Policy

Highlights Duration: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). ECB: The ECB has started to take notice of the latest batch of softening euro area economic data. Yet it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases by year-end. Canada: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Feature We're Sticking With Our Country Allocations One of our key investment themes for 2018 has been that economic growth, monetary policies and bond yields would be far less correlated between countries than was seen in 2017. This would create cross-country fixed income trading and investment opportunities that were much harder to come by last year. With the 10-year U.S. Treasury yield finally reaching the 3% level last week, that story looks to be playing out. Yields are going up elsewhere, but nothing like what is happening in the U.S., where growth remains firm compared to the string of negative data surprises seen in other countries (Chart of the Week). This theme of divergence can also be seen in the recent actions and comments from central bankers. Officials at the U.S. Federal Reserve have continued to signal, with increasing conviction, that additional rate hikes will be needed later this year (although not at this week's FOMC meeting). This is to be expected given that not only is U.S. growth holding up well (Q1 real GDP growth "only" slowed to an above-potential pace of 2.3%), but both core PCE inflation and the Wages & Salaries component of the Employment Cost Index are accelerating at a marginal pace not seen since the 2008 crisis (Chart 2). Chart of the WeekU.S. Economy Outperforming,##BR##USTs Underperforming U.S. Economy Outperforming, USTs Underperforming U.S. Economy Outperforming, USTs Underperforming Chart 2No Reason For The Fed##BR##To Turn Less Hawkish No Reason For The Fed To Turn Less Hawkish No Reason For The Fed To Turn Less Hawkish At the same time, policymakers in other major developed countries have turned somewhat more cautious: The Bank of Japan (BoJ) announced that it will no longer provide a specific date when it expects inflation to reach its target The European Central Bank (ECB) took the highly unusual step of holding a monetary policy meeting last week without actually discussing the monetary policy outlook, according to ECB President Mario Draghi Bank of England (BoE) Governor Mark Carney dampened expectations of a rate hike in May that was nearly fully discounted by markets The Bank of Canada (BoC), which had already delivered several rate hikes when inflation was below its 2% target, chose to keep rates on hold despite inflation finally breaching 2% Sweden's Riksbank pushed out the expected timing of its next rate hike (yet again) to the end of 2018, even with inflation now at target With global growth losing some momentum, it is no surprise that policymakers are trying to not sound too hawkish, which could trigger an unwelcome decline in inflation expectations. Here again, divergences between countries have opened up. Rising oil prices are translating into higher market-based inflation expectations in countries like the U.S. and Canada where growth is still above-potential and leading economic indicators are rising (Chart 3). This is not the case in places like the U.K., Australia and Japan where growth is sluggish, leading indicators are slowing, but with markets still pricing in interest rate increases over the next year (Chart 4). This divergence is a critical underpinning of our current recommended country allocation within government bond markets - overweighting the U.K., Australia and Japan where tighter monetary policy will be difficult to achieve; while underweighting the U.S. and Canada, where rate hikes are still in the cards. Chart 3Shifting Oil/Inflation Correlation... Shifting Oil/Inflation Correlation... Shifting Oil/Inflation Correlation... Chart 4...In Countries Where Growth Is Slowing ...In Countries Where Growth Is Slowing ...In Countries Where Growth Is Slowing The European Duration Call Gets A Bit Trickier The evidence on the euro area is a bit less conclusive on this front, however. The OECD's leading economic indicator has only dipped modestly from its recent peak, and the correlation between oil prices and inflation expectations has not broken down. Draghi stated in his press conference following last week's policy meeting that the ECB Governing Council was focused on "very important" current euro area economic data that had clearly lost momentum in the first quarter of this year. He noted that there were many one-off factors that could have caused the softer growth (weather, labor strikes, the timing of holidays), but that the slump was very broad-based and hit almost all euro area countries. This makes the next few months of data critical to determine the ECB's next policy move, which could be an announcement of a tapering of its asset purchases when the current program ends in September. From our perspective, the sluggish Q1 euro area economic performance looks to be driven by a major slowing of export growth. Industrial confidence remains at a high level and growth in retail sales volumes has remained stable since the middle of 2017 (Chart 5). Yet the annual growth rate of total euro area exports has slumped to less than 3%, with exports to Asia now contracting on a year-over-year basis (bottom two panels). If the export slump continues in the coming months, this could begin to impact hiring activity across the euro area. A rise in unemployment would definitely change the ECB's calculus in altering its policy stance. At the moment, the Governing Council can look at a steadily declining overall euro area unemployment rate - which is approaching the OECD's estimate of the full employment NAIRU - combined with moderate increases in core HICP inflation, wage growth and inflation expectations, as confirmation that trends are still broadly following the path laid out in its latest economic projections (Chart 6). Chart 5An Export-Led Cooling##BR##Of Euro Area Growth An Export-Led Cooling Of Euro Area Growth An Export-Led Cooling Of Euro Area Growth Chart 6ECB Will Not Lift Rates Until##BR##Inflation Expectations Move Back To 2% ECB Will Not Lift Rates Until Inflation Expectations Move Back To 2% ECB Will Not Lift Rates Until Inflation Expectations Move Back To 2% The ECB has made it clear that it views a tapering of its asset purchases and any subsequent interest rate hikes as separate policy decisions. The hurdle to end the bond purchases is much lower than it is for raising interest rates. On the former, as long as unemployment and inflation continue to evolve along the lines of the ECB's projections, then a full tapering of bond purchases will occur by year-end (with an announcement occurring at either of the June or July ECB meetings). On the latter, it will take inflation expectations (as measured by the 5-year EUR CPI swap, 5-years forward) rising back above 2% for the ECB to feel confident that rate increases will be necessary, as was the case during the mid-2000s tightening cycle and the 2011 mini-cycle (bottom panel). For now, we are maintaining our moderate underweight stance on euro area government debt. Looking ahead, we will be watching the correlation between oil prices denominated in euros and inflation expectations, as well as the development of leading economic indicators in the euro area. If the Q1 growth slump widens into a broader downturn, then the ECB could be forced to revise its economic projections lower and continue with the asset purchases into 2019. While that is not our base case scenario, such a development would force us to reconsider our stance on euro area debt. Bottom Line: The global bond bear market is still intact, although the "leadership" has passed over to the U.S. where growth is the firmest and inflation expectations are rising the fastest. Maintain an overall below-benchmark portfolio duration stance, focusing underweights in countries that can actually tighten monetary policy this year (U.S., Canada, the euro area). In Europe, it will take a much more prolonged slowdown for the ECB's medium-term economic forecasts to be proven incorrect, which would alter the likely timetable for a tapering of asset purchases later this year. Canada: Still On Track For More Hikes This Year The BoC has been sending more cautious signals of late regarding its next policy moves, after delivering 75bps of rate hikes since last summer. Some of this simply reflects a more measured tone taken by other central banks in response to signs of global growth losing some momentum, as discussed earlier. Yet in the case of Canada, it is difficult to make a credible case that the central bank should not continue its rate hiking cycle, particularly with inflation now above the midpoint of the BoC's 1-3% target band. Upside Risks To Canadian Growth Versus BoC Projections Yes, the Canadian economy has lost some of the rapid upward momentum seen in 2016 and 2017, led mostly by weakness in exports which are now contracting on a year-over-year basis (Chart 7). This was focused in aircraft, transportation equipment, and energy products. The latter is due to poor weather conditions and transportation bottlenecks involved in getting oil out of Alberta rather than a sign of weakening demand for Canadian oil. The BoC did take a more cautious view on exports in the latest set of economic projections presented in the April Monetary Policy Report (MPR). The central bank now expects real exports to be stagnant in 2018, downgrading the expected contribution to real GDP growth to zero from the +0.6 percentage points presented in the January MPR. This was, by far, the biggest downgrade to any of the GDP growth components in the BoC's forecast, and was main reason why the BoC downgraded its overall 2018 real GDP growth projection to 2.0% from 2.2%. Yet at the same time, the BoC actually upgraded its global growth projection to 3.8% from the 3.6% figure in the January MPR. We suspect that the downgrade to the export contribution to expected 2018 growth was the BoC trying to inject some room for error in its growth forecasts for any negative outcome in the current round of NAFTA trade negotiations with the U.S. and Mexico. Otherwise, it makes no sense to have such a large downgrade without becoming more pessimistic on global growth. Our Geopolitical strategists are now much more optimistic that a NAFTA deal will be reached, rather than having the U.S. exit the agreement as President Trump has threatened. If that happens, the BoC's growth projections may end up being too low. We can see a similar level of "excessive cautiousness" with regards to the BoC's assessment of the Canadian labor market and the outlook for consumption. Consumer spending has also cooled off a bit from very robust levels, although an unusually long and harsh winter likely played a large role there, as evidenced by the suspiciously large plunge in retail sales growth (Chart 8). The fundamental underpinnings for Canadian consumption still look solid, though. Chart 7Canadian Economy Holding Up Well,##BR##Despite Weak Exports Canadian Economy Holding Up Well, Despite Weak Exports Canadian Economy Holding Up Well, Despite Weak Exports Chart 8Solid Income Fundamentals##BR##For The Canadian Consumer Solid Income Fundamentals For The Canadian Consumer Solid Income Fundamentals For The Canadian Consumer Consumer confidence remains near cyclical highs. Wage growth currently sits at 3.2% in nominal terms and 1.5% in real terms. The BoC noted in its Spring Business Outlook Survey that wage pressures are increasing due to greater competition in the labor market (3rd panel) and, to a lesser extent, recent minimum wage increases. The BoC noted in the April MPR that wages were growing "somewhat below what would be expected were the economy operating with no excess labor." Yet that argument appears overly pessimistic - the unemployment rate is currently 0.7 percentage points below the OECD's NAIRU estimate, at a time when nominal wages are growing in excess of 3%. Again, there is a greater chance that the BoC will end up surprised by how strong Canadian wage growth will turn out over the next 6-12 months. Even the persistent structural problems of very high Canadian household debt levels and overheated house prices appear less of an issue at the moment. The household debt/GDP ratio has stabilized as growth in mortgage debt has decelerated since mid-2017 - an outcome that can be attributed to rising mortgage rates, tighter lending standards on mortgage lending and poor housing affordability in the major cities (Chart 9). Meanwhile, the supply side of the housing market is finally improving with housing starts now back to pre-recession levels. National house price inflation has cooled from the overheated 15% growth rates to a more "normal" pace around 5%, according to data from Terranet. There will be a long-term day of reckoning for the highly-indebted Canadian homeowner during the next recession. In the near term, however, the combination of rising supply, lower demand and softer house prices suggest that the Canadian housing market is trending in a direction of becoming less imbalanced. The BoC took note of these developments in the April MPR, using much less cautious language in describing the risk to the inflation outlook from household debt and overheated housing markets. The outlook for Canadian business investment also has the potential to give an upside surprise to the BoC. The Spring Business Outlook Survey showed that firms' capital spending intentions remain very strong (Chart 10), a fact confirmed by the robust growth in import volumes of machinery & equipment (middle panel). Finally, the overall financial condition for Canadian companies is in good shape, according to our new Canadian Corporate Health Monitor (CHM) that was introduced last week.1 The CHM correlates strongly with the overall Business Outlook Survey Indicator (bottom panel), which suggests that the cyclical improvement in the financial health of Canadian companies will support capital spending in the coming quarters - especially if the uncertainty over the NAFTA negotiations fades away. Chart 9A Better Supply/Demand Balance##BR##In Canadian Housing? A Better Supply/Demand Balance In Canadian Housing? A Better Supply/Demand Balance In Canadian Housing? Chart 10Canadian Capex##BR##Is In Good Shape Canadian Capex Is In Good Shape Canadian Capex Is In Good Shape The BoC Will Be Surprised By Canadian Inflation, Too Chart 11Inflation Now Above The BoC's 2% Target Inflation Now Above The BoC's 2% Target Inflation Now Above The BoC's 2% Target With the economy likely to continue expanding at an above-potential pace in the next 6-12 months, the current uptrend in inflation is should continue. Headline CPI inflation is already above the 2% target and core inflation is right at target (Chart 11). The BoC is forecasting that CPI inflation will only remain modestly above 2% until the end of 2018, and will return back to 2% in 2019. Yet there is essentially no spare capacity left in the Canadian economy, based on output gap estimates of both the BoC and International Monetary Fund (IMF). The BoC has slightly revised its projection for the Q1 2018 output gap, leaving it somewhat wider than the previous forecasts due to positive revisions of potential GDP growth (now 1.8% from 1.6% in the January MPR, based on a faster pace of trend labor productivity). These are small changes, however, and real GDP growth is likely to be faster than the BoC is projecting in 2018. Market-based inflation expectations have been steadily rising along with the increase in global energy prices (bottom panel), and we continue to expect inflation breakevens to widen over the balance of 2018. BoC Will Not Disappoint Market Expectations On Rate Hikes The markets are currently discounting a similar pace of rate hikes in Canada and the U.S. over the next year, according to pricing in the Overnight Index Swap (OIS) markets (Chart 12). The BoC's estimate of the neutral policy rate is between 2.5% and 3.5%, which is well above the current policy rate of 1.25%. The OIS market is discounting 75bps of hikes over the twelve months, which would take the policy rate to 2% - still a below-neutral, accommodative level for an economy that is already at full employment and where inflation has risen back to the BoC's target. We expect the BoC to continue to follow its typical pattern of following moves by the Fed with a lag. This is a sensible strategy given how exposed Canadian growth is to U.S. growth through exports, and also given how responsive the Canadian dollar is to the expected rate differentials between the U.S. and Canada. Given our view that the Fed will deliver at least another 50bps of rate hikes over the course of 2018, with the potential for more if inflation continues to accelerate without any growth slowdown, the BoC will likely deliver on the rate hikes currently discounted by markets. This is the main reason why we are maintaining our underweight stance on Canadian Government bonds (bottom panel). The BoC has a much higher potential to actually hike rates by at least as much as the market is expecting, which is not the case in every other developed market country except the U.S., where we are also underweight. This week, however, we are stopping ourselves out of our recommended Tactical Overlay trade in the Canadian BAX interest rate futures curve (long the Dec/18 contract versus the June/18 contract). We introduced that trade back in January, positioning for more rapid BoC rate hikes in the latter half of 2018 that would flatten the BAX futures curve. The recent dovish turn by the BoC has resulted in a steepening of the BAX futures curve, however, and we are stopping ourselves out at a modest loss of -0.12% (Chart 13). Chart 12Stay Underweight##BR##Canadian Government Debt Stay Underweight Canadian Government Debt Stay Underweight Canadian Government Debt Chart 13We Are Stopped Out Of##BR##Our BAX Futures Curve Trade We Are Stopped Out Of Our BAX Futures Curve Trade We Are Stopped Out Of Our BAX Futures Curve Trade Bottom Line: The Bank of Canada has adapted a more cautious tone of late, which seems overly pessimistic given the underlying trends in Canadian growth and inflation. Stay underweight Canadian government bonds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "BCA Corporate Health Monitor Chartbook: Growth Is Papering Over The Cracks", dated April 24, 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index From Convergence To Divergence From Convergence To Divergence Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Highlights The scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. Sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. We project this will boost steel and coal output by 5.2% and 4.7% respectively, this year at a time when demand is set to slow. Steel, coal, iron ore and coke prices are all vulnerable to the downside. Share prices of the companies and currencies of countries that supply these commodities to China are most at risk. Feature Last November, our report titled, "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," painted a negative picture for steel and coal prices over 2018 and 2019.1 Since then, after having peaked in December and February respectively, both steel and thermal coal prices have so far declined by about 20% from their respective tops (Chart 1). In the meantime, iron ore and coking coal have also exhibited meaningful weakness (Chart 2). Chart 1More Downside In Steel And Coal Prices More Downside In Steel And Coal Prices More Downside In Steel And Coal Prices Chart 2Iron Ore And Coking Coal Prices Are Also At Risk Iron Ore And Coking Coal Prices Are Also At Risk Iron Ore And Coking Coal Prices Are Also At Risk In this report, we revisit the topic of de-capacity reforms and examine how Chinese supply side reforms in 2018 will affect steel and coal prices. The key message is as follows: Having implemented aggressive capacity reduction over the past two years, the authorities are shifting the focus of supply side reforms from "de-capacity" to "replacement" of already removed capacity with technologically advanced capacity. This means the scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. In addition, sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. From an investing standpoint, this means both steel and coal prices are still vulnerable to the downside. Both could drop by more than 15% from current levels over the course of 2018. Diminishing Scale Of "De-Capacity" Reforms Reducing capacity (also called "de-capacity") in the oversupplied steel and coal markets has been a key priority within China's structural supply side reforms over the past two years. Steel Table 1 shows that the capacity reduction target for steel in 2018 is 30 million tons, which is much lower than the 45 million tons in 2016 and 50 million tons in 2017. Table 1Capacity Reduction: Target And Actual Achievement Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms In addition, between May and September 2017, the "Ditiaogang"2 removal policy eliminated about 120 million tons of steel capacity, and sharply reduced steel products production. Most of Ditiaogang capacity was completely dismantled last year. Therefore, there is not much downside to steel production from Ditiaogang output cutbacks going forward. Furthermore, between October and December 2017, environmental policies aimed at fighting against winter smog also cut steel products output substantially, which pushed steel prices to six-year highs in December (Chart 3). Chart 3Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector In particular, in the last quarter of 2017, to ensure fewer smog days around the Beijing area, Tianjin's steel products output was reduced by 50% from a year earlier. The second biggest contribution to total steel output decline occurred in Hebei - the largest steel-producing province in China - where steel output plummeted by 7%. Excluding Tianjin and Hebei, national steel products output fell only by 3.9% from a year ago. As a long-term solution to ameliorate ecology and air quality around Beijing, the government is aiming to reduce the heavy concentration of steel production in Tianjin and Hebei by shifting a considerable portion of steel capacity to other regions in 2018 and following years. These two provinces together accounted for about 30.6% of the nation's steel products output in 2016; their share dipped to 27.6% in 2017. As a result, next winter the required production reduction from these regions to achieve the air quality targets in Beijing will be smaller. In short, the scale of specific policy driven steel output reduction in 2018 will be meaningfully lower than last year. Coal For coal, despite the same target as last year (150 million tons), the actual capacity cut this year will be much less than last year's actual reduction of 250 million tons, which exceeded the 150 million-ton target. Amid still-high coal prices, the authorities will be more tolerant of producers not cutting too much capacity. Plus, with nearly two-thirds of the 2016-2020 target for capacity cuts having already been achieved in the past two years, there is much less outdated capacity in the industry (Table 1 above). In addition, the government's environment-related policies also led to a decline in total national coal output between October-December 2017 (Chart 4), with Hebei posting the biggest cut in coal output among all provinces. Chart 4Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector However, the authorities shortly thereafter relaxed restrictions on coal output, as the country was severely lacking gas supply for heating. In January and February of this year, the authorities reversed course, demanding that producers accelerate new advanced capacity replacement and increase coal production. Bottom Line: The scale of China's "de-capacity" reforms are diminishing, resulting in a lessening production cuts. Installing Technologically Advanced Capacity China's supply side reforms have included two major components - reducing inefficient capacity and low-quality supply that damaged the environment while boosting medium-to-high-quality production that is economically efficient and ecologically friendly. In brief, having removed significant obsolete capacity in the past two years, the policy focus is now shifting to capacity replacement. The latter enables China to upgrade its steel and coal industries to become more efficient and competitive worldwide, as well as ecologically safer. To guard against excessive production capacity of steel and coal, the authorities are reinforcing the following replacement principle: the ratio of newly installed-to-removed capacity should be less or equal to one. Two important points need to be noted: First and most important, the zero or negative growth of total capacity of steel and coal does not necessarily mean zero or negative growth in steel and coal output. For example, while total capacity for crude steel and steel products declined 4.8% and 1.8% year-on-year in 2016 respectively, output actually increased 0.5% and 1%. Despite falling total capacity, rising operational capacity could still contribute to an increase in final output. Total capacity (measured in tons) for steel and coal production includes both operational capacity and non-operational capacity, the latter representing obsolete/non-profitable capacity. As more technologically advanced capacity is installed to replace the already-removed one, both the size of operational capacity and the capacity utilization rate (CUR) will rise. Typically, advanced technologies have a higher CUR - consequently, production will grow. Second, an increase in the CUR of existing operational capacity will also result in rising output. In 2018, odds are that both the steel and coal industries in China will have non-trivial output increases as a result of new advanced capacity coming on stream. Steel Since late 2015, in environmentally sensitive areas of the Beijing-Tianjin-Hebei region and the Yangtze River Delta and the Pearl River Delta, steel plants have been required to add no more than 0.8 tons of new capacity for every 1 ton of outdated capacity removed. For other areas, the same ratio is 1 or less. Electric furnace (EF) steel-producing technology - which is cleaner, more advanced and used to produce high-quality specialized steel products - has become the major type of new capacity addition. This technology is favored by both the government and steel producers. Chinese EF-based steel production accounted for only 6.4% of the nation's total steel output in 2016, far lower than the world average of 25.7% (Chart 5). The EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. Graphite electrodes, which have high levels of electrical conductivity and the capability of sustaining extremely high levels of heat, are consumed primarily in electric furnace steel production. Chart 6 demonstrates that prices of both graphite electrode and scrap steel have surged since mid-2017. This signifies that considerable new EF production capacity has been coming on stream. Chart 5Chinese Electric Furnace Crude Steel ##br##Production Will Go Up Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms Chart 6Considerable New Addition Of##br## Chinese Electric Furnace Capacity Considerable New Addition Of Chinese Electric Furnace Capacity Considerable New Addition Of Chinese Electric Furnace Capacity Indeed, in 2017 alone, 44 units of EF were installed. In comparison, between 2014 and 2016, only 47 units of EF were installed. As the completion of a new EF installation in general takes eight to 10 months, all of EF capacity installed in 2017 - about 31 million tons of crude steel production capacity - will be operational in 2018. In addition, a report from China's Natural Resource Department indicates that as of mid-December there have been 54 replacement projects with total new steel production capacity of 91 million tons (including new EF capacity, new traditional capacity and recovered capacity). This compares to 120 million tons of capacity removed in 2016-'17. Assuming 60% of this 91 million tons capacity will be operating throughout 2018 at a utilization rate of 80% (the NBS 2017 CUR for the ferrous smelting and pressing industry was 75.8%), this alone will result in 43.6 million tons more output in 2018 from a year ago (5.2% growth from 2017 output) (Table 2). Table 2Strong Profit Margins Will Encourage Steel Production Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms At the same time, strong profit margins will encourage steel makers to produce as much as possible to maximize profits (Chart 7). This will be especially true if the incumbent companies have to absorb liabilities of firms that were shutdown (please refer to page 14 for the discussion on this point). Facing more debt from shutdowns of other companies, steel incumbent producers would have an incentive to ramp up their production to generate more cash. Yet, we do not assume a rise in CUR for existing steel capacity. Hence, crude steel output growth in 2018 will likely be around 5.2%, higher than the 3% growth in 2017. This is in line with the top 10 Chinese steel producers' projected crude steel output growth in 2018 of 5.5%, based on their published production guidance data. The Ditiaogang and environmental policy caused a significant contraction in steel products growth in 2017, but will have limited impact in 2018 as discussed above. Eventually, increasing crude steel output will translate into strong growth in steel products output3 (Chart 8). Chart 7Strong Profit Margins ##br##Will Encourage Steel Production Strong Profit Margins Will Encourage Steel Production Strong Profit Margins Will Encourage Steel Production Chart 8Steel Products Production ##br##Will Rebound In 2018 Steel Products Production Will Rebound In 2018 Steel Products Production Will Rebound In 2018 Coal China's current coal capacity is about 5310 million tons, with 4780 million tons as operational capacity and the remaining 530 million tons as non-operational capacity, which has not produced coal for some time. As in general it takes roughly three to five years to build a coal mine, it will take a long time to replace the obsolete capacity. Yet there is hidden coal capacity in China. The China Coal Industry Association estimated last year that there was about 700 million tons of new technologically advanced capacity that has already been built and is ready to use, but has not yet received government approval. This is greater than the 530 million tons of coal production removed in the past two years by de-capacity reforms - equivalent to about 20% of China's total 2017 coal output. This hidden capacity originated from the fact that coal producers in China historically began building mines before applying for approval. However, since 2015, all applications for new coal mines have been halted. Consequently, in the past three years a lot of capacity has already been built but has not been put into operation. Some 70% of this hidden capacity includes large-scale coal mines, each with annual capacity of above 5 million tons. In comparison, China has about 126 million tons of small mines with annual capacity of 90,000 tons that will be forced to exit the market this year as they are non-competitive due to their small scale and inferior technology. Why do we expect this hidden capacity to become operational going forward? The authorities now allows trading in the replacement quota for coal across regions. Producers having these ready-to-use high-quality mines can buy the replacement quota from the producers who have eliminated the outdated capacity. The government wants to accelerate the process of allowing the advanced capacity to be in operation as fast as possible. The following policy initiative supports this: A new policy directive released this past February does not even require coal producers with advanced capacity to pay the quota first in order to apply for approval - they can apply for approval to start the replacement process first, and then have one year to pay for it. Economically, quotas trading makes sense. The mines with advanced technology that have lower costs and higher profit margins should be able to pay a reasonably high (attractive) price for quotas to companies with inferior technologies, so that the latter will be better off selling their quotas than continuing operations. The proceeds from the selling quotas will be used to settle termination benefits for employees of low-quality coal mines. Regarding our projections for coal output in 2018, assuming 30% of the 700 million tons of capacity among high-quality mines will be operational this year at a CUR of 78% (the NBS 2017 coal industry CUR was 68.2%), this alone will bring a 164 million-ton increase in coal output (4.7% of the 2017 coal output) (Table 3). Table 3Chinese Coal Output Will Rise By 4.7% In 2018 Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms In addition, still-high profit margins could encourage existing coal producers to increase their CUR this year (Chart 9). Yet, we do not assume a rise in CUR for existing coal mining capacity. In total, Chinese coal output may increase 4.7% this year, higher than last year's 3.2% growth (Chart 10). Chart 9Strong Profit Margins Will Boost Coal Production Strong Profit Margins Will Boost Coal Production Strong Profit Margins Will Boost Coal Production Chart 10Coal Output Is Already Rising Coal Output Is Already Rising Coal Output Is Already Rising Bottom Line: Sizable technologically advanced new capacity is coming on stream for both steel and coal. This will boost both steel and coal output by about 5.2% and 4.7%, respectively, this year. Impact On Global Steel And Coal Prices In addition to diminishing capacity cuts and new technologically advanced capacity additions, the following factors will also weigh on steel prices: Relatively high steel product inventories (Chart 11, top panel) Weakening steel demand, mainly due to a potential slowdown in the property market4 Declining infrastructure investment growth (Chart 11, bottom panel). Chinese net steel product exports contracted 30% last year as steel producers opted to sell steel products domestically on higher domestic steel prices (Chart 12). Chart 11Elevated Steel Product Inventory##br## And Weakening Demand bca.ems_sr_2018_04_26_c11 bca.ems_sr_2018_04_26_c11 Chart 12China's Steel Product Exports ##br##Will Rebound China's Steel Product Exports Will Rebound China's Steel Product Exports Will Rebound Falling domestic steel prices may lead steel producers to ship their products overseas. In addition, the government has reduced steel products export tariffs starting January 1, 2018, which may also help increase Chinese steel product exports this year. This will pass falling Chinese domestic steel prices on to lower global steel prices. Between 2015 and 2017, about 1.6% of all Chinese steel exports were shipped to the U.S. Even if U.S. tariffs dampen its purchases of steel from China, mainland producers will try to sell their products to other countries. In a nutshell, U.S. tariffs will not prevent the transmission of lower steel prices in China to the global steel market. With respect to coal, in early April the Chinese government placed restrictions on Chinese coal imports at major ports in major imported-coal consuming provinces including Zhejiang, Fujian and Guangdong (Chart 13). The government demanded thermal power plants in those areas to limit their consumption of imported coal and use domestically produced coal. Clearly the government is trying to avoid cheaper imports flooding into the domestic coal market amid still elevated prices. This will help prevent a big drop in domestic coal prices but will be bearish for global coal prices. For example, 40% and 30% of Chinese coal imports are from Indonesia and Australia, respectively (Chart 14). These economies and their currencies are at risk from diminishing Chinese coal imports. Chart 13Chinese Coal Imports Will Decline Chinese Coal Imports Will Decline Chinese Coal Imports Will Decline Chart 14Indonesia and Australia May Face Falling ##br##Coal Demand From China Indonesia and Australia May Face Falling Coal Demand From China Indonesia and Australia May Face Falling Coal Demand From China For the demand side, continuing strong growth in non-thermal power supplies such as nuclear, wind and solar will curb thermal power growth in the long run and thus limit thermal coal consumption growth in China. This may also weigh on domestic coal prices and discourage coal imports. Bottom Line: The downtrend in domestic steel and coal prices will weigh on the global steel and coal markets. What About Iron Ore And Coking Coal? Iron ore and coking coal prices are also at risk: Chart 15Record High Chinese Iron Ore Inventory Record High Chinese Iron Ore Inventory Record High Chinese Iron Ore Inventory Given about 40% of newly installed steel capacity is advanced electric furnace (EF) based - which requires significant amounts of scrap steel rather than iron ore and coke - rising steel output will increase demand for iron ore and coke disproportionally less. As more Chinese steel producers shift to EF technology, mainland demand for iron ore and coke will diminish structurally in the years to come. Despite weakness in both domestic iron ore production and iron ore imports, Chinese iron ore inventories at major ports, expressed in number of months of consumption, have still reached record highs (Chart 15). This suggests rising EF capacity has indeed been constraining demand for iron ore. Increasing coal output will bring more coking coal and a corresponding rise in coke supply, thereby further depressing coke prices. Bottom Line: Global iron ore and coking coal prices are also vulnerable to the downside. Investment Implications From a macro perspective, investors can capitalize on these themes via a number of strategies: Shorting iron ore and coal prices, or these commodities producers' stocks. Chart 16Chinese Steel And Coal Shares:##br## Puzzling Drop Amid High Profit Chinese Steel And Coal Shares: Puzzling Drop Amid High Profits Chinese Steel And Coal Shares: Puzzling Drop Amid High Profits Going short the Indonesian rupiah (and possibly the Australian dollar) versus the U.S. dollar. Australia and Indonesia are large exporters of coal and industrial metals to China - they account for 30% and 40% of Chinese coal imports, respectively, so their currencies are vulnerable. Notably, although steel and coal prices are still well above their 2015 levels and producers' profit margins are very elevated, share prices of Chinese steel makers and coal producers have dropped almost to their 2015 levels (Chart 16). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of the peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. On a more granular level, rapidly expanding EF steel-making capacity in China will lead to outperformance of stocks related to EF makers, graphite electrode producers and domestic scrap steel collecting companies. First, demand for graphite electrodes continues to rise, as EF steel production expands. Prices of graphite electrodes may stay high for quite some time (Chart 6 above, top panel). Second, scrap steel prices may go higher or stay high to encourage more domestic scrap steel collection. Companies who collect domestic scrap steel may soon have beneficial policy support, which will create huge potential for expansion (Chart 6 above, bottom panel). Third, EF makers will also benefit due to strong sales of electric furnaces. As a final note, equity investors should consider going long thermal power producers versus coal producers as thermal power producers will benefit from falling coal prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@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, available at ems.bcaresearch.com. 2 "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. 3 The big divergence between crude steel production expansion and steel products output contraction last year was due to both the removal of "Ditiaogang" and statistical issues. "Ditiaogang" is often converted into steel products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. 4 Please see Emerging Markets Strategy Special Report, "China Real Estate: A New-Bursting Bubble?", dated April 6, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Our base case outlook is unchanged. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, the cycle is well advanced and, given current valuations, the long-term outlook for returns in the major asset classes is far less appealing. The risk/reward balance is unfavorable. Investors should therefore separate strategy from forecast. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, which means that the FOMC will have to consider becoming outright restrictive in order to slow growth and raise the unemployment rate. The risks facing equities, EM assets and spread product will escalate at that point. The advanced stage in the cycle and our bias for capital preservation requires us to heed the recent warnings from our growth indicators and 'exit' timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. The implication is that we are tactically trimming risk asset exposure to benchmark. We expect to shift back to overweight once our indicators improve and/or the geopolitical tensions fade. This month we provide total return estimates for the major U.S. asset classes under our base case outlook and two alternative scenarios. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession in 2019. We also review the U.S. fiscal outlook, which is clearly unsustainable over the long-term. While we do not see a dollar crisis anytime soon, the prospect of large and sustained federal budget deficits supports the view that the dollar will continue on a long-term downtrend (although it is likely to buck the trend in the coming months). It also supports our view that the multi-decade Treasury bull market is over. U.S. consumers will not be particularly sensitive to rising borrowing rates, although there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Feature It was the summer of 2009. Risk assets were bombed out, investor sentiment was deeply depressed, business leaders were shell-shocked, the Fed was easing and some 'green shoots' of recovery were emerging. Plentiful economic slack also meant that there was a long potential runway for the economy and earnings to grow. Given that backdrop, it was appropriate to begin rebuilding risk portfolios and ride out any additional turbulence in the markets. Today's situation is almost the mirror image. The economic expansion is well advanced, there is little slack, the Fed is tightening, risk assets are expensive, and investor equity sentiment is frothy. The long-term outlook for returns in the major asset classes is underwhelming to say the least. Table I-1 updates the long-run return expectations we published in the 2018 BCA Outlook. Some technical adjustments make the numbers look a little better but, still, a balanced portfolio will deliver average returns over the long-term of only 3.8% and 1.8% in nominal and real terms, respectively. Table I-110-Year Asset Return Projections May 2018 May 2018 For stocks, the expected returns are poor by historical standards because we assume a mean-reversion in multiples and a decline in the profit share of total income. These assumptions may turn out to be too pessimistic if there is no redistribution of income shares from the corporate sector back to labor and/or P-E ratios remain at historically high levels. Equities obviously would do better than our estimates in this case, but the point is that it is very hard to see returns in risk assets anywhere close to their 1982-2017 average over the long haul. On a two-year horizon, our base case outlook still sees decent equity returns. Nonetheless, the risk/reward balance has become quite unfavorable because the cycle is so advanced. It is therefore prudent to focus on capital preservation and be quicker to trim risk exposure when the outlook becomes cloudier. Losing Sleep Investors have cheered some easing in the perceived risk of a trade war in recent weeks. Nonetheless, a number of items have made us more nervous about the near term. First, our Equity Scorecard has dropped to one, well below the critical value of three that is consistent with positive equity returns historically (Chart I-1). Table I-2 updates our Exit Checklist of items that we believe are important for the equity allocation call. Five of the nine are now giving a 'sell' signal, pointing to at least a technical correction. Chart I-1Our Equity Scorecard Turned Negative Our Equity Scorecard Turned Negative Our Equity Scorecard Turned Negative Table I-2Exit Checklist For Risk Assets May 2018 May 2018 Moreover, we highlighted last month that global growth appears to be peaking (Chart I-2). Our Global Leading Economic Indicator is still bullish, but its diffusion index has plunged below zero. The Global ZEW index and our Boom/Bust indicator have fallen sharply and the global PMI index ticked down (albeit, from a high level). Industrial production in the major economies has eased. Korean and Taiwanese exports, which are a barometer of global industrial activity, have decelerated as well. Chart I-2Economic Indicators Have Softened Economic Indicators Have Softened Economic Indicators Have Softened While we expect global growth to remain at an above-trend pace for at least the next year, the peaking in some coincident and leading indicators is worrying nonetheless. Other items to keep investors up at night include the following: Loss Of Fed Put: With inflation likely to reach the Fed's target in the next couple of months, and policymakers worried about froth in markets, the FOMC will be less predisposed to ease at the first hint of economic softness (see below). Inflation Surge: There is a lot of uncertainty around estimates of the level of the unemployment rate that is consistent with rising wage and price pressures. Inflation could suddenly jump if unemployment is far below this critical level, leading to a blood bath in the bond market that would reverberate through all other assets. The fact that long-term inflation breakevens have surged along with the 10-year Treasury yield in the past couple of weeks is an ominous sign for risk assets. Neutral Rate: We agree with the Fed that the neutral fed funds rate is rising, but nobody knows exactly where it is at the moment. If the neutral rate is lower than the Fed believes, then the economy could suddenly stall as actual rates rise above the neutral level. Trade War: President Trump's popularity among Republican voters is rising, which gives him the ability to weather turbulence in the stock market while he 'gets tough' on trade. The fact that U.S. Treasury Secretary Mnuchin will visit China is a hopeful sign. Nonetheless, we do not believe that we have seen peak pessimism on trade because the President needs to placate his supporters in the mid-west that are in favor of protectionism. The summer months could be volatile as market confusion grows amidst a plethora of upcoming event risks.1 Iran: This year's premier geopolitical risk is the potential for renewed U.S.-Iran tensions. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has staffed his cabinet with two hawks (Bolton and Pompeo). Meanwhile, tensions in Syria are building with the potential for U.S. and Iranian forces to be directly implicated in a skirmish. Russia: Tensions between the West and Russia are also building again. Stroke Of Pen Risk: There is a rising probability that the current administration decides to up the regulatory pressure on Amazon. Other technology companies like Facebook and Google also face "stroke of pen" risks. On a positive note, first quarter earnings season is off to a good start in the U.S. Earnings have surprised to the upside by a wide margin, which is impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results to beat expectations. That said, a lot of good news is already discounted in the U.S. market. Chart I-3 highlights that bottom-up analysts' expected annual average EPS growth for the S&P 500 over the next five years has shot up to more than 15%, a level not seen since 1998! This is excessive even considering that the estimates include the impact of the tax cuts. History teaches that investors should be wary during periods of earnings euphoria. Chart I-3Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Five-Year Bottom-Up EPS Growth Estimates Are Impossibly High Given these risks, market pricing and our checklist, we adjusted the tactical (3-month) House View recommendation on risk assets to benchmark in April. We see this shift as tactical, and expect to move back to overweight once our growth indicators bottom and the geopolitical situation calms down a little. Our base case outlook remains constructive for risk assets on a cyclical (6-12 month) view. Three Scenarios This month we consider two alternative scenarios to our base case outlook and provide estimates of how several key asset classes would perform between now and the end of 2019: Base Case: U.S. real GDP growth accelerates to 3.3% year-over-year by the end of 2018 on the back of fiscal stimulus and improving animal spirits in the corporate sector. Growth is expected to decelerate in 2019, but remain above trend. Profit margins are squeezed marginally by rising wage pressure. The recession we expect to occur in 2020 is beyond the horizon of this exercise. Optimistic Case: The multiplier effects of the fiscal stimulus could be larger than we are assuming if consumers decide to spend most of the tax windfall, and the corporate sector cranks up capital spending due to accelerated depreciation, the tax savings and repatriated overseas funds. We assume that real GDP growth is about a half percentage point higher than the base case in both 2018 and 2019. This is only modestly stronger than the base case because, given that the economy is already at full employment, the supply side of the economy will constrain growth. Even more margin pressure partially offsets stronger top line growth for corporations. Pessimistic Case: The fiscal multiplier effects turn out to be smaller than expected, compounded by the growth-sapping impact of a tariff war and a spike in oil prices due to tensions in the Middle East. The corporate and consumer sectors are more sensitive to rising interest rates than we thought (see below for more discussion of U.S. consumer vulnerabilities). Growth begins to slow toward the end of 2018, culminating in a recession in the second half of 2019. Margins are squeezed initially, but then rise as labor market slack opens up next year. This is more than offset, however, by declining corporate revenues. Chart I-4 presents the implications for S&P 500 EPS growth in the three scenarios, according to our top-down model. Four-quarter trailing profit growth comes in at a respectable 15% and 8½%, respectively, in 2018 and 2019 in our base case. The optimistic scenario would see impressive profit growth of 20% and 13%. Trailing EPS expands by 9% this year in the pessimistic case, but contracts by about the same amount next year. Chart I-4Three Scenarios For S&P 500 EPS Growth Three Scenarios For S&P 500 EPS Growth Three Scenarios For S&P 500 EPS Growth In order to use these EPS forecasts to estimate expected S&P 500 returns, we made assumptions regarding an appropriate 12-month forward P/E ratio (Table I-3). We also translated our trailing EPS forecasts into 12-month forward estimates based on historical cyclical patterns. The 12-month forward P/E ratio is 17 as we go to press (based on Standard and Poors figures). We assume the ratio is flat this year in the base case, before edging lower in 2019 due to rising interest rates. The forward P/E is assumed to edge up in the optimistic case in 2019, but then falls back in 2019 as rates rise. In the recession scenario, we conservatively assume that this ratio falls to 15 by the end of this year, and to 13 by the end of 2019. We incorporate a 2% dividend yield in all scenarios. Over the next two years, the S&P 500 delivers an 8% annual average return in our baseline, and 13% in the optimistic case. As would be expected, investors suffer painful losses of 13% this year and roughly 20% next year in the case of recession, as the drop in multiples magnifies the earnings contraction. Table I-4 presents total return estimates for the 10-year Treasury under the three scenarios. The bond will provide an average return of close to zero in our base case. It suffers heavy losses in 2018 if growth turns out to be stronger than we expect, because a faster acceleration in inflation would spark a sharp upward revision to the path of short-term rates. Long-term inflation expectations would rise as well. The 10-year yield finishes 2019 at 3.5% in the base case, and at 3.75% in the optimistic growth scenario. In contrast, total returns are hefty in the recession case as the 10-year yield drops back below 2%. Table I-3S&P 500 Return Scenarios May 2018 May 2018 Table I-410-year Treasury Return Scenarios May 2018 May 2018 We believe the risk/reward profile is less attractive for corporate bonds than it is for equities (Table I-5). Strong profit growth in the base and optimistic cases is positive for corporates, but this is offset by deteriorating financial ratios as interest rates rise in the context of high leverage ratios. We expect investment-grade (IG) spreads to widen modestly even in the base case, providing a small negative excess return. We see spreads moving sideways at best in our optimistic scenario, giving investors a small positive excess return of about 100 basis points. In the case of a recession, we could see the option-adjusted spread of the Barclay's IG index surging from 105 basis points today to 250 basis points. Excess returns would obviously be quite negative. Table I-5U.S. Investment Grade Corporate Bonds May 2018 May 2018 All of these projected returns are only meant to be suggestive because they depend importantly on several key assumptions. Still, we wanted to provide readers with a sense of the risks for returns around our base case outlook. We place the odds at 50% for the base case, 20% for the optimistic scenario and 30% for a recession. U.S. Fiscal Policy: Good And Bad News The probabilities attached to the baseline and optimistic scenarios are supported by the U.S. fiscal stimulus that is in the pipeline. The IMF estimates that the tax cuts and spending increases will provide a fiscal thrust of 0.8% in 2018 and 0.9% in 2019, not far from the estimates we presented last month (Chart I-5).2 This represents a powerful tailwind for growth for the next two years. We must turn to the Congressional Budget Office (CBO) projections to gauge the longer-term implications. On a positive note, the CBO revised up its estimate of the economy's long-run potential growth rate on account of the supply-side benefits of lower taxes and the immediate expensing of capital outlays. Faster growth over the long run, on its own, reduces the projected cumulative budget deficit over the 2018-2027 period by $1 trillion. However, this positive impact is swamped by the direct effect on the budget of the tax breaks and increased spending. The CBO estimates that the net effect of the fiscal adjustments will be a $1.7 trillion increase in the cumulative budget deficit over the next decade, relative to the previous baseline (Chart I-6). The annual deficit is projected to surpass $1 trillion in 2020, and peak as a share of GDP at 5.4% in 2022. Federal government debt held by the private sector will rise from 76% this year to 96% in 2028 in this scenario. Chart I-5U.S. Fiscal Stimulus Will Support Growth May 2018 May 2018 Chart I-6U.S. Federal Budget: A Lot More Red Ink U.S. Federal Budget: A Lot More Red Ink U.S. Federal Budget: A Lot More Red Ink The deficit situation begins to look better after 2020 because a raft of "temporary provisions" are assumed to sunset as per current law, including some of the personal tax cuts and deductions included in the 2017 tax package. As is usually the case, the vast majority of these provisions are likely to be extended. The CBO performed an alternative scenario in which they extend the temporary provisions and grow the spending caps at the rate of inflation after 2020. In this more realistic scenario, the deficit reaches 6% of GDP by 2022 and the federal debt-to-GDP ratio hits almost 110% of GDP in 2028. This is not a pretty picture and investors are wondering what it means for government bond yields and the dollar. We noted in the March 2018 Bank Credit Analyst that academic studies published before 2007 suggested that every percentage point rise in the government's debt-to-GDP ratio added roughly three basis points to the equilibrium level of bond yields. If this is correct, then a rise in the U.S. ratio of 25 percentage points over the next decade would lift the equilibrium long-term bond yields by 75 basis points. This estimated impact on yields should not be thought of as a default risk premium because there is no reason to default when the Fed can simply print money in the event of a funding crisis. Rather, a worsening fiscal situation could show up in higher long-term inflation expectations if investors were to lose confidence in the Fed's inflation target. Higher real yields could also come about through the 'crowding out' effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Deficits And The Dollar We discussed the potential debt fallout for the U.S. dollar from an economic perspective in the April 2018 Special Report. While the fiscal stimulus means that the U.S. twin deficits are set to worsen, the situation is not so dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding U.S. debt sustainability among international investors. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. Nonetheless, with President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. This month's Special Report beginning on page 22 examines this issue. There is no evidence at the moment that the U.S. dollar is losing any market share and we do not foresee any sudden shifts away from the U.S. dollar as a reserve currency. However, cracks are beginning to form, especially with regard to the RMB. We also believe that the euro is likely to benefit from a structural tailwind as global reserve managers increase the share of the euro in their reserves. A trade war would accelerate the diversification away from the dollar. Chart I-7Economic Slack: U.S./Eurozone Comparison Economic Slack: U.S./Eurozone Comparison Economic Slack: U.S./Eurozone Comparison The conclusions of this month's Special Report support those of last month's analysis; the dollar will continue on its long-term downtrend, although there is still room for a counter-trend rally this year. We do not see much upside against the yen in the near term, but we expect some of the euro's recent strength to be unwound. A debate is raging within the halls of the European Central Bank regarding the amount of Europe's economic slack. On this we side with President Draghi, who believes that there is still plenty of excess capacity in the labor market. The Eurozone's unemployment rate has reached the level of full employment as estimated by the OECD. However, Chart I-7 shows various measures of hidden unemployment, including discouraged workers and those that have been out of work for more than a year. In all cases, the Eurozone appears to be behind the U.S. in terms of getting back to full employment. This, along with the recent softening in some of the Eurozone's economic data, will keep the ECB wedded to low interest rates even as it terminates the asset purchase program this autumn. Long-dated forward rate differentials are beginning to move back in favor of the dollar relative to the Euro. Dollar strength will also be at the expense of most of the EM currencies. The Long-Term Consequences Of Government Debt While it is somewhat comforting that the U.S. twin-deficits are unlikely to spark financial panic in the short- to medium term, the U.S. and global debt situations are not without consequences. The latest IMF Fiscal Monitor again sounded the alarm over global debt levels, especially government paper. The Fund argues that debt sustainability becomes increasingly questionable once the general government debt/GDP ratio breaches 85%. The IMF points out that more than one-third of advanced economies had debt above 85% in 2017, three times more countries than in 2000. And this does not include the implicit liabilities linked to pension and health care spending. The good news is that the IMF expects that most of the major economies will see a reduction in their general government debt/GDP ratios between 2017 and 2023. The big exception is the U.S., where the average deficit is expected to far exceed the other major countries (Charts I-8A and I-8B). The U.S. cyclically-adjusted budget deficit is projected to be almost 7% of GDP in 2019! Including all levels of government, the IMF estimates that the U.S. debt/GDP ratio will rise by about nine percentage points, to almost 117%, between 2017 and 2023. Chart I-8AIMF Projections (I) May 2018 May 2018 Chart I-8BIMF Projections (II) May 2018 May 2018 U.S. fiscal trends are clearly unsustainable in the long-term. Taxes will have to rise or entitlement programs will have to be slashed at some point. The question is whether Congress administers the required medicine willingly, or is forced to do so by rioting markets. We do not believe that the dollar's 'day of reckoning' will happen anytime soon, but growing angst over the U.S. fiscal outlook supports our view that the multi-decade Treasury bull market is over. In the near term, the main threat to the global bond market is a mini 'inflation scare' in the U.S. Fed Will Soon Reach 2% Goal Chart I-9Inflation May Soon Reach The Fed's Target Inflation May Soon Reach The Fed's Target Inflation May Soon Reach The Fed's Target The 10-year Treasury yield is testing the 3% support level as we go to press. In part, upward pressure on yields likely reflects some calming of tensions regarding global trade and the news that the U.S. will hold face-to-face discussions with North Korea. Moreover, long-term inflation expectations have been rising in most of the major countries. Investors appear to be waking up to how strong U.S. inflation has been in recent months, driven in part by an unwinding of base effects that temporarily depressed the annual inflation rate. U.S. core CPI inflation has already quickened from 1.8% in February to 2.1% in March (Chart I-9). This acceleration will also play out in the core PCE deflator, the Fed's preferred inflation metric. Even if the core PCE deflator rises only 0.1% month-over-month in March, year-over-year core PCE inflation will increase to 1.85%. This would be above Bloomberg and Fed estimates for the end of the year. If the core PCE deflator rises 0.2% m/m in March - a reading more consistent with recent trends - then year-over-year core PCE inflation will almost reach the Fed's 2% target. The FOMC will not be alarmed even if inflation appears set to overshoot the 2% target. Nonetheless, Fed officials will be forced to adjust the communication language because they can no longer argue that "accommodative" monetary policy is still appropriate. In other words, policymakers will have to openly admit that policy will have to become outright restrictive. The Fed's "dot plot" could then be revised higher. The policy risks facing equities, EM assets and spread product will escalate once it becomes clear that the FOMC is actively targeting slower economic growth and a higher unemployment rate. As for Treasurys, the surge in the 10-year yield to 3% has been quick and we would not be surprised to see another consolidation period. Eventually, however, we expect the yield to reach 3.5% before the bear phase is over. How Vulnerable Are U.S. Households? The ultimate peak in U.S. yields will depend importantly on the economy's sensitivity to rising borrowing costs. Our research on excessive borrowing in recent months has focussed on the U.S. corporate sector. Next month we will review corporate vulnerabilities in the Eurozone. But what about U.S. consumers? Overall debt as a ratio to GDP or personal income has fallen back to pre-housing bubble levels, underscoring that the household sector has deleveraged impressively (Chart I-10). Household net worth has surpassed the pre-Lehman peak and our "wealth effect" proxy suggests that the rise in asset prices and recovery in home values provide a strong tailwind for spending (Chart I-11). The proxy likely overstates the size of the tailwind due to the lack of cash-out refinancing. Chart I-10U.S. Consumers Have Deleveraged U.S. Consumers Have Deleveraged U.S. Consumers Have Deleveraged Chart I-11'Wealth Effect' Is A Tailwind ''Wealth Effect''' Is A Tailwind ''Wealth Effect''' Is A Tailwind The financial obligation ratio (FOR) - a measure of the debt service burden for the average household - is rising but is still close to the lowest levels in three decades (Chart I-12). Chart I-13 shows a broader measure of the burden that households face when paying for essentials; interest payments, food, medical care and energy. These are all expenses that are difficult to trim. Spending on essentials has increased over the past couple of years to a little under 42% of disposable income due to rising interest rates and a continuing uptrend in out-of-pocket medical care costs. However, the ratio is below the post-1980 average level and has only risen back to levels that existed in 2011/12. From this perspective, it is difficult to believe that rising gasoline prices will dominate the benefits of the tax cuts on household spending. Chart I-12Past The Peak Of U.S. Consumer Credit Quality Past The Peak Of U.S. Consumer Credit Quality Past The Peak Of U.S. Consumer Credit Quality Chart I-13Spending On Essentials Is Not Onerous Spending On Essentials Is Not Onerous Spending On Essentials Is Not Onerous The labor market is clearly supportive for consumer spending. Wage growth has been disappointing so far in this recover, and real personal disposable income has slowed over the past year. Nonetheless, the economy continues to produce new jobs at an impressive pace, unemployment claims are close to all-time lows, and households are feeling confident about their future income and job prospects. Some market pundits have pointed to the falling household savings rate as a warning sign that consumers are 'tapped out' (Chart I-14). We are less concerned. The savings rate tends to decline during economic expansions and rises almost exclusively during recessions. All else equal, one could make the case that U.S. households should save more over their lifetimes. Nonetheless, a falling savings rate is consistent with strong, not weak, economic activity. That said, some signs have emerged that not all consumer lending in recent years has been prudent. Bank and finance company loan delinquency rates are rising, especially for credit cards and autos (Chart I-15). While the FOR is still low, it is rising and it tends to lead bank loan delinquency rates (Chart I-12). These trends usually occur just prior to a recession. Chart I-14Savings Rate Falls During Expansions Saving Rate Falls During Expansions Saving Rate Falls During Expansions Chart I-15Some Signs Of Excessive Lending Some Signs Of Excessive Lending Some Signs Of Excessive Lending There has also been an alarming surge in credit card charge-off rates, which have reached recession levels among banks that are outside of the top 100 (Chart I-15, top panel). Anecdotal evidence suggests that large banks offered lush cash rewards and points to attract higher-quality customers. Smaller banks could not compete on cash rewards, and instead had to loosen credit requirements for card issuance. The deterioration in the credit-quality composition of these banks' loan portfolios helps to explain why delinquencies have increased despite a robust labor market. The Fed's senior loan officer survey shows that expected delinquencies and charge-offs are rising even among large banks. One risk is that, while overall credit growth has been weak in this expansion, it has been concentrated in lower-income households. However, the Fed's Survey of Consumer Finances does not flag a huge problem. Various measures of credit quality have not deteriorated for lower income households since 2007 (latest year available; Chart I-16). Chart I-16Credit Quality For Lower ##br##Income U.S. Households Credit Quality For Lower Income U.S. Households Credit Quality For Lower Income U.S. Households The bottom line is that there are pockets of excessive borrowing that will no doubt result in a spike in defaults in selected sectors when the next economic downturn arrives. Nonetheless, the backdrop for consumer health has not deteriorated to the point where the U.S. household sector will be ultra-sensitive to higher interest rates on a broad scale. Investment Conclusions Our base case outlook is unchanged this month. We do not see a recession in the U.S. before 2020, and the U.S. equity market could reward investors with high single-digit total returns this year and next. Nonetheless, one must separate strategy from forecast at this point in the cycle. U.S. unemployment is very low and we are beginning to see hints of late-cycle inflation dynamics. Core inflation could soon be at the Fed's 2% target, while rising energy and base metal prices add to the broader inflationary backdrop. Strong global oil demand growth and the OPEC/Russia production cuts are draining global oil inventories and supporting prices. Sanctions against Iran and/or Venezuela that further restrict supply could easily send oil prices to more than US$80/bbl this year. Investors should remain overweight energy plays. The implication is that the Fed may have to tighten into outright restrictive territory. The advanced stage in the cycle and our bias for capital preservation requires us to heed the warnings from our indicators and timing checklist. The geopolitical calendar is also stacked with risk for markets over the next month at least. Thus, we are tactically trimming risk asset exposure to benchmark until our indicators improve and/or geopolitical tensions fade. Investors should also be more cautious in their equity sector allocation for the very near term. We continue to favor Eurozone stocks over the U.S. (currency hedged), since the threat from monetary tightening is greater in the latter market and we expect the dollar to appreciate. We are neutral on the Nikkei because the risk of a rising yen offsets currently-strong EPS growth momentum. Stay short duration within global bond portfolios, and remain underweight the U.S., Canada and core Europe (currency hedged). Overweight Australia and the U.K. The Aussie economy will continue to underperform, and the U.K. economy will not allow the Bank of England to hike rates as much as is currently discounted. Mark McClellan Senior Vice President The Bank Credit Analyst April 26, 2018 Next Report: May 31, 2018 1 For a list of these events, see Table 2 in the BCA Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018, available at gps.bcaresearch.com. 2 The fiscal thrust is the change in the cyclically-adjusted budget balance as a share of GDP. It is a measure of the initial impetus to real GDP growth, but the actual impact on growth depends on fiscal "multipliers". II. Is King Dollar Facing Regicide? This month's Special Report is a joint effort by BCA's Geopolitical and Foreign Exchange strategists, along with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research). It is a companion piece to last month's Special Report, in which I discussed the short- and long-term outlook for the U.S. dollar from a purely economic perspective. This month's analysis takes a geopolitical perspective, focusing on the possibility that the U.S. dollar will lose its reserve currency status and weaken over the long term. I trust that you will find the Report as insightful as I did. Mark McClellan Reserve currencies are built on a geopolitical and macroeconomic foundation. For the U.S. Dollar, these foundations remain in place, but cracks are emerging. Relative decline in American power, combined with a loss of confidence in the "Washington Consensus" at home, are eroding the geopolitical foundations. Meanwhile, threats to globalization, a slower pace of petrodollar recycling, and stresses in the Eurodollar system are eroding the macroeconomic foundations. The Renminbi is not an alternative to King Dollar, but the euro remains a potential challenger in the coming interregnum years that will see the world transition from American hegemony... to something else. In the long run, we envision a multipolar currency regime to emerge alongside a multipolar geopolitical world order. In this report, BCA's Geopolitical and Foreign Exchange strategies join efforts with contributing editors Mehul Daya and Neels Heyneke (Strategists at Nedbank CIB Research) to examine the conditions necessary for the decline of a reserve currency. Specifically, we seek to answer the question of whether the U.S. dollar is at the precipice of such a decline. With President Donald Trump's overt calls for American geopolitical retrenchment from global commitments, investors have asked whether the end of the dollar as the global reserve currency is nigh. After all, King Dollar has fallen by 9.7% since President Trump's inauguration on January 20, while alternatives of dubious value, such as a slew of cryptocurrencies, have seen a rally of epic proportions (Chart II-1). Professor Barry Eichengreen, a world-renowned international economics historian,1 has recently penned an insightful paper proposing a link between the robustness of military alliances and currency reserve status.2 According to the analysis, reserve currency status reflects both economic fundamentals - safety, liquidity, network effects, and economic conditions - and geopolitical fundamentals. In the case of close U.S. military allies, such as South Korea and Japan, the choice of the dollar as store of value is explained far more by the geopolitical links to the U.S., rather than the importance of the dollar for their economies. The authors warn that if the U.S. "withdraws from the world," the impact could be as large as an 80 basis points rise in the U.S. long-term interest rate. Intriguingly, some of what Professor Eichengreen posits could happen has already happened. For example, the share of foreign holdings of U.S. Treasuries by military allies has already declined by a whopping 25% (Chart II-2). And yet the demand for King Dollar assets was immediately picked up by non-military allies, proving the resiliency of greenback's status as the reserve currency. Chart II-1Is Trump Guilty Of Regicide? Is Trump Guilty Of Regicide? Is Trump Guilty Of Regicide? Chart II-2Geopolitics Is Not Driving ##br##Demand For Treasuries Geopolitics Is Not Driving Demand For Treasuries Geopolitics Is Not Driving Demand For Treasuries When it comes to global currency reserves, the U.S. dollar continues to command 63%, roughly the same level it has commanded since 2000 (Chart II-3). Interestingly, alternatives remain roughly the same as in the past, with little real movement (Chart II-4). The Chinese renminbi remains largely ignored as a global reserve currency and its use across markets and geographies appears to have declined since the imposition of full capital controls in October 2015 (Chart II-5). Chart II-3Dollar Remains King Dollar Remains King Dollar Remains King Chart II-4The Euro Is The Only Serious Competitor To King Dollar... May 2018 May 2018 Chart II-5...The Renminbi Is Not May 2018 May 2018 However, some cracks in the foundation are emerging. A recent IMF paper, penned by Camilo E. Tovar and Tania Mohd Nor,3 uses currency co-movements to determine which national currencies belong to a particular reserve currency bloc.4 Their work shows that the international monetary system has already transitioned from a bi-polar system - consisting of the greenback and the euro - to a multipolar one that includes the CNY (Chart II-6). However, the CNY's influence does not extend beyond the BRICS and is scant in East Asia, the geographical region that China already dominates in trade (Chart II-7), albeit not yet geopolitically (Map II-1). Chart II-6Renminbi Does Command A Large Currency 'Bloc'... Renminbi Does Command A Large Currency '''Bloc'''... Renminbi Does Command A Large Currency '''Bloc'''... Chart II-7...But Despite China's Dominance Of East Asia... ...But Despite China's Dominance Of East Asia... ...But Despite China's Dominance Of East Asia... Map II-1...Renminbi's 'Bloc' Is Not In Asia! May 2018 May 2018 Our conclusion is that the geopolitical and economic tailwinds behind the greenback's status as a global reserve currency are shifting into headwinds. This process, as we describe below, could increase the risk of a global dollar liquidity shortage, buoying the greenback in the short term. In the long term, however, a transition into a multipolar currency arrangement could rebalance some of the imbalances created by the collapse of the Bretton Woods System and is not necessarily to be feared. The Geopolitical Fundamentals Of A Reserve Currency Nothing lasts forever and the U.S. dollar will one day join a long list of former reserve currencies that includes the Ancient Greek drachma, the Roman aureus, the Byzantium solidus, the Florentine florin, the Dutch gulden, the Spanish dollar, and the pound sterling. All of the political entities that produced these reserve currencies have several factors in common. They were the geopolitical hegemons of their era, capable of controlling the most important trade routes, projecting both hard and soft power outside of their borders, and maintaining a stable economy that underpinned the purchasing power of their currency. Table II-1 illustrates several factors that we believe encapsulate the necessary conditions for a dominant international currency. Table II-1Insights From History: What Makes A Reserve Currency? May 2018 May 2018 Geopolitical Power As Eichengreen posits, geopolitical fundamentals are essential for reserve currency status. Military power is necessary in order to defend one's national and commercial interests abroad, compel foreign powers to yield to those interests, and protect allies in exchange for their acquiescence to the hegemonic status quo. An important modern world example of such "gunboat diplomacy" was the 1974 agreement between the U.S. and Saudi Arabia.5 In exchange for dumping their petro-dollars into U.S. debt, Riyadh received an American commitment to keep the Saudi Kingdom safe from all threats, both regional (Iran) and global (the Soviet Union). It also received special permission to keep its purchases of U.S. Treasuries secret. Chart II-8The Exorbitant Privilege In One Chart May 2018 May 2018 As with all the empires surveyed in Table II-1, allies and vassal states were forced to use the hegemon's currency in their trade and investment transactions as a way of paying for the security blanket. To this day, there is no better way to explain the "exorbitant privilege" that the dollar commands. Chart II-8 illustrates that the U.S. enjoys positive net income despite a massively negative net international investment position. It is true that the U.S.'s foreign assets are skewed toward foreign direct investment and equities, investments that have higher rates of returns than the fixed-income liabilities the U.S. owes to the rest of the world. But the U.S.'s positive net income balance has been exacerbated by the willingness of foreigners to invest their assets into the U.S. for little compensation, something illustrated by the fact that between 1971 and 2007, the ex-post U.S. term premium has been toward the lower end of the G10. Additionally, as foreigners are also willing holders of U.S. physical cash, the U.S. government has been able to finance part of its budget deficit with instruments carrying no interest payments. This is what economists refer to as seigniorage, a subsidy to the U.S. government equivalent to around 0.2% of GDP per annum (or roughly $39.5 bn in 2017). In essence, American allies are paying for American hegemony through their investments in U.S. dollar assets, and this lets the U.S. live above its means. But ultimately, the quid pro quo is perhaps as much geopolitical as economic. There is one, non-negligible, cost for U.S. policymakers. The greenback tends to appreciate during periods of global economic stress due to its reserve currency status.6 This means that each time the U.S. needs a weak dollar to reflate its economy, the dollar moves in the opposite direction, adding deflationary pressures to an already weak domestic economy. Compared to the benefits, which offer the U.S. a steady-stream of seigniorage income and low-cost financing, the cost of reserve currency status is acceptable. Chart II-9U.S. Naval Strength Still Supreme... U.S. Naval Strength Still Supreme... U.S. Naval Strength Still Supreme... Economic Power Aside from brute force, an empire is built on commercial and trade links. There are two reasons for this. First, trade allows the empire to acquire raw materials to fuel its economy and technological advancement. Second, it also gives the "periphery" a role to play in the empire, a stake in the world system underpinned by the hegemonic core. This creates an entire layer of society in the periphery - the elites enriched by and entrenched in the Empire - with existential interest in the status quo. For the past five centuries, commercial dominance has been underpinned by naval dominance. As the Ottoman Empire and the Ming Dynasty closed off the overland routes in the fourteenth and fifteenth centuries, Europeans used technological innovation to avoid the off-limits Eurasian landmass and establish alternative - and exclusively naval - routes to commodities and new markets. This has propelled a succession of largely naval empires: Portuguese, Spanish, Dutch, French, British, and finally American. Several land-based powers tried to break through the nautical noose - Ottoman Turks, Sweden, Hapsburg Austria, Germany, and the Soviet Union - but were defeated by the superiority of naval-based power. Dominance of the seas allows the hegemonic core to unite disparate and far-flung regions through commerce and to call upon vast resources in case of a global conflict. Meanwhile, the hegemon can deny that commerce and those resources to land-locked challengers. This is how the British defeated Napoleon and how the U.S. and its allies won World War I and II. The U.S. remains the supreme naval power (Chart II-9). While China is building up its ability to push back against the U.S. navy in its regional seas (East and South China Seas), it will be decades before it is close to being able to project power across the world's oceans. While the former is necessary for becoming a regional hegemon, the latter is necessary for China to offer non-contiguous allies an alternative to American hegemony. Bottom Line: The foundation of a global reserve currency status is geopolitical fundamentals. The U.S. remains well-endowed in both. American Hegemony - From Tailwinds To Headwinds Chart II-10...But Overall Hegemony Is In Decline ...But Overall Hegemony Is In Decline ...But Overall Hegemony Is In Decline The U.S. is already facing a relative geopolitical decline due to the rise of major emerging markets like China (Chart II-10). This theme underpins BCA Geopolitical Strategy's view that the world has already transitioned from American hegemony to a multipolar arrangement.7 In absolute terms, the U.S. still retains the hard and soft power variables that have supported the USD's global reserve status and will continue to do so for the next decade (which is the maximum investment horizon of the vast majority of our clients). However, there are three imminent threats to the status quo that may accentuate global multipolarity: Populism: The global hegemon could decide to withdraw from distant entanglements and institutional arrangements. In the U.S., an isolationist narrative has emerged suggesting that America's status as the consumer and mercenary of last resort is unsustainable (Chart II-11). President Obama was elected on the promise of withdrawing from Iraq and Afghanistan; his administration also struck a major deal with Iran to reduce American exposure to the Middle East. Donald Trump won the presidency on an even more isolationist platform and he and several of his advisors have voiced such a view over the past 15 months. The appeal of isolationism could resurface as it is a potent political elixir based on a much deeper rejection of globalization among the American public than the policy establishment realized (Chart II-12). Chart II-11Trump Is Rebelling Against The Post-Cold War System May 2018 May 2018 Chart II-12Americans Are Rebelling Against The 'Washington Consensus' May 2018 May 2018 Return of the land-based empire: While the U.S. remains the preeminent naval power, its leadership in military prowess could be wasted through a suboptimal grand strategy. The U.S. has two geopolitical imperatives: dominate the world's oceans and ensure the disunity of the Eurasian landmass.8 Eurasia has sufficient natural resources (Russia), population (China), wealth (Europe), and geographical buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia would have no need for a navy as it would become a superpower by default. Why would America's European allies abandon their U.S. security blanket for an alliance with Russia and China? First, stranger shifts in alliance structure have occurred in the past.9 Second, because a mix of U.S. mercantilism and isolationism could push Europe into making independent geopolitical arrangements with its Eurasian peers, even if these arrangements were informal. The advent of the cyber realm: Finally, the advent of the Internet as a new realm of great power competition reduces the relative utility of hard power, such as a navy. Great empires of the past struggled when confronted with new arenas of conflict such as air and submarine. New technologies and new arenas can yield advantages in traditional battlefields. Today, the U.S. must compete for hegemony in space and cyber-space with China, Russia, and other rivals. In these mediums, the U.S. does not have as great of a head start as it has in naval competition. Bottom Line: The U.S. remains the preeminent global power. However, its status as a hegemon is in relative decline. Domestic populism, suboptimal grand strategy, and the advent of cyber and outer-space warfare could all accelerate this decline on the margin. The Economic Fundamentals Of U.S. Dollar Reserve Status One unique aspect of the U.S. dollar as a reserve currency is that it is a fiat currency, i.e. paper money limited in supply only by policy. Throughout human history, most dominant currency reserves were based on commodities that were rare or difficult to acquire, like silver or gold.10 When the U.S. dollar was decoupled from gold prices in 1971, it became the only recent example of a global reserve currency backed by nothing but faith (the pound was for most of its period of dominance backed by gold). Money serves three functions in the economy. It is a means of payment, a unit of account, and a store of value. The last comes into jeopardy when the reserve currency has to supply the world with more and more liquidity, also known as the "Triffin dilemma". By definition, as the global reserve currency, the USD has to be plentiful enough for the global economy and financial system to function adequately. The U.S. government must constantly supply dollars to this end. Chart II-13 illustrates the timeline of global dollar liquidity, which we define as the total U.S. monetary base in circulation (U.S. monetary base plus holdings of U.S. Treasury securities held in custody for foreign officials and international accounts). The world has seen an ever-expanding U.S. dollar monetary base since 1988. Only during periods where the price of money (i.e. the Federal funds rate) has increased, has the money creation process slowed. Now that the expansion of the global USD monetary base is slowing, overall dollar liquidity is as important as the price, if not more (Chart II-14). Chart II-13Global Dollar Liquidity... May 2018 May 2018 Chart II-14...Drives Global Asset Prices ...Drives Global Asset Prices ...Drives Global Asset Prices The constant increase of dollar liquidity has made the greenback the "lubricant" of today's global financial system. There are three major forces at work beneath this condition: Recycling of petrodollars into the global financial system; Globalization and the build-up of - mainly USD-denominated - FX reserves; Deregulation of the Eurodollar system.11 Petrodollars Commodity exporters, mainly oil producers, sell their products in exchange for U.S. dollars. In addition, most Middle Eastern producers recycle their profits into U.S. dollars due to the liquidity and depth of U.S. capital markets. By 1980, the majority of oil producers were trading in U.S. dollars and were similarly investing their surpluses into the U.S. financial system in the form of U.S. government debt securities. The growth in petrodollars has allowed the world's dollar monetary base to grow substantially. This was both enabled by direct issuance of U.S. debt securities funded by petrodollar purchases and also through the Eurodollar system whereby banks outside the U.S. held large deposits of surplus dollar earnings from Middle East oil producers. Globalization The contemporary wave of globalization began in the mid-1980s, when it became evident that the Soviet Union was in midst of a deep economic malaise. This prompted the new Soviet Premier Mikhail Gorbachev to launch perestroika ("restructuring") in 1985, throwing in the proverbial towel in the contest between a statist planned economy and a free market one. Alongside the rise in global trade, financial globalization rose at a very rapid pace as cross-border capital flows more than doubled as a percentage of global GDP from 1990 onward. In the U.S., the economic boom of the 1990s was the longest expansion in history, with growth averaging 4% during the period. The U.S. trade deficit ballooned, providing the world with large amounts of dollar liquidity in the process. The flipside of the massive current account deficit was the accumulation of FX reserves in Europe and Asia, largely denominated in U.S. dollars. These insensitive buyers of U.S. debt indirectly financed the U.S. trade deficit, and also indirectly fuelled the debt super cycle and asset inflation as the "savings glut" compressed the world's risk-free rate and term premium. In other words, financial globalization combined with excess international savings morphed into a global quid pro quo. The world economy needed liquidity to finance growth and capital investment. In a system where the greenback stood at the base of any liquidity build up, this meant that the world needed dollars to finance its development. The world was thus willing to finance the U.S. current account deficit at little cost. The Eurodollar System The Eurodollar system was originally a payment system introduced after World War II as a result of the Marshal Plan. Because global trade was dominated by the U.S. - the only country that retained the capacity to produce industrial goods - foreigners had to be able to access U.S. dollars where they were domiciled in order to buy capital goods. The U.S. current account deficit played a role in growing that Eurodollar market. While a lot of the dollars supplied to the rest of the world through the U.S. current account deficit ended up going back to the U.S. via its large capital account surplus, a significant portion remained in offshore jurisdictions, providing an important fuel for the Eurodollar markets. In fact, more than two-thirds of U.S.-dollar claims in the Eurodollar market can be traced back to U.S. entities. After this original impetus, the Eurodollar market grew by leaps and bounds amid a number of regulatory advantages introduced in the 1980s. These changes in regulations not only deepened the participation of European and Japanese banks in the offshore markets, it also allowed U.S. banks to shift capital to Europe, harvesting a lower cost of capital in the process.12 The next growth phase in the Eurodollar system came with the evolution of shadow banking, in which credit was created off balance sheet by lending out collateral more than once, thus enabling banks to obtain higher gearing. This process is known as "re-hypothecation." In the U.S. there was a limit to which banks were allowed to gear collateral, which was not the case in Europe. Hence, to take advantage of this regulatory leniency, global banks grew further through the offshore market, causing an additional expansion in the Eurodollar market.13 Ultimately, this implies that over the past 30 years, the growth of the Eurodollar system has mainly been a consequence of the architecture of the international financial system. Headwinds To Dollar Liquidity The forces contributing to the extraordinary growth in dollar liquidity have begun to fade. In brief: Protectionism and populism: A slowdown in global trade has occurred for a number of structural, non-geopolitical reasons, especially if one controls for the recovery of energy prices (Chart II-15).14 This slowdown implies a slower accumulation of international FX reserves and a reduction of the "savings glut." If protectionism were to compound the effects - by shrinking the U.S. trade deficit - the result for global dollar liquidity would be negative. The consequence would be a certain degree of "quantitative tightening" of global dollar liquidity. Energy prices: Despite the recovery in energy prices, oil producers continue to struggle to rein in their budget deficits. Deficits blew out during the high-spending era buoyed by high oil prices (Chart II-16). Today, oil producing countries have less oil revenues to spend on the Treasury market, as their cash is needed at home. Meanwhile, the U.S. is slowly moving towards partial energy independence, further shrinking its trade deficit. Chart II-15Global Trade Growth Has Moderated Global Trade Growth Has Moderated Global Trade Growth Has Moderated Chart II-16Petrodollars Are Scarce Petrodollars Are Scarce Petrodollars Are Scarce Eurodollar system: The monetary "plumbing" has become clogged since 2014 after the Fed stopped growing its balance sheet and sweeping Basel III bank regulations took effect. The cost of acquiring U.S. dollars in Eurodollar markets currently stands at a premium. This extra cost cannot be arbitraged away due to the restrictive capital rules imposed under Basel III, which have raised the cost of capital for banks. This can be seen in the persistent widening of USD cross-currency basis-swap spreads and more recently, in the rise of the Libor-OIS spread (Chart II-17). The introduction of interest on excess reserves by the Federal Reserve is further draining dollars from the Eurodollar system. The velocity of dollar usage in international markets is unlikely to return to the pace experienced from 1995 to 2008, when the shadow banking system grew rapidly. To complicate matters, dollar-denominated debt issued outside of the U.S. by non-U.S. entities such as banks, governments, and non-financial corporations has grown substantially. This could exacerbate the scramble for dollars in case of a global shortage. For example, the stock of outstanding dollar debt issued by foreign nonfinancial corporations currently stands at US$10 trillion (Chart II-18). Chart II-17Mounting Stress In The Eurodollar System Mounting Stress In The Eurodollar System Mounting Stress In The Eurodollar System Chart II-18Foreign Dollar Debt Is At $10 Trillion May 2018 May 2018 Why is the Eurodollar system so important? Today is the first time in the world's history that this much debt has been accumulated in the global reserve currency outside of the country that issues that currency. The Eurodollar system is thus a key source of liquidity for global borrowers. It is also necessary to ensure that these borrowers can access U.S. dollars when the time comes to repay their USD-denominated obligations. The U.S. trade deficit is effectively the source of the growth of the monetary base in the Eurodollar system, and the stock of dollar-denominated debt issued by non-U.S. entities is the world's broad money supply. With the money multiplier in the offshore USD markets having fallen in response to the regulatory tightening that followed the Great Financial Crisis, broad USD money supply in the Eurodollar system will be hyper sensitive to any decline in the U.S. current account deficit. Less global imbalances would therefore result in a further increase in USD funding costs in the international system, and potentially into a stronger U.S. dollar as well, making this dollar debt very expensive to repay. This raises the likelihood of a massive short-squeeze in favour of the U.S. dollar, challenging the current downward trajectory in the U.S. dollar, at least in the short term. Another consequence of a higher cost of sourcing U.S. dollars in the Eurodollar market tends to be rising FX volatility (Chart II-19). An increase in FX volatility should represent a potent headwinds for carry trades. This, in turn, will hurt liquidity conditions in EM economies. Hence, EM growth may be another casualty of problems in the Eurodollar system. Chart II-19Eurodollar Stress Produces FX Volatility Eurodollar Stress Produces FX Volatility Eurodollar Stress Produces FX Volatility Thus, the risks associated with U.S. protectionism go well beyond the risks to global trade. If severe enough, protectionism can threaten the plumbing system of the global economy. Bottom Line: The global economy has been supplied with dollar-based liquidity through the Eurodollar market. At the base of this edifice stands the U.S. trade-deficit, which was then magnified by the issuance of U.S. dollar-denominated debt by non-U.S. entities. This system is becoming increasingly tenuous as Basel III regulations have increased the cost of capital for global money-center banks, resulting in a downward force on the money multiplier in the offshore dollar funding system. In this environment, the risk to the system created by protectionism rises. If Trump and his administration can indeed scale back the size of the U.S. trade deficit, not only will the growth of the U.S. dollar monetary base be broken, but since the monetary multiplier of the Eurodollar system is also impaired, the capacity of the system to provide the dollars needed to fund all the liabilities it has created will decline. This could result in a serious rise in dollar funding costs as well as a tightening of global liquidity that will hurt global growth and result in a dollar short squeeze. This implied precarious situation raises one obvious question: Could we see the emergence of another reserve asset to complement the dollar, alleviating global liquidity risk? If Something Cannot Go On Forever, It Will Stop A global shortage of dollars is not imminent but could result from the forces described above. Even so, it is unlikely that the U.S. dollar faces any sudden end to its role as the leading global reserve currency. However, the world is unlikely to abide by a system that limits its growth potential either. The demise of the Bretton Woods system is important to keep in mind. The Bretton Woods system tied the supply of global liquidity to the supply of U.S. dollars. Initially this was not a problem as the U.S. ran a trade surplus. But it became a significant issue when the rest of the world began to question the U.S. commitment to honouring the $35/oz price commitment amidst domestic profligacy and money printing. Ultimately, the system broke down for this very reason. The strength of the global economy, along with the size of the U.S. current account deficit, was creating too many offshore dollars. Either the global money supply had to shrink, or gold had to be revalued against the dollar. The unpegging of the dollar from gold effectively resulted in the latter. However, the 1971 Smithsonian Agreement that replaced the gold standard with a dollar standard retained the dollar's hegemony. There was simply no alternative at the time. Today, it is unlikely that the global economy will stand idle in the face of a potentially sharp tightening of global liquidity conditions. We posit that this rising dollar funding costs will be the most important factor to decrease the importance of the dollar in the global financial system. Since the demand for the USD as a reserve currency is linked to its use as a liability by banks and financial systems outside of the U.S., if the USD gets downgraded as a source of financing by global banks, the demand for the greenback in global reserves will decline.15 As the share of dollars in foreign reserve coffers decreases, the dollar will likely depreciate over time as it will stop benefiting from the return-inelastic demand from reserve managers. Profit-motivated private investors will demand higher expected returns on dollar assets in order to finance the U.S. current account deficit. Despite this important negative, the dollar will still be the most important reserve asset in the world for many decades. After all, the decline of the pound as the global reserve asset in the interwar period was a gradual affair. Nonetheless, the share of reserves concentrated in USD assets as well as the share of international liabilities issued in USD will decrease, potentially a lot quicker than is thought possible. Chart II-20Reserve Currency Status ##br##Can Diminish Quickly May 2018 May 2018 For example, Eichengreen has shown that the pound sterling's share of non-gold global currency reserves fell from 63% in 1899 to 48% in 1913, just 14 years later (Chart II-20). It is instructive that this pre-World War I era coincides with today's multipolar geopolitical context. It similarly featured the decline of a status quo power (the U.K.) and the emergence of a rising challenger (the German Empire). What are the alternatives to the dollar? Obviously, the euro will have a role in this play. The euro today only represents 20% of global reserve assets, and considering the size of the Euro Area economy as well as the depth of its capital markets, the euro's place in global reserves has room to increase. In fact, the share of euros in global reserves is 15% smaller than that of the combined continental European national currencies in 1990 (see Chart II-4 on page 25). The CNY can also expect to see its share of international reserves increase. While China does not have the same capital-market depth as the Euro Area, it is gaining wider currency. The One Belt One Road project is causing many international projects to be financed in CNY and China's economic and military heft is still growing fairly rapidly. Nevertheless, China's closed capital account continues to weigh against the CNY's position. As Chart II-21 illustrates, there is a relationship between a country's share of international global payments and inward foreign investment. Essentially, investors want to know that they can do something (buy and sell goods and services) with the currency that they use to settle their payments. In particular, they want to know that they can use the currency in the economy that issues it. As long as it keeps its capital account closed, China will fail to transform the CNY into a reserve currency. Chart II-21A Reserve Currency With A Closed Capital Account? Forget About It! May 2018 May 2018 This means that for at least the next five years, the renminbi's internationalization will be limited. If U.S. protectionism is severe enough, China's economic transition is less likely to be orderly and capital account liberalization could be delayed further. In terms of investment implications, this suggests that for the coming decade, the euro is likely to benefit from a structural tailwind as global reserve managers increase their share of euro reserves. The key metric that investors should follow to gauge whether or not the euro is becoming a more important source of global liquidity is not just the share of euros in global reserves, but also the amount of foreign-currency debt issued in euros by non-euro area entities in the international markets. In all likelihood, before the world transitions toward a unit of account other than the USD, tensions will grow severe, as they did in the late 1960s. It is hard to know when these tensions will become evident. This past winter, the USD basis-swap spread began to widen along with the Libor-OIS spread, but while the Libor-OIS spread remains wide, basis-swap spreads have normalized. Nonetheless, by the end of this cycle, we would expect a liquidity event to cause stress in global carry trades and EM assets. It is important that investors keep a close eye on basis-swap and Libor-OIS spreads to gauge this risk (Chart II-22). Chart II-22Are We Nearing A Global Liquidity Event? Are We Nearing A Global Liquidity Event? Are We Nearing A Global Liquidity Event? Additionally, the more protectionist the U.S. becomes, the larger the diversification away from the dollar by both global reserve managers and international bond issuers could become. This is because of two reasons: First, if the U.S. actually manages to pare down its trade deficit, this will accentuate the decline in the supply of base money in the international system. Second, rising trade protectionism out of the White House gives the world the impression that economic mismanagement is taking hold of the U.S., raising the spectre of stagflation. Finally, the next global reserve asset does not have to be a currency. After all, for millennia, that role was fulfilled by commodities such as gold, silver, or copper. Thus, another asset may emerge to fill this gap. At this point in time it is not clear which asset this may be. Bottom Line: A severe liquidity-tightening caused by a scarcity of U.S. dollars would create market tumult around the world. We worry that such a risk is growing. However, it is hard to envision the global economy falling to its knees. Instead, the global system will likely do what it has done many times before: evolve. This evolution will most likely result in new tools being used to increase the global monetary base. At the current juncture, our best bet is that it will be the euro, which will hurt the USD's exchange rate at the margin on a secular basis. This brings up the very important question of whether the euro is politically viable. We have turned to this question many times over the past seven years. Our high conviction view is still that the euro will survive over the foreseeable time horizon.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist Mathieu Savary, Vice President Foreign Exchange Strategy Mehul Daya Consulting Editor Neels Heyneke Consulting Editor 1 And an erstwhile member of BCA's Research Advisory Board. 2 Please see Eichengreen, Barry et al, "Mars or Mercury? The Geopolitics of International Currency Choice," dated December 2017, available at nber.org. 3 Please see Tovar, Camillo and Tania Mohd Nor, 2018 "Reserve Currency Blocks: A Changing International Monetary System?," IMF Working Paper WP/18/20, Washington D.C. 4 The authors are essentially examining the extent to which national currencies are anchored to a particular reserve currency. 5 Please see David Shapiro, The Hidden Hand Of American Hegemony: Petrodollar Recycling And International Markets, New York: Columbia University Press. Also, Andrea Wong, "The Untold Story Behind Saudi Arabia's 41-Year Secret Debt," The Independent, dated June 1, 2016, available at independent.co.uk. 6 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "The Trump Doctrine," February 1, 2017, available at gps.bcaresearch.com. 9 Entente cordiale being particularly shocking at the time it was formalized in 1904. Other examples of ideologically heterodox alliances include the USSR's alliance first with Nazi Germany and then with Democratic America during World War II; the notorious alliance of Catholic France with Muslim Turks against its Christian neighbors throughout the seventeenth and eighteenth centuries; or Greek alliances with the Carthaginians against Rome in the third century BC. 10 Another exception to this rule was the Yuan Dynasty, established by Mongol ruler Kublai Khan, which issued fiat money made from mulberry bark. In fact, the mulberry trees in the courtyard at the Bank of England serve as a reminder of the origins of fiat money. 11 Eurodollar system simply refers to U.S. dollars that are outside the U.S. 12 Firstly, the absence of Regulation Q in offshore markets meant that regulatory arbitrage was possible, i.e. there was no ceiling imposed on interest rates on deposits at non-U.S. banks. Then, in the late 1990s, the Eurodollar system had another jump start with the amendment to Regulation D, which meant that non-U.S. banks were exempted from reserve requirements. 13 European banks specifically, but also U.S. banks with European branches, were aggressive buyers/funders of exotic derivatives products, such as CDO, MBS, SIVS. Most of these activities were off-balance sheet and took place in the Eurodollar system because a number of regulatory arbitrages existed. This is one of the main reasons that the Federal Reserve's bailout programs were largely focused towards foreign banks. The Fed's swap lines were heavily used by foreign central banks in order to clean up the operations of their own financial institutions. 14 Please see BCA Global Investment Strategy Special Report, "Why Has Global Trade Slowed?," dated January 29, 2016, available at gis.bcaresearch.com 15 Shah, Nihar, "Foreign Dollar Reserves and Financial Stability," December 2015, Harvard University. 16 Please see BCA Geopolitical Strategy Special Report, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011; "No Apocalypse Now?," dated October 31, 2011; "The Draghi 'Bait And Switch," dated January 9, 2013; "Europe: The Euro And (Geo)politics," dated February 11, 2015; "Greece After The Euro: A Land Of Milk And Honey?," dated January 20, 2016; "After BREXIT, N-EXIT?," dated July 13, 2016; "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017. III. Indicators And Reference Charts A key divergence has emerged between the U.S. corporate earnings data and our equity-related indicators. The divergence supports our tactical cautiousness on risk assets. Forward earnings have soared on the back of the U.S. tax cuts and upgrades to the growth outlook. Earnings are beating expectations by a wide margin so far in the Q1 earnings season, which is reflected in very elevated levels for the net revisions ratio and net earnings surprises. However, the S&P 500 has failed to gain any altitude on the back of the positive earnings news, in part because bond yields have jumped. Our Monetary Indicator moved further into bearish territory, and our Equity Technical indicator is below its 9-month moving average and is threatening to break below the zero line (which would be another negative signal). Valuation has improved marginally, but is still stretched, according to our Composite Valuation Indicator. Our Speculation Indicator does not suggest that market frothiness has waned at all, although sentiment has fallen back to neutral level. It is also worrying that our U.S. Willingness-to-Pay indicator took a sharp turn for the worse in April. 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. U.S. flows have clearly turned negative for equities, although flows into European and Japanese markets are holding up for now. Finally, our Revealed Preference Indicator (RPI) for stocks flashed a 'sell' signal in April. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. These indicators are not aligned at the moment, further supporting the view that caution is warranted. As for bonds, oversold conditions have emerged but valuation has not yet reached one standard deviation, the threshold for undervaluation. This suggests that there is more upside potential for Treasury yields. The U.S. dollar broke out of its recent tight trading range to the upside in April, although this has only resulted in an unwinding of oversold conditions according to our Composite Technical Indicator. The dollar is expensive on a PPP basis, but we still expect the dollar to rally near term. 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 The Philippines is seeing a genuine inflation outbreak. The Duterte administration's policies favor "growth at all costs." "Charter change," or constitutional revision, will stoke political polarization, erode governance, and feed inflation. We are neutral on Philippine stocks and bonds within EM benchmarks for now but are placing the country on downgrade watch. Feature Chart 1Markets Sold On Duterte Election Markets Sold On Duterte Election Markets Sold On Duterte Election It has been nearly two years since Rodrigo "Roddy" Duterte - the Philippines' populist and anti-establishment president - was elected. On May 11, 2016, two days after the vote, BCA's Geopolitical Strategy and Emerging Markets Strategy published a joint report arguing that Duterte would "take the shine off" the economic structural reforms that had taken place under the outgoing administration of President Benigno Aquino.1 We downgraded the bourse from overweight to neutral within the EM universe. Financial markets have largely vindicated this view. Philippine stocks peaked against EM stocks three days before Duterte's inauguration and have continued to underperform since then. The Philippine peso has also suffered, both in real effective terms and relative to the weakening U.S. dollar (Chart 1). Is it time to buy then? No. Duterte's policies will continue to erode the country's governance and macro fundamentals, overheating the economy and subtracting from investment returns. Of course, the country is well insulated from any China or commodity shock, and this is an important advantage over other EMs in the medium term. Also, equity and currency valuations have improved relative to other EMs. Hence we recommend clients remain neutral Philippine stocks, currency, and credit versus the EM benchmark for now, and use any meaningful outperformance to downgrade the country to underweight within aggregate EM portfolios. An Inflation Outbreak One of the most reliable definitions of a populist leader is one who pursues nominal, as opposed to real, GDP growth. While policymakers can stimulate nominal growth through various policies, real growth over the long run depends on productivity and labor force growth, which are much harder to control. The only way policymakers can affect real growth is by undertaking structural reforms - which are often painful and unpopular in the short run. By contrast, faster nominal growth as a result of higher inflation can create the "money illusion" among the populace and bring political rewards, at least for a time.2 Higher nominal growth might initially please the public, but when inflation escalates it will reduce living standards. Moreover, an inflation outbreak will eventually necessitate major policy tightening and a growth downturn to reverse inflation. A comparison of a range of populist political leaders with orthodox (non-populist) leaders across Latin America, Central Europe, and Central Asia demonstrates that populists really do tend to achieve higher nominal growth relative to non-populists in the first two years of their rule (Chart 2). This finding has served BCA's Geopolitical Strategy well in predicting that U.S. President Donald Trump would blow out the federal budget through tax cuts and government spending in pursuit of faster growth.3 With stimulus taking effect while the output gap is closed, inflationary pressures are likely to rise higher than they otherwise would have done over the next 12-to-24 months.4 Chart 2Populists Pursue Nominal GDP Growth The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion President Duterte of the Philippines also appears to fit this rubric. Like Donald Trump, he combines foul-mouthed eccentricity and personal risk-taking with a policy agenda of tax cuts, fiscal spending, and deregulation (Table 1).5 Yet unlike Trump, his infrastructure program - which is desperately needed in the Philippines, a laggard in this respect - is up and running, producing a large increase in capital expenditures and imports. The gap between nominal and real GDP growth - i.e. the inflation rate - looks likely to rise further. Table 1Duterte's Agenda Consists Of Drug War, Tax Cuts, And Big Spending The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Signs of an inflation outbreak are already evident. Chart 3 shows that both core and headline inflation measures are now rising sharply and have crossed the Bangko Sentral ng Pilipinas's (BSP) 3% inflation target by a wide margin, even rising above the 2%-4% target band. Further, local currency yields are rapidly ascending while the currency has been plunging against the weak U.S. dollar. These indicators suggest that the inflation outbreak that BCA's Emerging Markets Strategy warned investors about in October has now come to pass.6 The official explanation for the inflation spike this year is Duterte's tax reform bill, which took effect January 1 (and is the first of several such bills). The bill cuts taxes for households and raises excise taxes on a range of goods - from electricity, petroleum products, coal, and mining to sugary drinks and tobacco.7 The central bank has cited this law and its ramifications (including transportation costs and wage demands) as reasons for the inflation overshoot to be temporary. Yet Duterte's growth agenda and the BSP's simulative policies have created an environment ripe for inflationary pressures to build, namely by encouraging banks to expand their balance sheets and money supply (Chart 4). This has led to excessive strength in domestic demand. Chart 3An Inflation Outbreak An Inflation Outbreak An Inflation Outbreak Chart 4Stimulative Policies Stimulative Policies Stimulative Policies Further signs of a genuine inflation outbreak include: Twin deficits: both the current account and fiscal balances are negative in the Philippines, a significant development over the past two years (Chart 5). Further, the trade balance now stands at a nearly two-decade low of 9.5% of GDP (Chart 6). Worryingly, the current account has fallen into deficit despite the fact that remittances from Filipinos living abroad, which account for 9% of GDP, have been robust (Chart 6, bottom panel). Oil prices are surprising to the upside as global inventories drain and the geopolitical risk premium rises. This puts additional pressure on the current account balance and adds to inflationary pressures. Chart 5The Philippines Now Has Twin Deficits The Philippines Now Has Twin Deficits The Philippines Now Has Twin Deficits Chart 6Trade Deficit Worsens; Remittances The Saving Grace Trade Deficit Worsens Despite Remittances Trade Deficit Worsens Despite Remittances The Philippines' import bill is growing briskly, especially that of consumer goods (Chart 7, top panel). Meanwhile, overall export volumes and revenues of non-electronic/manufacturing exports are contracting (Chart 7, second panel). This is a sign that the Philippine economy is losing competiveness. Indeed, the third panel of Chart 7 shows that the country's global export market share is deteriorating. Wages are rising across many sectors (Chart 8). The imposition of excise taxes on electricity and fuel has prompted a wave of demands for higher wages from labor groups and provincial wage boards. Duterte is also said to be preparing a nationwide minimum wage law (to increase regional wages vis-à-vis the capital Manila) and an end to temporary employment contracts, which cover about 25% of the nation's workers and pay wages that are 33% lower on average. As wage growth outpaces productivity gains, unit labor costs are rising, eating into listed non-financial companies' profit margins (Chart 9). Chart 7Domestic Demand Surges While Competitiveness Falls Domestic Demand Surges While Competitiveness Falls Domestic Demand Surges While Competitiveness Falls Chart 8Wage Growth Is Strong Wage Growth Is Strong Wage Growth Is Strong On the fiscal front, the Duterte administration is pushing badly needed spending increases in infrastructure, health, and education. The investments amount to $42 billion over six years, or roughly 2% of GDP per year in new fiscal spending.8 While these investments will be beneficial in the long run as they augment both the hard and soft infrastructure of the nation, their size and timing needs to be modulated in real time to prevent them from creating excessive inflationary pressures in the short and medium run. This is difficult and the administration is likely to err on the side of higher spending that feeds inflation. Further, the administration's tax reform plan is unlikely to raise enough revenue to cover all the new spending. The first tax reform bill to pass through Congress cuts household tax rates for most brackets (with rates to fall further in 2023) and raises the threshold to qualify for income tax, thereby narrowing the tax base to 17% of the population. The value added tax (VAT) will also have its threshold increased. Corporate taxes will be cut next. Revenue shortfalls will add to the budget deficit. Loosening fiscal policy will foster higher inflation and will continue weighing on the currency. Despite the upside inflation surprise, the central bank has kept the policy rate at the record low level of 3% where it has been since 2014. It also cut reserve requirements in March, injecting liquidity into the system. Deputy Governor Diwa Guinigundo says that an inflation reading within the target band at the May 10 monetary policy meeting will increase the likelihood that no rate hikes will occur this year.9 The central bank explicitly views this year's high inflation as a passing phenomenon tied to the excise taxes. It may also have stayed its hand due to signs of waning momentum in certain segments of the economy such as autos and property construction, which are weakening (Chart 10). Chart 9Higher Labor Costs Eat Firm Margins Higher Labor Costs Eat Firm Margins Higher Labor Costs Eat Firm Margins Chart 10Central Bank Not Worried About Overheating Economy Is Not Invincible Economy Is Not Invincible But in light of the fiscal and credit trends outlined above, and given that the Philippine economy is domestically driven and insulated from the slowdown in global growth, we do not expect domestic growth to fall very far. Overall, the central bank has maintained accommodative monetary policy for too long and tolerated an inflation outbreak. At this stage, central bank independence thus becomes a critical question. The current governor, Nestor Espenilla, is a tough enforcer against financial crimes who may be willing to do what it takes to rein in inflation: his comments have been a mixture of hawkish and dovish. But he is also a Duterte appointee, and thus perhaps unwilling to counter a popular, and forceful, president. It is too soon to say that the BSP will fail in its duties, but it does have a reputation for dovishness that it has reinforced this year.10 This analysis points to a policy of "growth at all costs." Odds are that growth will remain fast, that the inflation outbreak will continue, and that the BSP has fallen behind the curve. Bottom Line: The Philippines is witnessing an inflation outbreak that is likely to continue. Credit growth is booming, fiscal policy is loose, and the central bank is behind the curve. This policy setup is negative for the currency and for stock prices and local bonds in the absolute. Cha-Cha: What Does It Mean? In the long run, Duterte's authoritarian leanings will weigh on the country's performance. Governance has declined since he took office, primarily because of his rampant war against drugs. The Drug War has officially led to the deaths of 6,542 people since July 1, 2016, according to the Philippine Drug Enforcement Agency.11 Human rights groups believe the actual tally is twice as high. Yet even if we exclude "political stability and absence of violence" from the Philippines' governance indicators, the country's score has declined under Duterte and is worse than that of its neighbors (Chart 11). And this score does not yet account for the fact that Duterte has imposed martial law on the southern island of Mindanao and is using his popularity (56% net approval, Chart 12) and supermajority in Congress (89% of seats in the House and 74% in the Senate) to push a constitutional rewrite that would give him even more extensive powers.12 Chart 11Even Excluding The Drug War, Philippine Governance Is Bad And Getting Worse The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Chart 12Duterte Is Popular (But Not That Popular) The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Like previous administrations, the Duterte administration wants to revise the 1987 Philippine constitution. There are three current proposals, each of which would change the government from a "unitary" to a "federal" system.13 Manila would remain the capital but the provinces would be incorporated into states or regions that would have their own governments and greater autonomy. The proposals differ in detail, but if and when congressmen and senators reconstitute themselves into a Constituent Assembly to rewrite the charter, they will have complete freedom, i.e. will not be limited to the specifics of these proposals. A popular referendum will be necessary to approve the results and could occur as early as May 13, 2019, when Senate elections will be held, or the summer afterwards.14 "Charter change" or Cha-cha is a perennial preoccupation in the country with three main drivers (Table 2). First, successive Philippine presidents try to revise the constitution so that they can stay in power longer than the single, six-year term limit. Second, provincial political forces seek to change the constitution to decentralize power. Third, economic reformers and business interests seek to remove protectionist articles embedded in the constitution, particularly limitations on private and foreign investment. Table 2History Of Cha-Cha In The Philippines The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion In general, Manila is seen as a distant and unresponsive capital ruling over an extremely diverse and disparate archipelago. The centralized system is prone to corruption due to the pyramid-like patronage structure descending from a handful of elite, Manila-based, families at the top. Meanwhile the provinces lack autonomy and economic development. While the capital region only contains 13% of the population, it accounts for 38% of GDP. The central government has trouble raising resources - as indicated by a low tax revenue share of GDP compared to neighbors (Chart 13). It is at times incapable of providing essential services like security and infrastructure, particularly in far-flung provinces like Mindanao or parts of the Visayas where poverty, under-development, natural disasters, and militancy reign. The chief goal of those who want a federal system is to decentralize power in order to strengthen the provinces. They argue that reversing the role of central and regional fiscal powers will improve government effectiveness overall by bringing the government closer to the people it governs. Today, the central government controls about 93.7% of the revenues and 82.7% of the spending while local governments control about 6.3% and 17.3% respectively (Chart 14). Chart 13The Philippine Government Is Underfunded And Weak The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Chart 14The Philippine Government Is Heavily Centralized The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Under a federal system these roles would reverse. Local governments would gain greater powers to tax and spend within their jurisdictions, while also improving tax collection. This would enable them to improve public services while still providing the federal government with resources to pursue national goals. Better funded and more autonomous local governments would presumably be more responsive to public demands within their jurisdictions. This is especially the case given the country's population and geography, with 101 million people spread out over more than 7,000 islands. The result - say the proponents - would be better governance all around, including greater economic development across the regions. From this point of view, over the long run, Cha-cha appears to be a pro-market outcome. In particular, the proposed changes will probably include greater openness to foreign direct investment (FDI), easing restrictions on land ownership, utilization, and resource exploitation that have long been difficult to remove because of their constitutional status (a vestige of anti-colonial sentiment). The Philippines falls markedly behind its peers in attracting FDI (Chart 15). This change would likely have a positive impact on FDI and productivity, as the Philippines has long suffered from its closed, protectionist, and heavily regulated model.15 Chart 15The Problem With Constitutional Restrictions On Foreign Investment The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion However, Cha-cha's opponents argue that the net effect will be negative for the business community and financial markets because of the drastic shift in the status quo. They argue that the 1987 constitution provides ample authority for decentralization but that Congress has refused to pass implementing legislation due to vested interests. As opposed to reforming the Local Government Code and other laws on the books, a total change of the government system would be controversial, expensive, and prone to expanding bureaucracy (as it would replicate the current national government institutions for each state/region in the new federal system). It would also be self-interested. Cha-cha would give Duterte additional powers to oversee the chaotic transition, and likely give him new powers in the aftermath as a result of the provisions themselves.16 Weighing both sides, we expect that charter change will require a massive political struggle and a long transition period in which economic uncertainty will spike. It will also give Duterte more arbitrary power and weaken central institutions and legal frameworks designed to keep him in check. While he insists that he will step down in 2022 according to existing term limits, Cha-cha could remove the constitutional limit on his time in office or allow him to resume as prime minister indefinitely. He would also have extensive powers of appointment and dismissal affecting the judiciary and other checks and balances. Is creeping authoritarianism market-negative? Not necessarily. Authoritarian governments in some cases have greater ability to make difficult, unpopular decisions that benefit national interests in the long run - including on macroeconomic policy. Singapore, Taiwan, and China are famous regional examples. Nevertheless, the Philippines is not Singapore or China - it is not a weak or non-existent democracy with a strong central government, but rather a strong democracy with a weak central government. It will not be easy for Duterte to seize ever-greater control if he should attempt to. He will eventually meet resistance from "people power" - mass protests from civil society such as those that overthrew dictator Ferdinand Marcos in 1986 and President Joseph Estrada in 2001. Such a movement may not develop in the short run, given his popularity, but the distance from here to there will involve political instability and a deterioration of monetary and fiscal management. To illustrate this process, consider the Philippines' record in the "Polity IV" dataset, which is a political science tool that provides a standardized measure of the quality of democracy in different regimes across the world.17 A time series of the Philippines' Polity scores illustrates the drastic collapse of governance under Marcos (Chart 16), who imposed martial law from 1972-81 and plunged the country into a morass of oppression, dysfunction, and corruption. This ended with the first People Power Revolution in 1986 and the promulgation of the 1987 constitution. Since then, Polity scores have improved markedly. Today the Philippines scores an eight, within the range of western democracies. The democratic era has been a boon for investors who have seen the Philippines improve its macroeconomic and business environment over this period. But Duterte is a Marcos-like figure who could reverse this process even if he does not drag the country all the way down into the worst conditions of the 1970s-80s. Could Duterte succeed in charter change where his post-Marcos predecessors have failed? Yes. He has a lot of political capital and is well situated to push for dramatic change. He is an anti-establishment political outsider - the first Philippine president from the deep south - elected amidst a wave of disenchantment over persistent, endemic problems like poverty, corruption, lawlessness, and lack of development. He has high public approval ratings and a supermajority in Congress (Chart 17). It is too early in the game to give firm probabilities on whether the constitutional changes will pass the necessary popular referendum in spring or summer 2019, but it is perfectly possible for Duterte to succeed judging by his standing today. Chart 16The Marcos Dictatorship Was Inflationary The Marcos Dictatorship Was Inflationary The Marcos Dictatorship Was Inflationary Chart 17Duterte's Legislative Supermajority The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion What will be the economic effects? Aside from policy uncertainty, decentralization will be good for growth and inflation. Local leaders will have more tax money to spend and less central discipline. Pent-up demand for development in the provinces will be unleashed, with local political leaders likely to encourage credit expansion. In the context outlined above this change means higher inflation. Inflation rates in the provinces should start to climb toward those of the capital region, while those of the capital region would have no reason to fall amid the flurry of new activity. Hence investors interested in the Philippines must monitor the long and rocky road of charter change. They should look to see if the Congress and Senate do indeed merge into a Constituent Assembly (the quickest yet most controversial way of revising the constitution because it is the least constrained); what proposals look to be codified in the drafting of the constitution and assembly debates; if Duterte retains his popularity throughout the constitutional process; and whether the public is supportive of the proposals.18 Our rule of thumb is that a constitutional process focused on decentralization and removal of protectionist provisions would be market-positive in principle. However, if authoritarian provisions creep into the final text, they may reveal the market-negative priorities and a lack of constraints on policymakers in Manila. Bottom Line: Philippine governance will continue to decay under the Duterte administration. Revisions to the constitution will have pro-market aspects, and net FDI will probably continue to rise. But these positive aspects will be overweighed by the politically polarizing and destabilizing process of charter change itself. Moreover, decentralization will feed into the current credit boom and inflationary backdrop and could produce excesses. The U.S.-China Crossfire The Philippines is a strategically located island chain that frames the South China Sea (Diagram 1). It has been caught in great power struggles for centuries. The rising U.S. colonial power displaced the remnants of the established Spanish colonial power there in 1898; the rising Japanese empire displaced the established U.S. in 1941, only to be defeated by the U.S. and its allies in 1944. Diagram 1The South China Sea: Still A Risk The Philippines: Duterte's Money Illusion The Philippines: Duterte's Money Illusion Now China is the rising power in Asia and is applying pressure on America's visiting forces. The Philippines is again caught in the middle. It relies on the U.S. more than China economically and strategically, but China is rapidly catching up, as is clear in trade data (Chart 18). And China's newfound naval assertiveness must be taken seriously. Indeed, Duterte claims that Chinese President Xi Jinping threatened him with war if his country crossed China's red line in the South China Sea.19 Chart 18China Rivals U.S. In The Philippines China Rivals U.S. In The Philippines China Rivals U.S. In The Philippines Geopolitical risk has fallen since Duterte's election as a result of his pledge to improve relations with China and distance his country from the United States. This was a sharp reversal of Philippine policy. From 2010-16, the Aquino administration engaged in aggressive strategic balancing against China. The country was threatened by China's militarization of the Spratly Islands in the South China Sea and encroachment into Philippine maritime space and territory. The pro-American direction of Aquino's policy culminated in the signing of the Enhanced Defense Cooperation Agreement (EDCA), which granted the American military the right, for ten years, to rotate back into Philippine bases. In July 2016, the Permanent Court of Arbitration ruled in favor of the Philippines, against China, in a landmark case of international law. It held that the South China Sea "islands" were not islands at all and that China could not base territorial or maritime claims off them.20 This strategic balancing brought tensions with China to a near boiling point. However, the pot was taken off the fire when the Philippine public elected the outspokenly anti-American, pro-Chinese, and communist-sympathizing Duterte. Duterte immediately set about courting Chinese investment, calling for bilateral China-Philippine solutions in the South China Sea (such as joint energy development), and denouncing President Barack Obama, the West, and various international legal bodies.21 As a result, China has largely dropped its pressure tactics against the Philippines. It has been investing more in the country over time (Chart 19) and has recently proposed a range of new projects worth a headline value of $26 billion. In the short run, Duterte's policy is positive because it enables the country to extract economic and security benefits from both the U.S. and China. China has reduced its coercive tactics, while the U.S. under President Trump has taken an easy-going attitude both toward Duterte's human rights violations and his pro-China (and pro-Russia) leanings. Duterte, for his part, has not tried to nullify the 2014 military pact with the U.S., but rather reversed his claim that he would sever ties with the U.S. by asking for American counter-insurgency support during the 2017 Siege of Marawi. Eventually, however, the emerging U.S.-China "Cold War" could force Duterte to make unpopular choices that violate economic relations with China or security protections from the U.S. The Philippine public is largely pro-American and suspicious of China.22 Thus, if Duterte pushes his foreign policy too far, he will provoke a backlash. This could take the form of a revolt against Chinese investments in the economy - as Chinese companies will be eager to take advantage of greater FDI access, especially under constitutional reform. Or it could take the form of a revolt against Chinese encroachments in the South China Sea, which are bound to recur.23 Alternatively, if the Philippines takes China's side, the U.S. could threaten to cut off market access, remittances, or (less likely) military support. A rupture in U.S. or China relations could spark or feed into domestic opposition to Duterte over political or constitutional issues or trigger a tense U.S.-China diplomatic standoff with economic ramifications. This is something to monitor in case a conflict emerges such as that which occurred in 2012-14 at the height of Philippine-China tensions, or in South Korea in 2015-16. In both cases, China imposed discrete economic sanctions against American allies as a result of foreign policy moves they took in stride with the United States (Chart 20). Chart 19Chinese Investment Will Rise Under Duterte Chinese Investment Is Growing Over Time Chinese Investment Is Growing Over Time Chart 20China Imposes Sanctions In Geopolitical Spats China Imposes Sanctions In Geopolitical Spats China Imposes Sanctions In Geopolitical Spats Bottom Line: Geopolitical risks have abated over the past two years and should remain contained for the next few years, as China wishes to reward Duterte and his foreign policy. However, relations between the U.S. and China are getting worse, which puts the Philippines in the middle of the crossfire. The South China Sea remains a fundamental, not superficial, source of tension. Investment Conclusions Chart 21Stocks And Bonds Will Underperform 21. Stocks And Bonds Will Underperform 21. Stocks And Bonds Will Underperform This scenario is negative for financial markets and will cause stocks to fall and local bonds yields to rise in absolute terms (Chart 21). Philippine equities remain very expensive. At this point only policy tightening by the BSP can control inflation, but that, even if it were to occur (unlikely in our opinion), will be negative for growth and financial markets in the short-to-medium term. Relative to other EMs, Philippine financial markets have underperformed considerably for the past few years, and thus might experience a relative rebound. If so, it will not be due to Philippine fundamentals but to the fact that in other EMs, fundamentals are deteriorating and financial markets selling off. These markets have had a good run in the past two years and are vulnerable to the downside. In this context, it matters that the Philippines is not a major commodity exporter and not highly vulnerable to a Chinese growth slowdown. Oversold conditions relative to EM peers and lower commodity prices could allow the Philippine bourse and currency to outperform those peers for a time. We thus maintain neutral allocation on Philippine stocks and bonds within EM benchmarks for now but are placing it on downgrade watch. On the political side, President Duterte is making investments in the country that will improve the supply side, but his policies will feed inflation in the short term and erode governance in the long term. His push to reshape the political and governmental system will increase political risk at a rare moment when geopolitical risks have somewhat abated. The latter are significant, but latent, and could flare up significantly in the long run due to U.S.-China conflicts. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Ayman Kawtharani, Associate Editor Emerging Markets Strategy ayman@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 2The "money illusion" is a concept in macroeconomics coined by economist Irving Fisher, who wrote a book of the same title in 1928, to describe the failure of economic actors to perceive fluctuations in the value of any unit of money. In other words, people tend to pay more attention to nominal than to real changes in money or prices. The concept is valid today, albeit subject to academic debate over its precise workings. 3 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, and Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Perched On An Icy Cliff," dated March 29, 2018, and "Two Tectonic Macro Shifts," dated January 31, 2018, available at ems.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 6 Please see "The Philippines: An Overheating Economy Requires Policy Tightening" in BCA Emerging Markets Strategy Weekly Report, "Is The Dollar Expensive, And Are EM Currencies Cheap?" dated October 11, 2017, available at ems.bcaresearch.com. 7 Please see Office of the Presidential Spokesperson, "A Guide To T.R.A.I.N. Tax Reform for Acceleration and Inclusion (Republic Act No. 10963," dated January 2018, available at www.pcoo.gov.ph, and Department of Finance, "The Tax Reform For Acceleration And Inclusion (TRAIN) Act," dated December 27, 2017, available at www.dof.gov.ph. 8 Please see the Philippine Department of Finance, "The Comprehensive Tax Reform Program: Package One: Tax Reform For Acceleration And Inclusion (TRAIN)," January 2018, available at www.dof.gov.ph. 9 At its March policy meeting the BSP decided to keep interest rates on hold despite a March inflation reading of 4.3%, above the top of the target range of 4%. For Guinigundo's comments about the May 10 meeting, please see "Philippines c. bank says monetary policy still data-driven, may hold rates," April 20, 2018, available at www.reuters.com. 10 The BSP has reportedly only surprised markets four times out of 84 scheduled monetary policy meetings over the past ten years. Please see Siegfrid Alegado, "Life Is Getting Harder For Philippine Central Bank Watchers," dated March 21, 2018, available at www.bloomberg.com. 11 Please see Rambo Talabong, "Duterte gov't tally: At least 4,000 suspects killed in drug war," dated April 5, 2018, available at www.rappler.com. 12 Duterte's personal popularity is overstated. He was elected in a landslide, but only received 39% of the popular vote. The Pulse Asia quarterly polls suggest his popularity and "trust" ratings have ranged from 78%-86% since his inauguration (currently 80%), but this falls to 60% if undecided voters and disapproving voters are netted out. The Social Weather Station polls, which we cite, show a 56% net approval rating, which is mostly in line with Duterte's predecessor President Aquino at this stage in his term. 13 There are currently three draft proposals. The first is Senate Resolution No. 10, filed by Senator Nene Pimentel; the second is House Resolution No. 08, filed by Representatives Aurelio Gonzales and Eugene Michael de Vera; the third is the ruling PDP Laban Party's proposal, from Jonathan E. Malaya at the party's Federalism Institute. 14 The funding to hold a referendum in 2018 does not exist nor are legislators ready. A "special budget" will coincide with the plebiscite, no doubt strictly to pay for the polling and not to grease the wheels of the "yes" vote! Please see Bea Cupin, "Charter Change timetable: Plebiscite in 2018 or May 2019, says Pimentel," I, February 2, 2018, available at www.rappler.com. 15 Please see Gary B. Olivar, "Update On Constitutional Reforms Towards Economic Liberalization And Federalism," American Chamber of Commerce Legislative Committee, dated September 27, 2017, available at www.investphilippines.info. 16 Please see Neri Javier Colmenares, "Legal Memorandum on Charter Change under the Duterte Administration: Resolution of Both Houses No. 8 Proposed Federal Constitution," December 4, 2017, available at www.cbcplaiko.org. 17 Please see the Center for Systemic Peace and Monty G. Marshall, Ted Robert Gurr, and Keith Jaggers, "Polity IV Project: Political Regime Characteristics and Transitions, 1800-2016," July 25, 2017, available at www.systemicpeace.org. 18 Local elections in May 2018 may also provide some indications of popular support, as well as the Senate elections in May 2019 (if the referendum is not simultaneous). 19 Please see Richard Javad Heydarian, "Did China threaten war against the Philippines?" Asia Times, dated May 23, 2017, available at www.atimes.com. 20 Please see BCA Geopolitical Strategy Special Report, "South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 21 He has since said the Philippines will leave the International Criminal Court, which it joined in 2014, and arrest any prosecutor of the court who comes to the Philippines to investigate the government and police handling of the drug war. Please see Rosalie O. Abatayo, "Arresting ICC prosecutor could get Duterte in more legal trouble, says lawyer," The Philippine Daily Inquirer, April 22, 2018, available at globalnation.inquirer.net. 22 Please see Jacob Poushter and Caldwell Bishop, "People In The Philippines Still Favor U.S. Over China, But Gap Is Narrowing," Pew Research Center, September 21, 2017, available at www.pewglobal.org. 23 At present the Association of Southeast Asian Nations is negotiating a long-awaited, albeit non-binding, "code of conduct" with China in the South China Sea that could be concluded as early as this or next year. However, South China Sea tensions could heat up again at any point due to Chinese encroachments, U.S. pushback, or other regional actions. Also, with oil prices set to increase rapidly, non-U.S./OPEC/Russia international offshore oil rigs could begin to increase again, renewing an additional source of tension in the sea.

Highlights Corporate Bonds & The Yield Curve: Corporate bond excess returns fall sharply once the yield curve flattens to below 50 basis points, though they typically remain positive until the yield curve inverts. Interestingly, excess returns for equities relative to Treasuries exhibit the opposite pattern. Corporate Bonds & Leverage: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year, meaning that leverage is likely to rise. Rising leverage will be a signal to reduce exposure to corporate bonds. Bond Map: We perform a back-test to assess the effectiveness of the Bond Map framework for sector allocation that was introduced in last week's report. Feature It's been a while, but last week's bond market performance was reminiscent of an old fashioned risk-on phase. The 10-year Treasury yield reached its highest level since early 2014, causing a temporary halt in the yield curve's flattening trend. Spread product also responded to investor optimism, and returns from the investment grade corporate bond index now lag the duration-equivalent Treasury index by only 52 basis points year-to-date, up from a mid-March trough of -94 bps (Chart 1). High-Yield index returns also rebounded, and that index is now outpacing Treasuries by +150 bps so far this year. Chart 1Corporate Credit: Annual Excess Returns Corporate Credit: Annual Excess Returns Corporate Credit: Annual Excess Returns But for corporate bond investors, now is not the time for complacency. Out of the criteria we use to signal turns in the credit cycle, we are progressively checking more and more off our list.1 Spreads are already tight relative to history and corporate debt levels are already high. That much has been true for some time. Next up, we await a more restrictive monetary policy and a more severe slow-down in corporate profit growth to below the pace of corporate debt growth. Both of those conditions also need to be met before corporate defaults start to occur and spreads start to widen materially. In this week's report we consider each of those two conditions in turn, noting the triggers that will need to be hit for us to downgrade our current overweight allocation to corporate bonds. Condition 1: Restrictive Monetary Policy Chart 2Monetary Policy Not Yet Restrictive Monetary Policy Not Yet Restrictive Monetary Policy Not Yet Restrictive On the monetary policy front, we expect that monetary conditions will turn restrictive in the not-to-distant future (Chart 2). For the time being, long-maturity TIPS breakeven inflation rates are still below levels that are consistent with the Fed achieving its 2% inflation target. The 10-year TIPS breakeven inflation rate is currently 2.17% and the 5-year/5-year forward TIPS breakeven inflation rate is 2.24%. But once both of those rates reach a range between 2.3% and 2.5%, they will be consistent with well-anchored inflation expectations and the Fed will have one less reason to stay cautious. We will start paring exposure to corporate bonds once both the 10-year TIPS breakeven inflation rate and the 5-year/5-year forward TIPS breakeven inflation rate cross above the 2.3% threshold. The re-anchoring of inflation expectations will also impart further upside to nominal Treasury yields, and we therefore maintain our below-benchmark duration stance and continue to follow the road-map laid out in our February report detailing the two-stage Treasury bear market.2 Another traditional signal of restrictive monetary policy is a flat or inverted yield curve (Chart 2, panel 2). Intuitively, a very flat yield curve tells us that the market expects very few (if any) Fed rate hikes in the future. An inverted yield curve tells us that the market actually anticipates rate cuts. While the yield curve is not yet close to inverting, it is approaching levels that are consistent with much lower (and often negative) excess returns for both investment grade and high-yield corporate bonds, as is discussed below. A third indicator of the stance of monetary policy is simply the spread between the real federal funds rate and an estimate of its equilibrium level - the level consistent with neither an accommodative nor a restrictive policy stance (Chart 2, bottom panel). While the fact that the real fed funds rate is currently quite close to the popular Laubach-Williams estimate of its equilibrium level certainly reinforces our view that policy is almost restrictive, the large degree of uncertainty inherent in this sort of estimate leads us to prefer the market signals from the slope of the yield curve and TIPS breakeven inflation rates when forming an investment strategy. The Yield Curve And Corporate Bond Returns To assess the importance of the yield curve as a predictor of turns in the credit cycle, we split each cycle going back to the mid-1970s into regimes based on the yield curve slope. We then calculate excess returns during each phase for both investment grade and high-yield corporate bonds, as well as the stock-to-bond total return ratio. We use the 3/10 yield curve slope instead of the more often quoted 2/10 slope because it allows for the inclusion of more historical data. This decision did not materially impact the results of our analysis. Chart 3 shows how we divided each cycle into three phases: Chart 3Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Corporate Bond Performance And The Yield Curve Phase 1 runs from the end of the previous NBER-defined recession until the slope crosses below 50 bps. Phase 2 runs from the time that the slope crosses below 50 bps until it crosses below zero. Phase 3 runs from the time that the yield curve first inverts to the start of the next recession. Notice that we do not include recessionary periods in our analysis, usually the periods with the worst excess corporate bond returns. The results of our analysis are shown in Table 1, and the first obvious result is that corporate bond excess returns are much higher in Phase 1 than in Phase 2, although Phase 2 returns are usually still positive.3 Negative excess returns occur more often than not in Phase 3, after the yield curve has inverted. Table 1Risk Asset Performance In Different Yield Curve Regimes As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt The biggest exception to the above observations is that Phase 2 High-Yield returns actually exceeded Phase 1 High-Yield returns in the 2001-07 cycle. In our view, this exception results from the fact that corporate profit growth was well above corporate debt growth in 2005, and did not really decline until 2007, shortly after the yield curve inverted. In contrast, Phase 2 returns were exceptionally weak in the prolonged period between 1994 and 2000. In this instance, corporate profit growth actually fell below corporate debt growth in 1998, well before the yield curve inverted in 2000. This reinforces that both the stance of monetary policy and the trend in corporate leverage matter for corporate bond returns. The latter is discussed in the next section of this report. Another interesting result shown in Table 1 is that the pattern of stock market excess returns over Treasuries is the mirror image of the pattern in corporate bond excess returns. The stock market tends to perform better in Phase 2 than in Phase 1, and often even performs well in Phase 3 after the yield curve has inverted. This means that multi-asset investors should consider paring exposure to corporate bonds relative to Treasuries before they think of reducing exposure to the stock market. Bottom Line: Restrictive monetary policy is one condition that must be met before we reduce exposure to corporate bonds in our recommended portfolio. The first indication of this will likely be the re-anchoring of long-maturity TIPS breakeven inflation rates in a range between 2.3% and 2.5%. We will start paring exposure to corporate bonds when that occurs. The slope of the yield curve is already at levels that are consistent with very low excess returns. Though we demonstrate that an inverted yield curve is historically linked to even lower returns. Conviction that the yield curve is about to invert will be another trigger to further reduce corporate bond exposure in the future. Condition 2: Rising Leverage The second condition that will cause us to take even more credit risk off the table is when gross leverage for the nonfinancial corporate sector - calculated as total debt over pre-tax profits - enters an uptrend. Chart 4 shows that periods of spread widening almost always coincide with rising gross leverage, or put differently, periods when the rate of debt growth exceeds the rate of profit growth. Profit growth has kept pace with debt growth during the past few quarters, causing leverage to flatten-off and allowing corporate spreads to narrow. Going forward, the outlook for top-line corporate revenue growth (a.k.a. net value added) remains favorable, owing to an ISM index that is well above the 50 boom/bust line and still climbing (Chart 5). But on the expense side of the ledger, employee compensation - the largest expense for the corporate sector - is also poised to increase in the months ahead. Unit labor costs jumped sharply in the fourth quarter of 2017 (Chart 5, panel 2), and with the unemployment rate at 4.1% and the economy still adding jobs at a robust pace - nonfarm payrolls have increased by an average of +211k during the past six months - a further acceleration in employee compensation is likely this year. Chart 4Corporate Leverage Has Flattened Off Corporate Leverage Has Flattened Off Corporate Leverage Has Flattened Off Chart 5Wage Growth Will Hamper Profits Wage Growth Will Hamper Profits Wage Growth Will Hamper Profits The key question then becomes whether corporations will be able to offset rising compensation costs by lifting prices. This remains uncertain, but early indications are not favorable. Our Profit Margin Proxy - the growth in the corporate sector's implicit selling price deflator relative to the growth in unit labor costs - does an excellent job tracking pre-tax profits (Chart 5, bottom panel). At the moment, this indicator signals that profit growth will moderate in the coming quarters. Bottom Line: The outlook for top-line corporate revenue growth is strong, but employee compensation costs will also rise this year. We are doubtful that corporate profit growth will keep pace with debt growth for the remainder of year. A decline in the rate of profit growth to below the rate of corporate debt growth will be another signal to reduce exposure to corporate bonds. The Bond Map Back-Test Last week we introduced the BCA Bond Map, a graphical depiction of the current risk/reward trade-off on offer from the different sectors of the U.S. bond market.4 To summarize, in our excess return Bond Map we plot the number of days of average spread tightening required for each sector to earn 100 bps of excess return on the vertical axis, and the number of days of average spread widening required for each sector to lose 100 bps versus Treasuries on the horizontal axis (Chart 6). The diagram is then split into four quadrants based on the location of the Bloomberg Barclays Aggregate index, which we have modified to also include junk bonds. The upper-left quadrant, which we label "Best Bets", contains those sectors that offer less risk and greater excess return potential than the benchmark. The upper-right quadrant, which we label "Exciting", contains those sectors that offer higher risk than the benchmark but also higher potential returns. The bottom-left ("Boring") quadrant contains those sectors with low risk of losses but also low probability of gains, and the bottom-right ("Avoid") quadrant contains those sectors with higher risk than the benchmark and lower expected returns. As can be seen in Chart 6, the current excess return Bond Map shows that Local Authorities, Foreign Agencies and investment grade corporate bonds offer the best combination of risk and expected return. No sectors currently plot in the "Avoid" quadrant. Chart 6Excess Return Bond Map (As Of April 20, 2018) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt This week, we publish the results of a back-test of the real time performance of our Bond Map. To do this we produced the Bond Map at the beginning of each calendar year starting in 2006 and then calculated average excess returns for each quadrant. For example, if three sectors were in the "Best Bets" quadrant at the beginning of the year, we calculated 12-month excess returns for each sector and then averaged them together to get an excess return for "Best Bets" sectors that year.5 Table 2 shows the average and standard deviation of calendar year excess returns for each quadrant, using a sample that spans from 2006-2017. As would be expected, the "Exciting" quadrant displays the highest average excess return, but also the highest standard deviation. Conversely, the "Boring" quadrant delivers the lowest average return and the lowest risk. The performance of the "Best Bets" quadrant is somewhere in between, delivering a greater average return than the "Boring" quadrant with less risk than the "Exciting" quadrant. Although the Sharpe Ratio for the "Best Bets" quadrant turns out to be worse than the Sharpe ratio for both the "Exciting" and "Boring" quadrants. This provides some support for the investment strategy of favoring either the "Exciting" or "Boring" quadrants depending on your assessment of the macro environment. The "Avoid" quadrant actually delivered negative excess returns on average, with elevated risk. Table 2Excess Return Bond Map Track Record (2006-2017) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt For comparison we also show the average and standard deviation of excess returns for the Bloomberg Barclays Aggregate index, augmented with High-Yield. The benchmark delivered excess returns only slightly greater than the "Boring" quadrant, with significantly more risk. The total return version of the Bond Map is shown in Chart 7. This is identical to the excess return Bond Map, except it shows the number of days of average increase/decrease in yields for each sector to lose/earn 5% total return. We perform the identical back-test as with the excess return map, and display the results in Table 3. Chart 7Total Return Bond Map (As Of April 20, 2018) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt Table 3Total Return Bond Map Track Record (2006-2017) As Good As It Gets For Corporate Debt As Good As It Gets For Corporate Debt Here we see the interesting result that the average total returns are higher in the "Best Bets" quadrant than in the "Exciting" quadrant, but strangely the "Best Bets" quadrant also delivered greater volatility. The "Boring" quadrant delivered the best Sharpe Ratio, while the "Avoid" sector delivered both lower average returns and greater volatility than the "Boring" quadrant. For comparison, the average total returns for the Aggregate index (plus High-Yield) were lower than the total returns from any of the four quadrants, but also with less volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 We define the "turn" in the credit cycle as when corporate defaults start to occur and corporate spreads enter a sustained widening phase. 2 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 For the Phase 1 period in Cycle 2 we use an interval of June 1983 to July 1988 because High-Yield excess returns are only available starting in June 1983. In reality, the Phase 1 period should have started when the prior recession ended in December 1982. Using the correct interval (starting in December 1982) investment grade corporate bond excess returns are +131 bps and the stock-to-bond ratio returns are +5.19%, both annualized. 4 Please see U.S. Bond Strategy Weekly Report, "Back To Basics", dated April 17, 2018, available at usbs.bcaresearch.com 5 We started our back-test sample in 2006 even though our sector data goes back to 2000. Because our bond map relies on historical estimates of spread/yield volatility, we wanted a sample of at least five years of data before starting the test. With each passing year more back-data is incorporated into our spread/yield volatility estimates, which should improve the Bond Map's accuracy over time. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Our indicators suggest that investors should be especially cautious in the next month or two. April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes this year. However, the nation's trade policy is a concern for businesses. BCA's Bankers' Beige Book is booming. The Q1 earnings reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. Feature U.S. equity prices may struggle in the next few months. BCA's base case is that global growth will stabilize at an above-trend pace. Fiscal policy is a tailwind and global monetary policy remains easy, although several central banks are removing some of the accommodation. Moreover, the Fed sees only moderate risks to financial stability at home and abroad, its latest Beige Book is upbeat amid concerns over trade and labor shortages, and the Q1 earnings season is off to a strong start. BCA's Bankers' Beige Book for Q1 is booming. Nonetheless, BCA's Global Investment Strategy's MacroQuant model1 suggests that equities will struggle in the short-term. In our Bank Credit Analyst publication, the Equity Scorecard (Chart 1) and its Bear Market Checklist (Table 1) are both flashing red.2 The U.S.-China trade spat will linger for several more months and trade protectionism remains a risk. BCA's Geopolitical Strategy service notes that the stock market will likely seesaw during the summer as confusion grows amidst the upcoming geopolitical event risk (Table 2).3 Markets could also dip on Iran-U.S. tensions, an escalation of the conflict in Syria and a Russia-West confrontation. Indeed, sanctions on Russia are already pushing some base metal prices higher. Moreover, oil prices are more susceptible to supply disruptions given the tightness of global oil markets (Chart 2). BCA views any spike in oil prices as a tax on U.S. consumers. Chart 1Equity Scorecard: Flashing Red Equity Scorecard: Flashing Red Equity Scorecard: Flashing Red Table 1Exit Checklist Short-Term Caution Warranted Short-Term Caution Warranted Table 2Protectionism: Upcoming Dates To Watch Short-Term Caution Warranted Short-Term Caution Warranted Chart 2Oil Markets Are Tight Oil Markets Are Tight Oil Markets Are Tight Bottom Line: The 12-month cyclical outlook is still reasonably positive for risk assets such as stocks. Nonetheless, the near-term is fraught with risk. Our indicators suggest that investors should be especially cautious in the next month or two. Focus On Financial Stability Chart 3FOMC Is Closely Monitoring##BR##Financial Stability FOMC Is Closely Monitoring Financial Stability FOMC Is Closely Monitoring Financial Stability BCA views financial stability as a third mandate4 for the Fed, along with low and stable inflation, and full employment. Financial stability was not discussed at the FOMC's March 20-21 meeting, despite the spike in financial market volatility in early February. At the prior meeting in January, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance, but they declined to provide an assessment of foreign financial stability (Chart 3). However, in November 2017, Fed staff highlighted specific vulnerabilities in various foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sector, rising property prices, overhangs of sovereign debt and significant susceptibility to various political developments. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment was only in January 2016 but since then, it has upped its discussions. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated the issue at all but 1 of its 8 meetings in 2017, and in 13 of the 16 since April 2016. Fed Chair Jay Powell has followed his predecessor's lead in highlighting financial stability. Former Chair Janet Yellen elevated the topic during her tenure, leading discussions or staff briefings in 26 of the 32 meetings she presided over. The February 2018 edition of the Fed's semiannual Monetary Policy Report (MPR),5 which was the first one in Powell's tenure, has a full section devoted to financial stability. The report characterized the vulnerabilities of the financial system as moderate. Every MPR since July 2013 has provided an update on financial stability. Powell addressed financial stability in a June 2017 speech when he was a Fed governor and also reviewed the concern at his Senate confirmation hearing in November 2017. Moreover, in March's post-FOMC news conference, Powell answered a question about market bubbles by detailing the FOMC's approach to financial stability, and reiterated that financial vulnerabilities were "moderate." The San Francisco Fed noted that a more restrictive monetary policy could pose risks to financial stability.6 A surprise tightening can pressure U.S. bank balance sheets via higher market leverage. Moreover, a higher fed funds rate often leads to an expansion of assets held by money market funds (MMFs) (Chart 4). It concluded that during the 2007-2009 crisis, funding problems for MMFs spread across to the financial system and infected the real economy. In October 2016, the SEC introduced reforms aimed at targeting instability in the MMF sector. Still, the FOMC will closely watch MMF flows as the tightening cycle continues. Chart 4Money Market Funds And The Fed Funds Rate Money Market Funds And The Fed Funds Rate Money Market Funds And The Fed Funds Rate Bottom Line: BCA expects the Fed to remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses developing if policy stays too loose for too long. Beige Book Highlights The Beige Book released last week ahead of the FOMC's May 1-2 meeting suggested that uncertainty surrounding U.S. trade policy was an important headwind in March and early April. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the Beige Book; there were only 3 mentions in the March edition. Moreover, uncertainty came up nine times in April (Chart 5, panel 5) and eight were related to trade policy. There were just two mentions of the word in the March Beige Book. BCA's view is that trade-related uncertainty will persist through at least mid-year.7 Chart 5Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy BCA's quantitative approach8 to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 5, panel 1 shows that at 55% in April, BCA's Beige Book Monitor dipped to its lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of "weak" words in the Beige Book remained near four-year lows; the number of strong words returned to last summer's hurricane levels. The tax bill was noted five times in the latest Beige Book, down from 15 in March and 12 in January. The legislation was cast in a positive light in five of six mentions. Based on minimal references to a robust dollar in the past seven Beige Books, the greenback should not be an issue for corporate profits in Q1 2018. The handful of references sharply contrasts with 2015 and early 2016 when there were surges in Beige Book comments (Chart 5, panel 4). The last time that seven consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The disagreement on inflation between the Beige Book and the Bureau of Labor Statistics widened in April's Beige Book (Chart 5, panel 3). The number of inflation words in the Beige Book rose to a nine-month peak in April, nearly matching the cycle high hit in July 2017. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator and CPI failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. April's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Several contacts noted trouble finding moderately skilled workers in the manufacturing sector. Additionally, a lack of truck drivers, IT and software employees, and construction workers were often cited. Table 3 shows industries with labor shortages. In the year ended March 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are currently the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.9 BCA's Beige Book Commercial Real Estate (CRE) Monitor10 remains in a downtrend (Chart 6). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.11 Table 3Labor "Shortages" Identified##BR##In The Beige Book Short-Term Caution Warranted Short-Term Caution Warranted Chart 6Beige Book Commercial##BR##Real Estate Monitor Beige Book Commercial Real Estate Monitor Beige Book Commercial Real Estate Monitor Bottom Line: April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes by the end of the year. Labor shortages may be spreading from highly skilled to moderately skilled workers. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. Bankers' Beige Book Booming Chart 7Bankers' Beige Book Bankers' Beige Book Bankers' Beige Book BCA's Big 5 Bank Lending Beige Book12 for Q1 2018 highlights several positive trends in the financial sector. All five banks were uniformly upbeat about loan growth, although there was some unease about commercial real estate loans. Chart 7 shows key banking-related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q1 2018. Several bank executives noted that Q1 was a seasonally weak time for loan growth. Comments on the credit quality of the banks' loan and credit card portfolios were equally positive. Bank managements highlighted how higher rates have improved their net interest margins in Q1 and noted that further Fed rate hikes would benefit operations. Moreover, our panel of bank CFOs and CEOs cited the positive impact of the 2017 Tax Cut and Jobs Act on their businesses via better loan growth, stronger capital market activity and more capital spending. Several noted that their corporate clients are also experiencing benefits from the tax bill. Bottom Line: The banking system is humming. Lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. The tax bill continues to be a positive for banks and their corporate clients. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.13 Strong Start The Q1 reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. We previewed the S&P 500's Q1 2018 earnings earlier this month.14 Just under 15% of companies have reported results thus far, with 77% beating consensus EPS projections, which is well above the long-term average of 69%. Furthermore, 75% posted Q4 revenues over expectations, exceeding the long-term average of 56%. The surprise factor for Q1 stands at 5% for EPS and 2% for sales. Both readings are right at the average surprise recorded in the past five years. The surprise figures are even more impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results. Table 4S&P 500: Q1 2018 Results* Short-Term Caution Warranted Short-Term Caution Warranted We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is stout at 19% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain at a high level on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 4). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly robust in energy (71%), financials (29%), materials (27%) and technology (24%). The energy, materials and technology sectors likewise all experienced substantial sales gains (14%, 12% and 14% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 18%. Our U.S. Equity Strategy service introduced profit models for the S&P 500's sectors in January.15 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 8). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. As of April 19, 2018, the estimate is 20%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 8The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon While the ebullience is due to the tax bill, solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As noted in the previous section, U.S. trade policy is a concern in several industries. Table 5 reports the Q4 2017 profit and sales performance of globally - and domestically - oriented firms (Q1 data will be available later this quarter). At year-end, domestic firms' earnings and revenue surprise outpaced that of global industries. However, global firms saw more robust sales and EPS growth than companies with sales mainly from domestic sources. Analysts expect EPS growth to slow considerably in 2019 from the anticipated 2018 clip, which matches BCA's view (Chart 9). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Table 52017 Q4 Earnings##BR##Breakdown Short-Term Caution Warranted Short-Term Caution Warranted Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Bottom Line: 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 (Chart 9). The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Is China Headed For A Minsky Moment?," dated April 13, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Bank Credit Analyst Monthly Report, dated February, 2018. Available at bca.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-summary.htm 6 https://www.frbsf.org/economic-research/publications/economic-letter/2018/february/monetary-policy-cycles-and-financial-stability/ 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," April 17, 2017. Available at usis.bcaresearch.com. 9 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments," January 20, 2014. Available at usis.bcaresearch.com. 13 Please see BCA Research's U.S. Equity Strategy Weekly Report, "High Conviction Calls," dated November 27, 2017. Available at uses.bcaresearch.com. 14 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Peril," dated April 9, 2018. Available at usis.bcaresearch.com. 15 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," January 16, 2018. Available at uses.bcaresearch.com. Appendix: Bankers Beige Book Short-Term Caution Warranted Short-Term Caution Warranted

Dear Client, Alongside this week's report we are also sending you a fascinating short Special Report written by Jennifer Lacombe of our Global ETF Strategy sister service. The report, which demonstrates the use of ETF flows as a leading indicator of FX trends, points to downside for the EUR/USD and GBP/USD this year. I trust you find the piece informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A debate over slack is raging within the ECB. We tend to side with President Draghi, and believe there is more labor market slack in the euro area than suggested by the OECD's measures. Arguing in favor of this case is the presence of hidden labor market slack, the paucity of wage gains, even in Germany, and the potential for NAIRU to decline in many large economies. With global and European growth slowing, this will limit how hawkish the ECB can be in the short term, and thus limits the euro's gains in 2018. However, on a long-term basis, the presence of slack today argues that the euro area's potential GDP is higher than if there were no slack, and therefore policy rates and the euro have more long-term upside. Feature The recent release of the European Central Bank's account of its March policy meeting was very revealing. The ECB is currently torn between two camps: one believing there is little slack in the euro area labor market, and the other, led by ECB President Mario Draghi and chief economist Peter Praet, arguing that the continent's job market is still replete with excess capacity. This debate has enormous implications for the path of the euro. If there is no slack left in the euro area, this would point to an immediate need for higher rates and a higher euro, but it would also suggest the scope for the terminal policy rate in Europe to rise is limited. The long-term upside in the euro would therefore also be small. If there is still a large amount of slack in the euro area labor market, this implies that policy rates do not have much scope to rise over the next 18 months, and that the euro will find it difficult to appreciate much over this time frame. However, it also suggests that the potential growth rate of the euro area is higher than would otherwise be the case and that terminal policy rates can rise more in the long-run - implying that on a long-term basis the euro still has meaningful upside. We side in the latter camp. Chart I-1No Slack In Europe? No Slack In Europe? No Slack In Europe? Hidden Labor Market Slack... The question of slack in the euro area has been ignited by a simple reality: both the OECD's measure of the European output gap and the difference between the official unemployment rate and the equilibrium unemployment rate calculated by the OECD (NAIRU) are close to zero (Chart I-1). This observation would vindicate the desire of some ECB members to increase rates sooner than later, since the absence of an unemployment gap should lead to both higher wages and higher inflation. But before making too prompt a judgment, the U.S.'s recent experience is illuminating. Only now that the unemployment rate is 0.5% below NAIRU are U.S. wages and core inflation showing some signs of life (Chart I-2). In the U.S., we observed that while the headline unemployment rate has been consistent with accelerating wages as early as in 2015, discouraged workers back then represented 0.4% of the working age population, and were in fact willing participants in the job market. Only now that this number has fallen back to 0.27% - levels associated with full-employment in the previous business cycle - are employment costs perking up. There is little reason to believe that the eurozone economy is very different from the U.S. in this respect. In fact, the euro area suffered a double-dip recession, the second leg of which ended only in 2013, suggesting Europe suffered a severe enough shock to also fall victim to the symptoms of hidden labor market slack. A simple comparison helps illustrates that Europe is likely to still be experiencing labor market slack. Chart I-3 shows various measures of total and hidden labor market slack in the U.S. and the euro area. To begin with, despite a sharp rise in the female participation rate, the euro area's employment-to-population ratio for prime-age workers is not only well below the level that currently prevails in the U.S., it is also below its 2008 peak by a greater extent than is the case on the other side of the Atlantic. This suggests there is greater total labor market slack in Europe than in the U.S. Additionally, discouraged workers and long-term unemployment remain much closer to post-crisis highs in the euro area than in the U.S. In the latter, these ratios have mostly normalized close to levels consistent with full employment. Chart I-2The U.S. Experience WIth##br## Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack The U.S. Experience WIth Hidden Labor Market Slack Chart I-3The Euro Area Still Has ##br##Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack The Euro Area Still Has Plenty Hidden Slack Looking at some euro area-specific variables also dispels the idea that the European job market is near full employment and about to generate inflation: The ECB's labor underutilization measure1 still shows a high level of slack, especially in the European periphery (Chart I-4). Another problem for Europe is irregular work contracts. Europe, like Japan, is plagued with a dual labor market. On one hand, permanent employees are still protected by generous employment laws. On the other hand, employees under temporary work contracts are not. In Japan, this same disparity has been blamed for keeping wages down, as temporary employees are often willing to switch to positions offering the protection of regular job contracts for no wage increases. These workers are a form of hidden labor-market slack. Temporary employment in Europe remains at elevated levels, and contract work represents a record share of employment in Italy and France (Chart I-5), suggesting the same disease present in Japan also lingers in vast swaths of the European economy. Chart I-4The ECB's Metrics Also Show ##br##Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization The ECB's Metrics Also Show Elevated Labor Underutilization Chart I-5A Dual Labor Market Weighs ##br##On Wage Growth A Dual Labor Market Weighs On Wage Growth A Dual Labor Market Weighs On Wage Growth Labor reforms could also be creating labor market slack in Europe. As Chart I-6 shows, after Germany implemented its Hartz IV labor reforms in 2004, NAIRU collapsed. Spain, which has implemented equally draconian measures, could also witness its own equilibrium unemployment rate trend sharply lower over the coming years (Chart I-6, bottom panel). In France, timid reforms were implemented during the Hollande presidency, but President Macron is pushing an agenda of deep job market reforms. While Italy remains a laggard and its current political miasma offers little hope, the reality remains that much of Europe could also be experiencing a decline in NAIRU like Germany did last decade. Even Germany shows limited signs of an overheating labor market, despite an unemployment rate of 5.3%, the lowest reading ever in re-unified Germany: not only have German wages been unable to advance at a faster pace than the experience of the past 15 years, recent quarters have seen a slowdown in wage growth (Chart I-7). The presence of slack in the rest of Europe therefore appears to be limiting wage pressures even in that booming economy. Chart I-6The Impact Of Labor Reforms##br## On Full Employment The Impact Of Labor Reforms On Full Employment The Impact Of Labor Reforms On Full Employment Chart I-7No Wage Growth##br## In Germany No Wage Growth In Germany No Wage Growth In Germany Bottom Line: The euro area is likely to be under the same spell as the U.S. was a few years ago. Traditional metrics portend a labor market at full employment, but broader measures in fact highlight that there is still plentiful slack. Additionally, the implementation of labor market reforms in key European economies in recent years could imply that Europe's NAIRU is lower than the OECD's estimate and may further decline in coming years. ... And Slowing Global Growth It is one thing for Europe to be experiencing hidden labor market slack, but if growth is set to accelerate further, this would mean that this slack could nonetheless dissipate fast enough to allow for a more hawkish ECB in the short run. However, this is not the case. The European economy is very sensitive to global growth gyrations, and signs are accumulating that the global synchronized boom is petering out. As we have already highlighted, the diffusion index of the OECD global leading economic indicator has plummeted well below the boom/bust line, pointing to a sharp slowdown in the LEI itself (Chart I-8, top panel). EM carry trades have been underperforming, which normally leads a slowdown in global industrial activity (Chart I-8, middle panel). Additionally, Japanese export growth is decelerating sharply (Chart I-8, bottom panel). In a previous report we attributed major responsibility for this slowdown to monetary, fiscal and regulatory tightening in China. Europe is not immune to this malaise. European exports growth and foreign orders are all slowing sharply, but interestingly domestic factors are also at play. As the top panel of Chart I-9 illustrates, the European credit impulse is now contracting, suggesting domestic demand is set to slow. In fact, this has already begun as the growth of German domestic manufacturing orders is in negative territory (Chart 9, bottom panel). Chart I-8Global Growth Is Slowing Clouds##br## Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Global Growth Is Slowing Clouds Hanging Over Global Growth Chart I-9Euro Area Domestic##br## Growth Is Flagging Euro Area Domestic Growth Is Flagging Euro Area Domestic Growth Is Flagging No matter the source, the end result for Europe is the same: the torrid pace of European growth is set to slow, not accelerate. Not only have European economic surprises fallen precipitously (Chart I-10, top panel), but the Ifo survey - a key bellwether of German activity - has also peaked. Moreover, the Sentix survey points to a sharp slowdown in the manufacturing PMIs (Chart I-10, bottom panel). Because there is slack in the European economy and growth is set to slow, there is a good reason for the Draghi-led ECB to remain very cautious in the coming quarters before sounding hawkish. As a result, the euro faces strong headwinds over the next six months or so, especially as the Federal Reserve faces milder handicaps than the ECB: U.S. economic slack has dissipated and U.S. inflation is rising. These inflationary pressures could even intensify thanks to U.S. President Donald Trump's late-cycle fiscal stimulus. Relative growth dynamics also support the dollar this year as euro area industrial production is already lagging behind the U.S. (Chart I-11). This trend is set to continue for the coming quarters because the U.S. economy is less exposed to a global growth slowdown and U.S. households' are experiencing sharply accelerating disposable income growth, a support for domestic demand. Chart I-10Weakening European ##br##Growth Outlook Weakening European Growth Outlook Weakening European Growth Outlook Chart I-11European Growth Will ##br##Underperform The U.S. Further European Growth Will Underform The U.S. Further European Growth Will Underform The U.S. Further Bottom Line: Not only is there still slack in the euro area labor market, global growth is showing signs of a slowdown. This is likely to have a deleterious impact on European growth as the eurozone credit impulse is already contracting. As a result, European growth is likely to lag that of the U.S., an economy where there is no more slack, and where inflation is perking up. This combination represents a potent headwind for the euro over the next six months or so. The Euro Cyclical Bull Market Is Far From Over The combination of slowing global growth and labor market slack in the euro area suggests the euro may depreciate by six to eight cents over the next six months, but it does not sound the death knell of the euro's cyclical rally. To the contrary, the presence of slack in Europe suggests the euro still has significant cyclical upside. Historically, the euro performs well when the U.S. business cycle enters the last two years of expansion (Chart I-12). This is because European growth begins to outperform U.S. growth in the late stages of the economic cycle, allowing investors to upgrade their assessment of the path of long-term monetary policy in the euro area relative to the U.S. This time an additional impetus could emerge. If there is more slack in the euro area than traditional unemployment metrics imply, the euro area's potential GDP is also higher than these traditional metrics would submit - i.e. trend growth in Europe could be higher than once thought. The impact of labor market reforms in France and Spain further bolster this possibility. A consequence of a higher trend growth rate would also be a higher than originally assessed level for euro area neutral interest rates, or the so-called r-star. The European five-year forward 1-month OIS could therefore have significant upside from current levels (Chart I-13, top panel). This would also imply that expected rates in Europe have room to increase versus the U.S., lifting the euro in the process (Chart I-13, bottom panel). Chart I-12The Euro Rallies Late##br## In The Business Cycle The Euro Rallies Late In The Business Cycle The Euro Rallies Late In The Business Cycle Chart I-13European Slack Today Means ##br##Higher Rates Tomorrow European Slack Today Means European Slack Today Means European Slack Today Means European Slack Today Means Bottom Line: The presence of slack in Europe suggests that its potential GDP is higher than once thought. Hence, Europe could still have a few more years of robust growth in front of her. The following paradox ensues: if the presence of slack limits the upside for European interest rates today, it also suggests that European policy rates can rise much more in the future than if there was no slack today. Therefore, while this limits the capacity of the euro to rise further this year, the euro cyclical bull market has much more upside than if there was no slack in Europe today. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 This underutilization measure is based on the number of unemployed and underemployed, those available to work but not seeking a job and those seeking a job but not available for one. 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 U.S. data was decent: Retail sales ex. Autos increased at a 0.2% monthly pace, in line with expectations; Housing starts and building permits both beat expectations, coming in at 1.319 million and 1.354 million, respectively; Industrial production grew by 0.5% at a monthly pace, beating expectations; Capacity utilization also increased to 78%; Continuing and initial jobless claims both came out higher than expected; U.S. data continues to generally beat expectations, especially when contrasted with European data, representing a sharp reversal from last year's environment. The yield curve has flattened which has weighed on the greenback preventing the USD from rallying despite an outperforming U.S. economy. Report Links: U.S. Twin Deficits: Is The Dollar Doomed? - April 13, 2018 More Than Just Trade Wars - April 6, 2018 Do Not Get Flat-Footed By Politics - March 30, 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 has been disappointing: German Wholesale price index increased by only 1.2%, less than the expected 1.5%; European industrial production grew at a 2.9% yearly pace, less than expectations of 3.8%; The ZEW Economic Sentiment and Current Situation Survey for Germany disappointed; European headline inflation disappointed, coming in at 1.3%, while core was in line with expectations of 1%. Signs of a slowdown are now emerging in European data, however the euro has yet to follow. The euro area's leading economic indicator is rolling over, suggesting that cyclical factors could drag the euro down in the coming months. The waning of inflationary pressures across the euro area is likely prompt a dovish tone in upcoming ECB communications, which will induce a downward revision in rate expectations by investors. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 The Euro's Tricky Spot - February 2, 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 negative: Exports yearly growth underperformed expectations, coming in at 2.1%. Moreover, imports yearly growth also surprised to the downside, coming in at -0.6%. Finally industrial production yearly growth also disappointed, coming in at 1.6%. USD/JPY has remained relatively flat this week. Overall, we expect that the yen will continue to appreciate, as global geopolitical risks are on the rise and a potential slowdown in China's growth could will likely lead to a pick-up in FX market volatility. On the other hand, the yen remains at risk in the long term, given that economic data continues to underperform due to the strong yen and Japan's great exposure to global growth. This means that the BoJ will have to keep policy easy in order to support the economy. 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: Headline inflation underperformed expectations, coming in at 2.5%. Moreover, core inflation also surprised negatively, coming in at 2.3%. Retail prices yearly growth also underperformed, coming in at 3.3%. However, the ILO unemployment rate surprised positively, coming in at 4.2%. After being up nearly 1.4% this week, GBP/USD fell more than a percentage point following the disappointing inflation numbers. Overall, the data follows our prediction from a couple of weeks ago: inflation in the U.K. is set to decline substantially despite a tightening labor market. This is because inflation in the U.K. is mainly driven by previous currency movements. Therefore, given the steep appreciation of the pound since 2017, prices will likely fall, causing the hawkishly-priced BOE to tighten less than expected, hurting the pound in the process. 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 The Aussie has traded in a wave pattern against the greenback since the beginning of 2016. This week, AUD once again rebounded off the trough of the wave, catalyzed by higher prices in the metals space. Recent announcements by Anglo-Australian group BHP Billiton about curtailing production forecasts provided a boost to iron ore prices. This was coupled with the PBOC's decision to cut banks' reserve requirements which is raising the specter of a potential reflation wave in China. While, for now, external factors are proving to be positive for the Antipodean economy and its currency, the domestic story remains the same: labor market slack, high debt loads, and not enough wage inflation. Recent employment figures confirm this reality: employment grew by only 4,900, driven by a decline in full-time employment of 19,900. 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 Recent data in New Zealand has been mixed: The food price index month-on-month growth came in at 1%. Meanwhile, headline inflation came in at 1.1%, in line with expectations. NZD/USD has fallen by nearly 1.3% this week. Overall, we expect that the NZD will suffer in the current environment of rising volatility and geopolitical risks. Moreover, on a long term basis, the kiwi continues to be at risk, given that the new populist government is set to decrease immigration and implement a dual mandate for the RBNZ; both factors would lower the real neutral rate. 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 This year's disappointing first quarter GDP growth of 1.7% QoQ growth was regarded as an important factor in the BoC's decision this week to hold interest rates unchanged. The statement recognized the weaker housing market and flailing exports as the two culprits in this development. Bank officials denoted the tight capacity utilization as a constraint to further export growth, stating that growth will not be sufficient "to recover the ground lost during recent quarters". While this was an overall dovish policy statement, the Bank still continues to see robust growth going forward, revising their 2019 growth forecast from 1.6% to 2.1%. Importantly, this revision widened the output gap as the potential growth rate was revised higher. In terms of monetary policy, investors still predict two more rate hikes this year, bringing the benchmark rate to 1.75%, which is still below the Bank's estimated neutral rate of 2.5% - 3.5%. This means that if NAFTA is not abrogated in any major way - our base case scenario for the current negotiations - there is still plenty of upside for Canadian rates, and therefore, the CAD. Report Links: More Than Just Trade Wars - April 6, 2018 Who Hikes Again? - February 9, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has gone up by 1% this week. Overall, we continue to believe that the franc will continue to depreciate on a cyclical basis, given that Swiss inflationary pressures remain too weak and economic activity is still highly dependent on the easy monetary conditions brought about by the weak franc and low rates. Therefore, the SNB will remain very dovishly enclined in order to keep an appreciating franc from hurting the economy. Moreover, the Swiss franc continues to be expensive, putting further downward pressure on this currency. On a tactical basis however, this cross could have some downside in an environment of rising volatility and rising geopolitical risk. 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. We continue to be negative on the krone against the U.S. dollar, even in an environment of rising oil prices. This is because this cross is more correlated to real rate differential than it is to crude. Therefore, in an environment where the Fed hikes more than expected, real rates should move in favor of the U.S., helping USD/NOK in the process. That being said, the krone will likely outperform other commodity currencies like the AUD, as oil has a relatively lower beta than industrial metals to global growth and Chinese economic activity. 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 A slight economic slowdown is still being felt in the Scandinavian economy. As leading economic indicators in both Sweden and the euro area roll over, disinflationary winds continue to batter Swedish shores. As a result, EUR/SEK continues to trade at lofty levels, especially as global investors remain nervous about the risks of a global trade war. The Swedish yield curve has flattened 53 bps since January highs, which is one of the most severe moves in the G-10. It seems that Stefan Ingves' extreme dovishness is again being taken seriously by investors, especially as core CPI is at a mere 1.5%, despite CPIF clocking in at 2%. This core measure and global reflation will need to pick up for Ingves to change his view. While the SEK is cheap, and thus have limited downside from current levels, this economic backdrop suggests it is still risky for short-term investors to buy the SEK. Long-term players, however, should use current weaknesses as a buying opportunity. 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 The global economy is slowing. However, growth should stabilize at an above-trend pace over the next few months, as fiscal policy turns more stimulative and interest rates remain in accommodative territory. President Trump's macroeconomic policies are completely at odds with his trade agenda. Fortunately, Trump appears willing to cut a deal on trade, even if it is on terms that are not nearly as favorable to the U.S. as he might have touted. The recently renegotiated South Korea-U.S. Free Trade Agreement is a case in point. We remain cyclically overweight global equities, but acknowledge that valuations are stretched and the near-term market environment could remain challenging until leading economic indicators improve. Feature Global Equities: Near-Term Outlook Is Still Hazy We published a note on February 2nd entitled "Take Out Some Insurance" warning investors that the stock market had become highly vulnerable to a correction.1 The VIX spike began the next day. Although volatility has fallen and equities have rebounded so far in April, we are reluctant to sound the all-clear. The near-term signal from the beta version of our MacroQuant model has improved a bit but remains in bearish territory, as it has for over two months now (Chart 1). Chart 1MacroQuant Model Suggests Caution Is Warranted Growth, Trade, And Trump Growth, Trade, And Trump The model is highly sensitive to changes in growth. Starting early this year, it began to detect a weakening in a variety of leading economic indicators in the U.S. and, to an even greater degree, abroad. Most notably, global PMIs and the German IFO have dipped, Korean and Taiwanese exports have decelerated, Japanese machinery orders have fallen, and the Baltic Dry Index has swooned by 36% from its December high (Chart 2). The model also noted an increase in inflationary pressures, suggesting that monetary policy would likely end up moving in a less accommodative direction. The emergence of stagflationary concerns came at a time when bullish stock market sentiment stood at very elevated levels (Chart 3). Our empirical work has shown that equities perform worst when sentiment is deteriorating from bullish levels and perform best when sentiment is improving from bearish levels (Chart 4). Chart 2Growth Has Peaked Growth Has Peaked Growth Has Peaked Chart 3Stock Market Sentiment Was Very ##br##Bullish Earlier This Year Stock Market Sentiment Was Very Bullish Earlier This Year Stock Market Sentiment Was Very Bullish Earlier This Year Chart 4Swings In Sentiment And ##br##Stock Market Returns Growth, Trade, And Trump Growth, Trade, And Trump Waiting For The Economic Data To Stabilize The good news is that the drop in equity prices has caused sentiment to return to more normal levels. The bad news is that the activity data has continued to disappoint at the margin, as evidenced by the weakness in economic surprise indices and various "nowcasts" of real-time growth (Chart 5). Ultimately, we expect global growth to stabilize at an above-trend pace over the coming months, which should allow equities to grind higher. Monetary policy is still quite accommodative. The yield on the JP Morgan Global Bond Index has averaged 1.88% since the end of the Great Recession (Chart 6). We do not know where the "neutral" level of bond yields has been over this period. However, we do know that unemployment in the major economies has been falling, which suggests that monetary policy has been in expansionary territory. Despite the move away from quantitative easing by many central banks, the yield on the JP Morgan Global Bond Index is only 1.53% today. This implies a fortiori that bond yields today are well below restrictive levels. The conclusion is further strengthened if one assumes, as seems highly plausible, that the neutral bond yield has risen over the past few years, as deleveraging headwinds have abated and fiscal policy has turned more stimulative (Chart 7). Chart 5Unexpected Slowdown In Growth Unexpected Slowdown In Growth Unexpected Slowdown In Growth Chart 6Interest Rates Are Off Their Bottom, ##br##But Are Not Restrictive Interest Rates Are Off Their Bottom, But Are Not Restrictive Interest Rates Are Off Their Bottom, But Are Not Restrictive Chart 7Fiscal Policy Will Be Stimulative ##br##This Year And Next Growth, Trade, And Trump Growth, Trade, And Trump The Protectionism Bugbear Global growth has not been the only thing on investors' minds. The specter of a trade war has also loomed large. It is true that the standard early-19th century Ricardian model that first-year economics students learn predicts very small welfare losses from increased protectionism.2 The model, however, makes highly antiquated assumptions about how trade works. Trade today bears little resemblance to the world in which David Ricardo lived - the one where England exchanged cloth for Portuguese wine (the example Ricardo used to illustrate his famous principle of comparative advantage). Chart 8Trade In Intermediate Goods Dominates Growth, Trade, And Trump Growth, Trade, And Trump To an increasingly large extent, countries do not really trade with one another anymore. One can even go as far as to say that different companies do not really trade with each other in the way they once did. A growing share of international trade is between affiliates of the same companies. Trade these days is dominated by intermediate goods (Chart 8). The exchange of goods and services takes place within the context of a massive global supply chain, where such phrases as "outsourcing," "vertical integration" and "just-in-time inventory management" have entered the popular vernacular. This arrangement has many advantages, but it also harbors numerous fragilities. A small fire at a factory in Japan that manufactured 60 percent of the epoxy resin used in chip casings led to a major spike in RAM prices in 1993. Flooding in Thailand in 2011 wreaked havoc on the global auto industry.3 The global supply chain is highly vulnerable to even small shocks. Now imagine an across-the-board trade war. Equities represent a claim on the existing capital stock, not the capital stock that might emerge after a trade war has been fought. A trade war would result in a lot of stranded capital. It is not surprising that investors are worried. Trump's Dubious Trade Doctrine The psychology of a trade war today is not that dissimilar to that of an actual war among the great powers. It would be immensely damaging if it were to happen, but because everyone knows it would be so damaging, it is less likely to occur. How then should one interpret President Trump's tweet that "Trade wars are good, and easy to win?" One possibility is that he is bluffing. The U.S. exported only $131 billion in goods to China last year, which is less than the $150 billion in Chinese imports that Trump has already targeted for tariffs. China simply cannot win a tit-for-tat trade war with the United States. Unfortunately, there is also a less charitable interpretation, as revealed by the second part of Trump's tweet, where he said, "When we are down $100 billion with a certain country and they get cute, don't trade anymore - we win big. It's easy!" Trump seems to equate countries with companies: Exports are revenues and imports are costs. If a country is exporting less than it is importing, it must be losing money. This is deeply flawed reasoning. I run a trade deficit with the place where I eat lunch, but I don't go around complaining that they are ripping me off. One would think that Trump - whose businesses routinely spent more than they earned, accumulating debt in the process - would understand this. But apparently not. As we discussed two weeks ago, the U.S. runs a trade deficit mainly because its deep and open financial markets, along with a relatively high neutral rate of interest, make it an attractive destination for foreign capital.4 If a country runs a capital account surplus with the rest of the world - meaning that it sells more assets to foreigners than it buys from foreigners - it will necessarily run a current account deficit. Trump's Macro Policy Colliding With His Trade Policy In this respect, President Trump's macroeconomic policies are completely at odds with his trade agenda. By definition, the current account balance is the difference between what a country saves and what it invests. The U.S. fiscal position is set to deteriorate over the coming years, even if the unemployment rate continues to fall - an unprecedented occurrence (Chart 9). A bigger budget deficit will drain national savings. Chart 9The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline The U.S. Budget Deficit Is Set To Widen Even If The Unemployment Rate Continues To Decline Meanwhile, an overheated economy will cause capital spending to rise as firms run out of low-cost workers. If Trump succeeds in boosting infrastructure spending, aggregate U.S. investment will rise even more. The current account deficit is highly likely to widen in this environment. A Temporary Reprieve? Chart 10Trump's Protectionist Agenda Is A ##br##Popular One Among Republican Voters Trump's Protectionist Agenda Is A Popular One Among Republican Voters Trump's Protectionist Agenda Is A Popular One Among Republican Voters The prospect of a wider trade deficit means that Trump's protectionist wrath will not go quietly into the night. It may, however, go into remission for a little while. Trump's approval rating has managed to rise over the past few months because his protectionist agenda is popular with a large segment of the population (Chart 10). However, if the problems on Wall Street begin to show up on Main Street - as is likely to happen if stocks resume their decline - Trump will change his tune. This is especially true if a trade war threatens to hurt U.S. agricultural interests. Rural areas have been a key source of support for Trump's populist rhetoric. Trump has shown a willingness to cut a deal on trade even if the negotiated outcome falls well short of his bluster. Consider the agreement between the U.S. and Korea in late March to amend their existing trade pact. Trump had called the South Korea-U.S. Free Trade Agreement an "unacceptable, horrible deal" and a "job killer." After the agreement was renegotiated, the President described it as a "wonderful deal with a wonderful ally." What did Trump get that was so wonderful? The Koreans agreed to double the ceiling on the number of U.S. automobiles that can be exported to Korea without having to meet the country's tough environmental standards to 50,000. The problem is that the U.S. only shipped 11,000 autos to Korea last year, so the original quota was nowhere close to binding. The Koreans also agreed to reduce steel exports to the U.S. to about 70% of the average level of the past three years in exchange for a permanent exemption from Trump's 25% steel tariff. That may sound like a major concession, but keep in mind that only 12% of Korea's steel exports go to the United States. Korea also re-exports steel from other countries. These re-exports can be curtailed without causing major damage to Korea's steel industry. The shares of Korea's largest publicly-listed steel companies jumped by 1.7% on the first trading day after news of the deal broke, eclipsing the 0.8% rise in the KOSPI index. Investment Conclusions The global economy is going through a soft patch and this could weigh on stocks in the near term. However, if trade frictions fade into the background and global growth stabilizes over the coming months, as we expect will be the case, global equities should rally to fresh cycle highs. Granted, we are in the late stages of the business-cycle expansion. U.S. interest rates are likely to move into restrictive territory in the second half of 2019. Given the usual lags between changes in monetary policy and the real economy, this would place the next recession in 2020. By then, barring any fresh stimulus, the U.S. fiscal impulse will have dropped below zero. It is the change in the fiscal impulse that matters for growth. If growth has already slowed to a trend-like pace by late 2019 due to a shortage of workers, the economy could easily stall out in 2020. Given the still-dominant role played by U.S. financial markets, a recession in the U.S. would quickly be transmitted to the rest of the world. Stocks will peak before the next recession starts, but if history is any guide, this will only happen six months or so before the economic downturn begins (Table 1). This suggests that the equity bull market still has another 12-to-18 months of life left. The extent to which investors may wish to participate in any blow-off rally this year is a matter of personal preference. As was the case in the late 1990s, long-term expected returns have fallen to fairly low levels. A comparison between the Shiller P/E ratio and subsequent 10-year returns over the past century suggests that the S&P 500 will deliver a total nominal annualized return of only 4% during the next decade (Chart 11). A composite valuation measure incorporating both the trailing and forward P/E ratio, price-to-book, price-to-cash flow, price-to-sales, market cap-to-GDP, dividend yield, and Tobin's Q shows only modestly higher expected returns for stock markets outside the U.S. (Appendix A). Table 1Cyclically, It Is Too Soon To Get Out... Growth, Trade, And Trump Growth, Trade, And Trump Chart 11...But Long-Term Investors, Take Note ...But Long-Term Investors, Take Note ...But Long-Term Investors, Take Note As such, while we recommend overweighting global equities over a 12-month horizon, we would not fault long-term investors for taking some money off the table now. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018. 2 Roughly speaking, the Ricardian model predicts that the welfare loss from protectionism will be one-half times the average percentage-point increase in tariffs times the change in the import-to-GDP ratio. Imports are about 15% of U.S. GDP. Consider a 10 percent across-the-board increase in tariffs. Assuming a price elasticity of import demand of 4, this would reduce trade by 1-0.96^10=0.33 (i.e., 33%), which would take the import-to-GDP ratio down from 15% to 10%. As such, the welfare loss would be 0.5*0.1*(15%-10%)=0.25%, or just one quarter of one percent of GDP. 3 James Coates, "Real Chip Shortage Or Just A Panic, Crunch Is Likely To Boost Pc Prices," Chicago Tribune, dated August 6, 1993. "Thailand Floods Disrupt Production And Supply Chains," BBC.com, dated October 13, 2011; Ploy Ten Kate, and Chang-Ran Kim, "Thai Floods batter Global Electronics, Auto Supply Chains," Reuters.com, dated October 28, 2011. 4 Please see Global Investment Strategy Weekly Report, "U.S.-China Trade Spat: Is R-Star To Blame?" dated April 6, 2018. APPENDIX A Chart 1Long-Term Real Return Prospects Are Slightly Better Outside The U.S. Growth, Trade, And Trump Growth, Trade, And Trump Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Our analysis is often focused on China, commodities prices and Asia's business cycle. The key points of these discussions are applicable to the majority of EM countries and their financial markets. Yet, there are some countries that are not exposed to China, commodities or global trade. India and Turkey are two prominent examples from the EM space that fall into this category. This week we re-visit our analysis on these economies and their financial markets. Feature India: Inflation Holds The Key Indian government bonds sold off sharply over the past eight months, with the yield gap widening significantly relative to EM local currency bonds (Chart I-1, top panel). During this time, the country's stock market has been underperforming the EM benchmark notably (Chart I-1, bottom panel). Rising Indian inflation was a main culprit behind the selloff. However, the most recent print for headline CPI was down (Chart I-2). Diminished inflation worries have recently led to a modest drop in bond yields. Chart I-1India Relative To EM: Bonds And Stocks India Relative To EM: Bonds And Stocks India Relative To EM: Bonds And Stocks Chart I-2Indian Inflation Has Accelerated Indian Inflation Has Accelerated Indian Inflation Has Accelerated The key question for investors is if inflation will rise or stay tame. This, by extension, will determine whether Indian stocks will outperform their EM counterparts. Risks: Inflation, Fiscal Balance And Bond Yields Odds point to upside inflation surprises ahead, and a potential rise in bond yields: The supply side of the economy has been stagnant. Chart I-3 illustrates that Indian consumption has been outpacing investments since 2012, creating a significant accumulated gap. Capex is now picking up (Chart I-4, top panel) but the fact that past investment was low means that the output gap could become positive sooner than later. Chart I-3Consumption Is Outpacing Investments Consumption Is Outpacing Investments Consumption Is Outpacing Investments Chart I-4Timid Pick Up In Capex Insufficient Pickup In India's Supply Side Insufficient Pickup In India's Supply Side Crucially, in order for the capex rebound to be robust and sufficient to expand the economy's productive capacity, Indian commercial banks need to finance corporate investments aggressively. The bottom panel of Chart I-4 shows that this is not yet the case. On the fiscal front, the Indian central government released a mildly expansionary 2018-2019 budget, and is pushing for fiscal consolidation beyond 2019. Importantly, this was the last budget announcement of the ruling National Democratic Alliance (NDA) coalition before the 2019 general elections. It therefore entails a 10% increase in government expenditures. Growing government expenditures are often inflationary in India; hence a 10% rise in government spending could boost inflation modestly (Chart I-5). Additionally, there are also non-trivial risks that the Bharatiya Janata Party (BJP) government might end up spending beyond the official budget announcement in order to appease voters in the run-up to the 2019 general elections. The risks of overspending extend to state governments as well. The latter plan to raise their employees' housing rental allowances (HRA). Depending on the magnitude and timing of these increases, inflation could accelerate significantly and have spillover effects. Turning to bond yields, excess demand for credit by borrowers against a restricted supply of financing by banks is also creating a ripe environment for higher bond yields: The combined Indian central and state fiscal deficit is very wide, signaling strong demand for credit by the government (Chart I-6, top panel). Yet broad money creation by banks has generally been weak (Chart I-6, bottom panel). Chart I-5Indian Government ##br##Expenditure Is Inflationary Indian Government Expenditure Is Inflationary Indian Government Expenditure Is Inflationary Chart I-6Large General Fiscal Deficit ##br##Amid Slow Money Creation Large General Fiscal Deficit Amid Slow Money Creation Large General Fiscal Deficit Amid Slow Money Creation Chart I-7 illustrates that the combined central and state government fiscal deficit plus the annual change in the total broad stock of money is negative. This signals that new money creation might be insufficient. Commercial banks' holdings of government bonds is also falling (Chart I-8, top panel). Indian banks are at the margin beginning to turn their focus to private sector lending (Chart I-8, bottom panel). Chart I-7Insufficient New Funding ##br##For The Economy India: Insufficient Funding For The Economy India: Insufficient Funding For The Economy Chart I-8Indian Commercial Banks Are Shifting ##br##Focus To The Private Sector Indian Commercial Banks Are Shifting Focus To The Private Sector Indian Commercial Banks Are Shifting Focus To The Private Sector This is expected as commercial banks' holdings of government bonds have reached 29% of total deposits, which is significantly above the minimum required Statutory Liquidity Ratio (SLR) of 19.5%. Given the ongoing improvement in private sector growth and hence demand for credit, Indian banks are now more inclined to augment their loan portfolios. Non-bank financial corporations such as insurance companies could offset banks' lower demand for government securities, but the former are not as large players as banks to make a meaningful impact. They own only 24% of government bonds compared to the banks' 42% ownership. Mutual funds and other non-bank finance corporations' ownership of government bonds is even smaller than that of insurance companies. Chart I-9India's Cyclical Profile India's Cyclical Profile India's Cyclical Profile Bottom Line: Upside risks to government spending, the budget balance and inflation will likely keep upward pressure on domestic bond yields. That amid high equity valuations might lead to lower share prices in absolute terms. India Can Still Outperform The EM Benchmark While Indian government bonds could sell off and stocks could fall in absolute terms, India is in a better position relative to its EM counterparts. Our view remains that we will see a material slowdown in Chinese growth this year - which is negative for commodities prices and EM economies. This scenario will be beneficial for India at the margin relative to other EM bourses. Importantly, Indian economic activity is gaining upward momentum: Overall loan growth has picked up meaningfully, and consumer loan growth in particular is accelerating at a double-digit pace (Chart I-9, top panel). Motorcycle sales have resumed their upward trend (Chart I-9, panel 2). Commercial vehicle sales are now accelerating robustly (Chart I-9, panel 2) and manufacturing production has picked up noticeably (Chart I-9, panel 3). Bottom Line: We recommend investors keep an overweight position in Indian equities versus the EM benchmark. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkish Markets Are In Freefall The lira has been in freefall and local bond yields have spiked (Chart II-1) following the Turkish government's announcement that it wants to stimulate growth even further by implementing a new investment incentive package worth $34 billion, or 5% of GDP. Our view is that the recent lira depreciation as well as the selloff in stocks and bonds have further room to go. Stay short/underweight Turkish risk assets. The Turkish economy is clearly overheating and inflation has broken out into double digit territory (Chart II-2). This comes as no surprise, given high and accelerating wage growth together with stagnant productivity gains (Chart II-3, top panel). Unit labor costs are surging in both manufacturing and services sectors (Chart II-3, bottom panel). Demand is booming, as such firms will likely succeed in hiking selling prices further, reinforcing the wage-inflation spiral. Chart II-1Turkey: Currency Is Falling And ##br##Bond Yields Are Rising Turkey: Currency Is Falling And Bond Yields Are Rising Turkey: Currency Is Falling And Bond Yields Are Rising Chart II-2Turkey: Genuine Inflation Breakout Turkey: Genuine Inflation Breakout Turkey: Genuine Inflation Breakout Chart II-3Turkey: Wage Growth Is Too High Turkey: Wage Growth Is Too High Turkey: Wage Growth Is Too High Most alarmingly, Turkish policymakers are doing the opposite of what is currently needed - instead of tightening, they have been easing policy: On the fiscal side, government expenditures excluding interest payments have accelerated significantly (Chart II-4). On the monetary policy side, Turkey's banking system has been relying on enormous amounts of liquidity provisions by the central bank (Chart II-5, top panel) to sustain its ongoing credit boom and hence economic growth. Chart II-4Turkey: Fiscal Policy Is Easing Turkey: Fiscal Policy Is Easing Turkey: Fiscal Policy Is Easing Chart II-5Turkey: Monetary Policy Is Too Accommodative Turkey: Monetary Policy Is Too Accommodative Turkey: Monetary Policy Is Too Accommodative On the whole, the central bank's net liquidity injections into the banking system continue to increase rapidly. The nature of the central bank's reserves provisions to commercial banks has shifted away from open market operations and more towards direct lending to banks (Chart II-5, bottom panel). Yet, the essence remains the same: to provide liquidity to banks so that the latter can continue expanding their balance sheets. Adding all the liquidity facilities - the intraday, overnight and late window facilities - the Central Bank of Turkey's (CBT) outstanding funding to banks is TRY 90 billion, or 3% of GDP, abnormally elevated on a historical basis. All this entails that monetary policy is too loose. Consistently, even though local currency bank loan growth has moderated, it still stands at 18% (Chart II-6). With the newly announced government stimulus plan, bank loan growth will likely accelerate from an already high level. As debt levels rise, so are debt servicing costs (Chart II-7). Notably, debt (both domestic/local currency and external debt) servicing costs will continue to escalate as the currency plunges. The reason is that Turkish private sector external debt stands at 40% of GDP, with 13% of GDP being short-term, the highest among EM countries. Currency depreciation will make external debt more expensive to service. Chart II-6Turkey: Rampant Credit Growth Turkey: Rampant Credit Growth... Turkey: Rampant Credit Growth... Chart II-7Higher Debt Servicing Costs ...Means Higher Debt Servicing Costs ...Means Higher Debt Servicing Costs Lastly, the Turkish authorities are expanding the Credit Guarantee Fund, what we would call the "free money" program. The aim of this fund is to incentivize banks to lend more, making the government essentially assume credit risk on loans extended to small and medium enterprises. Under this scheme, the government is effectively giving a green light to flood the economy with more money/credit. This will only heighten inflationary pressures and lead to much more currency devaluation. So far, the scheme has been responsible for the creation of TRY 250 billion, or 8% of GDP worth of new credit. The new tranche of this program announced in January of this year entails another TRY 55 billion. While smaller than the previous tranche, it is still significant at 1.8% of GDP. Fiscal and monetary policies are overly simulative and the country's twin deficits - both fiscal and current account - are widening (Chart II-8). The current account deficit now exceeds 6% of GDP. With foreign holdings of equities and government bonds already at historic highs (Chart II-9), it is questionable whether Turkey has the capacity to attract more capital inflows to finance a widening current account deficit on a sustainable basis. Chart II-8Turkey: Large Twin Deficits Turkey: Large Twin Deficits Turkey: Large Twin Deficits Chart II-9Turkey: Foreign Holdings Of ##br##Stocks And Bonds Are Large Turkey: Foreign Holdings Of Stocks And Bonds Are Large Turkey: Foreign Holdings Of Stocks And Bonds Are Large Remarkably, despite extremely strong exports due to robust growth in the euro area, the current account deficit in Turkey has been unable to narrow at all. This confirms the excessive domestic demand boom. Chart II-10The Turkish Lira Is Not Cheap The Turkish Lira Is Not Cheap The Turkish Lira Is Not Cheap Even after undergoing large nominal depreciation, Chart II-10 demonstrates that the Turkish lira is still not cheap, according to unit labor cost-based real effective exchange rate, which in our opinion is the best valuation measure for currencies. With wage and general inflation in the double digits and escalating, it will take much more nominal deprecation for the lira to become cheap. At this point, the Turkish authorities are clearly over-stimulating growth while disregarding inflation. The current policy stance will all but ensure that the lira depreciates much further. Excessive money creation is extremely bearish for the local currency. To put the amount of outstanding money into perspective and gauge exchange rate risk, one can compute the ratio of foreign exchange reserves to broad money (local currency money supply). Chart II-11 illustrates that the current net level of foreign exchange reserves (excluding banks' foreign currency deposits at the central bank) including gold currently stands at US$30 billion, which is equivalent to a mere 11% of broad local currency money M3. The ratio for other EM countries is considerably higher (Chart II-12). Chart II-11Turkey: Central Bank FX ##br##Reserves Level Is Inadequate Turkey: Central Bank FX Reserves Level Is Inadequate Turkey: Central Bank FX Reserves Level Is Inadequate Chart II-12Foreign Exchange Reserves Adequacy In EM Country Perspectives: India And Turkey Country Perspectives: India And Turkey Given the inflationary backdrop and the risk of further currency depreciation, interest rates will have to rise. With time this will inevitably trigger another upward non-performing loan (NPL) cycle. Banks are very under-provisioned for non-performing loans (NPLs). Even worse, banks have been reducing the ratio of NPL provisions to total loans in order to book strong profits. NPLs and NPL provisions are set to rise substantially, and banks' equity will be considerably eroded as a result. Lastly, as Chart II-13 demonstrates, rising interest rates are bearish for bank share prices. Investment Implications The government is doubling down on pro-growth policies and is disregarding inflation. Hence, inflation will spiral out of control and the central bank will fall even more behind the curve. This is extremely bearish for the lira. We are reiterating our short position on the lira. We remain short the lira versus the U.S. dollar, but the lira will likely also continue to plummet versus the euro as well. As such, we are also reiterating our underweight/short stance on Turkish stocks in general, and banks in particular (Chart II-14). Chart II-13Turkey: Higher Interest Rates ##br##Will Hurt Bank Stocks Turkey: Higher Interest Rates Will Hurt Bank Stocks Turkey: Higher Interest Rates Will Hurt Bank Stocks Chart II-14Stay Short/Underweight Turkish Stocks Stay Short/Underweight Turkish Stocks Stay Short/Underweight Turkish Stocks A weaker lira will undermine returns for foreign investors on Turkish domestic bonds and assures widening sovereign and corporate credit spreads. Dedicated EM fixed income and credit portfolios should continue to underweight Turkey within their respective EM universes. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations