order has also worked perfectly this year, and we expect it to continue working through the summer months. Cyclical Sectors Had Bullish Groupthink Groupthink in any investment is a warning sign that the investment's trend is approaching exhaustion, because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when market participants disagree with each other. Consider a stock whose price is rising strongly: a momentum trader wants to buy it, while a value investor wants to sell it. Hence, the market participants trade with each other with plentiful liquidity. Liquidity starts to evaporate when too many market participants agree with each other. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders fuel the trend. But when all the value investors have become momentum traders, the trend reaches a tipping point. If a value investor suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, our proprietary fractal analysis measures whether groupthink in a specific investment has become excessive, signalling the end of its price trend. Furthermore, using a 130-day groupthink indicator (fractal dimension), the fractal framework provides a powerful and independent reinforcement of our mini-cycle framework. This is because 130 (business) days broadly aligns with the mini half-cycle length. Fractal analysis reinforces our decision to underweight cyclical sectors, because it shows excessive (bullish) 130-day groupthink in these economically sensitive sectors (Chart I-5). Chart I-5Excessive Bullish Groupthink In Cyclical Sectors Excessive Bullish Groupthink In Cyclical Sectors Excessive Bullish Groupthink In Cyclical Sectors It also shows excessive (bearish) 130-day groupthink in government bonds, suggesting that the sell-off in bonds is due a retracement, or at least a respite (Chart I-6). Chart I-6Excessive Bearish Groupthink In Government Bonds Excessive Bearish Groupthink In Government Bonds Excessive Bearish Groupthink In Government Bonds Rich Valuations Are Contingent On Low Bond Yields On price to sales, world equities are as richly valued as they were at the peak of the dot com boom in 2000. The observation is important because price to sales has proved to be a near-perfect predictor of future 10-year returns. It shows that in 2010, world equities were priced to generate 8% a year compared with 4% a year available from global bonds. Today, richer valuations mean that both world equities and global bonds are priced to generate a paltry 2% a year (Chart I-7). Chart I-7World Equities As Richly Valued As At The Peak Of The Dot Com Boom World Equities As Richly Valued As At The Peak Of The Dot Com Boom World Equities As Richly Valued As At The Peak Of The Dot Com Boom Nevertheless, this makes perfect sense, because when bond yields are at 2%, bonds and equities are equally risky as each other. It follows that they must offer the same return as each other. One of the biggest errors in finance is to define an investment's risk in terms of its (root mean squared) volatility. This is incorrect because nobody fears sharp gains, they only fear sharp losses. Consider an investment whose price goes up sharply one day and then sideways the next day ad infinitum. The investment has a very high volatility, but it has no risk. You can never lose money, you can only make money. This leads us to the correct definition of risk, as defined by Professor Daniel Kahneman. He proved that investors are not concerned about volatility per se, they are concerned about the ratio of potential short-term losses versus short-term gains, a measure known as 'negative skew'. The important point is that at low bond yields, bond returns start to exhibit negative skew. Intuitively, this is because the lower bound to yields forces an unattractive asymmetry on bond returns: prices can fall a lot, but they cannot rise a lot. Specifically, at a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-8). And as the two asset classes are equally risky, they must offer the same return, 2% (Chart I-9). Chart I-8At A 2% Bond Yield, 10-Year Bonds##br## Have The Same Negative Skew As Equities... Market Turbulence: What Lies Ahead? Market Turbulence: What Lies Ahead? Chart I-9...So At A 2% Bond Yield, ##br##Equities Must Also Offer A 2% Return Market Turbulence: What Lies Ahead? Market Turbulence: What Lies Ahead? Therefore, equities find themselves in a precarious equilibrium. Rich valuations are justified if bond yields remain at low levels or fall, but rich valuations become increasingly hard to justify if bond yields march higher. Seen through this lens, the rise in bond yields at the start of the year is one important reason why equities have experienced a turbulent 2018 so far. What lies ahead? The combination of our economic mini-cycle, market technicals and valuation perspectives suggests that the equity sector and currency trends established since the start of the year should persist into the summer. As for equities in aggregate, the greatest structural threat would arise if bond yields gapped upwards. But for the time being, this is not our expectation. Happy Easter! Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 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 Given the Easter holidays, there are no new trades this week. But we are pleased to report that our long global utilities versus market trade achieved its 3.5% profit target and is now closed. Out of our four open trades, three are in profit with the short nickel / long lead trade already up sharply in its first 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-10 Nickel vs. Lead Nickel vs. Lead * 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 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 - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The 2018 outlook for both economic growth and corporate profits remains constructive for risk assets, although evidence is gathering that global growth is peaking. Some measures of global activity related to capital spending have softened in recent months. Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, suggesting that it is too soon to call an end in the mini capital spending boom. Our global leading indicators are not heralding any major economic slowdown. The dip in early 2018 in the Global ZEW index likely reflected uncertainty over protectionist trade action. Economic growth in the major countries outside of the U.S. may have peaked, but will remain robust at least through this year. The potential for a trade war is a key risk facing investors. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy. That said, there are hopeful signs that the latest trade skirmish will not degenerate into a full-blown trade war and thereby cause lasting damage to risk assets. Stay overweight equities and corporate bonds. President Trump will announce on May 19 whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Stay long oil and related investments. The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated. EPS growth is peaking in Europe and Japan, but has a bit more upside in the U.S. later this year. Cross-country equity allocation is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. Rising U.S. corporate leverage is not an issue now, but could intensify the next downturn as ratings are slashed, defaults rise and banks tighten lending standards. The bond bear market remains intact, although the consolidation phase has further to run. By Q1 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below NAIRU. Policymakers will then try to nudge up the unemployment rate, but the odds of avoiding a recession are very low. Feature Investors are right to be concerned following the March 23 U.S. announcement of tariffs on about $50 billion of Chinese imports. The President is low in the polls and needs a victory of some sort heading into midterm elections. Getting tough on trade plays well with voters, and the President faces few constraints from Congress on this issue. Trump wants a raft of items from China, including opening up to foreign investment and a crackdown on intellectual theft. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy.1 That said, we do not expect the latest trade skirmish to degenerate into a full-blown trade war. First, China has already signaled it wants to avoid significant escalation. Beijing has offered several concessions, and its threat of retaliatory trade action has been measured so far. On the U.S. side, the fact that the Administration has decided to bring its case against China to the World Trade Organization (WTO) shows that the Americans are willing to proceed through the normal trade-dispute channels. The bottom line is that, while we cannot rule out escalating trade action that causes meaningful damage to the equity market, it is more likely that the current round of tensions will be limited to brief flare-ups. Investors should monitor the extent of European involvement. If Europe joins the U.S. effort to force China to change its trade practices via the WTO, then China will have little choice but to give in without a major fight. In terms of other geopolitical risks, North Korea should move to the back burner for a while now that the regime has agreed to negotiations. Of greater near-term significance is May 19, when Trump will announce whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Oil prices would benefit if the May deadline for issuing waivers on Iran sanctions passes. Trade penalties against Iran would reduce its oil production and exports. The U.S. is also considering sanctions on Venezuela's oil industry. Moreover, Russia and Saudi Arabia are reportedly considering a deal to greatly extend their alliance to curb oil supply. While there are downside risks as well, our base case outlook sees the price of Brent reaching US$74 before year end. Global Growth: Some Mixed Signs Also facing investors this year is the risk that the recent softening in the economic data morphs into a serious growth scare. The 2018 outlook for both the economy and corporate profits remains constructive in our view, but evidence is gathering that global growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart I-1). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports, a leading indicator for the global business cycle, have also softened. The Chinese economy is decelerating and we believe the growth risks are underappreciated. President Xi has cemented his power base and there has been a shift toward accelerated reform. Chinese leaders recognize that leverage in the system is a problem, and the regime is tightening policy on a multi-pronged basis. Structural reforms are positive for long-term growth, but are negative in the short term. The tightening in financial conditions is already evident in the Chinese PMI and the sharp deceleration in the Li Keqiang index (although the latest reading shows an uptick; not shown). A hard landing is not our base case, but the risks are to the downside because the authorities will err on the side of tight policy and low growth. It is also disconcerting that some of our measures of global activity related to capital spending have softened in recent months, including capital goods imports and industrial production of capital goods (Chart I-2). Nonetheless, the fact that the G3 aggregate for capital goods orders remains in an uptrend suggests that it is too soon to call an end in the mini capital spending boom. Consumer and business confidence continues to firm in the major economies. Chart I-1Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Some Signs Of A Peak In Global Growth Chart I-2A Soft Spot For Capital Spending A Soft Spot For Capital Spending A Soft Spot For Capital Spending Our global leading indicators are not heralding any major economic slowdown (Chart I-3). BCA's Global LEI remains in an uptrend and its diffusion index is above the 50 line. In contrast, the global measure of the ZEW investor sentiment index plunged in March. We attribute the decline to the announcement of steel and aluminum tariffs and the subsequent market swoon, suggesting that the ZEW pullback will prove to be temporary. Turning to the U.S., retail sales disappointed in January and February, especially considering that taxpayers just received a sizable tax cut. Nonetheless, this probably reflects lagged effects and weather distortions. Our U.S. consumer spending indicator continues to strengthen as all of the components remain constructive outside of auto sales. Household balance sheets are the best that they have been since 2007; net worth is soaring and the aggregate debt-to-income ratio is close to the lowest level since the turn of the century (Chart I-4). Given robust employment growth and the tightest labor market in decades, there is little to hold U.S. consumer spending back. We expect that the tax cut effect on retail sales will be revealed in the coming months, helping to sustain the healthy backdrop for corporate profits. Chart I-3Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Global Leading Indicators Mostly Positive Chart I-4U.S. Consumers In Good Shape U.S. Consumers In Good Shape U.S. Consumers In Good Shape Global Margins Still Rising The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated (Chart I-5). Earnings-per-share surged in the early months of the year in both the U.S. and Japan, although they languished in the Eurozone according to IBES data (local currencies; not shown). Relative equity returns in local currency tend to follow relative shifts in 12-month forward EPS expectations over long periods, and bottom-up analysts have lifted their U.S. earnings figures in light of the fiscal stimulus (Chart I-6). Chart I-5Global Margins Still Rising Global Margins Still Rising Global Margins Still Rising Chart I-6EPS And Relative Equity Returns EPS And Relative Equity Returns EPS And Relative Equity Returns The key question is: can the U.S. market outperform again in 2018 now that the tax cuts have largely been priced in? One can make a compelling case either way. Growth: Global growth will remain robust for at least the next year, and the Eurozone and Japanese markets are more geared to global growth than is the U.S. However, the impressive fiscal stimulus in the pipeline means that economic growth momentum is likely to swing back toward the U.S. this year. GDP growth in Europe and Japan will remain above-trend, but it has probably peaked for the cycle in both economies. Valuation: Our composite measure of valuation suggests that Europe and Japan are on the cheap side relative to the U.S. based on our aggregate valuation indicator, which takes into consideration a wide variety of yardsticks (Chart I-7). That said, one of the reasons why European stocks are on the cheap side at the moment is that export-oriented German exporters are quite exposed to rising international tariffs. Earnings: Previous currency shifts will add to EPS growth in the U.S. in the first half of the year, but will be a drag in Europe and Japan (Chart I-8). However, these effects will wane through the year unless the dollar keeps falling. Indeed, we expect the dollar to firm modestly over the next year, favoring the European equity market at the margin. In contrast, we expect the yen to strengthen in the near term, which will trim Japanese EPS growth. Chart I-7Valuation Ranking Of Nonfinancial ##br##Equity Markets Relative To The U.S. April 2018 April 2018 Chart I-8Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Impact Of Currency Shifts On EPS Growth Chart I-9 updates the forecast from our top-down earnings models. The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up. Narrowing margins are less of a risk in Europe. U.S. EPS growth should be above that of Europe in 2018, but will then fall to about the same pace in 2019. We expect Japanese profit growth to remain very strong this year and next, given Japan's highly pro-cyclical earnings sensitivity. However, this does not incorporate the risk of further yen strength. Earnings expectations will also matter. Twelve-month bottom-up expectations are higher than our U.S. forecast ('x' in Chart I-9 denotes 12-month forward EPS expectations). In contrast, expectations are roughly in line with our forecast for the European market. It will therefore be more difficult at the margin for U.S. earnings to surprise to the upside. Monetary Policy: The relative shift in monetary policies should favor the European and Japanese markets to the U.S. The FOMC will continue tightening, with risks still to the upside on rates in absolute terms and relative to the other two economies. Sector Performance: Sector skews should work in Europe's favor. Financials are the largest overweight in Euro area bourses, while technology is the largest overweight in the U.S. We are constructive on the financial sector in both markets, but out-performance of the sector will favor the Eurozone broad market. Meanwhile, tech companies are particularly sensitive to changes in discount rates, since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening. The Japanese market has a relatively high weighting in industrials and consumer discretionary. The market will benefit if the global mini capex boom continues, but this could be counteracted by softness in global auto sales and further yen strength. It is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. We continue to avoid the Japanese market for the near term because of the potential for additional yen gains. As for the equity sector call, investors should remain oriented toward cyclicals versus defensives. Our key themes of a synchronized global capex mini boom, rising bond yields and firm oil prices favor the industrials, energy and financial sectors. Chart I-10 highlights four indicators that support the cyclicals over defensives theme, the dollar and the business sales-to-inventories ratio. Telecom, consumer discretionary and homebuilders are underweight. Chart I-9Profit Forecast Profit Forecast Profit Forecast Chart I-10These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks These Indicators Favor Cyclical Stocks We will be watching the indicators in Chart I-10 to time the shift to a more defensive equity sector allocation. Leverage And The Next Recession As the economic expansion enters the late stages, investors are focused on where leverage pressure points may lurk. Last month's Special Report on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. For our sample of 770 companies, we estimated how much interest coverage for the average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits fall by 25% peak to trough. Given all the client inquiries, we decided to delve deeper into the results. We were concerned that our sample of high-yield companies distorted the overall results because it includes many small firms and outliers. We are more comfortable with the results using only the investment-grade firms, shown in Chart I-11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart I-12 shows that the interest coverage ratio has declined even as profit margins have remained elevated. Normally the two move together through the cycle. Chart I-11Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Corporate Leverage Will Take A Toll Chart I-12The Consequences Of Rising Leverage The Consequences Of Rising Leverage The Consequences Of Rising Leverage The implication is that the next recession will see interest coverage fare worse than in previous recessions. Of course, there are many other financial ratios and statistics that the rating agencies employ, but our results suggest that downgrades will proliferate when the agencies realize that the economy is turning south. Moreover, banks may tighten C&I lending standards earlier and more aggressively because they will also be finely attuned to the first hint of economic trouble given the leverage of the companies in their portfolio. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressure in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a greater overall tightening in financial conditions. Corporate leverage could therefore intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macro-economic imbalances, such as areas of overspending, that could turn a mild recession into a nasty one. As long as growth remains solid, the market and rating agencies will ignore the leverage issue. Indeed, ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart I-13). We remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios for now. The European corporate sector is further behind in the leverage cycle (Chart I-14). Europe does not appear to be nearly as vulnerable to rising interest rates. Nonetheless, our European Corporate Health Monitor (CHM) has deteriorated over the past couple of years due to some erosion in profit margins, debt coverage and the return on capital. Meanwhile, the U.S. CHM has improved in recent quarters because the favorable earnings backdrop has temporarily overwhelmed rising leverage (top panel of Chart I-14). For the short-term, at least, corporate health is moving in favor of the U.S. at the margin. Chart I-13Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Ratings Migration Is Constructive For Now Chart I-14Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. Corporate Health Trend Favors U.S. The implication is that, while we see trouble ahead for the U.S. corporate sector in the next economic downturn, in the short term we now favor the U.S. over Europe in the credit space. We are watching our Equity Scorecard, bank lending standards, the yield curve and our profit margin proxy in order to time our exit from both corporate bonds and equities (see last month's Overview section). We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. Powell Doesn't Rock The Boat The Fed took a measured approach when reacting to the fiscal stimulus that is in the pipeline. The FOMC lifted rates in March and marginally raised the 'dot plot' for 2019 and 2020. Policymakers shaved the projection for unemployment to 3.6% by the end of 2019. This still appears too pessimistic, unless one assumes that the labor force participation rate will rise sharply. Table I-1 provides estimates for when the unemployment rate will reach 3½% based on different average monthly payrolls and participation rates. Our base case scenario, with 200k payrolls per month and a flat participation rate, sees the unemployment rate reaching 3½% by March 2019. Table I-1Dates When 3.5% Unemployment Rate Threshold Is Reached April 2018 April 2018 The soft-ish February reports for consumer prices and average hourly earnings took some of the heat off the FOMC. Core CPI, for example, rose 'only' 0.2% from the month before. Still, when viewed on a 3-month rate-of-change basis, underlying inflation remains perky; the core CPI inflation rate increased from 2.8% in January to 3% in February (Chart I-15). Inflation in core services excluding medical care and shelter, as well as in core goods, have also surged on a 3-month basis. We expect the latter to continue to pressure overall inflation higher, following the upward trend in import prices. The recent downtrend in shelter inflation should also stabilize due to the falling rental vacancy rate. Chart I-15U.S. Inflation Is Perky U.S. Inflation Is Perky U.S. Inflation Is Perky Moreover, the NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. The ISM manufacturing survey shows that companies are paying more for their inputs and experiencing delays with suppliers. This describes a late-cycle environment marked with rising inflationary pressures. We expect that core inflation will grind up to the 2% target by early next year. By the first quarter of 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below its estimate of the non-inflationary limit. Policymakers will then attempt a 'soft landing' in which they tighten policy enough to nudge up the unemployment rate. Unfortunately, the Fed has never been able to generate a soft landing. Once unemployment starts to rise, the next recession soon follows. Our base case is that the next recession begins in 2020. Bond Bear In Hibernation For Now The bond market showed that it can still intimidate in February, but things have since calmed down as the U.S. mini inflation scare ebbed, some economic data disappointed and trade friction created additional macro uncertainty. Bearish sentiment and oversold technical conditions suggest that the consolidation period has longer to run. Nonetheless, unless inflation begins to trend lower, the fact that even the doves on the FOMC believe that the headwinds to growth have moderated places a floor under bond yields. Fair value for the 10-year Treasury is 2.90% based on our short-term model, but we expect it to reach the 3.3-3.5% range before the cycle is over. Both real yields and long-term inflation expectations have room to move higher. Private investors will also have to absorb US$680 billion worth of bonds this year from governments in the U.S., Eurozone, Japan and U.K., the first positive net flow since 2014 (see last month's Overview). Yields may have to fatten a little in order for the private sector to make room in their portfolios for that extra government supply. In the Eurozone, the net supply of government bonds available to the private sector will still be negative this year, even if the ECB tapers to zero in September as we expect. Some investors are concerned about a replay in the European bond markets of the Fed's 'taper tantrum' of 2013, when then-Chair Bernanke surprised markets with a tapering announcement. The ECB has learned from that mistake and has given several speeches recently highlighting that policymakers will be making full use of forward guidance to avoid "...premature expectations of a first rate rise."2 We think they will be successful in avoiding a similar tantrum, but the flow effect of waning bond purchases will still place some upward pressure on the term premium in Eurozone bonds (Chart I-16).3 Chart I-16ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium ECB: End Of QE Will Pressure Term Premium The bottom line is that monetary policy will undermine global bond prices in both the U.S. and Eurozone, but we expect U.S. yields to lead the way higher this year. Japanese bond prices will be constrained by the 10-year yield target. Investors with a horizon of 6-12 months should remain overweight JGBs, at benchmark in Eurozone government bonds and underweight Treasurys within hedged global bond portfolios. We recommend hedging the currency risk because we continue to expect the dollar to rebound this year. This month's Special Report, beginning on page 18, discusses the cyclical factors that will support the dollar: interest rate differentials, a rebound in U.S. productivity growth and a shift in international growth momentum back in favor of the U.S. In terms of the longer-term view, the Special Report makes the case that the U.S. dollar's multi-decade downtrend will persist. This does not mean, however, that long-term investors will make any money by underweighting the greenback. The 30-year U.S./bund yield spread of 190 basis points means that the €/USD would have to rise to more than 2.2 to offset the yield disadvantage of being overweight the euro versus the dollar over the next 30-years. Indeed, once it appears that the U.S. yield curve has discounted the full extent of the Fed tightening cycle (perhaps 12 months from now), it will make sense for long-term investors to go long U.S. Treasurys versus bunds on an unhedged basis. Conclusion Recent data releases suggest that global growth is peaking, especially in the manufacturing sector. Nonetheless, we do not believe that this heralds a slowdown in growth meaningful enough to negatively impact the profit outlook in the major countries. Indeed, the major fiscal tailwind in the U.S. will lift growth and extend the runway for earnings to expand at least through 2019. That said, fiscal stimulus at this stage of the U.S. business cycle will serve to accentuate a boom/bust cycle, where stronger growth in 2018/19 gives way to higher inflation a hard landing in 2020. The Fed is willing to sit back and watch the impact of fiscal stimulus unfold in the near term. But by early 2019, the Fed will find itself behind the curve with rising inflation and an overheating economy. The monetary policy risk for financial markets will then surge, setting up for a classic end to this expansion. The consequences of years of corporate releveraging will come home to roost. This year, trade skirmishes will be a headwind for risk assets and will no doubt generate further bouts of volatility. Nonetheless, recent signals from both the U.S. and China suggest that the situation will not degenerate into a trade war. The bottom line is that, while the economic expansion and equity bull market are both in late innings, investors should stay overweight risk assets and short duration for now. Stay overweight cyclical stocks versus defensives, overweight corporate bonds versus governments, overweight oil-related plays, and modestly long the U.S. dollar against most currencies except the yen. Our checklist of items to time the exit from risk is not yet flashing red. We would change our mind if our checklist goes south, our forward-looking indicators turn sharply lower or U.S. inflation suddenly picks up. We are also watching closely the situation in Iran, the U.S./China trade spat and NAFTA negotiations. Mark McClellan Senior Vice President The Bank Credit Analyst March 29, 2018 Next Report: April 26, 2018 1 For more information on why we believe that Sino-American conflict will be a defining feature of the 21st century, please see BCA Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com 2 ECB President Mario Draghi. Speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html 3 For more information, please see BCA's Global Fixed Income Strategy Weekly Report "Bond Markets Are Suffering Withdrawal Symptoms," dated March 20, 2018, available at gfis.bcaresearch.com II. U.S. Twin Deficits: Is The Dollar Doomed? In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart II-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. Chart II-1At Full Employment, Import Tariffs Raise Rates April 2018 April 2018 The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up, as we discuss in the Overview section. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart II-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart II-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart II-2A Replay Of The Nixon Years? A Replay Of The Nixon Years? A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart II-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart II-3Twin Deficits And The Dollar Twin Deficits And The Dollar Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart II-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. Chart II-4Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar Structural Drivers Of the U.S. Dollar The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart II-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next (see the Overview section). (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart II-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart II-5Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart II-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart II-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart II-6U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns U.S. Investors Harvest Higher Returns Chart II-7Composition Of Net International ##br##Investment Position April 2018 April 2018 A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart II-6, top panel). In Chart II-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart II-8Primary Investment Balance Simulations Primary Investment Balance Simulations Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart II-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart II-9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart II-9 reveals. Chart II-9U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart II-1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. III. Indicators And Reference Charts The earnings backdrop remains constructive for the equity market. In the U.S., bottom-up forward earnings estimates and the net earnings revisions ratio have spiked on the back of the tax cuts. Unfortunately, many of the other equity-related indicators in this section have moved in the wrong direction. The monetary indicator is shifting progressively into negative territory as the Fed gradually tightens the monetary screws. Valuation in the U.S. market improved a little over the past month, but our composite Valuation Indicator is still very close to one sigma overvalued. Technically, our Speculation Indicator is still in frothy territory, but our Composite Sentiment Indicator has pulled back significantly toward the neutral line. Our Technical Indicator broke below the 9-month moving average in March (i.e. a 'sell' signal). These are worrying signs. Nonetheless, at this point we believe they are a reflection of the more volatile late-cycle period that the market has entered. An equity correction could occur at any time, but a bear market would require a significant and sustained economic downturn that depresses earnings estimates. Our checklist does not warn of such a scenario over the next 12 months. It is also a good sign that our Willingness-to-Pay indicator is still rising, at least for the U.S. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. While this suggests that investor flows remain positive for the U.S. equity market, the WTP appears to have rolled over in both Europe and Japan. This goes against our overweight in European stocks versus the U.S. in currency hedged terms (see the Overview section). Our Revealed Preference Indicator (RPI) remained on its bullish equity signal in March. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. So far, the indicator has not flashed 'red'. Treasurys are hovering on the 'inexpensive' side of fair value, but are not cheap based on our model. Extended technicals suggest that the period of consolidation will persist for a while longer. Value is not a headwind to a continuation in the cyclical bear phase. Little has changed on the U.S. dollar front. It is expensive by some measures, but is on the oversold side technically. We still expect a final upleg this year, before the long-term downtrend resumes. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights China and Brazil are two extremes in regard to investment and savings - the former saves and invests a lot, the latter very little. The key difference between Brazil and China is neither the existing amount of deposits nor their propensity to save. Rather, it is their real economies' capacity to produce goods and services. Regardless of how capital expenditures are financed, when inputs for capital spending are procured domestically it is recorded as national "savings," but when they are imported there is no change in the level of national "savings." In China, policymakers are currently being forced to walk a very thin line between inflation and deflation. Brazilian consumers do not need to save more for companies to get financing for their investments. Instead, businesses - along with facilitation from the government - should build the supply side. Banks can finance the latter by originating loans "out of thin air." However, the natural consequence of this adjustment in Brazil will be considerable currency deprecation. Feature The Fallacy This is the fifth report in our series on money, credit, savings and investment. Its objective is to show that financing of investments is not constrained by national and foreign savings. This report argues against a postulate in mainstream economic literature which holds that in order to invest, nations with low savings rates need to either reduce consumption and boost national savings or to borrow foreign savings. Some examples of this economic thesis can be seen here: As Lindner neatly summarizes: "Many economists hold the position that "saving finances investment." They argue that saving - a reduction of consumption relative to income - is necessary for the provision of loans and the financing of investment." (Lindner 2015).1 Linder also provides other examples suggesting that this thesis is well entrenched in the economic theory and analysis. For example, he cites Gregory Mankiw's influential introductory macroeconomics textbook that upholds: "Saving is the supply of loans - individuals lend their saving to investors, or they deposit their saving in a bank that makes the loan for them. [. . . ] At the equilibrium interest rate, saving equals investment, and the supply of loans equals the demand." (1997, p. 63) (Lindner 2015).2 This mainstream economic thesis - that financing is constrained by savings - is intuitive, and not surprisingly many investors take it for granted. Yet this is a false proposition. This thesis is correct for barter economies but is not pertinent to modern economies with their own banking systems and national currencies. Further, Lindner (2015)3 argues: "The fallacies loanable funds theory commits might be explainable by the mis-application of some ideas and concepts of neoclassical growth models - especially the Ramsey (1928), Solow (1956) and Diamond (1965) models - to the sphere of money and finance... The Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called "corn". Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it..." Clearly, modern economies with their fiat money systems are much more complicated than a barter economies with no banks and money. The Veracity: Financing Is Different From "Savings" This and previous reports4 clarify and elaborate on the following aspects of banking, money creation and financing as well as savings and investments: 1. Attributing the lack of investment in many emerging market (EM) economies to their low savings is a major fallacy. Borio (2015)5 argues: "Crucially, the provision of financing does not require someone to abstain from consuming. It is purely a financial transaction and hence distinct from saving... The equality of saving and investment is an accounting identity that always holds ex post and reveals nothing about financing patterns. In ex post terms, being simply the outcome of expenditures, saving does not represent a constraint on how much agents are able to spend ex ante. If we step back from comparative statics and consider the underlying dynamics, it is only once expenditures take place that income and investment, and hence saving, are generated." 2. Banks do not need deposits or "savings" to lend. They create money/deposits when they originate loans or buy assets from non-banks. To settle payments with their peers as well as the central bank, they require reserves at the central bank. Reserves at the central bank - not client deposits - constitute true liquidity for banks. For a more detailed discussion on loan origination and money creation in absence of new deposits entering into the banking system, please refer to Appendix 1 and 2 on pages 14 and 18. Certainly, there are several factors such as regulations and shareholder preferences that can curtail banks' ability to expand their balance sheets. However, households' or nations' "savings" do not constrain banks' ability to originate new loans/create deposits. 3. In an economy where banks exist, "savings" and financing are very different things. Many investors use the term "savings" to refer to bank deposits. Yet, in macroeconomics, national and household "savings" are not related to deposits or money in the banking system at all. Chart I-1 demonstrates that there is no relationship between the savings and changes in the amount of money in the banking system. Chart I-1Savings And New Money ##br##Creation Do Not Correlate Savings And New Money Creation Do Not Correlate Savings And New Money Creation Do Not Correlate The confusion between national "savings" and financing creation is dealt with nicely again by Fabian Lindner. Having modelled it, Lindner argues: "... the aggregate economy's saving is equal to the newly produced tangible assets and inventories. That total saving is equal to just the increase in tangible assets ... (because) all changes in net financial assets in the economy add up to zero... Thus, for every economic agent increasing her net financial assets, there is a corresponding decrease in net financial assets of all other economic agents in the economy (Lindner 2015).6 Put in more general terms: An economic agent can only save financially if other agents dis-save financially by the same amount... That is why in the entire economy (that is the world economy or a closed economy) only the increase in tangible assets, thus investment, is saving...." In another paper, Lindner asserts: "Investment is the production of any non-financial asset in an economy and thus is always directly and unambiguously savings: it increases the economy's net worth... The economy as a whole cannot change its net financial wealth since it always equals zero. The aggregate economy can only save in the form of non-financial assets...The only way an economy can save is by increasing its non-financial wealth, i.e., its physical capital stock" (Lindner 2012).7 On the whole, deposits are a monetary concept; they represent money savings. Deposits are created by banks "out of thin air," as illustrated in Appendix 1 on page 14. Meanwhile, "savings" are a net addition to capital stock. Not surprisingly, there is no relationship between "real savings" and money savings, as illustrated in Chart I-1. In a nutshell, "savings" is an addition to the capital stock of a nation, which is the same as investment. Hence, the Savings = Investment identity for a closed economy is nothing other than a tautology as it de-facto means Investment = Investment. That is why in this report we use "savings" in quotations whenever we refer to it in the traditional sense of economic theory. 4. Households' (or businesses') propensity to save alters the velocity of money, not the amount of deposits/money in the banking system. A decision by a household to spend more rather than save does not change the amount of deposits in the banking system and does not affect the banking system's ability to provide more financing. When households or companies decide to spend their deposits, the velocity of money rises. Conversely, when households and companies decide to save (retain) their deposits, the velocity of money drops. The amount of deposits in the banking system stays constant. In turn, the amount of deposits and hence broad money supply in any banking system equals the cumulative net money creation by banks and the central bank over the course of their history. This has nothing to do with household and national "savings," which form the country's capital stock. 5. In a country with its own national currency, the true macro constraint on commercial banks' ability to expand financing infinitely are inflation and currency depreciation - not "savings." This is of course apart from demand for loans, regulations and shareholder preferences that can limit commercial banks' capacity to expand their balance sheets. Bottom Line: In an economy with banks, one does not need to save in the form of a deposit in a bank for the latter to lend money to another entity. Tales Of Brazil And China Chart I-2Two Extremes Of Investment ##br##And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil Two Extremes Of Investment And Savings: China And Brazil We use China and Brazil solely for illustrative purposes. One can use any country with a low savings rate instead of Brazil or a high savings rate economy such as Korea, Taiwan or Singapore in place of China. China has enjoyed a very high national savings rate and has been investing substantially (Chart I-2). In contrast, both the national savings rate and the investment-to-GDP ratio in Brazil have been depressed. It is very tempting to argue that Brazil has been experiencing very low investment because it saves so little. The narrative goes like this: Brazil's national savings rate is low because households save so little and the public sector dis-saves a lot - i.e., the government runs enormous fiscal deficits. This constrains the pool of available "savings" to finance private capital expenditures. This typical analysis concludes that Brazil needs to boost its "savings" - i.e., reduce its spending. This will allegedly enlarge the pool of available "savings" for investment and allow the country to invest, and consequently boost productivity and its potential growth rate. This narrative is misplaced in our view, because as we have shown in the past and in this report, banks do not need households, businesses or the government to save in order to provide financing. Banks can provide financing by simply expanding the money multiplier, among other things (see a more detailed discussion about the money multiplier below). So what is the true difference between Brazil and China? How has the latter achieved such high savings and investment rates, while the former has failed to finance its capital spending? Why have Brazilian banks not expanded their balance sheets more rapidly to finance investment (Chart I-3)? Chart I-3Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Snapshot Of Bank Assets-To-GDP Ratios Let's consider a hypothetical example. For simplicity and illustrative purposes, we assume there are two economies of equal size and have the same level of investment: savings and net exports. In short, they have identical starting points. We refer to these economies as Brazil and China. Now, commercial banks in both countries provide new financing of $50 - or equal to 5% of their respective GDP - to businesses for infrastructure building. This is new purchasing power created by commercial banks "out of thin air" in both economies. We assume that the only difference between these two countries is that in China, 100% of inputs for infrastructure (materials, machinery/equipment and so on) are produced/purchased domestically. In contrast, in Brazil, 100% of the inputs for infrastructure construction are imported, because this economy lacks production capacity. Table I-1 illustrates this hypothetical numerical example. As this infrastructure project is implemented, Brazil's imports will surge, and its net exports will deteriorate. Chart I-4 shows that this indeed is the case in Brazil - when capital spending expands, its current accounts deficit widens, entailing that Brazil imports a considerable portion of inputs for its investments. Table I-1A Hypothetical Example Of Investment - Saving Dynamics Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Chart I-4Foreign Content Of Brazil's ##br##Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High Foreign Content Of Brazil's Capital Spending Is High If there is no matching rise in foreign investor demand for Brazilian assets, the nation's currency will depreciate. Consequently, to support the plunging currency, Brazilian interest rates would have to rise. As a result, higher borrowing costs short-circuit the credit cycle. In China, because inputs for infrastructure are sourced and procured locally, there is no impact on its exchange rate or interest rates. If there is excess capacity in China to produce these inputs for infrastructure building, this new purchasing power will not lift inflation. A caveat is in order: Similar dynamics in trade balance deterioration, currency depreciation and inflation will prevail if there is a rise in consumer spending instead of capital expenditures. Importantly, the outcome will be the same in both economies if investment spending is done using existing money savings (deposits), not new credit. This example illustrates that a similar amount of capital expenditures financing via money creation "out of thin air" in both economies has increased national savings in China from $250 to $300, yet Brazilian savings stayed at $250 (Table I-1). In terms of savings rate, China will record a rise in its national savings rate from 25% to 28.6% of GDP (Table I-1). In Brazil, however, the national savings rate will remain at 25% of GDP, even though its banks, like Chinese ones, originated money "out of thin air" to finance infrastructure spending. The starting-point difference between China and Brazil is neither their banking systems' ability to expand their balance sheets nor the existing amount of deposits and assets. Rather, it is their real economies' capacity to produce goods and services. Therefore, we conclude: Regardless of how capital expenditures are financed - via new borrowing from banks or non-banks or using the investing company's own financial resources - when inputs for capital spending are procured domestically it is recorded as an increase in national "savings" level, but when they are imported there is no change in the level of national "savings." Over the decades, China, Korea, Taiwan, Singapore and Japan have all aggressively expanded their capacity to produce goods and services. They funded this capacity build-up via both money creation "out of thin air" and by attracting foreign capital. In the meantime, their large exports shielded their currencies from abrupt depreciation - as and when local bank financing was used to acquire foreign inputs. In the past decade, in China, loans - which banks have originated to build infrastructure - were largely spent on domestic inputs: cement, steel, chemicals, machinery and equipment all produced in the mainland. Even though some of that money/loans was used to purchase foreign inputs (commodities and equipment), China had large U.S. dollar revenues from exports that acted as an offset in its balance of payments. In short, Brazil and other low "savings" rate nations do not need to raise interest rates to curtail consumption and boost savings in order to release funds for financing capital expenditures. Chart I-5 demonstrates that there has been no positive relationship between real interest rates and the national savings rate in Brazil. Remarkably, real interest rates in this nation were often very high but that still did not lead to high "savings." Chart I-5Real Interest Rates And Savings Are Not Positively Correlated As They Are Supposed To Be Real Interest Rates And Savings Are Not Correlated Real Interest Rates And Savings Are Not Correlated What Brazil and other low "savings" rate economies need is to build efficient and competitive productive capacity - i.e., they need changes in the supply side of their economies. Only then can their banks expand their balance sheets and provide financing similar to how banks in high "savings" countries do. However, to shield the exchange rate from depreciation, these nations need to boost their exports first. This can be done by depreciating the currency and developing their global competitiveness. This is in effect what China has done in the past 25-30 years. Bottom Line: The key difference between Brazil and China is not their propensity to consume versus save, but their ability to produce goods and services domestically. So long as a nation builds and maintains excess productive capacity, its banks can originate loans "out of thin air" and finance capital and consumer expenditures. Money Multiplier Versus "Savings" Redundancy of the mainstream economic view that a pool of "savings" represents a constraint on financing investments becomes apparent when one applies the money multiplier concept, which is in fact accepted by mainstream economic theory. The money multiplier is the ratio of broad money relative to excess reserves. A rise in the money multiplier will lead to more money creation and financing in an economy per one unit of excess reserves (liquidity provided by the central bank), everything else held constant. In brief, money supply/the amount of deposits in the banking system will change regardless of the level of national or household "savings." Let's assume two countries with the same level of income per capita and GDP have identical national savings and investment rates as well as money supply and excess reserves. In short, they have indistinguishable macro parameters. Now suppose their banking systems in the past year had different money multipliers. The monetary authorities in both countries maintain the banking system's excess reserves at 10 units. If the money multiplier were to remain constant, say at 15, the money supply/deposits in both banking systems would remain at 150 units (10x15). Let's assume the money multiplier increased to 20 in Country A while held constant at 15 in Country B. In such a case, broad money supply would have risen to 200 units (10x20) in Country A and would stay at 150 (10x15) units in Country B. This entails that banks in Country A increased their funding yet those in Country B did not. That is despite the fact that the savings rates (and amount of savings) were identical before the change in the money multipliers occurred. This is one way to prove that a nation does not need to cut consumption for its banks to provide financing. The reason why the money multipliers could vary in these two countries with otherwise similar macro-economic parameters is due to animal spirits: In Country A, banks may have felt increasingly confident to lend more per one unit of their excess reserves, and there was demand for credit from borrowers. In the meantime, the money multiplier remained the same in Country B. In China, the money multiplier - the ratio of broad money to excess reserves - has risen dramatically since 2013 (Chart I-6). Interestingly, the amount of excess reserves at the People's Bank of China has been broadly the same over the past five years, yet broad money has grown by an enormous 75% (Chart I-6, middle and bottom panel). The exponential money/credit creation in China since 2009 has to a large extent been due to the rising money multiplier - wild animal spirits among bankers and borrowers - rather than high national "savings." Bottom Line: In any country, banks can provide more financing simply by expanding the money multiplier. This can happen regardless of the country's savings rate. Investment Relevance Why is this analysis pertinent to investors? First, this issue is critical to assess whether China's excessive credit expansion is an outcome of the nation's high savings - like many economists and investors claim - or due to the enormous amount of money/deposits and credit originated by the mainland's banks "out of thin air." If it is the former, investors have no need to worry about China's money and credit dynamics. If it is the latter, we are facing a typical banking and money/credit bubble. This report corroborates that it is the latter. Chart I-7 shows that China's broad money has grown 4-fold since January 2009 and has reached RMB 200 trillion, or the equivalent of $30 trillion. Chart I-6China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot China: Money Multiplier Has Risen A Lot Chart I-7A Money Bubble In China? A Money Bubble In China? A Money Bubble In China? Does this enormous quantity of RMBs pose an inflation and/or currency depreciation risk? Or will the ongoing policy tightening cause another deflationary slump in China? It is clear that Chinese policymakers are currently being forced to walk a very thin line: On the one hand, the immense amount of money created "out of thin air" could stoke inflation or currency depreciation. It may not take much of a rise in the velocity of money for inflation to become a problem. On the other, tightening policy amid high leverage in an economy that is addicted to money and credit could push it into a growth slump and deflation. There is always a chance that policymakers will get it right and manage it perfectly so that neither inflation/currency depreciation nor a growth slump transpire. We would assign a 25-30% probability to this benign outcome. Hence, in our opinion there are 70-75% odds of either inflation or deflation in China in the next 12-24 months. Given these odds, we have been and remain reluctant to chase the rally in EM and China-related plays. In particular, the Chinese authorities have been tightening liquidity and banking/shadow banking regulation as well as projecting the ongoing anti-corruption campaign into the financial industry. This poses a meaningful risk given the existing macro imbalances. Second, this analysis re-shapes how investors should think about economic development and understand how nations with low savings can grow without relying on foreign funding. This provides us with a framework to assess the developmental path and the sustainability of growth in various developing economies. These include but are not limited to nations with low national savings rates such as Brazil, South Africa, Turkey, Russia, Colombia and many others. Finally, this analysis leads us to argue that Brazil does not need to maintain high real interest rates as a way to force consumers to cut spending and boost savings. In fact, this is the wrong prescription for Brazil. The most optimal macro adjustment path for Brazil is to reduce interest rates much further and encourage banks to finance private investment. Brazil needs to build an efficient supply side, and banks can provide funding by originating loans "out of thin air." Brazilian consumers do not need to save more for companies to get financing for their projects and invest. The natural causality of this adjustment will be considerable currency deprecation. However, Brazil is currently suffering from low inflation and high real interest rates (Chart I-8). Hence, reflationary policies are the right policy prescription. Chart I-8Brazil Needs To Reduce ##br##Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Brazil Needs To Reduce Interest Rates Much Further Foreign investors are therefore at risk due to potential currency depreciation. The new leaders to be elected in the October presidential elections may well adopt such a macro policy mix. Markets will front run this by pushing the real down and this will be negative for foreign investors. However, there will be a buying opportunity after the currency finds a floor. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Appendix 1: Loan Origination, Deposits/Money Creation And Settlement The amount of deposits is not a constraint on a banking system's ability to make loans and buy assets from non-banks. Figure I-1 and I-2 present stylized cases of how commercial banks can originate new loans without requiring a new deposit or extra excess reserves entering the banking system. Specifically Figure I-1 illustrates how commercial banks can originate loans with the subsequent net settlements among themselves taking place via inter-bank borrowing/lending. In this stylized example, the banking system is comprised of three commercial banks. These commercial banks hold all deposits in the system. Cash does not exist and all payments are done via wire transfers. Figure I-1Money Creation By Banks With Net Settlement Among Banks Via Inter-Bank Lending/Borrowing Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil Figure I-2Money Creation By Banks With Net Settlement Between Banks & Central Bank Is Investment Constrained By Savings? Tales Of China And Brazil Is Investment Constrained By Savings? Tales Of China And Brazil 1. Loan Origination/Money Creation In the morning, Bank 1 originates a new loan worth $100 for Client 1. This transaction creates a new asset and, for the balance sheet to balance, Bank 1 should also increase the liabilities side of its balance sheet. Therefore, it simultaneously credits Client 1's chequing account by $100. Bank 1 does not transfer other depositors' money to Client 1's chequing account; it creates a new $100 deposit. The rest of the bank's depositors still have their full deposits, which they can draw on. In a nutshell, both assets and liabilities of Bank 1 rose by $100 - this was done "out of thin air" by just pressing the enter button on the computer. That also means that a $100 of new money was created by Bank 1 which increases the overall money stock in the banking system. Meanwhile, Bank 2 lends $200 to Client 2 and Bank 3 lends $300 to Client 3. Let's assume these were the only lending transactions during that day. In aggregate, the three banks originated $600 of new loans, and consequent new deposits/money "out of thin air." 2. Money Transfer / Payments Debtors do not borrow money and leave it sitting idle. They borrow money to pay their suppliers and others they owe. Even though Clients 1, 2 and 3 wire their payments to their respective suppliers on the same day, the total amount of deposits in the banking system does not change: Deposits simply move from one bank to another or from one bank client to another. In Figure I-1, Client 1 wires its $100 from Bank 1 to Supplier B that has an account at Bank 2; Client 2 pays its $200 invoice to Supplier C which in turn has an account at Bank 3; and finally Client 3 transfers $300 to Supplier A, who holds an account at Bank 1. The amount of money/deposits in the overall banking system has not changed as a result of these wire transfers. 3. Multilateral Net Settlement At the end of the day, banks should settle with other banks. Many countries employ a multilateral net settlement system typically operated by the central bank. In a multilateral net settlement system, at the end of the day, each bank pays (receives from) the system only the net amount they are due to pay to (receive from) other banks combined. Importantly, banks settle their payments with other banks using their excess reserves (herein called reserves) at the central bank, not the deposits of their clients. This entails that banks do not need deposits to pay their dues to other banks or the central bank. Figure I-1 illustrates the impacts on the banks' reserves under the multilateral net settlement system: Bank 1's reserves at the central bank change as follows: -$100 (Client 1's wire transfer out) + $300 (this is the amount that Supplier A with an account in Bank 1 gets from Client 3) = $200. The impact on Bank 2's reserves is as follows: -$200 (Client 2's wire transfer out) + $100 (this is the amount that Supplier B with an account in Bank 2 gets from Client 1) = -$100. The net change in Bank 3's reserves is: -$300 (Client 3's wire transfer out) + $200 (this is the amount that Supplier C with an account in Bank 3 gets from Client 2) = -$100. If we assume that all banks had no excess reserves before this day, then how do they settle their accounts? There are various alternatives, but we highlight two: Figure I-1 demonstrates the case of interbank lending. As a result of the settlements, Bank 1 has $200 in extra reserves, while Bank 2 and Bank 3 each have a $100 deficit in reserves. As such, Bank 1 lends $100 to each of Bank 2 and Bank 3. Why does it lend to other banks rather than keeping these reserves at the central bank? Because interbank rates are typically slightly above the central bank's rate - the rate Bank 1 would get if it were to lend the $200 to the central bank. Figure I-2 portends the same transactions with the sole difference being the reserves flow. Unlike Figure I-1, here banks do not lend to/borrow from each other. Banks lend excess reserves to the central bank as well as borrow deficient reserves from the central bank. This is done to settle their payments with other banks. Bank 1 lends its free reserves of $200 to the central bank. Bank 2 and Bank 3 each borrow $100 reserves from the central bank to settle with the system at the end of the day. As a result, the aggregate amount of reserves at the central bank does not change. On the whole, banks created $600 of new deposits/money/loans during the day without requiring savings from households, companies, the government or foreigners. Thereby, the money supply was expanded and new financing in the amount of $600 was provided "out of thin air." Appendix 2: Deposits Versus Liquidity Below are additional questions that we seek to answer to provide further elaboration on the issues of banks creating money and the difference between deposits and liquidity: 1. Why would central banks provide reserves to banks? When a central bank targets interest rates, which is nowadays the most common policy framework in both advanced and developing countries, it must provide liquidity to banks: the latter is required to preclude interbank rates from deviating from the policy rate. Under an interest rate targeting regime, the central bank does not have complete control over banks' reserves nor broad money supply. A central bank can control either the quantity of money or the price of money (interest rates), but not both simultaneously. The following two quotes from the New York Federal Reserve Chairman William Dudley and the European Central Bank confirm that central banks nowadays provide banks with reserves on demand - i.e., the amount of reserves is determined by demand from banks. "The Federal Reserve has committed itself to supply sufficient reserves to keep the fed funds rate at its target. If banks want to expand credit and that drives up the demand for reserves, the Fed automatically meets that demand in its conduct of monetary policy. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves or not." (Dudley, 2009) European Central Bank (2012), May 2012 Monthly Bulletin: "The Eurosystem ... always provides the banking system with the liquidity required to meet the aggregate reserve requirement. In fact, the ECB's reserve requirements are backward-looking, i.e. they depend on the stock of deposits (and other liabilities of credit institutions) subject to reserve requirements as it stood in the previous period, and thus after banks have extended the credit demanded by their customers." 2. Why do banks compete for deposits if they create deposits themselves? The true reason banks compete for deposits is not that they require more deposits, but because they require more reserves. When a bank attracts a deposit from another bank, the latter must transmit to the former reserves equal to the amount of the deposit transferred. When a bank is experiencing a liquidity shortage, more deposits are of no help. Banks can always create more deposits themselves, but they cannot create reserves at the central bank. The true liquidity for banks is their reserves at the central bank - not deposits. Reserves are solely created by central banks "out of thin air." A central bank may decide not to provide funding to certain banks in some cases when the authorities deem these banks insolvent and/or in breach of regulations. Otherwise, if the central bank wants to keep policy rates stable, it must provide all liquidity (reserves) banks require. 3. Why do banks attract deposits if the central bank provides liquidity on demand? The primary reason why banks seek to attract deposits instead of borrowing from the central bank is due to the cost of funding and duration of liabilities as well as regulatory requirements. Deposits may be cheaper and have longer duration than short-term funding from the central bank. 1 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 2 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 3 Lindner, F. (2015), "Does Savings Increase the Supply of Credit? A Critique of Loanable Funds Theory", Macroeconomic Policy Institute, World Economic Review 4, 2015. 4 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November 23, 2016, January 18, 2017 and December 20, 2017; available on ems.bcaresearch.com 5 Borio, C. and Disyatat, P. (2015), "Capital flows and the current account: Taking financing (more) seriously", BIS Working Papers, No. 525, October 2015. 6 Lindner, F. (2015), "Did Scarce Global Savings Finance the US Real Estate Bubble? The Global Saving Glut thesis from a stock flow Consistent Perspective", Macroeconomic Policy Institute, Working Paper 155, July 2015. 7 Lindner, F. (2012), "Savings does not finance Investment: Accounting as an indispensable guide to economic theory", Macroeconomic Policy Institute, Working Paper 100, October 2012. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Consumer spending is well supported despite weak readings on household purchases in early 2018. The recent rollover in M&A activity does not signal a top in equity markets nor warns that a recession looms. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. Feature Investors began to worry last week about a slowing U.S. economy sending prices of risk assets and Treasury yields lower. The threat of a wider trade spat with China was also a concern, along with the latest round of political intrigue at the White House. Oil fell more than 1% on supply concerns. While the U.S. economic surprise index moved lower since the start of the year, BCA's view is that the U.S. economy is poised to grow well above potential in the first half of the year. Consumer spending is well supported despite weak readings on household purchases in early 2018. The FOMC will provide a new set of economic forecasts and dot plots at this week's meeting. BCA expects the Fed to raise rates this week and three additional times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. According to our U.S. Equity Strategy service's "buy the dip" cycle-on-cycle analysis, a retest of the recent equity lows typically occurs in the first month following the initial shock, suggesting that the S&P 500 is already out of the woods.1 The return of vol may keep a lid on the SPX for a while longer, but our strategy since February 8 is to buy the dips as we do not foresee an end to the business cycle in 2018. Moreover, the recent weakness in M&A activity is not a sign that the bull market is finished. Despite the dip below 2.90% last week, BCA's U.S. Bond Strategy services pegs fair value for the 10-year Treasury yield at 2.96%.2 Assuming a 3% terminal fed funds rate, our U.S. Bond Strategy team expects the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%.3 Too Cold? Chart 1Weak February Retail Sales At Odds##BR##With Strong Consumers Fundamentals Weak February Retail Sales At Odds With Strong Consumers Fundamentals Weak February Retail Sales At Odds With Strong Consumers Fundamentals The Tax Cut and Jobs Act put extra cash into consumers' pockets and helped to lift consumer confidence to a cycle high. Household net worth is at a record level, the labor market is strong and wage growth is accelerating, albeit modestly at this point in the cycle. Despite the favorable backdrop, consumers are on the sidelines in early 2018 (Chart 1). Moreover, early March's unusually harsh winter weather in the Northeastern U.S. may prolong consumers' malaise for another month. The retail sales control group, which feeds into GDP calculations, rose a scant 0.1% m/m in February. The reading was well below the consensus of a 0.5% m/m gain. Headline retail sales dipped by 0.1%, well short of expectations (+0.4%). Auto sales (-0.9%) declined for the fourth month in a row in February. It is clear that the surge in auto sales in the wake of last fall's hurricanes pulled up demand. The weakness in February's spending was broadly based, with 7 of 13 major retail sales categories showing month-over-month declines. However, the recent weakness in consumer outlay masks the robust activity in the past 12 months. Overall retail sales are up a solid 4.1% from a year ago, while sales in the retail control group rose by 4.3%. In addition, sales are higher in 12 of the 13 main categories in the past year, led by non-store retailers (+10.1%), miscellaneous store retailers (+7.5%), clothing (+4.9%) and building materials (+4.6%). As a result of the tepid consumer spending readings in early 2018, the Atlanta Fed's GDPNow model has projected Q1 real GDP growth of just 1.8%, adjusted downward from 2.5% on March 9 (Chart 2). At the start of this month, the Atlanta Fed pegged Q1 GDP at 3.5%. Accordingly, some investors are concerned that household spending is nearing a peak and a recession may be imminent. We see it differently. BCA's stance is that consumer spending should continue to grow by at least 2% in 2018. U.S. consumer health has improved markedly in the past year, driving BCA's Consumer Health Indicator into positive territory (Chart 3). Higher equity prices, a stout labor market and an acceleration in real incomes are behind the improvement. Consumer spending growth tends to accelerate when the Health Indicator is rising. The improvement supports BCA's view of a stronger U.S. economy alongside a global synchronized recovery, at least in the next 12 months. Chart 2Q1 GDP Estimates Have Moved Sharply Lower Q1 GDP Estimates Have Moved Sharply Lower Q1 GDP Estimates Have Moved Sharply Lower Chart 3The Consumer Is In Good Shape The Consumer Is In Good Shape The Consumer Is In Good Shape Household net worth in 2017Q4 was at a record high, the result of stable house prices and frothy equity markets, according to the latest Flow of Funds data for 2017Q4 (Chart 4). Moreover, the composition of households' balance sheet is less alarming today than at prior peaks, because equities and real estate relative to household income or total assets are more reasonable. Furthermore, debt levels are tamer today than in 2006. Households may be less vulnerable to unexpected shocks (Chart 4 again) in light of their more resilient balance sheets. BCA's view is that financial vulnerabilities from the household sector are well contained. Household borrowing is increasing modestly at an annual pace of 4%, in sharp contrast with a 12% rate in the middle of the first decade of the 2000s. A broad measure of household solvency, such as the household debt-to-income ratio, is within the range of the past few years and back to pre-recessionary readings. Furthermore, liquidity buffers (liquid assets-to-liabilities) are almost as high as the levels that preceded the equity market boom/bust in 1999-2000 (Chart 5). Chart 4Household Sector Balance Sheet Composition Household Sector Balance Sheet Composition Household Sector Balance Sheet Composition Chart 5Household Sector Buffers Are Solid Household Sector Buffers Are Solid Household Sector Buffers Are Solid Nevertheless, risks may dampen the pace of consumer spending. Debt-to-income ratios have bottomed for the cycle (Chart 5 again) and banks are tightening their lending standards. The result is that consumer delinquency rates are on the upswing, notably in credit cards and autos (Chart 6). Moreover, the personal savings rate cannot sustainably remain around its recovery low of 3.2% (Chart 7, last panel). Chart 6Consumer Loan Metrics Consumer Loan Metrics Consumer Loan Metrics Chart 7Key Supports For Consumer##BR##Spending Remain In Place Key Supports For Consumer Spending Remain In Place Key Supports For Consumer Spending Remain In Place At 2.8%, annual wage compensation growth remains sluggish and far from the 3-4% rate per year that the Fed stated would be consistent with an economy closer to 2% inflation (Chart 7, panel 4). Moreover, households are still unlikely to binge on more debt to smooth out their expenditures as they did in the middle years of the first decade of the 2000s. A further acceleration in consumer spending would occur only alongside steady improvement in the labor market and improving household confidence on future employment and income gains. Bottom Line: Consumers' good mood and healthy balance sheets have not translated into firmer spending growth so far in 2018. Nonetheless, even with below-average consumer spending, the U.S. economy is expanding above the Fed's estimate of potential GDP, the labor market is tightening and inflation is grinding higher. The Fed remains on track to hike rates four times this year. The outlook for the U.S. consumer remains bright because of solid fundamental tailwinds such as strong employment growth, stable disposable incomes, frothy household net worth and buoyant confidence. Consumer headwinds to monitor are households' historically low saving rates, still tepid wage inflation and escalating delinquency rates. Too Hot? U.S. merger and acquisition (M&A) volume peaked along with U.S. equity prices in the late 1990s and in 2007. Some investors are concerned that the recent rollover in deal volume is a signal that a recession or an equity market top is nigh. Deal volume in dollars and relative to market cap peaked in 1999, again in 2007, and more recently in mid-2015, before a 13% pullback in the S&P 500 in late 2015 and early 2016. Since then, merger activity has moved lower. The decline in corporate combinations accompanied a sizeable rally in equity markets and robust U.S. and global economies. Although not shown on the chart, deal volume surpassed its late 1980s' pinnacle in 1995, five years before equity markets reached record highs in 2000. The recent peak in corporate takeovers (July 2017) relative to GDP matched those prior highs, but remained below the 1999, 2007 and 2015 tops as a percentage of market cap. Furthermore, last summer's zenith in global or cross-border M&A, a better indicator of market zest than U.S.-only activity, did not eclipse the peaks in 2007. Even at last summer's high, measured against both global GDP and market cap, worldwide corporate combinations remained below their 2015 top and well below their 2007 peak. At just 6.5% in early 2017, the GDP-based metric was significantly under the 2007Q3 pinnacle of 10%. That said, it is difficult to analyze this in context as the time series does not reach back to the late 1990s, which were boom years for M&A. Moreover, Phase I of the Fed funds rate cycle4 (the Fed is tightening, but policy is still accommodative) supports accelerating M&A activity (Chart 8A). Corporate combinations also climb during Phase II (Fed tightening, but policy is restrictive). However, M&A activity peaked at the end of Phase II in 2000 and 2007 (Chart 8B). BCA's view is that we will remain in Phase I until at least the end of 2018 and that Phase II may not be over until the end of 2019 or later. Chart 8AM&A Activity In Phase I Of The Fed Cycle... M&A Activity In Phase I Of The Fed Cycle... M&A Activity In Phase I Of The Fed Cycle... Chart 8BM&A Activity In Phase II Of The Fed Cycle... M&A Activity In Phase II Of The Fed Cycle... M&A Activity In Phase II Of The Fed Cycle... Bottom Line: The recent rollover in M&A activity does not signal a top in equity markets nor warn that a recession looms. Overall net equity withdrawal (which includes the net impact of IPOs, share buybacks and M&A) is not out of line with previous economic expansions (Chart 9). Stay overweight stocks versus bonds as the U.S. economic expansions becomes a decade-long phenomenon. Chart 9Comparison Of Corporate Outlays Across Four Economic Expansion Phases Goldilocks Goldilocks Just Right Wage inflation remains in a gradual upward trend, accelerating just enough to nudge up price inflation and prompt the Fed to hike rates four times this year. Although the labor market is tight in many areas, labor costs are not poised to blast off, but neither will they roll over. However, the January reading (+2.8 yoy) on average hourly earnings (AHE) stoked fears of the former, while the February reading (+2.6%) raised concerns of the latter. Chart 10 confirms that most measures of labor market slack have returned to normal. Moreover, the latest soundings on the job market from the National Federation of Independent Business suggest that small business owners have the most job openings in at least 18 years (Chart 11, panel 1). In addition, key concerns have shifted to the quality of the job applicants (panel 2) and the cost of labor (panel 3), away from taxes and over-regulation. Chart 10Labor Market Slack##BR##Is Disappearing Labor Market Slack Is Disappearing Labor Market Slack Is Disappearing Chart 11Hiring And Labor Costs A##BR##Key Concern For Small Businesses Hiring And Labor Costs A Key Concern For Small Businesses Hiring And Labor Costs A Key Concern For Small Businesses Those concerns were underscored in the Federal Reserve's January and February Beige books. Table 1 shows industries with labor shortages; in the year ended February, the gain in average hourly earnings in all but 3 of the industries was faster than average. Moreover, in all but 1 of these categories, labor market conditions are now the tightest since before the onset of the 2007-2009 recession. A recent Fed study5 examines the labor shortages in the manufacturing sector in more detail. The Beige Books noted that many businesses are having trouble finding low-skilled (and to a lesser extent, middle-skilled) workers, with a few mentions of the challenges of finding/retaining highly skilled employees, especially in STEM job functions. Chart 12 shows the wage gains for supervisory staff, a proxy for skilled (panel 1) and non-supervisory employees, and an imperfect proxy for low-skilled workers (panel 2). Both metrics are rising, but the skilled worker proxy accelerated more than the low-skilled metric. Moreover, at 3.1%, the latest reading on supervisory employees is nearly double the pace of non-supervisory personnel. The Atlanta Fed's Wage Tracker provides another lens on wage gains by skill level. Chart 13 shows that wage inflation among skilled positions is running well above average. Raises among mid- and low-skilled labor lag far behind. Notably, wages in all three have rolled over since late 2016. Table 1Labor "Shortages" Identified##BR##In The Beige Book Goldilocks Goldilocks Chart 12Supervisory Vs. Production##BR##Wage Inflation Supervisory Vs. Production Wage Inflation Supervisory Vs. Production Wage Inflation Chart 13Wage Inflation##BR##By Skill-Level Wage Inflation By Skill-Level Wage Inflation By Skill-Level Chart 14 argues that slightly faster compensation growth is imminent. The top panel shows that more than 80% of U.S. states register unemployment below the Fed's estimate of full employment. In the past, rates over 60% have been associated with wage pressures. The percentage climbed above 60% in January. The bottom panel of Chart 14 demonstrates the relationship between state unemployment rates and wage gains in each state. Chart 1480%+ Of States Have Unemployment Rates Below NAIRU 80%+ Of States Have Unemployment Rates Below NAIRU 80%+ Of States Have Unemployment Rates Below NAIRU Bottom Line: The labor market is back to normal, but is not overly tight, as shown in Chart 10. Wages and employment costs are in an uptrend, yet firms are still reluctant to give large pay increases to their labor force. That said, against the backdrop of fiscal stimulus, real GDP growth will remain well above potential, which means that the unemployment rate is headed to 3½% or even below. At some point, the labor market will overheat. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Equity Strategy Weekly Report "Reflective Or Restrictive", published March 12, 2018. Available at uses.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "From Headwinds To Tailwinds", published March 6, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's U.S. Bond Strategy Weekly Report "The Two-Stage Bear Market In Bonds", published February 20, 2018. Available at usbs.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Lingering In The Policy Sweet Spot," September 26, 2016 and "Stocks And The Fed Funds Rate Cycle," December 23, 2013. Both available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run China: Slowdown Has Further To Run China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Asia Exports Are Slowing Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Global Cyclicals Have Begun Underperforming... Global Cyclicals Have Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks ...Including Machinery And Chemical Stocks ...Including Machinery And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech EM Tech Has Started Underperforming DM Tech EM Tech Has Started Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM: Disguised Risks EM: Disguised Risks Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Asia's Semiconductor Industry Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise The UAE Interest Rates Will Rise The UAE Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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