Policy

Highlights Chart I-1The Economy Has Stabilized##br## But Has Not Recovered Brazil desperately needs to boost nominal growth to avoid public debt spiraling out of control1. We do not think it is possible without resorting to meaningful currency depreciation and much lower interest rates. The Brazilian economy has stabilized, but it has not yet recovered (Chart I-1). To stage a sustainable recovery, much easier monetary conditions and fiscal stance are required. However, monetary conditions remain tight and fiscal policy is tightening: Feature Real interest rates are about 5.5-6% - as high as they were before the current rate-cut cycle commenced (Chart I-2). The Brazilian central bank's aggressive rate cuts have largely matched the drop in the inflation rate, keeping real borrowing costs elevated. Besides, household debt servicing costs (interest payments and principal) are high, above 20% of disposable income (Chart I-3) and employment conditions remain extremely poor. In this environment, households will not be inclined to expand leverage considerably. The Brazilian real is not cheap. In fact, the real effective exchange rate is slightly above its fair value (Chart I-4). Nominal GDP growth is currently running close to 4%, while the government's budget assumption for nominal GDP growth in 2017 is 5-5.5%. Not surprisingly, government revenues are disappointing and the budget deficit is above its target (Chart I-5). Furthermore, the improvement in government revenues in the past 12 months has been due to one-off measures such as non-recurring privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL and tax amnesty/capital repatriation programs that will not be repeated. In brief, more tax hikes are needed to achieve revenue targets but higher taxes will in turn jeopardize the economic revival. Taxes on fuel have been raised in recent weeks. Chart I-2Interest Rates Are##br## Still Very High Chart I-3Household Debt Servicing##br## Ratio Has Not Yet Declined Chart I-4The Real Is Not Cheap Chart I-5Brazil: No Improvement In Fiscal Accounts Given that fiscal policy is straightjacketed by high and rapidly rising public debt levels, the onus of boosting nominal growth is squarely on the central bank. Not only have the monetary authorities cut interest rates, they have also been monetizing government debt. Chart I-6 shows that the central bank's holdings of government securities have skyrocketed, i.e., the central bank has bought BRL531 billion of government paper since January 2015. While it has partially sterilized its debt monetization by using these securities as reverse repos with banks, the amount of high-powered money/liquidity withdrawal via repos has been much smaller than the central bank's liquidity injections. Chart I-6aBrazil: Central Bank Has##br## Been Monetizing Public Debt... Chart I-6b...And Sterilizing It ##br##Only Partially This has helped liquidity in the banking system considerably, and smoothed the banking system adjustment at a time of surging non-performing loans. However, it has not generated enough purchasing power in the economy to boost nominal growth. Notably, broad money growth is slowing (Chart I-7). Even though bank loan growth may have troughed (Chart I-7, bottom panel), it is unlikely to recover strongly due to high real rates. Broad money captures the stance of credit and fiscal policies because broad money reflects purchasing power created by commercial banks and central bank when lending to and buying government bonds from non-banks. Remarkably, the broad money impulse - which is the second derivative of outstanding broad money - points to weakness in nominal GDP growth (Chart I-8). Chart I-7Brazil: Broad Money##br## And Bank Loans Chart I-8Broad Money And Terms Of Trade Point ##br## To Weaker Nominal Growth In addition, nominal GDP growth correlates with terms of trade, and the latter has also relapsed (Chart I-8, bottom panel). Furthermore, high-frequency data reveal that manufacturing PMI and consumer confidence have also rolled over lately, pointing to stalling improvement in both the manufacturing sector and consumer spending (Chart I-9). All in all, policymakers are behind the curve. The central bank could continue cutting interest rates, increase its purchases of government bonds, and also use other measures to inject more money – both high-powered money and broad money – into circulation. If they do so, it will eventually help the economy recover and boost inflation, yet it is bearish for the exchange rate. However, if the exchange rate relapses on its own (due to other factors), that will limit the authorities' ability to reduce interest rates further. This is on top of heightened political uncertainty that does not bode well for Brazilian financial markets. In a nutshell, Brazil needs to engineer currency depreciation to boost nominal growth and make public debt sustainable. This is true especially as Argentina is opting to keep its currency competitive, and it will be even more critical if commodities prices relapse, as we expect (Chart I-10). Provided the share of foreign currency public debt is low, reflating via currency depreciation is the least painful way out for Brazil. Bottom Line: Policymakers are desperate to boost nominal growth to stabilize public debt. Yet, in our opinion, nominal growth will not improve without further sizable rate cuts and meaningful currency depreciation. Eventually, policymakers will allow the BRL to depreciate 20%-plus, which will hurt foreign investments in local asset markets. We remain negative on/underweight Brazil equities, currency and sovereign debt. That said, we recommend fixed-income investors to bet on the 3/1-year yield curve flattening: receive 3-year / pay 1-year swap rate (Chart I-11). Chart I-9High-Frequency Indicators:##br## Improvement Has Stalled Chart I-10Other Headwinds##br## For BRL Chart I-11A New Trade: ##br## Bet On 3/1-Year Yield Curve Flattening Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Has Brazil Achieved Escape Velocity?", dated February 8, 2017, link available on page 11 - we argued that Brazil's public debt dynamics is unsustainable without strong nominal growth and/or social security reforms. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Feature Recommended Allocation When Central Banks Turn Hawkish It seems almost as though, when central bank governors gathered in Portugal for the ECB's annual confab in late June, they agreed to start sounding more hawkish. ECB President Mario Draghi's speech included the line: "The threat of deflation is gone and reflationary forces are at play." Bank of Canada Governor Stephen Poloz went ahead and on July 12 announced Canada's first rate hike in seven years. Indeed, BCA's Central Bank Monitors (Chart 1) suggest that, with the exceptions of Japan and possibly the euro area, all major developed central banks need to tighten monetary policy. Does this matter for risk assets, such as equities? Historical evidence suggests not, as long as the central bank is tightening because it is confident about the outlook for growth and unconcerned about financial risks (rather than, for example, reacting to a sharp rise in inflation). Equity markets typically move up in the early stages of a tightening cycle (Chart 2); it is only when the central bank tightens excessively (usually later in the cycle) that risk assets start to anticipate that this will trigger a recession. Even in the U.S. which, after four rate hikes since December 2015, is the furthest advanced in tightening, the real effective Fed Funds Rate is still -0.3%, below the 0.3% that the Fed believes to be the neutral real rate at the moment (Chart 3). The Fed expects the neutral rate to rise to 1% in the longer run. Chart 1Most Central Banks Need To Tighten Chart 2Equities Usually Rise During Rate Hike Cycle Chart 3Fed Policy Is Still Accommodative But the order in which central banks tighten will be a major driver of currencies (as has been clear with the sharp appreciation of the CAD and AUD in recent weeks). Our current asset recommendations are based on the belief that the market has become too complacent about the speed at which the Fed will tighten (with futures pricing only 26 bp of hikes over the next 12 months), and too nervous about the ECB (Chart 4). As the market starts to understand that the Fed has fallen a little behind the curve, and that the ECB will remain cautious (given continuing weakness in peripheral economies, and a lack of underlying inflationary pressures), we expect to see the dollar begin to appreciate again. A key to all this is whether the recent softness in U.S. inflation data (core PCE inflation has fallen from 1.8% YoY to 1.4% since January) proves to be temporary. A rebound in inflation would allow the Fed to continue to hike without bringing the real rate close to the neutral level yet. It is worth remembering that inflation is a lagging indicator: the recent weakness is largely a reflection of last year's soggy GDP growth (Chart 5), as well as some transitory technical factors (particularly drug and wireless data prices). The recent dollar depreciation should also boost inflation via the import price channel over the coming months (Chart 6). Chart 4Markets Views On Fed And ECB Have Diverged Chart 5Inflation Lags GDP Growth Chart 6Dollar Deprecation Will Raise Prices However, with global equities having produced a total return of 35% since their recent bottom in February last year, and 17% year to date, valuations are unattractive and, on some measures, sentiment is quite optimistic (Chart 7). What catalysts are there left to give risk assets further upside? We see two. First, earnings. The Q2 U.S. results season has seen 77% of S&P 500 companies surprising on the upside at the sales line, with EPS rising 7% compared to the same quarter in 2016. Most of our indicators suggest that earnings have further to rise this year (Chart 8), yet the consensus EPS forecast for 2017 as a whole remains at just over 10%, where it has been since January. Strong earnings momentum is likely to remain a positive at least through the end of the year. Second, tax cuts. Our Geopolitical Strategy service1 remains optimistic that the U.S. Congress will pass tax legislation to come into effect in early 2018. The failure to repeal Obamacare means that the Republican Party will need a big legislative win going into the mid-term elections in November 2017. Tax cuts (which the market is no longer pricing in - Chart 9) is one policy on which there is little disagreement within the GOP. Chart 7Are Investors Getting Too Optimistic? Chart 8Earnings Can Still Surprise On Upside Chart 9No One Expects Tax Cuts Any More None of the recession indicators we highlighted in our most recent Quarterly 2 (global PMIs, the shape of the yield curve, or credit spreads) are pointing to a downturn in the next 12 months. So, given the environment described above, we are happy to remain overweight equities versus bonds, and to maintain our pro-risk and pro-cyclical tilts. But we continue to warn of the risk of a recession in 2019 - probably triggered by the Fed needing to tighten more aggressively - and might look to lower our risk profile in the first half of next year. Equities: We favor DM equities over EM. An appreciating dollar, rising interest rates, weak industrial metals prices this year and uncertain growth prospects for China all represent headwinds for EM equities. Our strong dollar view points to an overweight in U.S. equities in USD terms but, in local currencies, our preference is for euro area and Japanese equities. Both are relatively high-beta, have strongly cyclical earnings momentum, and central banks that are likely to stay dovish. In Japan, the falling popularity rating of the Abe administration might compel it to ramp up fiscal spending to boost the economy, which would help the Bank of Japan in its efforts to rekindle inflation. Chart 10Everyone Has Turned Bullish On The Euro Fixed Income: Our macro outlook, with faster rate hikes and rebounding inflation in the U.S., is very negative for rates. We are underweight government bonds, short duration and prefer inflation-linked bonds to nominal ones. Valuations in credit are no longer particularly attractive but, with a 100 bp spread for U.S. investment grade bonds and a 230 bp default-adjusted spread for high-yield, returns are likely to be satisfactory as long as the economic cycle continues to improve. Currencies: Our fundamental view of the dollar is that relative monetary policy and interest rates point to further appreciation, especially against the yen and euro. The timing of the dollar's rebound, though, is harder to pinpoint. The euro could rise further over the next couple of months. However, given speculators' large net long positions in the euro - a big turnaround from the start of the year (Chart 10) - the likely announcement by the ECB in September or October of a reduction in its asset purchases might be the catalyst for a reversal (as a classic "buy the news, sell the rumor" event), particularly if Mario Draghi dresses it up as a "dovish tapering." Commodities: Oil inventories have begun to draw down in line with our expectations (Chart 11). Continued discipline by OPEC producers until next March, combined with a slowdown in the growth of U.S. shale production (reflecting the weaker crude price this year) should bring inventories down further (despite production increases in such countries as Libya and Iran), and push the price of WTI above $55 a barrel by year end. Industrial commodity prices have rebounded somewhat in the past six weeks, mainly on the back of moderately brighter economic data out of China (Chart 12). But, given uncertain prospects about the sustainability of this growth, especially beyond the Communist Party Congress in the fall, and amid some signs of weakness in Chinese monetary and credit aggregates,3 we remain cautious about the outlook for metals prices over the next 12 months. Chart 11Oil Inventories Will Draw Down Further in Chart 12Tick-Up In Chinese Data? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bca.research.com. 2 Please see BCA Global Asset Allocation, "Quarterly Portfolio Review," dated July 3, 2107, available at gaa.bcaresearch.com. 3 Please see BCA Emerging Markets Strategy Weekly Report, "Follow The Money, Not The Crowd," dated July 26, 2017, available at ems.bcaresearch.com. Recommended Asset Allocation

Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Structural Bond Backdrop: The secular global bond market outlook is slowly deteriorating on the margin. The structural forces that have driven down bond yields over the past few decades are in the process of stabilizing or even slowly reversing. With central banks moving away from "emergency" stimulative monetary policies that were designed to fight imminent deflation risks that are no longer needed, the path of least resistance for global bond yields is up. Central Bank Liquidity & Volatility: The current low volatility backdrop is a function of solid global economic growth and accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but monetary policies will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds for the rest of 2017. Feature The End Of The Bond Bull Market, One Year Later In July of last year, BCA put its flag in the ground and declared the end of the 35-year global bond bull market.1 This was not a view that a new fixed income bear market was about to immediately unfold. Rather, we concluded that all the bond-bullish factors of the past few decades - aging populations, anemic productivity growth, structurally declining global inflation rates - were more than fully reflected in the level of bond yields seen after the shocking result of the U.K. Brexit referendum. Even in the most pessimistic of future scenarios for the global economy, a 10-year U.S. Treasury yield at 1.37% or a 10-year German Bund yield at -0.18% (the intraday lows seen immediately after the Brexit vote) discounted an awful lot of bad news. Chart of the WeekA Less Market-Friendly##BR##Backdrop On The Horizon? We believed that central bankers would likely respond to the uncertainties created by the growing wave of political populism evidenced by Brexit (and, later, Trump) by keeping monetary settings as loose as possible for as long as possible. Overly accommodative policy would provide a reflationary tailwind to global growth - especially if governments also looked to placate voter uprisings with looser fiscal policy. Coming at a time when many of the powerful structural factors that have acted to suppress bond yields in recent decades were starting to lose potency, the risks were tilted toward a cyclical rise in yields that could turn into something longer lasting. Roll the tape forward one year, and some parts of our prediction have already come to fruition. The major developed economy central banks have generally leaned on the dovish side. Policy rates have been kept well below "equilibrium" - in some cases, below zero. Only the U.S. Federal Reserve has been able to raise interest rates a handful of times, and even then while still maintaining a bloated balance sheet left over from the QE era. More importantly, the European Central Bank (ECB) and the Bank of Japan (BoJ) have continued with asset purchase programs that have added a combined $3.5 trillion in monetary liquidity over the past two years. That massive dose of money printing has helped keep global bond yields low while supporting a coordinated economic recovery that has underwritten equity and credit bull markets worldwide (Chart of the Week). The structural aspects of our long-term call on global bonds are less evident in the current economic data, but we are even more convinced that the tide is turning. This week, we are including a pair of additional Special Reports, recently authored by BCA's Chief Global Strategist, Peter Berezin, and Mark McClellan, Chief Strategist for our flagship publication, The Bank Credit Analyst. Mark discusses how many of the secular drivers of the current low level of global bond yields - aging populations; excess global savings, especially from China; the absorption of low-cost labor from the emerging world; globalization of world trade and supply chains - are waning or may even be reaching an inflection point. Peter takes an even more provocative stand in his report, laying out a case for why the current backdrop of low global productivity growth will eventually lead to higher real interest rates and faster inflation. In this Weekly Report, we tackle the more immediate issue of the shifting outlook for central bank policies and what it implies for the current state of low market volatilities. The growth rate of the "G-3" aggregate balance sheet has already peaked which, combined with early warning signs on future growth signaled by measures like our diffusion index of global leading economic indicators, suggests that a turning point in the current low volatility, pro-risk backdrop may start to unfold in the months ahead - but not before government bond yields move higher on the back of rebounding inflation and central bank tightening actions. Are Central Banks To Blame For Low Volatility? Perhaps the hottest topic among investors at the moment is what to make of the exceptionally low levels of market volatility. The so-called "fear gauge" - the U.S. VIX index - fell into single digits last month to the lowest level since 1993. This is not the only measure of market volatility that is probing historic lows, however. In Chart 2, we show the range of realized total return volatilities for major global asset classes dating back to 1999. The current volatilities all sit very close to the low end of the historical range, from bonds to equities to currencies to commodities. Part of this can simply be chalked up to the broad-based acceleration of global growth seen over the past year, which has supported stable earnings-driven equity bull markets. Chart 2It's Not Just The VIX ... All Market Volatilities Are Historically Low The slow response of central banks to this upturn is an even bigger factor, helping keep bond volatility depressed. Low rates of realized inflation, and restrained levels of expected inflation, have allowed policymakers to maintain accommodative monetary policies and not engineer slower growth to cool overheating economies. Corporate profits have enjoyed a cyclical boost as a result, to the benefit of equities and corporate credit. For the VIX index, which is based on option-implied volatilities for the S&P 500, the current low level is consistent with a more stable environment for economic growth and corporate profits. The standard deviations of the growth rates of U.S. real GDP and reported S&P earnings have fallen to the lowest levels seen since 1990 (Chart 3). Against this backdrop, it is no surprise that the realized volatility of the S&P 500 is also depressed (bottom panel). The previous dovish biases of central bankers have also played a role in helping keep volatility low. Interest rates been kept at low levels relative to policymakers' own estimates of "neutral". Asset purchase programs in Europe and Japan have acted as a signaling mechanism to markets to delay expectations of future interest rate increases, helping suppress bond yield levels and bond price volatility. This has acted to boost risk-seeking behavior among investors seeking adequate investment returns given rock-bottom risk-free interest rates. In the U.S., policymakers still have strong memories of the mid-2000s period where predictable monetary policy, even during a tightening cycle, led to an extended period of low market volatility and encouraged risk-taking behavior fueled by excessive leverage. A greater focus on "financial stability" issues has likely played a hand in the timing of the Fed's rate hikes earlier this year, given that growth and inflation data were not rapidly accelerating (especially prior to the June rate hike). In other words, the Fed was seeing soaring equity prices, tightening credit spreads and a weaker U.S. dollar as an easing of financial conditions that could set the stage for more rapid economic growth, and more "frothy" investor behavior, down the road. The Fed can take some comfort in the fact that some signs of speculative excesses in the U.S. corporate bond market are not at levels seen during the credit boom of the prior decade. Our preferred measure of corporate balance sheet leverage, debt less cash relative to the EBITD measure of earnings, is rising but remains below prior peaks despite the current lower level of corporate borrowing rates (Chart 4). Inflows into corporates from foreign buyers are far below the levels seen in the mid-2000s, while domestic retail buying of corporate bond funds is within historic norms (middle panel). Some signs of excess are appearing, however, with the share of leveraged loan issuance taken up by so-called "covenant-lite" deals offering reduced protection for lenders soaring to a record high earlier this year (bottom panel). Chart 3A Low VIX Reflects More Stable Growth & Earnings Chart 4Not At 2000s Credit Bubble Levels...Yet The Fed will never explicitly say that monetary policy is being tightened to cool off booming financial markets. However, numerous Fed officials have mentioned signs of stretched market valuations in their public speeches in recent months. This suggests that there is growing concern about leaving monetary policy too accommodative for too long and potentially fueling future asset bubbles. We remain of the view that faster growth and rebounding inflation will prompt the next wave of Fed rate hikes over the next year - which is not currently discounted in financial markets, leading us to maintain a below-benchmark recommended duration stance in the U.S. Yet the very easy level of financial conditions will also play a role in the Fed's next move. In many ways, the current backdrop is similar to 2014. Realized U.S. inflation was falling rapidly then, but financial conditions were easing and leading economic indicators were rising, even as the Fed was tapering its QE purchases to zero (Chart 5). At the beginning of the Fed's tapering process in the spring of 2014, there was barely one 25bp rate hike priced into the Overnight Index Swap (OIS) curve. As the Fed began to taper its bond buying, even while inflation was falling, investors got the hint that the Fed was serious about becoming less accommodative and began to price in more future rate hikes (bottom panel). Chart 52014 Revisited? Chart 6The ECB Will Taper Next Year We see a similar dynamic playing out in Europe in the coming months as the markets begin to more seriously price in a slower pace of ECB bond purchases in 2018, which the central bank is likely to formally announce next month (Chart 6). In Japan, the BoJ has already been buying bonds at a slower pace this year after shifting to a bond yield target from a quantitative purchase target last September (Chart 7). Combined with the additional Fed hikes that are likely to come, in addition to the Fed beginning to "normalize" the size of its swollen balance sheet (Chart 8), the central bank liquidity backdrop is about to become much less friendly for financial markets. Chart 7The BoJ Has Already Tapered Chart 8Let The Fed Runoff Begin We have seen the lows in market volatility for this business cycle. This will become a bigger issue for risk assets after monetary policy becomes even less accommodative and economic data begins to slow in response, likely sometime in the first half of 2018. Until then, the current healthy pace of global growth will put more upward pressure on bond yields than downward pressure on equity or credit market valuations over the rest of the year. Bottom Line: The current low volatility backdrop is a function of solid global economic growth with accommodative (and predictable) central banks. The growth momentum is likely to persist for at least the next 3-6 months, but the monetary policy backdrop will continue to shift in a less dovish direction. Stay below-benchmark overall portfolio duration and favor corporate credit over government bonds over the rest of 2017. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Investment Strategy Third Quarter 2016 Strategy Outlook, "The End Of The 35-Year Global Bond Bull Market", dated July 8th 2016, available at gis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Easier financial conditions will lift U.S. growth in the second half of this year. However, given the Fed's dovish predisposition, aggressive tightening measures are unlikely until next year, when inflation will begin to accelerate. We see little downside for the dollar over the coming months, but think the next major leg of the structural dollar bull market will only come in 2018, as the Fed begrudgingly comes to terms with the fact that it has been behind the curve in raising rates. Even then, the Fed's efforts to tighten monetary policy will not be enough to prevent a secular rebound in inflation from taking root. Structural factors, ranging from population aging to chronically weak productivity growth, will further fuel inflation in the U.S. and around the world. Political populism - historically, an inflationary force - will come roaring back, while globalization, a deflationary force, will remain in retreat. Remain overweight global equities for now, but look to raise cash next summer. A structurally underweight position in government bonds is appropriate. Feature The Fed Stands Pat As expected, the Fed kept rates on hold this week and signaled its intention to start shrinking its balance sheet later this year. The FOMC upgraded its assessment of the state of the labor market to "solid," but sounded a note of caution on the recent weak inflation readings. It was the latter point that caught investors' attention. The dollar promptly sold off. We went long the DXY index in October 2014. We maintained our bullish dollar view going into the U.S. presidential elections, controversially arguing in September 2016 that "Trump will win and the dollar will rally."1 While our long dollar trade is still comfortably in the black, the dollar's recent swoon does imply that we stayed at the party longer than was warranted. Chart 1Investors Dismiss Future Inflation Risk What went wrong this year? The failure of the Trump administration to make progress on tax reform in recent months has hurt the dollar. So has the decline in core inflation. Core PCE inflation registered 1.4% in May, down from a high of 1.8% in January. As a result, the market is now pricing in only 26 basis points of rate hikes over the next 12 months and just a 45% chance that the Fed will raise rates by December. Hawkish comments from the ECB, the Bank of Canada, and several other central banks have added fuel to the dollar selloff. Shifts in speculative positioning haven't helped either. Investors were extremely bullish the dollar going into 2017 while bearish the euro. Today, euro longs are at record highs, while sentiment towards the dollar is in the pits. Looking out, sentiment towards the dollar should normalize, while U.S. growth should surprise to the upside over the next few quarters. U.S. financial conditions have eased sharply this year thanks to the decline in bond yields, narrower credit spreads, higher equity prices, and of course, a weaker dollar. Historically, easier financial conditions have boosted growth with a lag of 6-to-9 months. In contrast, euro area growth may be close to plateauing, as already foreshadowed this week by the decline in the PMI for July. All this should be enough to put a floor under the dollar over the remainder of the year. However, at this point, it looks increasingly likely that the next (and last) leg of the dollar bull market will have to wait until inflation begins to accelerate. This may not happen until 2018, suggesting that the dollar could trade in a range until then. We are maintaining our view that EUR/USD will eventually reach parity, but now see this as most likely to happen in the second half of next year. Many investors are skeptical that inflation will rise even if the unemployment rate continues to trend downwards. They argue that the relationship between economic slack and inflation - epitomized by the so-called Phillips curve - has completely broken down. We disagree with this assessment. As we argue below, not only is inflation likely to accelerate next year, but a number of powerful structural factors will propel inflation higher over a longer-term horizon. In fact, the 2020s could turn out to look a lot like the 1970s. Current market-based inflation expectations do not reflect this risk at all (Chart 1). Cyclical Forces Will Boost Inflation Spare capacity has declined significantly in most economies since 2009 (Chart 2). By many measures, the U.S. is now close to full employment (Table 1). Historically, diminished slack has corresponded with higher inflation (Chart 3). Chart 2Output Gaps Have Narrowed Table 1Comparing Current Labor Market Slack With Past Cycles Chart 3Diminished Slack Has Corresponded With Higher Inflation The fact that decreased spare capacity has not yet translated into higher inflation is not especially surprising. Inflation is a severely lagging indicator. As we noted last week, inflation typically does not peak until well after a recession has begun and does not bottom until well after it has ended (Chart 4).2 Trying to infer the true level of economic slack from today's inflation rate is like trying to read the speedometer of an automobile when there is a 30-second delay between what the dial says and when you step on the accelerator. Chart 4Inflation Is A Lagging Indicator Moreover, the relationship between slack and inflation tends to be highly non-linear. When there is a lot of spare capacity, reducing it modestly tends not to have much of an effect on inflation. However, when there is little or no slack, even a small reduction in spare capacity can lead to a big jump in inflation. The 1960s provide an extreme example of what can happen (Chart 5). The unemployment rate steadily declined between 1960 and 1966. Yet, core inflation remained remarkably stable during this period, consistently hovering between 1.5% and 2%. In early 1966, the unemployment rate finally broke below 4%. Within the span of 12 months, core inflation jumped from 1.5% to 3.7%. Such a rapid burst in inflation is unlikely in the near term. Inflation expectations are better anchored and unions have less power today than in the 1960s. Moreover, unlike then, some of the excess in aggregate demand can be absorbed through a larger trade deficit rather than through higher prices for goods and services. Nevertheless, as slack elsewhere in the world comes down, global inflation will rise. Our "pipeline inflation" indices, comprised of such variables as core PPI inflation and unit labor costs, are already pointing in that direction (Chart 6). The cyclical pressure on inflation will only intensify if crude prices grind higher, as our energy strategists expect they will. Chart 5Inflation In The 1960s Took Off Once ##br##The Unemployment Rate Fell Below 4% Chart 6Pickup In Global Pipeline Measures Of Inflation Structural Trends Are Becoming More Inflationary Meanwhile, several structural forces will slowly lift inflation over a longer-term horizon of five-to-fifteen years. Weaker productivity growth is one of them (Chart 7). We have argued in the past that much of the decline in global productivity growth reflects structural factors.3 As a matter of arithmetic, gross domestic output (GDP) must equal gross domestic income (GDI). If productivity growth stays weak, slow income growth could end up depressing savings by more than it depresses investment. This could push up equilibrium real interest rates. Unless central banks respond by raising policy rates, inflation will rise. The retirement of millions of highly paid baby boomers could also lead to labor shortages and lower aggregate savings. Chart 8 shows the estimated consumption and income profile for a typical U.S. individual over a lifetime. Notice that consumption tends to peak very late in life due to rising health care expenditures. Chart 7Productivity Growth Has Fallen, ##br##Particularly In Developed Economies Chart 8Spending And Saving Over The Lifecycle Using existing demographic projections, we can compute the impact that population aging is likely to have on savings. The effect is substantial. In the U.S., aging will reduce the household saving rate by about four percentage points between now and 2030. In Germany, the saving rate will sink by six points, while in China it will decline by five points. This will reduce the massive current account surpluses in these two countries, which have been major contributors to the global savings glut and the corresponding low level of real interest rates. The Japan Experience Japan's household saving rate will also continue to fall, having already declined from 14% in the late 1980s to 2% today. Amazingly, the decline in Japan's saving rate over the past few decades has occurred even though a larger share of the population is employed today than in 1980 (Chart 9). Rising female participation accounts for this. However, now that Japan's female employment rate has surpassed America's and Europe's, this demographic tailwind will dissipate (Chart 10). As a result, Japan's labor force will begin to shrink in earnest, while spending on health care and pensions will keep rising. What will be left is a large government debt burden. Chart 9Japan: Saving Rate Has Fallen Despite Rising Employment/Population Chart 10Japan: Female Employment-To-Population ##br##Has Surpassed The U.S. And Euro Area Whether debt is inflationary or deflationary depends both on economic and political considerations. On the one hand, a high degree of indebtedness may restrain spending throughout the economy. That is deflationary. On the other hand, high debt levels may provide an incentive for governments to crank up inflation in order to reduce the real value of outstanding debt obligations. Historically at least, the latter factor has often won out. One can debate whether Japan would have welcomed higher inflation even if it had the means to generate it. There are good arguments for both sides of the issue. But, in practice, the Bank of Japan's ability to create inflation was cut off very early into its first lost decade. This is because falling property prices and pervasive corporate deleveraging pushed the neutral nominal interest rate deep into negative territory. This meant that even an interest rate of zero was not enough to boost inflation. Now that property prices appear to be bottoming, corporate balance sheets are in reasonably good shape, and the prospect of significant labor shortages looms on the horizon, Japan may finally be able to gain some traction over monetary policy. Such an outcome would come as a complete surprise to most investors. The Benefits Of Higher Inflation Japan's struggles illustrate the pitfalls of excessively low inflation. Had Japanese inflation been higher in the early 1990s, the Bank of Japan might have been able to bring real rates far enough into negative territory without ever encountering the zero-bound constraint on nominal rates. This may have prevented a vicious circle where falling inflation put upward pressure on real rates, leading to weaker growth and even lower inflation. Fast forward to the present and what was once regarded as a uniquely Japanese problem is now seen as a concern in many countries. It is not surprising, therefore, that a growing chorus of economists is advocating that central banks aim for a higher inflation target than the standard 2%. The logic is straightforward: If inflation is 4% and a deep economic downturn requires that central bankers temporarily bring real rates down to -3%, this can be achieved by cutting nominal rates to 1%. In contrast, if inflation is 2%, it may be difficult to cut nominal rates to -1% since people could choose to hold cash over a negative-yielding asset. Another lesson that central bankers have learned from both the Great Recession and the recession that followed the dotcom boom is that burst asset bubbles can cause significant harm to economies. Here again, a bit more inflation can provide a safety valve of sorts. If the trend rate of inflation had been higher going into the housing bust, nominal home prices would have fallen less for any given change in real prices. This implies that fewer mortgages would have gone underwater. A higher underlying inflation rate would have also made it more difficult for lenders to offer zero-interest mortgages since their funding costs in real terms would have been greater. This would have imposed more discipline on lenders and borrowers alike. Then there is the labor market. The reluctance of workers to accept nominal wage cuts makes it difficult for real wages to adjust downwards in the face of adverse economic shocks when underlying inflation is very low. If inflation is higher, that problem diminishes. This point is especially relevant for the euro area, where labor markets are quite inflexible to begin with and many countries do not have the ability to respond to adverse shocks with either countercyclical fiscal policy or currency depreciation. Inflation As A Political Choice It is sometimes said that low inflation or even outright deflation is the natural state of affairs in capitalist economies. This is arguably true under monetary regimes such as the gold standard, but it is not true in a world of fiat money. Inflation took off in the late sixties because policymakers who grew up during the 1930s were more concerned about propping up aggregate demand than keeping a lid on prices. In contrast, the generation that reached adulthood in the 1970s was more worried about runaway inflation. It is this latter group that has run the world's central banks for the better part of the past few decades. As they step aside, they will be replaced by a younger cohort whose formative years were shaped by the financial crisis and the deflation shock that followed. Things have come full circle again. A recent NBER paper documented that age plays a major role in determining whether central bankers turn out to be dovish or hawkish.4 Those who witnessed stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in diapers back then. The implication is the future generation of central bankers is likely to see the world through a more dovish lens than its predecessors. Globalization In Retreat, Populism Ascendant Globalization has been a strong deflationary force through history. That force is now waning, as evidenced by the stagnation in global trade (Chart 11). In contrast, political populism - historically, a highly inflationary force - is on the rise. Much of the slowdown in globalization can be attributed to structural factors. Tariff rates fell steadily in the second half of the 20th century, helping to boost global trade in the process (Chart 12). Now that most goods cross borders duty free, further efforts at trade liberalization will be subject to diminishing returns. The same goes for outsourcing. In fact, growing evidence suggests that many firms have outsourced too much, leaving them with an unwieldy maze of suppliers around the world. Chart 11Globalization Has Stalled Chart 12Global Trade Was Boosted By Falling Tariffs ##br## In The Second Half Of The 20th Century Likewise, the integration of Eastern Europe and China into the capitalist economy brought a billion additional workers into the global labor force, giving globalization a huge boost (Chart 13). Nothing similar awaits over the horizon. Chart 13The Transition To Capitalism Enlarged The Global Labor Force Politics represents another headwind to globalization. Trade among rich countries tends to have smaller distributional consequences than trade between rich and poor countries. As emerging markets have become larger players in the global trading system, the impact on less-skilled workers in developed countries has grown. People in Michigan, Ohio, and Pennsylvania voted for Trumpism, not Trump. The problem is that Trump does not understand this, as his cyberbullying of Attorney General Jeff Sessions this week demonstrates. If Trump deserts his base, his base will find someone more to their liking. Either way, populism will prevail. For their part, the Democrats are also honing their populist message. Their "Better Deal" agenda harkens back to the populist roots of FDR's New Deal. It promises to "raise the wages and incomes of American workers," "crack down on unfair foreign trade and fight back against corporations that outsource American jobs," and root out "monopolies and the concentration of economic power," while also making sure that "Wall Street never endangers Main Street again."5 Bernie Sanders may have lost the Democratic nomination, but he won the soul of the Democratic party. European populists have been on the back foot over the past year, having suffered defeats in the Dutch, Austrian, and French elections. Yet, it would be a mistake to count them out. Populists do best when times are tough. European growth is strong these days and unemployment is falling. When the next recession rolls around, populist parties will gain favor. This will especially be the case if the migrant crisis re-escalates, as seems likely. Investment Conclusions Getting inflation up to 2% - let alone something higher - has seemed like "mission impossible" for most of the past eight years because of elevated levels of economic slack. However, as this slack is absorbed, boosting inflation will become easier. Central banks only need to raise rates by less than standard Taylor rules imply. As we discussed last week, the Fed, the Bank of Canada, the Swedish Riksbank, and the central banks of Australia and New Zealand are all somewhat behind the curve in raising rates.6 As inflation in these economies picks up next year, they will be forced to raise rates more aggressively than what the markets are currently discounting, causing bond yields to rise and their currencies to strengthen. This could sow the seeds of a slowdown or even a recession in 2019. The recession is unlikely to be especially severe since financial and economic imbalances are not as pronounced today as they were a decade ago. Yet, the policy reaction will be disproportionately large: Interest rates will be cut and talk of additional asset purchases will begin to swirl. Inflation will come down, but not all the way back to current levels. Likewise, bond yields will fall, but nowhere close to the secular lows recorded in mid-2016. As in previous inflationary episodes, the path for nominal bond yields over the next 15 years will be marked by higher highs and higher lows. Fixed-income investors should pare back duration and increase exposure to inflation-indexed securities. Gold will become a valuable hedge once the dollar peaks next year. Equities will suffer in a stagflationary environment. We remain cyclically overweight global stocks for now, as reflected in our asset allocation recommendations (Appendix 1). However, we will be looking to reduce exposure significantly next summer. Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Are Central Banks Behind The Curve Or Ahead Of It?" dated July 21, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?" dated May 31, 2017, available at gis.bcaresearch.com. 4 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 5 Chuck Schumer, "A Better Deal for American Workers," The New York Times, July 24, 2017, and "A Better Deal," available at http://www.democraticleader.gov. 6 Please see footnote 2. Appendix 1 Tactical Global Asset Allocation Monthly Update To complement our analysis, we use a variety of time-tested models to assess the global investment outlook. At present, these models generally favor global equities over bonds over a three-month horizon (Appendix Table 1). Our business cycle equity indicators remain firmly in bullish territory, as reflected in strong global growth and rising corporate earnings. The monetary and financial indicators are also flashing green. In contrast, our sentiment readings are sending mixed signals. Low implied equity volatility points to a heightened risk of complacency, while continued investor skepticism towards the rally (especially among retail investors) suggests that stocks have further to run. As has been the case for some time, our valuation measures are saying stocks are expensive, but these are typically useful only for horizons beyond one or two years. Calendar effects are also negative at the moment due to the tendency of stocks to underperform during the summer months. Regionally, we see more upside in more cyclically-exposed, higher-beta equity markets such as those in Europe and Japan. Canada also looks attractive based on our cyclically positive outlook for crude prices. Emerging market equities are fairly valued, although China still appears cheap based on our measures. Within the fixed-income arena, U.S. Treasurys remain overvalued based on the cyclical outlook, as do, to a lesser extent, most European bonds. Japanese bonds are the default winners simply because JGB yields are likely to remain flat on account of the BoJ's interventions. Appendix Table 1BCA's Tactical Global Asset Allocation Recommendations* Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Major central banks outside the U.S. have fired a warning shot across the bow of global bond markets by signaling that "emergency" levels of monetary accommodation are no longer required. Pipeline inflation pressures have yet to show up at the consumer price level outside of the U.K. Most central bankers argue that temporary factors are to blame, but longer-lasting forces could be at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. However, this is not confirmed in the productivity data. Productivity is dismally low and we do not believe it is due to mismeasurement. The Phillips curve is not dead. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus. The real fed funds rate is not far from the neutral short-term rate, but it is still well below the Fed's estimate of the long-run neutral rate. Market expectations for the Fed are far too complacent; keep duration short. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts. Expansionary fiscal policy would make life more difficult for the FOMC, given that unemployment is on course to reach the lowest level since 2000. This would force the Fed to act more aggressively, possibly triggering a recession in 2019. The peak Fed/ECB policy divergence is not behind us, implying that recent dollar weakness will reverse. However, the next dollar upleg has been delayed. Fading market hopes for U.S. fiscal stimulus this year have not weighed on equities, in part because of a solid earnings backdrop. Global EPS growth continues to accelerate in line with the recovery in industrial production. In the U.S., results so far suggest that Q2 will see another quarter of margin expansion. Overall earnings growth should peak above our 20% target later this year. It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. Expect to downgrade stocks in the first half of 2018. Corporate bonds are also benefiting from the robust profit backdrop. Balance sheet health continues to deteriorate, but the spark is missing for a sustained corporate bond spread widening. Feature Chart I-1Sell-Off In Global Bond Markets ##br##Triggered By Central Bank Talk Major central banks outside the U.S. fired a warning shot across the bow of global bond markets by signaling a recalibration of monetary policy at the ECB's Forum on Central Banking in late June (Chart I-1). The heads of the Bank of England (BoE), Bank of Canada (BoC) and Swedish Riksbank all took a less dovish tone, warning that the diminished threat of deflation has reduced the need for ultra-stimulative policies. The BoC quickly followed up in July with a rate hike and a warning of more to come. The central bank now expects the economy to reach full employment and hit the inflation target by mid-2018, much earlier than previously expected. The Riksbank also backed away from its easing bias at its most recent policy meeting. The ECB's shift in stance was evident even before its Forum meeting, when President Draghi gave a glowing description of the underlying strength of the Euro Area economy. The labor market is about two percentage points closer to full employment than the U.S. was just before the infamous 2013 Taper Tantrum.1 European core inflation is admittedly below target today, but so was the U.S. rate leading up to the 2013 Tantrum. We have not forgotten about Europe's structural problems or the inherent contradictions of the single currency. Banks are still laden with bad debt (although the recapitalization of Italian banks has gone well so far). Nonetheless, from a cyclical economic standpoint, solid momentum this year will allow Draghi to scale back the ECB's ultra-accommodative monetary stance by tapering its asset purchase program early in 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank (CB) Monitors, which measure pressure on central bankers to raise or lower interest rates (Chart I-2). The Monitors became less useful when rates hit the zero bound and quantitative easing was the only game in town, but they are becoming relevant again as more policymakers consider their exit strategy. All of our CB Monitors are currently in "tighter policy required" territory except for Japan and the Eurozone (although even those are close to the zero line). The Monitors have been rising due to both their growth and underlying inflation components. Another tick higher in PMI's for the advanced economies in July underscored that the rebound in industrial production is continuing (Chart I-3). Our short-term forecasting models, which include both hard and soft data, point to stronger growth in the major countries in the second half of 2017 (Chart I-4). Chart I-2Most In The "Tighter Policy Required" Zone Chart I-3Industrial Production Recovery Is Intact On the inflation side, our pipeline indicators have all signaled a modest building of underlying inflation pressure over the past year (although they have softened recently in the U.S. and Eurozone; Chart I-5). In terms of the components of these indicators, rising core producer price inflation has been partly offset by slower gains in unit labor costs in some economies. Chart I-4Our Short-Term Growth Models Are Bullish Chart I-5Some Rise In Pipeline Inflation Pressure These pipeline pressures have yet to show up at the consumer level. Most central bankers argue that temporary special factors are to blame, but many investors are wondering if longer-lasting forces are at work. There are numerous examples of deflationary pressure driven by waves of innovation, cost cutting and changing business models. Amazon, Uber, robotics and shale oil production are just a few examples. If this is the main story, then the inability for central banks to reach their inflation targets is a "good thing" because it reflects the adaptation of game-changing new technology. There is no doubt that important strides are being made in certain areas where new technologies are clearly driving prices down. The problem is that, at the macro level, it is not showing up in the productivity data. Productivity is dismally low across the major countries and we do not believe it is simply due to mismeasurement. A Special Report from BCA's Global Investment Strategy2 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, it appears that productivity is over-estimated in some industries. It is also important to keep in mind that technological change is nothing new. There is a vigorous debate in academic circles on whether today's new technologies are anywhere near as positive as previous ones like indoor plumbing, electricity, the internal combustion engine and the internet. We are wowed by today's new gizmos, but they are not as transformative as previous innovations. While productivity is surging in some high-profile firms, studies show that there is a long tail of low-productivity companies that drag down the average. A full discussion is beyond the scope of this report and more research needs to be done, but we are not of the view that technology and productivity preclude rising inflation. We expect that inflation will firm by enough to allow central banks to continue scaling back monetary stimulus in the coming months and quarters. Did Yellen Turn Dovish? As with other central banks, the consensus among Fed policymakers is willing to "look through" low inflation for now. Yellen's Congressional testimony did not deviate from that view, although investors interpreted her remarks as dovish. The financial press focused on her statement that "...the policy rate is not far from neutral." However, this was followed up by the statement that "...because we also anticipate that the factors that are currently holding down the neutral rate will diminish somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion and return inflation to our 2 percent goal." Chart I-6Bond Market Does Not Believe The Fed The Fed believes there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is currently close to the short-term neutral level, which is depressed by economic headwinds. However, Yellen and others have made the case that the short-term neutral rate is trending up as headwinds diminish, and will converge with the long-term neutral rate over time. The Fed's Summary of Economic Projections reveals what the FOMC thinks is the neutral long-term real fed funds rate; the median forecast calls for a nominal fed funds rate of 2.9% at the end of 2019 and 3% in the longer run. Incorporating a 2% inflation target, we can infer that the Fed anticipates a real neutral rate of 1% in the longer run. The Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart I-6 shows this estimate of the neutral rate, called R-star, alongside the real federal funds rate that is calculated using 12-month trailing core PCE. The resulting real fed funds rate has risen sharply during the past seven months due to both three Fed rate hikes and a decline in inflation. If the Fed lifts rates once more this year and core inflation stays put, then the real fed funds rate would end 2017 close to zero, only 42 bps below neutral. However, it's more likely that the Fed will need to see inflation rebound before it delivers another rate hike. In a scenario where core inflation rises to 1.9% and the Fed lifts rates once more, then the real fed funds rate would actually decline between now and the end of the year. The implication is that the real fed funds rate is not far from R-star, but the nominal rate will have to rise a long way before the real rate reaches the Fed's estimate of the long-term neutral rate. Investors simply don't believe Fed policymakers. According to the bond market, the real fed funds rate will not shift into positive territory until 2021 (see real forward OIS line in Chart I-6). We think this is far too complacent. U.S. Health Care Reform: RIP The speed at which short-term rates converge with the long-run neutral rate will depend importantly on the path of fiscal policy. The Republicans' failure to pass their health care legislation is leading the investors to doubt the prospect for (stimulative) tax cuts. This may be premature. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for President Trump and the Republican Party. According to the Congressional Budget Office, the proposed legislation would have caused 22 million fewer Americans to have health insurance in 2026 compared with the status quo. The Senate bill would have also led to substantial cuts to Medicaid relative to existing law, as well as deep cuts to insurance subsidies for many poor and middle-class families. Many of these voters came out in support of Trump last year. The failure to repeal Obamacare could actually increase the motivation of Republicans to move forward on tax cuts anyway. The chances for broad tax reform have certainly diminished, since that will be just as difficult to get passed as healthcare reform. The GOP also wanted to use the roughly $200 billion in savings from healthcare reform to fund reduced tax rates. However, tax cuts are something that all Republicans can easily agree too, and they will need to show a legislative victory ahead of next year's mid-term elections. The difficulty will be how to pay for these cuts. We expect them to be "fully funded" in the sense that there will be offsetting spending cuts, but these will be back-loaded toward the end of the 10-year budget window, whereas the tax cuts will be front-loaded. This would generate a modest amount of fiscal stimulus over the next few years. Sub-4% U.S. Unemployment Rate Followed By Recession? Chart I-7Inside The Fed's Forecasts Expansionary fiscal policy would make life more difficult for the FOMC, which may have already fallen behind the curve. The unemployment rate is below the Fed's estimate of the full employment level, and it will continue to erode unless productivity picks up soon. We backed out the productivity growth rate implied by the Fed's latest Summary of Economic Projections, given its assumption that real GDP growth will be roughly 2% over the next couple of years and that the unemployment rate will stabilize near the current level. This combination implies that productivity growth will accelerate from the average rate observed so far in this expansion (0.7%) to about 1%, which is consistent with monthly payrolls of 135,000 assuming real GDP growth of 2% (Chart I-7). If we instead assume that productivity does not accelerate (and real GDP growth is 2%), then payrolls must jump to 160,000 and the unemployment rate would fall below 4% next year. The implication is that the unemployment rate is likely to soon reach levels not seen since 2000, which would force the FOMC to tighten more aggressively. The Fed would hope for a soft landing as it tries to nudge the unemployment rate higher, but the more likely result is a recession in 2019. For this year, we expect the Fed to begin balance sheet runoff in the autumn, followed by a rate hike in December. The latter hinges importantly on at least a modest rise in core PCE inflation in the coming months. A rebound in oil prices would help the Fed reach its inflation goal, even though energy prices affect the headline by more than the core rate. Saudi Energy Minister Khalid al-Falih indicated at a recent press conference in St. Petersburg that no changes are presently needed to the production deal under which OPEC and non-OPEC producers pledged to remove 1.8mn b/d from the market. The Saudi energy minister's remarks leave open the possibility of deeper cuts later this year if global inventories do not draw fast enough, or for the cuts to be extended beyond March 2018 if officials are not satisfied with progress on the storage front. We still believe they are capable of meeting this goal, despite rising shale production. Chart I-8Forecast Of Oil Inventories Our commodity strategists expect OECD oil inventories to reach their five-year average level by year-end or early 2018 Q1 (Chart I-8). In the absence of additional cuts, the five-year average level of OECD inventories will be higher than we estimated earlier this year, indicating that our expectation for the overall inventory drawdown later this year has been trimmed. Still, our oil strategists believe the inventory drawdowns will be sufficient to push WTI above the mid-$50s by year-end. If this forecast pans out, rising oil prices will push up headline inflation and inflation expectations in the major advanced economies. The bottom line is that the backdrop has turned bond-bearish now that central bankers in the advanced economies are in the process of scaling back the easier monetary policy that followed the deflationary 2014/15 oil shock. Duration should be kept short within global fixed income portfolios. In terms of country allocation, our global fixed income strategists have downgraded the Eurozone government bond market to underweight, joining the Treasury allocation, in light of the pending ECB tapering announcement that could place more upward pressure on yields. This was offset by upgrading Japan to maximum overweight. Max Policy Divergence Has Not Been Reached Chart I-9Europe Has A Lower Neutral Rate The change in tone by central bankers outside the U.S. has weighted heavily on the U.S. dollar. The Canadian dollar and the Euro have been particularly strong. Investors have apparently decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but rate hikes are a long way off because there remains a substantial amount of economic slack in the Eurozone. Laubach and Williams estimate R-star in the Eurozone to be close to zero, which is 50 basis points below the U.S. neutral rate (Chart I-9). The difference is related to slower potential growth and greater unemployment. Labor market slack across the euro area as a whole is still 3.2 percentage points higher than in 2008, and 6.7 points higher outside of Germany. The current real short-term rate is about -1%. We expect U.S. R-star to rise in absolute terms and relative to the neutral rate in the Eurozone because the U.S. is further advanced in the economic expansion. As Fed rate hike expectations ratchet up in the coming months, interest rate differentials versus Europe will widen in favor of the dollar. It is the same story for the dollar/yen rate because the Bank of Japan is a long way from raising or abandoning its 10-year bond yield peg. Japanese core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year. The annual shunto wage negotiations this summer produced little in the way of salary hikes. The major exception to our "strong dollar" call is the Canadian loonie, which we expect to appreciate versus the greenback. We also like the Aussie dollar, provided that the Chinese economy continues to hold up as we expect. Stocks Get A Free Pass For Now Chart I-10Global EPS And Industrial Production Fading market hopes for U.S. fiscal stimulus have weighed on both U.S. Treasury yields and the dollar, but the equity market has taken the news in stride. Are equity investors simply in denial? We do not think so. The equity market appears to have been given a "free pass" for now because earnings have been supportive. The combination of robust earnings growth, steady real GDP growth of around 2%, and low bond yields has been bullish for stocks so far in this expansion. At the global level, EPS growth continues to accelerate in line with the recovery in industrial production, which is a good proxy for top line growth (Chart I-10). Orders and production for capital goods in the major advanced economies have been particularly strong in recent months. The global operating margin flattened off last month according to IBES data, although margins continued to firm in the U.S. and Europe (Chart I-11). The profit acceleration is widespread across these three economies in the Basic Materials and Consumer Discretionary sectors. Industrials, Energy, Health Care and Consumer Staples are also performing well in most cases. Telecom is the weak spot. Our sector profit diffusion indexes paint an upbeat picture for the near term (Chart I-12). Chart I-11Operating Margins On The Rise Chart I-12Earnings Diffusion Indexes Are Bullish In the U.S., the second quarter earnings season is off to a good start. Results so far suggest that Q2 will see another quarter of margin expansion. We believe that U.S. margins are in a secular decline, but they are in the midst of a counter-trend rally that will last for the rest of this year. Using blended results for the second quarter, trailing S&P 500 EPS growth hit 18½% on a 4-quarter moving total basis (Chart I-13). The acceleration in earnings is impressive even after excluding the Energy sector. We projected early this year that EPS growth would peak at around 20%4 by year end, but it appears that earnings will overshoot that level. Chart I-13Robust EPS Growth Even Without Energy It will be tougher sledding in the equity market once profit growth peaks in the U.S. because of poor valuation. We are expecting to scale back our overweight equity recommendation sometime in the first half of 2018, although the global rally could be extended by constructive earnings data in Europe and Japan. The earnings recovery in both economies is behind the U.S., such that peak growth will come later in 2018. There is also more room for margins to expand in Europe than in the U.S. The relative earnings cycle is one of the reasons why we continue to favor Eurozone and Japanese stocks to the U.S. in local currency terms. Japanese stocks are also cheap to the U.S. based on our top-down valuation indicator (Chart I-14). European stocks are not far from fair value relative to the U.S., after adjusting for the fact that Europe trades structurally on the cheap side. The message from our top-down valuation indicator for European stocks is confirmed when using the bottom-up information contained in the new BCA Equity Trading Strategy platform. The Special Report beginning on page 20 describes a bottom-up valuation measure that we will use in conjunction with our top-down (index-based) measures. Corporate Bonds: Kindling And Sparks Healthy EPS growth momentum is also constructive for corporate bonds, although overall balance sheet health continues to erode in the U.S. The release of the U.S. Flow of Funds data allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart I-15). The level of the CHM moved slightly deeper into "deteriorating health territory." Chart I-14Top-Down Relative Equity Valuation Chart I-15Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years, calling almost all major turning points in advance. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. It also requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to ramp up, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist normally occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. It will be some time before U.S. short-term interest rates reach restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart I-16 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, eased in the fourth quarter 2016 and the first quarter of 2017 (Chart I-17). Ratings migration has also improved (i.e. moderating net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The diminished appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart I-16Still Some Value In ##br##High-Yield Corporates Chart I-17Net Transfers To Shareholders ##br##Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle. Value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Investment Conclusions A key change in the global financial landscape over the past month is a signal from central banks that they see the need for policy recalibration. Policymakers view sub-target inflation as temporary, and some are concerned that low interest rates could contribute to the formation of financial market bubbles. The bond market remains skeptical, given persistent inflation undershoots and growing anecdotal evidence that new technologies are very deflationary. It would be extremely bullish for stocks if these new technologies were indeed boosting the supply side of the economy at a faster pace than the official data suggest. Robust advances in output-per-worker would allow profits to grow quickly, and would provide the economy more breathing space before hitting inflationary capacity limits (keeping the bond vigilantes at bay). We acknowledge that there are important technological breakthroughs being made, but we do not see any evidence that this is occurring on a widespread basis sufficient to "move the dial" in terms of overall productivity growth. Indeed, the stagnation of middle class personal income is consistent with a poor productivity backdrop. Chart I-18 highlights that "creative destruction" is in a long-term bear market. Chart I-18Less Creative Destruction That said, the equity market is benefiting from the mini-cycle in corporate profits, which are still recovering from the earnings recession in 2015/early 2016. We expect the recovery to be complete by early 2018, which will set the stage for a substantial slowdown in EPS growth next year. It won't be a disaster, absent a recession, but demanding valuations suggest that the market could struggle to make headway through next year. We expect to trim exposure sometime in the first half of 2018. To time the exit, we will watch for a roll-over in the growth rate of S&P 500 EPS on a 4-quarter moving total basis. Investors should look for a peak in industrial production growth as a warnings sign for profits. We are also watching for a contraction in excess money, which we define as M2 divided by nominal GDP. Finally, a rise in core PCE inflation to 2% would be a signal that the Fed is about to ramp up interest rates. For now, remain overweight equities relative to bonds and cash. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. We are comfortable with our pro-risk recommendations and our below-benchmark duration stance. Unfortunately, that can't be said of our bullish U.S. dollar and oil price house views. Both are controversial calls among our strategists. As for oil, supply and demand are finely balanced and our positive view hinges importantly on OPEC agreeing to more production cuts. The obvious risk is that these cuts do not materialize. The dollar call has gone against us as the latest signs of improving global growth momentum have admittedly been outside the U.S. Meanwhile, the U.S. is stuck in a political morass, which delays the prospect of fiscal stimulus. This is not to say that U.S. growth will slow. Rather, the growth acceleration may fall short of the high expectations following last November's election. We continue to believe that the market is too complacent on the pace of Fed rate hikes in the coming quarters. An upward adjustment in rate expectations should push the dollar higher on a trade-weighted basis, as outlined above. Nonetheless, this shift will require higher U.S. inflation, the timing of which is highly uncertain. We remain dollar bulls on a 12-month horizon, but we are stepping aside and calling for a trading range in the next three months. Mark McClellan Senior Vice President The Bank Credit Analyst July 27, 2017 Next Report: August 31, 2017 1 Please see Global Fixed Income Strategy Weekly Report, "Central Banks Are Now Playing Catch-Up," dated July 4, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 3 Kathryn Holston, Thomas Laubach, and John C. Williams "Measuring The Natural Rates Of Interest: International Trends And Determinants," Federal Reserve Bank of San Francisco, Working Paper 2016-11 (December 2016). 4 Calculated as a year-over-year growth rate of a 4-quarter moving total of S&P data. II. The BCA ETS Trading Platform Approach To Valuing Eurozone Stocks The performance of European stocks relative to the U.S. has been dismal in the post-Lehman period. However, the Eurozone economy is performing impressively, profit growth is accelerating and margins are rising. This points to a period of outperformance for Eurozone stocks, at least in local currency terms. Standard valuation measures based on index data suggest that Eurozone stocks are cheap to the U.S. Nonetheless, the European market almost always trades at a discount, due to persistent lackluster profit performance. In Part II of our series on valuation, we approach the issue from a bottom-up perspective, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The ETS software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction. Investors can be confident that they will make money on a 12-month horizon by taking a position when the new bottom-up indicator reaches +/-1 standard deviations over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of fundamental or technical factors. Valuation alone does not justify overweight Eurozone positions at the moment, although we like the market for other reasons. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. Total returns in the European equity market have bounced relative to the U.S. since 2016 in both local-currency and common currency terms (Chart II-1). However, this has offset only a tiny fraction of the dismal underperformance since 2007. In local currencies, the relative EMU/U.S. total return index is still close to its lowest level since the late 1970s. Compared with the pre-Lehman peak, the U.S. total return index is more than 96% higher according to Datastream data, while the Eurozone total return index is only now getting back to the previous high-water mark when expressed in U.S. dollars (Chart II-2). Chart II-1EMU Stocks Lag Massively... Chart II-2...Due To Depressed Earnings The yawning return gap between the two equity markets was almost entirely due to earnings as market multiples have moved largely in sync. Earnings-per-share (EPS) generated by U.S. companies now exceed the pre-Lehman peak by about 19%. In contrast, earnings produced by their Eurozone peers are a whopping 48% below their peak (common currency). This reflects both a slower recovery in sales-per-share growth and lower profit margins. Operating margins in Europe have been on the upswing for a year, but are still depressed by pre-Lehman standards. Margin outperformance in the U.S. is not a sector weighting story; in only 2 of 10 sectors do European operating margins exceed the U.S. The return-on-equity data tell a similar story. Nonetheless, a turning point may be at hand. Chart II-3Europe Trades At A Discount The Eurozone economy has been performing well, especially on a per-capita basis, and forward-looking indicators suggest that growth will remain above-trend for at least the next few quarters. U.S. profit margins have also been (temporarily) rising, but the Eurozone economy has more room to grow because there is still slack in the labor market. There is also more room for margins to rise in the Eurozone corporate sector than is the case in the U.S., where the profit cycle is further advanced. Traditional measures of value based on the MSCI indexes suggest that European stocks are on the cheap side. But are they really that cheap? Based on index data, Eurozone stocks trade at a hefty discount across most of the main valuation measures (Chart II-3). This is the case even for normalized measures such as price-to-book (P/B). However, Eurozone stocks have almost always traded at a discount. There are many possible explanations as to why there is a persistent valuation gap between these two markets, including differences in accounting standards, discount rates and sector weights. The wider use of stock buybacks in the U.S. also favors American stock valuations relative to Europe. But most important are historical differences in underlying corporate fundamentals. U.S. companies on the whole were significantly more profitable even before the Great Financial Crisis (Chart II-3). U.S. companies also tend to have lower leverage and higher interest coverage. Better profitability metrics in the U.S. are not solely an artifact of sector weighting either. RoE and operating margins are lower in Europe even applying U.S. sector weights to the European market.1 Why corporate Europe has been a perennial profit under-achiever is beyond the scope of this paper. U.S. companies reaped most of the benefit from productivity gains over the past 25 years, with the result that the capital share of income soared while the labor share collapsed. European companies were less successful in squeezing down labor costs. Measuring Value In the first part of our two-part Special Report on valuation, published in July 2016, we took a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for different sector weights and persistent differences in the underlying profit fundamentals. A regression approach that factored in various profitability measures performed reasonably well, but the top-down "mechanical" approach that relied on a 5-year moving average provided the most profitable buy/sell signals historically. We approach the issue from a bottom-up perspective in Part II of our series, utilizing the powerful analytics provided by BCA's exciting new Equity Trading Strategy (ETS) platform. The software allows us to compare U.S. and European companies on a head-to-head basis and rank them based on a wide range of characteristics. The bottom-up approach avoids the problems of index construction when trying to gauge valuation across countries. The web-based platform uses over 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries, allowing clients to find stocks with winning characteristics at the global level. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top-decile of stocks ranked using the "BCA Score" methodology have outperformed stocks in the bottom decile by over 25% a year.2 The BCA Score includes all 24 factors when ranking stocks, but we are interested in developing a valuation metric that provides valued added on its own and is at least as good as the top-down index-based measure developed in Part I. The five valuation measures in the ETS database are trailing P/E, forward P/E, price-to-book, price-to-sales and price-to-cash flow. We combine all of the Eurozone and U.S. companies that have total assets of greater than $1 billion into one dataset. The ETS platform then ranks the stocks from best to worst on a daily basis (i.e. cheapest to most expensive), using an equally-weighted average of the five valuation measures. The average score for U.S. stocks is subtracted from the average score for European stocks, and then divided by the standard deviation of the series. This provides a valuation metric that fluctuates roughly between +/- 2 standard deviations. Chart II-4 presents the resulting bottom-up indicator, along with our previously-published top-down valuation measure. A high reading indicates that European stocks are cheap to the U.S., while it is the opposite for low readings. Chart II-4Eurozone Equity Relative Valuation Indicators The underlying bottom-up data extend back to 2000. However, the bursting of the tech bubble in the early 2000's causes major shifts in relative valuation among sectors and between the U.S. and Eurozone that skew the indicator when constructed using the entire data set. We obtain a cleaner indicator when using only the data from 2005. As with any valuation indicator, it is only useful when it reaches extremes. We calculated the historical track record for a trading rule that is based on critical levels of over- and under-valuation. For example, we calculated the (local currency) excess returns over 3, 6, 12 and 24-month horizon generated by (1) overweighting European stocks when that market was one and two standard deviations cheap versus the U.S. market, and (2) overweighting the U.S. when the European market was one and two standard deviations expensive (Table II-1). Table II-1Value Indicator: Trading Rule Returns And Batting Average The trading rule returns were best when the indicator reached two standard deviations cheap or expensive, providing average returns of almost 11 percent over 12 months. The trading rule returns when the indicator reached +/-1 standard deviation were not as good, but still more than 3% on 12- and 24-month horizons. Table II-1 also presents the trading rule's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. The batting average ranged from 50% on a 3-month horizon to 68% over 24 months when buy/sell signals are triggered at +/- 1 standard deviation. The batting average is much higher (80-100%) using +/- 2 standard deviations as a trigger point, although there were only five months over the entire sample when the indicator reached this level. The charts and tables in the Appendix present the results of the same analysis at the sector level. The results are equally as good as the aggregate valuation indicator, with a couple of exceptions. European stocks are cheap to the U.S. in the Energy, Financials, and Utilities sectors, while U.S. stocks offer better value in Consumer Discretionary, Consumer Staples, Health Care, Industrials and Technology. Materials, Real Estate, and Telecommunications are close to equally valued. Sharpening The Buy/Sell Signals We then augmented the valuation analysis by adding information on company fundamentals, such as EPS growth and profit margins among others. The ETS software ranked the companies after equally-weighting the valuation and fundamental factors. However, this approach yielded poor results in terms of the trading rule. This is because, for example, when European stocks reach undervalued levels relative to the U.S., it is usually because the European earnings fundamentals have underperformed those of the U.S. companies. Thus, favorable value is offset by poor fundamentals, muddying the message provided by valuation alone. In contrast, adding some information from the technical factors in the ETS model does add value, at least when using +/-1 standard deviations as the trigger point for trades (Chart II-5). Excess returns to the trading rule rise significantly when the medium-term momentum and long-term mean reversion factors are included in the valuation indicator (Table II-2). The batting average also improves. Chart II-5Indicators: Value And Value With Technical Information Table II-2Value And Technical Indicator: Trading Rule Returns And Batting Average Adding technical information does not improve the trading rule performance when +/-2 sigma is used as the trigger point. Investment Conclusions Our new ETS platform provides investors with a unique way of picking stocks by combining top-down macro themes with company-specific information. It also allows us to develop valuation tools that avoid some of the pitfalls of index data by comparing stocks on a head-to-head basis. Historical analysis using a trading rule demonstrates that the new bottom-up valuation indicator provides real value to investors. We would normally evaluate its track record using stretching analysis, where we use only the historical information available at each point in time when determining relative value. However, the relatively short history of the available data precludes this test because we need at least a few cycles to best gauge the underlying volatility in the data. Still, investors can be fairly confident that they will make money on a 12-month horizon by taking a position when the bottom-up indicator reaches +/-1 sigma over- or under-valued, although technical information should be taken on board to sharpen the timing. The +/-2 sigma level gives clear buy/sell signals irrespective of the fundamental or technical factors. The bottom-up valuation indicator will not replace our top-down version that is based on index data, but rather will be considered together when evaluating relative value. At the moment, the top-down version proposes that European stocks are somewhat cheap to the U.S., while the bottom-up indicator points to slight overvaluation. Considering the two together suggests that valuation is close enough to fair value that investors cannot make the decision on value alone. Valuation indicators need to be near extremes to be informative. Our global equity strategists recommend overweighting Eurozone stocks versus the U.S. at the moment, although not because of valuation. Rather, the Eurozone economy and corporate earnings have more room to grow because of lingering labor market slack. This also means that the ECB can keep rates glued to the zero bound for at least the next 18 months while the Fed hikes, which will place upward pressure on the dollar and downward pressure on the euro. Mark McClellan Senior Vice President The Bank Credit Analyst Appendix: Trading Rule Returns By Sector Chart II-6, Chart II-7, Chart II-8, Chart II-9, Chart II-10, Chart II-11, Chart II-12, Chart II-13, Chart II-14, Chart II-15, Chart II-16. Chart II-6Consumer Discretionary Chart II-7Consumer Staples Chart II-8Energy Chart II-9Financials Chart II-10Health Care Chart II-11Industrials Chart II-12Materials Chart II-13Real Estate Chart II-14Utilities Chart II-15Technology Chart II-16Telecommunication 1 Please see The Bank Credit Analyst Special Report, "Are Eurozone Stocks Really That Cheap?" July 2016, available at bca.bcaresearch.com. 2 Please see Equity Trading Strategy Special Report, "Introducing ETS: A Top Down Approach to Bottom-Up Stock Picking," December 2, 2015, available at ets.bcaresearch.com. III. Indicators And Reference Charts Stocks continue to outperform bonds against a constructive backdrop of improving global economic prospects and accelerating EPS growth, while low inflation is expected to keep central banks from tightening quickly. Our main equity and asset allocation indicators remain bullish for risk, with a few exceptions. Our new Revealed Preference Indicator (RPI) jumped back to a 100% equity weighting in July. We introduced the RPI in last month's Special Report. Quite simply, it 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. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks for the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The U.S. WTP remains bullish, but has topped out, suggesting that flows into the U.S. market are beginning to moderate. In contrast, the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway, although it has not yet shown up in terms of equity market outperformance versus the U.S. On the negative side, our Monetary Indicator last month fell a little further below the zero line and our composite Technical Indicator appears to be rolling over; the latter generates a 'sell' signal when it drops below its 9-month moving average. Value is stretched, but our Valuation Indicator has not yet reached the +1 standard deviation level that indicates clear over-valuation. As highlighted in the Overview section, the U.S. and global earnings backdrop continues to support equity markets. Forward earnings estimates are in a steep uptrend, and the recent surge in the net revisions ratio and the earnings surprise index suggests that EPS growth will remain impressive for the remainder of the year. Bond valuation is largely unchanged from last month, sitting very close to fair value. We still believe that fair value is rising as economic headwinds fade. However, much depends on our forecast that core inflation in the major countries will grind higher in the coming months. Central banks stand ready to "remove the punchbowl" if they get the green light from inflation. The dollar's downdraft in July reduced some of its overvaluation based on purchasing power parity measures. The dollar appears less overvalued based on other measures. Our composite Technical Indicator has fallen hard, but has not reached oversold levels. This suggests that the dollar has more downside before it finds a bottom. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen TechnicalsChart III-21Euro/Yen Technicals Chart III-20Euro TechnicalsChart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China

Highlights Strengthening income growth is apparent in DM and EM trade volumes, real wages in the U.S., and industrial commodity prices, chiefly oil and copper. This indicates inflation at the consumer level will move higher in the near future, most likely in 2H2018. We believe 10-year U.S. Treasury Inflation-Indexed securities (TIPS) trading below 0.52 do not reflect the risk of higher inflation and are, therefore, going long at tonight's close. Energy: Overweight. Crude oil prices rallied 4.6% this week, following the OPEC 2.0 meeting in St. Petersburg. Although ministers did not announce additional cuts to the 1.8mm b/d agreed at the end of last year, Saudi Energy Minister Khalid al-Falih said the Kingdom would reduce August exports to 6.6mm b/d, which is more than 300k b/d below May's level, the latest month for which data are available from JODI. Given strong global demand, if this export reduction persists - and if others join the Kingdom - it would speed the drawdown in global inventories. Base Metals: Neutral. Copper pushed through $2.80/lb on the COMEX, a level not seen since May 2015. Underlying strength in EM economic activity - seen most recently in global trading activity (discussed below) - and a weaker USD are supporting base metals. Precious Metals: Neutral. Gold fell below $1,257/oz earlier this week, and was trading ~ $1,250/oz going to press Wednesday. We remain long gold as a portfolio hedge; the position is up 1.7% since it was initiated on May 4, 2017. Ags/Softs: Underweight. Harsh weather is impacting grains. The USDA rated 62% of the U.S. corn crop in the 18 states comprising 92% of total output good or excellent last week, down from 76% in 2016. For beans, the split was 58% last week vs. 71% last year. Feature The expansion in global trade that began toward the end of last year continues, which, based on our modeling, indicates inflation at the consumer level likely will move higher in the short run (Chart of the Week). Trade expansion, particularly in EM economies, is consistent with rising incomes, which, all else equal, will keep industrial commodities - oil and copper, in particular - well supported, given income and demand for these commodities are closely aligned.1 These fundamentals dovetail with other indications of stronger growth, particularly in DM economies, where trade volumes also are growing (Chart 2). In the U.S., for example, wage growth continues to outpace inflation, and monetary conditions remain benign (Chart 3). Our colleagues at BCA Research's Global Investment Strategy believe the Fed actually may be behind the curve in reacting to nascent inflationary pressures emerging in the U.S.2 Chart of the WeekRising EM Trade Volumes Consistent##BR##With Higher U.S. CPI Inflation Chart 2DM Trade Volumes Are Expanding##BR##At ~ 5% Pace ... Chart 3U.S. Labor Market Tightening,##BR##Financial Conditions Remain Loose Trade Growth Supports Higher Inflation U.S. CPI is highly correlated with EM trade volumes (imports and exports) as shown in the Chart of the Week. In recent research into inflation and trade, we also showed EM oil demand and world base metals demand are highly correlated with EM trade volumes.3 Chart 4EM Trade Volumes##BR##Continue To Strengthen Growth EM import growth continues to expand at a faster pace than DM growth (Chart 4). Year-on-year (yoy) EM import growth came in at 7.7%, a full 2 percentage points above DM growth. This is not to minimize DM growth - it finally broke out of its lethargy in May with a sharp advance of close to 6%, which will lift the trend rate of growth (the 12-month moving average, or 12mma) higher going forward. EM export growth in May was only slightly above DM growth for the month - 5.4% yoy vs. 5.2% yoy. These stout monthly trade performances will, in the next few months, offset the lethargic growth seen in EM and DM prior to the expansion begun at the end of 2016, as weaker monthly performance falls off the trend calculations. Over the year ended in May, within EM markets the annual trend in imports (the 12mma to May 2017) has barely grown more than 1% yoy, dragged down by a 6% contraction in the Middle East and Africa (MEA) and a 2.1% contraction in Latin American growth. The trend in EM - Asia's imports is up, rising 3.2% over the same period. For the year ended in May, imports into central and Eastern Europe were mostly flat; however, since November 2016, the trend turned sharply positive with 3.3% yoy growth. The trend in export volumes is expanding for in MEA and Latin America economies - 3.5% yoy trend growth (12mma) in MEA, and 4.4% growth in Latin America, which is slightly higher than the overall 2.2% rate of trend growth in EM exports. Still, lower oil and commodity prices, along with reduced volumes are curtailing an income recovery in these regions. Central and Eastern Europe's rate of export expansion leads EM generally at close to 4% yoy trend growth. Favor Gold And TIPS Ahead Of Higher Inflation As the labor market tightens and real-wage growth continues to outpace productivity growth, we expect U.S. inflation to pick up. Growth in trade volumes also will support growth in EM oil demand and world base metal demand, as noted above. This will feed into U.S. core PCE, the Fed's preferred inflation gauge (Chart 5). As we've highlighted in the past, there is very strong co-movement among these variables: We've found that, all else equal, a 1% increase in the non-OECD oil demand implies an increase in the core PCE of slightly less than 50bp. If the trend in overall EM trade volumes persists, the likelihood we will be increasing our estimate of non-OECD oil consumption for 2H17 and 2018 increases. U.S. CPI and EM trade volumes show similar co-movement properties, as the Chart of the Week shows. A 1% increase in EM import volumes translates into a 0.53% increase in the U.S. CPI, while a 1% increase in EM export volumes implies a 0.49% increase in the CPI. EM import volumes over the January - May 2017 interval have been growing at slightly more than 8% yoy, while exports have been growing at slightly more than 3%. Continued strength in the EM trade data implies U.S. CPI could grow well above what's currently being priced in inflation markets and by Fed policymakers. This leads us to favour gold and TIPS as inflation hedges. If we do get a larger-than-expected move in the U.S. CPI, gold should respond well. The modelling depicted in Chart 6 shows a 1% increase in the CPI translates into a 4.1% increase in gold. Chart 5Core PCE Will Pick Up##BR##As Commodity Demand Grows Chart 6Gold Will Pick Up##BR##Larger-Than-Expected CPI Moves For this reason we recommend getting long U.S. Treasury Inflation-Protected Securities (TIPS), which will appreciate as the U.S. CPI moves higher.4 We will be getting long as of tonight's close. We remain long low-risk calls spreads in Dec/17 WTI and Brent - long $50/bbl strikes vs. short $55/bbl strikes. We are up 39.3% and 32.9% on the Brent and WTI positions, respectively, from last week, and 47.2% and 89.2% since inception. U.S. Monetary Policy Remains A Huge Risk To EM Trade As we've noted in the past, U.S. monetary policy can have an outsized effect on EM trade volumes. In an update of an earlier model using U.S. M2 and the broad trade-weighted USD (TWIB), we find a 1% increase in the broad trade-weighted USD translates into a 1.1% drop in EM imports, while a 1% increase in U.S. M2 (broad money) implies an 85bp increase in EM imports (Chart 7).5 Chart 7EM Trade Volumes Highly Sensitive##BR##To U.S. Monetary Policy This demonstrates the feedback loop we've identified between U.S. monetary policy and EM trade. EM trade volumes affect inflation at a global level. We've found inflation in the U.S., EU and China to be co-integrated - i.e., these price gauges all follow the same long-term trend. Inflation and inflation expectations drive Fed policy, which drives the price formation of the USD - i.e., the FX rates included in the USD TWIB - and affect Fed policy on M2. These U.S. monetary variables, in turn, affect EM trade volumes. And so it goes ... Too-aggressive a tightening by the Fed as it normalizes its interest-rate policy regime could destabilize EM economies - either via too-sharp an appreciation in the USD TWIB, a larger-than-expected deceleration in M2 growth, or both - and negatively affect trade flows. At the end of the day, this would redound to the detriment of the U.S. economy, as the different feedback mechanisms kick in. This says the Fed's policy doesn't just affect the U.S. economy, or that EM economies essentially are on their own in the policy tools they deploy to adjust to Fed innovations. Like it or not, the Fed has to consider these types of feedback loops in its decision-making, since the Open Market Committee will be dealing with the fallout of its earlier policies. Bottom Line: EM trade volumes continue to grow yoy, continuing the trend that began at the end of last year. This performance, coupled with a tightening labor market in the U.S. and a still-loose financial backdrop, raises the odds inflation will exceed what's currently priced into market and Fed expectations. We are getting long U.S. 10-year TIPS at tonight's close, and remain long gold as a strategic portfolio hedge. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 The income elasticity for industrial commodities in EM economies is ~ 1.0, according to the OECD. Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). 2 Please see BCA's Global Investment Strategy Weekly Report titled "Are Central Banks Behind The Curve Or Ahead Of It?," published on July 21, 2017. It is available at gis.bcaresearch.com. Among other things, the Global Investment Strategy team notes labor-market slack is dissipating, real wages are increasing, and easier financial conditions are spurring credit growth. Our colleagues note, "The prospect of stronger growth over the next few quarters implies that the unemployment rate is likely to fall below 4% early next year, possibly breaking through the 2000 low of 3.8%." BCA's Global Investment Strategy believes U.S. inflation could move higher by 2H18. 3 Please see BCA Commodity & Energy Strategy Weekly Reports titled "EM Trade Volumes Continue Trending Higher, Supporting Metals" and "Strong EM Trade Volumes Will Support Oil," published June 29, and June 8, 2017. Both are available at ces.bcaresearch.com. 4 U.S. TIPS increase in value as the Consumer Price Index (CPI) rises, and fall in value as the index declines. Please see "TIPS: Rates & Terms" on the UST's TreasuryDirect web page (https://www.treasurydirect.gov/indiv/research/indepth/tips/res_tips_rates.htm). 5 This model covers 2000 to the present, using monthly data. The R2 for the cointegrating regression is 0.96. These variables do not explain EM exports, which are not cointegrated with U.S. monetary variables. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Highlights To shed light on the dichotomies that have surfaced in China's money and credit variables, we have calculated a new credit-money. This new measure is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. We do not mean that investors should put all of their faith in this new measure. Yet, other measures of money and credit such as M1, M2 and banks' total assets all point to an impending deceleration in economic growth in China. While many global investors take for granted that the central government will underwrite credit risk in the entire economy, the top leadership in Beijing is sending the opposite message, at least for now. A new fixed income trade: pay Czech / receive Polish 10-year swap rates. Feature Chart I-1China: A Business Cycle Top Is In The Making Typically, the phrase 'Follow The Money' is used in the investment community to advise in favor of chasing investment flows. Today, we use this phrase in the context of not following investor crowds, per se, but money growth - especially in China. Judging from market actions and elevated inflows into EM assets and investable Chinese stocks, we can infer that investor consensus on China/EM is rather bullish. In the meantime, China's money/credit growth is sending a bearish signal. Investors should heed the downbeat message from Chinese money/credit and not chase EM risk assets higher. To reconcile the different messages from various measures of Chinese money and credit aggregates (more on the differences below), we calculated a new measure of money/credit creation - commercial banks' total credit (referred to below as banks' credit-money). Banks' credit/-oney is the sum of commercial banks' claims on companies, households, non-bank financial institutions, and all levels of government, as well as commercial banks'' and PBoC's foreign assets. Also, we deduct government deposits at the central bank (see below for the rationale). This measure, a de-facto aggregate of credit/money originated by banks and the PBoC, is computed using the asset side of banks' balance sheets. The key message from this report is that mainland banks' credit-money growth has already decelerated meaningfully, and points to a considerable slump in China's business cycle and imports in the months ahead (Chart I-1). Notably, banks' credit-money growth is at the lowest level of the past 10 years, excluding the Lehman crisis. It is also well below 2015 lows when the economy was acutely struggling. Exploring Money And Credit Dichotomies In China There has lately been a puzzling divergence between the growth rates of banks' credit-money, M2, and total social financing (TSF) (Chart I-2). Chart I-2Dichotomy Among Various Credit And Money Aggregates In China In 2016, banks' credit-money growth accelerated to 20%, while the pick-up in M2, and bank loan growth was modest. At the same time, TSF and corporate and household credit growth was largely flat. Lately, M1 growth has slowed, M2 and banks' total asset growth have dropped to all-time lows, while banks' loan and total social financing have remained flat. So, what is the true picture of money and credit growth in China? What are these critical variables telling us about the growth outlook? Our measure of banks' credit-money should by and large match broad money (M2) because the former is calculated by adding up various assets, and the latter by aggregation of various liabilities. Indeed, both were correlated well in the past, but decoupled in 2013 (Chart I-3, top panel). There has been another money/credit paradox: banks' credit-money on the one hand, and TSF and banks' RMB loans on the other, also have decoupled since 2013 (Chart I-3, middle and bottom panels). Overall, neither M2 nor TSF and banks' RMB loans mirrored the surge in banks' money-credit origination in 2015 and 2016, as portrayed in Chart I-3. We have been relying on the M2 and TSF aggregates published by China's central bank. Their tame readings in 2016 were the main reason we underestimated the duration and magnitude of China's economic recovery in the past year or so, as well as its impact on the rest of EM and commodities. As to components of banks' credit-money, Chart I-4 demonstrates that the deceleration has been due to the claims on non-financial organizations (companies), non-bank financial institutions and government. In brief, the slowdown has been broad-based; only claims on households continue expanding at a robust rate of 25% from a year ago (Chart I-4, bottom panel). Chart I-3M2 And Total Social Financing Have Not ##br##Reflected Money Created by Banks Chart I-4Individual Components Of Commercial ##br##Banks' Money Origination We suspect burgeoning financial engineering in China, credit shenanigans, and the non-encompassing nature of the People's Bank of China's broad money (M2) calculation along with the local government debt swap conducted in 2015 have all distorted credit and money data in recent years, producing the above dichotomies. To shed light on these dichotomies and calculate what has been true money/credit origination in China, we have revisited the basics of money and credit creation and have attempted to make sense of the data and the underlying trends. Overall, we have the following observations and comments: New nominal purchasing power in any economy is created by banks when they originate new loans. Hence, measuring properly the amount of new credit/money origination is of paramount importance to forecasting business cycle dynamics in any country. As we argued in our trilogy of Special Reports on Money, Credit and Savings, banks do not need savings or deposits to originate loans.1 They simultaneously create an asset (a loan) and a liability (a deposit) when extending credit to a borrower, which creates purchasing power in the economy. Importantly, there is no need for someone to save (i.e., forego consumption) in order for a bank to create a new loan / originate new money. In the case of China, commercial banks have an enormous amount of deposits - not because households and companies save a lot but because the banking system altogether has originated a lot of credit/money. The household and national savings rates quoted by economists refer to excess production/overcapacity in the real economy and not deposits in the banking system. We have discussed this issue in the past2 and will revisit it in future reports. The restraining factors for banks to originate new credit/money are their capital, regulations, loan demand, and liquidity - but not deposits. Liquidity is banks' excess reserves at the central bank. Commercial banks create deposits but they cannot engender reserves at the central bank, i.e., liquidity. Only the central bank can expand or shrink the amount of liquidity/reserves commercial banks hold with it. Finally, commercial banks do not lend their reserves; they use the reserves to settle transactions with other banks. In turn, central banks do not create new money/purchasing power unless they lend to or buy assets from governments and non-bank entities or issue currency. Central banks have a monopoly over the creation of bank reserves and currency in circulation - high-powered money. A liquidity crunch at a bank occurs when a bank runs out of excess reserves at the central bank, and it cannot borrow/attract additional reserves. Nowadays, many central banks targeting interest rates supply reserves and lend to commercial banks unlimited amounts of reserves on demand to assure interbank rates stay close to their policy target rate. Therefore, in such settings one can infer that banks are not restrained by liquidity to produce new money/expand their assets. In the case of China, the PBoC's claims on banks have skyrocketed - they have surged by 4.5-fold since 2014 (Chart I-5) - entailing that the former has supplied a lot of liquidity to commercial banks. Such liquidity expansion by the PBoC has in turn allowed banks to create tremendous amounts of new money (new purchasing power). To put the amount of money/credit originated by Chinese commercial banks in context, we have calculated the ratio of their credit/money stock to China's nominal GDP and global nominal GDP (Chart I-6). Chart I-5The PBoC Has Injected A Lot Of##br## Liquidity/Reserves Into The System Chart I-6Chinese Banks' Colossal ##br##Money Creation The broad measure of banks' credit/money created presently stands at 250% of Chinese GDP and 32% of global GDP, or US$29 trillion. The latter compares with the U.S. Wilshire 5000 equity market cap of US$ 26 trillion at a time when American share prices are at all-time highs, and the median P/E ratio is at a record high as well. In 2016 alone, Chinese banks' originated RMB 21 trillion, or US$1.7 trillion in new money-credit. Since January 2009, when the credit boom commenced, mainland commercial banks have cumulatively generated RMB 141 trillion, or US$21.12 trillion, of new money/credit. Banks create new money/deposits when they lend or acquire assets. Exceptions are when banks lend to the central bank or to other commercial banks. In those circumstances, a bank draws on its reserves at the central bank, and no new money - and by extension purchasing power - is created. Fluctuations in reserves/liquidity affect purchasing power in an economy indirectly rather than directly. Expanding reserves/liquidity encourage banks money/credit creation and vice versa. In China, commercial banks' excess reserves at the PBoC are presently contracting and stand at historically low level relative to outstanding stock of credit/money (Chart I-7). This is one of the reasons why banks have been scaling back their credit/money origination. Chart I-7China: Banks' Liquidity/##br##Excess Reserves Are Thin The fiscal authorities play a unique role in money creation. Because of the authorities typically have accounts at both the central bank and commercial banks, they can alter the money supply by shifting deposits back and forth between their accounts at the central bank and commercial banks. By transferring deposits from a commercial bank to the central bank, the fiscal authorities can destroy money; by the same token, they can create money by doing the opposite. This is why when computing Chinese banks' credit-money aggregate we have deducted from the credit/money aggregate government deposits at the PBoC. Finally, there is a difference between credit-money originated by banks, and non-bank credit. Non-banks are financial intermediaries that transfer existing deposits into credit. By doing so they do not create new purchasing power. When banks lend or acquire various assets, they do generate new purchasing power - i.e., they create new deposits that did not exist before. This is why banks are not financial intermediaries. This is true for any country and financial system. For more detailed analysis on the difference between banks and non-banks, please refer to the linked paper.3 When examining leverage in the system, one should consider bank and non-bank credit. Yet, when looking to gauge the outlook for growth and inflation, one should consider new credit/money originated by banks. The purpose of this report is to examine and compute new credit-money that determine nominal economic growth in China rather than discuss leverage even though they are often interlinked. Therefore, we are focused on new credit-money originated by banks, and not on the amount of and changes in leverage in the economy. Bottom Line: Whether one prefers M2, banks' total assets or our new measure of banks' credit/money, the message is by and large the same: money-credit growth is slowing and is very weak. Credit-Money And Business Cycle Chart I-8Comparing Two Impulse Indicators How good is the bank credit-money in terms of being an indicator for China's business cycle? We have one caveat to mention before we illustrate its relevance: Banks' credit-money is a stock variable, and our goal is to gauge business cycle trends - i.e., changes in flow variables such as output, capital spending, profits and imports. Also, the first derivative of a stock variable is a flow, while the second derivative of a stock variable is a change in its flow. Therefore, we have calculated credit/money impulse as the second derivative of outstanding credit/money, or a change in annual change, to align it with the growth rate of flow variables. The following illustrates that banks' credit-money impulse has been an extremely good leading indicator for many economic and financial variables. The new impulse of banks' credit-money has since 2014 diverged from the nation's credit and fiscal impulse (Chart I-8). Nevertheless, the new credit-money impulse leads numerous business cycle variables such as nominal GDP, producer prices, electricity output, machinery sales, freight volumes, and manufacturing PMI (Chart I-9A and Chart I-9B). Chart I-9AChina's Growth To Decelerate A Lot (II) Chart I-9BChina's Growth To Decelerate A Lot (I) Not surprisingly, this impulse also leads property sales and starts as well as construction nominal GDP (Chart I-10). This impulse often precedes swings in the LMEX industrial metals index and iron ore prices (Chart I-11). Further, it is also a reasonably good indicator for EM EPS growth (Chart I-11, bottom panel). As discussed above, banks' new credit-money creation determines nominal - not real - growth. Chart I-10China: Property / Construction ##br##Are At A Major Risk Chart I-11Downbeat Message For Industrial ##br##Metals And EM Profits By expanding their assets, banks generate new purchasing power, but they do not have any control over whether this new purchasing power is used to boost real output or prices. The recovery of the past 12 months have in some cases boosted prices more than volumes. It might be that China is inching closer to an inflation inflection point. We are not saying that China has runaway inflation at the moment, but persistent enormous overflow of money-credit will inevitably produce higher inflation. If inflation does indeed rise materially, policymakers will have no choice but to tighten. Monetary tightening will be devastating for an economy with already high leverage. Bottom Line: The new measure of banks' credit-money is currently corroborating a very downbeat outlook for Chinese growth and China-related plays. Beijing's Priorities And Investment Implications It is generally believed in the global investment community that China's authorities will not allow the economy to slump - they will boost credit/money growth and fiscal spending to ensure solid growth. It is true that no government wants to see their economy crumble, and China is no exception. However, there are several reasons to expect growth to slump considerably before the government responds: The central bank has been guiding interest rates higher across the entire yield curve. Short-term interbank rates (7-day Interbank Fixing Rate) and 5-year AA domestic corporate bond yields have risen by about 100 and 200 basis points, respectively, since November 2016. In addition, financial regulators are clamping down on off-balance-sheet and fancy financial engineering practices of banks and other financial institutions. Monetary policy works with a time lag, and the current tightening along with the government's regulatory clampdown will impact economic growth in the months ahead. The sharp deceleration in banks' credit/money confirms this. Even though interest rates have recently stopped rising, the damage to banks' credit/money growth has been done as shown in Chart I-12. Business activity is lagging money/credit and will be next to suffer. The central government in Beijing has largely lost control over credit creation/leverage build-up since 2009. The top leadership in Beijing did not want credit to explode and speculative behavior to profligate. Two recent articles by Caixin news agency (links are in footnote4) corroborate that Beijing is unhappy with credit creation and allocation practices prevailing in the financial system as well as among SOEs and local governments. The top leadership appears decisive, at least for now, in clamping down on ballooning credit/money growth and the ensuing misallocation of capital and bubbles. Interestingly, while many global investors take for granted that the central government will underwrite credit risk in the entire economy, or at least among state-owned companies, Beijing is sending the opposite message for now. True, when an economy and financial system crumbles, the central government will undoubtedly step in. However, investors do not want to be on the long side of China-related markets when this occurs. Buying opportunities may occur at that point, but for now the risk-reward profile is extremely poor. The authorities in Beijing tolerated colossal money/credit creation and misallocation of capital when growth in the advanced economies was extremely feeble. Now, with DM economies expanding at a solid pace and China's growth having recovered, they are comfortable tightening. As for the resulting investment strategy conclusions, it is too late to chase this rally in EM risk assets and other China-related assets. We do not mean that investors should put all of their faith in our new measure of China's credit/money. Yet, other measures of money and credit such as M1, M2 or banks' total assets all point to an impending deceleration in economic growth in China. In EM ex-China, narrow (M1), broad money and private credit growth have been and remain lackluster (Chart I-13). As China's growth and imports slump, the majority of EM economies will be materially affected. Chart I-12China: Interest Rates And Money Creation Chart I-13EM Ex-China: Subdued Money / Credit Growth There is no change in our overall investment strategy. Specific country recommendations and positions across all asset classes are always presented at the end of our reports, presently on pages 18-19. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Caitlynn Qi Zeng, Research Assistant caitlynnz@bcaresearch.com Central Europe: A New Fixed-Income Trade In a Special Report titled Central Europe: Beware Of An Inflation Outbreak from June 21st 2017 - the link is available on page 20, we argued that labor shortages in central Europe have been pushing up wage growth, generating genuine inflationary pressures. The Polish, Czech and Hungarian economies are overheating, warranting imminent monetary policy tightening. We elaborated on the reasons why this is happening in that report and as such we will not go through it in detail again here. Based on this theme, our primary investment recommendation was in the currency market: go long the PLN and CZK versus the euro and/or EM currencies. This recommendation remains intact. Today we recommend a new trade based on the same theme: pay Czech / receive Polish 10-year swap rates (Chart II-1). The negative 143 basis points yield gap between Czech and Polish 10-year swap rates is unsustainable and it will mostly close for the following reasons: The relative output gap between the Czech Republic and Poland is showing that the Czech economy is overheating faster than in Poland (Chart II-2). This will eventually lead to inflation rising faster in Czech Republic than in Poland as per Chart II-2. Markedly, relative trend in headline inflation warrants shrinking swap spread between Czech and Polish swap rates (Chart II-3). In effect, the Czech National Bank (CNB) will be forced to hike rates at a faster pace and more than the National Bank of Poland (NBP). The CNB has been artificially depressing the value of its exchange rate by pegging it to the euro since November 2013. Despite the fact that the CNB abandoned its peg in April of this year, the CNB continues to artificially suppress the exchange rate by printing money and accumulating foreign exchange reserves. Chart II-1Pay Czech / Receive Polish ##br##10-year Swap Rates Chart II-2Czech Economy Will Overheat ##br##Faster Than Poland's Chart II-3Inflation Dynamics Warrant ##br##Smaller Swap Spread Foreign exchange reserves, measured in euros, in the Czech Republic are growing at an astronomical 60% annually while growth and inflation are already in full upswing (Chart II-4, top panel). Due to the ongoing foreign currency accumulation - accompanied by insufficient sterilization - the CNB has generated an overflow of liquidity and money/credit in the Czech economy (Chart II-4, middle panels). Chart II-4Monetary Conditions Are Easier In ##br##Czech Republic Relative To Poland In turn, this liquidity overflow has led a real estate boom and has super-charged overall growth (Chart II-4, bottom panel). On the contrary, the NBP has been much less aggressive in easing monetary conditions. The policy rate in Poland is at 1.5% while it is 0.05% in Czech Republic. Therefore, any potential upside in inflation and bond yields will be more limited in Poland than in the Czech Republic. Even though both Czech and Polish economic growth are robust, the Czech economy is showing more imminent signs of overheating and inflationary outbreak than Poland. The CNB is further behind the curve than the NBP. When a central bank is behind the curve, its yield curve should be steeper than a central bank that is not. However, the 10/1-year swap curve is as steep in Poland as it is in the Czech Republic. With the policy rate at a mere 0.05%, the Czech economy is sitting on the verge of an inflationary precipice. The longer the CNB maintains such a low policy rate, the higher long-term bond yields will rise. The basis being that the longer policymakers wait, the more they will have to tighten to slow growth and bring down inflation. Finally, this relative trade offers a hefty 143 basis points carry and is thus very attractive. Investment Conclusions In the fixed income and currency space in central Europe, we have been and continue recommending the following relative positions: A new fixed income trade: pay Czech / receive Polish 10-year swap rates Continue betting on yield curve steepening in Hungary: Receive 1-year / paying 10-year Hungarian swap rates Long Polish and Hungarian 5-year local currency bonds / short South African and Turkish domestic bonds. Long PLN and CZK versus EM currencies and/or the euro - we are long the following crosses: PLN/HUF, PLN/IDR, CZK/EUR For dedicated EM equity investors, we continue to recommend overweighting central Europe within an EM equity portfolio. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports titled, "Misconceptions About China's Credit Excesses", dated October 26, 2016; "China's Money Creation Redux And The RMB", dated November 23, 2016; "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; links available on page 20. 2 Please refer to the Emerging Markets Strategy Special Report titled, "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017; link available on page 20. 3 Werner, R. (2014b), "How Do Banks Create Money, and Why Can Other Firms Not Do the Same?", International Review of Financial Analysis, 36, 71-77. 4 Please see, "Local Officials Now Liable for Bad Debt-Management Decisions for Life", July 17th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-17/101117307.html Please see, "Local Governments Find New Ways to Play Debt Game", July 14th 2017, Caixin Global, available at http://www.caixinglobal.com/2017-07-14/101116048.html Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The "Trump Put" rumbles on, spurring equities, driving U.S. Treasury yields down, and hurting the dollar; White House incompetence, which underpins the "Trump Put," is about quantitative and qualitative staffing decisions, not the Russia collusion investigation; Tax reform will happen, but Congress is now in charge; Watch for the next Fed Chair nomination, more dollar downside could be ahead; China has preempted the next financial crisis with new regulatory oversight; The death of Abenomics is overstated. Feature We introduced the "Trump Put" in a recent report as a risk to our view that President Trump would get his populist economic agenda through Congress.1 The Trump Put posits that White House disarray and congressional incompetence will combine with decent earnings growth and steady global growth to produce Goldilocks conditions for U.S. equities, while simultaneously weakening the USD and supporting Treasuries. Thus far, the Trump Put continues to be in effect (Chart 1). Our House Views of further yield-curve steepening and a stronger USD have suffered from the ongoing "gong show" that is the Trump administration. The saving grace has been our high-conviction bullish equity view (Chart 2).2 Chart 1The Trump Put: Good For Equities,##br## Bad For Everything Else Chart 2S&P 500 Does Not##br## Care About Russia That said, we maintain our high-conviction view that the GOP will pass tax legislation in Q1 2018. Why? First, the failure to repeal Obamacare means that congressional Republicans will enter the midterm election season with no legislative wins. That is extraordinary given Republican control of both chambers of Congress and the executive. The House GOP members will not want to face an angry electorate in primary elections a year from now, or the general election, without a single major accomplishment. Second, Trump's low popularity will be an albatross around the neck of GOP candidates in the November 2018 elections, with potentially ominous results (Chart 3). Trump needs to pass a major piece of legislation; GOP congressmen have an interest in lifting Trump's popularity. Third, the House has passed the FY2017 budget resolution, which includes reconciliation instructions for tax reform. Given that only one budget resolution can be effective at any one time, the Obamacare replacement effort will end with the current fiscal year, on October 1.3 Chart 3GOP Is Running Out Of Time While we remain confident that some form of tax legislation will ultimately pass - either watered down tax reform or mere tax cuts - we are far less confident that it will be stimulative. In other words, it will be done according to the congressional, not the White House, blueprint. House Speaker Paul Ryan has long demanded revenue-neutral reform. The just-passed budget resolution calls for $203 billion in spending cuts in order to make tax cuts revenue-neutral. This is a reversion to form after the period earlier this year in which several fiscal conservatives, like Representatives Kevin Brady and Mark Meadows, intoned that they would be comfortable with tax reform that was not revenue-neutral. At the beginning of the year, it looked like Trump would be able to use his bully pulpit to cajole the Congressional Republicans into stimulative tax reform or tax cuts. Previous Presidents, including Obama with the Affordable Care Act, have been able to punish overly ideological legislators for the sake of pragmatism and/or expediency. Certainly Trump remains popular with GOP voters (Chart 4), suggesting that he might be able to do so as well. Chart 4Trump Retains Political ##br##Capital With GOP Voters Six months into his presidency, however, Trump remains a no-show in terms of leadership. This is not merely the result of distraction with the "Russian collusion" charges against his campaign team and inner circle. The White House is simply not playing its traditional coordinating role to shepherd key bills through Congress. Political insiders, even the ones close to Trump, are signaling privately and via the media that the White House is in disarray and understaffed both quantitatively and qualitatively. It is in no shape, in other words, to coordinate the legislative process and play the role of peacemaker between the different congressional factions. At the heart of the disarray is an elite dispute within the White House itself between what we call the "Goldman" and "Breitbart" factions of the administration. The Goldman Clique: Donald Trump has staffed his administration with several financial sector luminaries whom he met while building his business empire. At the head of this faction is Gary Cohn, Director of the National Economic Council and leading candidate for the next Chair of the Board of Governors of the Federal Reserve System (more on that later). Other members are Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross, and the most recent addition to the administration, the new White House Communications Director Anthony "the Mooch" Scaramucci. This faction is pragmatic, un-ideological (Cohn and "the Mooch" are essentially Democrats), and focused on passing tax reform and pro-business regulation. They prefer tax reform to mere tax cuts, and want middle class tax cuts to be balanced with pro-business corporate tax reform. The Breitbart Clique: Most commentators see the Goldman clique as the more powerful of the two White House factions, but Trump owes his electoral victory to a campaign molded along the ideological bent in line with the Breitbart faction. This group is led by Chief Strategist Steven Bannon and policy advisor Steven Miller.4 Behind the scenes, Bannon and Miller have managed to staff the White House with several Breitbart alumni, such as presidential advisors Sebastian Gorka and Julia Hahn, and (until her departure this month) Security Council Deputy Chief of Staff Tera Dahl. Factional fighting is not new to the White House. For example, the Obama administration was divided between foreign policy hawks - Secretary of State Hillary Clinton and Secretary of Defense Robert Gates - and doves - National Security Advisor Susan Rice and Ambassador to the UN Samantha Power. White House policy is often a product of compromise between different factions, producing sub-optimal outcomes. The problem with the Trump administration, however, is that the Breitbart faction is severely outmatched and unqualified for the job of coordinating legislative policy. Putting aside its ideological zealotry, this faction consists mainly of journalists without policy experience. This inexperience came to light with Trump's original executive order banning entry into the U.S. of nationals of several countries, penned by Bannon and Miller, which would have barred green card holders from entry. While that order may or may not have been constitutional, it was clearly impractical and aggressive. Another clear problem for the Trump administration is that its current Chief of Staff, former RNC Chairman Reince Priebus, is weak and ineffective. Priebus was a compromise candidate between the two factions and someone seen as acceptable to Republicans in Congress. Since his appointment, however, he has been a no-show. It was his idea to focus on replacing Obamacare ahead of tax reform (despite the absence of a GOP blueprint for the former and the existence of a blueprint for the latter), and it was his idea to give the overmatched Sean Spicer the role of managing the press. The chief of staff should be a force of nature, capable of instilling fear into the president's congressional allies in order to get legislation moving and reduce cliquish in-fighting. A successful chief of staff is usually a controversial and abrasive figure, such as Rahm Emanuel at the beginning of President Obama's first term. He bullied and cajoled Democrats into passing Obamacare with legendary brutality. BCA's Geopolitical Strategy rarely delves into personality-driven analysis. It is too idiosyncratic, not systematic. However, as a country's political leadership becomes more "charismatic"5 - driven by personality rather than institutions - individuals, factions, and court intrigue matter more. What does all of this mean for investors? First, the White House is failing in its coordinating role. As such, Republicans in the House will take the lead on tax reform. Revenue neutrality will be emphasized. For this to change, the White House would have to reshuffle its personnel more extensively, including replacing Priebus. Second, if fiscal policy fails to take off, Trump will put greater stock in monetary policy. Our colleagues - who are economists, not political analysts - believe that the U.S. is likely to enter into recession in 2019, as the 2020 electoral campaign heats up. However, folks like Gary Cohn and Steve Mnuchin can see the same writing on the wall, and will probably try to avoid such a badly timed recession. Chart 5 shows that household debt has continued to decline as a share of disposable income; the share of national income going to labor has increased; and wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All of this should give consumers the wherewithal to spend more, warranting higher interest rates. Meanwhile, financial conditions have significantly eased due to USD weakness and declining bond-yields, which should boost growth in the second half of this year (Chart 6). Chart 5Households Have The ##br##Wherewithal To Spend More Chart 6Financial Conditions##br## Have Eased With Congress increasingly in charge of fiscal policy and a recession possible in 2019, we would expect Trump to do everything he can to ensure that the Fed retains its dovish bias when Chair Janet Yellen's term expires on February 3. This means that he is likely to favor a non-economist and a loyal adviser, like Gary Cohn, over any of the more traditional, and hawkish, Republican candidates. While there is some speculation regarding Cohn's policy preference, we are yet to find an insider (either of the FOMC or the White House) who denies that he is a dove. The intrigue should not last long. Both Yellen and Bernanke were nominated with considerable lead time: 114 days before the end of her predecessor's term for Yellen, and 91 days for Bernanke (Chart 7). We would therefore expect the next Fed Chair to be known by Thanksgiving. Is Cohn a controversial pick? Not really. As our colleague John Canally of BCA's U.S. Investment Strategy has pointed out, lack of Fed experience does not make Cohn particularly unique as a candidate. Since the late 1970s, presidents have tended to select the Fed Chair based on their relationship with a candidate, not previous central banking experience (Table 1).6 Cohn would only break the orthodoxy by being the first candidate to be appointed from across the ideological aisle, given that he is a Democrat. (Although several chairs have been reappointed by presidents from opposing political parties.) Chart 7How Long Does It Take To Confirm The Fed Chair? Table 1Characteristics Of Fed Chairs Since 1970 A number of previous Fed chairs were selected for loyalty over academic merit or central banking experience. President Nixon's pick for the chair, Arthur Burns (Chair from 1970-1978), was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to Nixon before being appointed. William Miller (Chair from 1978-1979), although having served as an outside director for the Boston Fed, was appointed largely because of his work on the political campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as Chair of President Reagan's Social Security Commission in the early 1980s, Chair of President Ford's CEA, and advised Nixon's campaign in 1968. Only Volcker, Bernanke, and Yellen had previously held posts in the Federal Reserve System. The market cares about the appointment of the Fed chair. In 2013, for example, Larry Summers and Janet Yellen were in the running for the position, with Summers viewed as the more hawkish of the two. When he withdrew from the race on September 15, the market's expected pace of rate hikes plunged and long-dated TIPS breakevens surged on the expectations of a more dovish Fed (Chart 8). Given that the market is currently discounting just 27.4 bps of rate hikes during the next 12 months, down from the recent peak of 36 bps (Chart 9), there may not be much room to get more dovish.7 Chart 8Yellen Vs. Summers Drove Markets In 2013 Chart 9Market May Be Right? Nonetheless, President Trump may not want to gamble with his Fed appointments. If we are right to assume that he is an economic populist, and that his fiscally stimulative agenda is slipping away, then we would expect the White House to err on the side of Fed appointments that would be behind the proverbial curve. In addition to Yellen, Trump will have the opportunity to appoint a new Vice Chairman of the Fed in place of Stanley Fischer on June 12, 2018 (Diagram 1), as well as another candidate for the Board of Governors (after already having nominated Marvin Goodfriend and Randal Quarels). By mid-2018, the Fed will start to take on a new composition altogether. Diagram 1Federal Reserve Board Of Governors Calendar Staffing the Fed with doves fits at least two of President Trump's campaign promises. First, if the Fed were to fall behind the curve, nominal GDP would likely surprise to the upside. Second, the USD would continue its downward trajectory, helping rebalance America's trade deficit. As such, we take the potential nomination of Gary Cohn seriously. And we expect the market will as well. That said, a Cohn-led Fed would not be a fundamental break with the past. In fact, Yellen has herself intoned that the Fed may want to let inflation run above 2% in past speeches. In addition, Trump's first two nominees to the Fed do not fit a dovish mold. Conservative economist Marvin Goodfriend is a hawk and favors rule-based policymaking. Randal Quarels will focus on regulating the financial sector, or rather deregulating it, although his policy orientation is largely unknown. Furthermore, other potential Fed Chair nominees, such as Kevin Warsh and Richard Fisher, would be more hawkish than Yellen. And if they are not selected to replace Yellen, they could replace the current Vice-Chairman Fischer. As such, investors should not overreact to a Cohn appointment. However, currency markets might, given that the Trump White House has been highly unorthodox. Bottom Line: There is likely more downside to the USD over the rest of the year. China: A Preemptive Dodd-Frank Last week we argued that China is likely to escalate financial regulation considerably over the next 6-12 months.8 Essentially, the "financial crackdown" or "deleveraging campaign" seen in H1 of this year was just a dress rehearsal for what is to come. The larger policy shift will exert downward pressure on economic growth in H2 2017 and throughout 2018, essentially putting a cap of about 7% on China's growth rate. True, the Chinese government will strive to avoid letting the new regulatory push lead to a sharp slowdown, i.e., shattering its preexisting commitment to an average GDP growth rate of 6.5% per year through 2020. However, the risks lie to the downside over the next 18 months due to the combination of unaddressed structural imbalances, cyclically fading economic tailwinds, and further policy tightening. We have outlined the structural flaws before. In brief, they include: Demographics: The working-age population is declining, yet the social systems to improve productivity are not yet adequate. Economic model: The investment-led model has become inefficient, requiring China to add more and more debt in order to generate the same amount of growth, in a manner reminiscent of South Korea prior to the Asian Financial Crisis (Chart 10). The transition to consumer-led growth is incomplete, with households still reluctant to take over from corporates in driving spending. Financial transmission: China's banking sector has expanded quickly, leading to a rise in bad loans and "special mention" assets, as losses from large companies remain elevated (Chart 11). The shadow banking sector is highly leveraged, poorly regulated, and extremely risky, and has mushroomed since 2008. Fiscal system: Local governments lack stable sources of funding and therefore rely on SOE debt and manipulation of the land market in order to fund their 85% share of China's fiscal spending. The government's recent fiscal reforms (the VAT extension) have actually further deprived local governments of revenues. Inequality and social ills: Wealth inequality, social immobility, regressive taxation (Chart 12), and an inadequate social safety net have hindered the development of the consumer society as well as innovation and entrepreneurship. Centralized authoritarianism: The political system perpetuates the above ills by disallowing free speech, free association, free movement, and other freedoms that would encourage innovation and total factor productivity. Chart 10More And More Reliant On Debt For Growth Chart 11Bad Loans Rising Chart 12Communism Fails To Redistribute Income Meanwhile, we have several reasons for anticipating a larger, less accommodative policy shift over the next six-to-twelve months: Policy drift: China's economic policy has been adrift over the past year and a half, as reflected by elevated economic policy uncertainty. While President Xi Jinping's anti-corruption campaign is no longer relevant in a macroeconomic sense - and this theoretically opens the way for him to pursue his ambitious economic reform agenda - he has so far chosen stimulus over restructuring due to the instability of 2015-16. Now, as the latest stimulus measures fade (Chart 13), the question of how to go forward is pressing, since to re-apply the same policy mix in 2018 would be to forgo his reform agenda until 2019 ... and probably once and for all. Warning signs: The central government's launch of a deleveraging campaign this year was risky and surprising. It was risky because central financial authorities in any country threaten a liquidity squeeze when they tighten financial conditions into large and rapidly growing leverage. It was surprising because the authorities chose to do so when a mistake could have upset political stability in advance of the midterm party congress. The implication is: (1) authorities intended a limited campaign from the beginning; (2) the newly appointed leaders of financial regulatory bodies are no-nonsense people.9 They take very seriously, as we do, China's systemic financial risks. They believe risky measures are necessary to prevent the dangerous credit excesses. The National Financial Work Conference: The conference concluded with Xi putting his imprimatur on a renewed policy focus on the financial sector: Reducing systemic risk, reducing speculation (lending to the real economy), and eventually putting the sector back on the path of liberalization. The specific outcomes amount to something like a preemptive Dodd Frank: The People's Bank of China will take on a larger role in identifying and monitoring systemically important institutions; it will also host a new inter-agency body - the Financial Stability and Development Committee (FSDC) - that will ostensibly ensure better cooperation and coordination between the regulators of banks, stock markets, insurance, etc. Finally, the meeting signaled that this year's deleveraging campaign would expand (beyond shadow banking, insurance companies, and private companies roving overseas) to affect over-leveraged SOEs and local government financing vehicles. Significantly, local government officials will be made accountable for excessive debt. This last point should not be underrated. At the height of the anti-corruption campaign, in late 2014, fiscal spending numbers remained depressed and government agency cash deposits continued rising even after the central government tried to encourage faster growth (Chart 14), suggesting that local officials were refraining from spending due to fears that they would be punished for it.10 We consider these announcements to be substantive - i.e., not the usual propaganda - even if they take some time to get off the ground. The financial conference was frowned upon by much of the mainstream media because some interpret the FSDC as failing to live up to the rumor that China would create a new "financial super-ministry." But the rise of super-ministries under the Hu Jintao administration resulted in very little substantive change to Chinese policy. By contrast, Xi Jinping signaled that the PBoC would be the chief instrument of the new financial regulatory push, and he has already shown he can operate exceedingly effectively through existing institutions - namely the Central Discipline and Inspection Commission (CDIC), which went from being an ineffective intra-party corruption watchdog to a nationwide vehicle for the party's most aggressive corruption investigations and personnel purges in recent memory. We are willing to bet that the PBoC's new powers, including the new financial stability committee, will be more aggressive than the merely status quo multiplication of administrative functions that the financial media and markets apparently expect. The changing of the PBoC's Guard: It is not a coincidence that greater regulatory powers are being planned for the PBoC in the final months of Governor Zhou Xiaochuan's term. Zhou has been in office since late 2002. He has been a cornerstone figure in China's financial stability and reform throughout this period, including during the global crisis and the various financial panics from 2010-16. He has allegedly desired a more muscular central bank to tackle the country's ballooning credit risks. By handing off the baton, he clears the way for a new, ambitious governor to succeed him, one who will maintain policy continuity while also taking the opportunity of the transition to implement a new and tougher regulatory framework. Consider that after Xi put the ambitious Guo Shuqing in charge of the China Banking Regulatory Committee in February, Guo immediately launched a notable crackdown on shadow banking.11 Guo is a possible contender for the central banker position; the other likely contenders have strong credentials in regulatory oversight as well as banking. The 19th National Party Congress: The midterm leadership reshuffle will mark Xi's consolidation of power, which will enable him to pursue his policy preferences more effectively in 2018-22. He could still be prevented by exogenous events, but domestic politics should be less of an obstacle for him going forward. Chart 13China's Economic##br## Tailwinds Fading Chart 14Anti-Corruption Campaign Hindered##br## Local Government Spending What about Xi's political capital within the top Communist Party bodies? We are in the thick of major decisions as we go to press. The highest level of leadership - the Politburo Standing Committee (PSC) - is expected to have its members chosen, in secret, in August when the current PSC and other party heavyweights will likely convene at Beidaihe to settle the list. The fall of Chongqing Party Secretary Sun Zhengcai in mid-July gives a few hints as to what might occur. Sun was ostensibly sympathetic with Xi, and until now the likeliest candidate for Premier Li Keqiang's replacement in 2022. His ouster means that four of the top five candidates on the PSC come from the rival camp to President Xi, i.e., the "Hu Jintao faction," which is rooted in the Chinese Communist Youth League (CCYL) (Diagram 2). Diagram 2Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced? There are two likely pathways from here: either Sun's fall is part of a bargaining process and other CCYL members will soon be removed from the running for the PSC; or they will not be removed, which would mean that Xi gets along much better with the top CCYL members than is generally believed. The latter is unlikely, but possible, given that Xi and former President Hu Jintao did cooperate on critical power arrangements in the 2012 leadership transition. However, the most recent reports suggest that several CCYL members who were seen as rising stars (for 2022 leadership and beyond) have not received invitations to the party congress, including the current party secretary of the CCYL.12 If this proves to be the case, then it strongly suggests that Xi is continuing to undercut the CCYL. That, in turn, suggests that Xi will not tolerate the current scenario in which he stands to be outnumbered four-to-one on a five-member PSC. Instead, we should expect at least one major CCYL contender for the PSC to be removed in the coming months. This would enable Xi to gain the balance on a seven-member PSC. If the PSC is to be reduced to five members, then he would have to oust two major CCYL members - a more dramatic power play, but presumably within his reach given what he has achieved so far. Ultimately it is impossible to predict the PSC (and broader Politburo) membership precisely. All we can point out is that a failure by Xi to consolidate control on the top bodies - which is no longer our baseline view - would have bullish short-term but bearish long-term implications for growth. It would suggest, first, that Xi is weaker than he appears; second, that the aggressive financial regulatory drive outlined above, as well as other painful but necessary reforms, will be watered down as a result of resistance at top levels; third, that China is increasingly resisting the "creative destruction" that Xi threatens to bring about in the pursuit of making China more efficient. Bottom Line: A number of signs suggest that Chinese politics will become a headwind, rather than tailwind, to growth after the party congress. Xi's move to undercut the opposing CCYL faction ahead of the party congress confirms this view. His new policy will focus on deleveraging and financial sector restrictions. The commitment to stability will remain in place, however. Japan: Abe Is Not Yet Dead, Long Live Abenomics Shinzo Abe's approval rating has plummeted since June (Chart 15). His Liberal Democratic Party (LDP) has also seen its popularity fall. This has been notable in relation to the flat polling of the LDP's main coalition partner, New Komeito (Chart 16). Chart 15Abe's Luck Runs Out? Chart 16Ruling LDP Also In Trouble Abe has been buffeted by a combination of spiraling corruption scandals and the loss of the Tokyo Metropolitan legislature in the local election of July 2. As if this were not bad enough, the Japanese economy is set to slow down (Chart 17).13 Chart 17A Slowdown In Japan Our readers will recall that we think there is a deeper cause for Abe's sudden loss of popularity: his proposed constitutional revisions, which he laid out in detail in May. Ever since he secured a virtual two-thirds supermajority in the House of Councillors (the Upper House) in July 2016, we have maintained that he would push ahead with controversial constitutional revisions that aim to enshrine the Japanese military. We expected that these changes would sap Abe's support - as did the debate over the new national security law in 2015 (Chart 18), only bigger this time because the matter is constitutional.14 However, the Tokyo election loss does not portend the death of Abe, and regardless, Abenomics itself will survive. Why? Because it is Abe's constitutional and security agenda that is unpopular, not Abenomics. Understood as economic reflation with elements of restructuring, like wage growth, Abenomics will actually intensify over the next year and a half as a result of the new threats to Abe's and the LDP's popularity and agenda, to which they will respond. Abe is more deeply committed to this constitutional mission than to Abenomics. It is his most ambitious plan and his economic policy supports it. Revising the constitution is about Japan seizing its own destiny again as a sovereign nation and also locking in the American alliance by offering greater military assistance to the U.S. Hence, at this point, economic reflation is not only an end in itself but also a means to a constitutional end. First, note that Abe's coalition in the upper house is not as "super" of a super-majority as is widely believed. He needs the support of smaller right-wing parties that are sympathetic toward his constitutional revisions to cross the 162-seat threshold for a two-thirds vote in the upper House of Councillors to approve constitutional reforms. But the LDP's three partner parties that are in favor of revision, as well as at least one independent, could raise objections and that would sink the revisions (Diagram 3). There are others with misgivings. Economic slowdown is not a recipe for Diet members to make big political sacrifices on Abe's account, so we expect monetary and fiscal policy to remain easy. Chart 18Abe Loses Support When He Talks ##br##Security Instead Of Economy Diagram 3Super-Majority ##br##Barely Within Reach Second, if the constitutional changes pass the upper and lower houses of the Diet by two-thirds votes, they must pass a nationwide referendum. While there is majority support for revisions of some sort, there is a roughly 50-50 division on the question of altering Article 9 (Chart 19), the article that forbids Japan to maintain military forces. This is the bullseye of Abe's proposal. The need for 50% of the nation to vote "yes" is an even bigger reason for Abe to pull policy levers to keep the economy humming before a potential referendum date in December 2018. Finally, even in the unlikely scenario that Abe's approval rating drops into the mid-20s or below and the LDP ousts him, we do not expect the next LDP leader to alter Abenomics in any significant way. The frontrunners for Abe's replacement in the September 2018 LDP party leadership poll, such as Foreign Minister Fumio Kishida, would likely soften their predecessor's policy on remilitarization and constitutional revision, but would also launch a substantively similar economic policy that the media would promptly dub "Kishidanomics," "Ishibanomics," or "Asonomics." Thus, on fiscal policy, the focus will remain on fiscal support and lifting wages and social spending. Rules calling for fiscal restraint will be relaxed. On monetary policy, BoJ Governor Haruhiko Kuroda is eligible for reappointment on April 8, 2018. So are his two deputies. Furthermore, the monetary policy committee members appointed since Kuroda have also been ultra-dovish like him.15 In short, the BoJ underwent a regime change in 2012 and will not revert back to the norms that prevailed before the global financial crisis, before the LDP lost power to a serious opposition party (2009), and before the shock to the national psyche that occurred during the 2011 earthquake, tsunami, and nuclear crisis. Further, Japanese households are only hardly net savers anymore (Chart 20), and have for five years voted for a more reflationary policy. And aside from the current path of stealth debt monetization, there is no other way of managing the nation's debt other than fiscal austerity, which is not an option for an increasingly elderly population dependent on government social spending. The era of BoJ unorthodoxy is here to stay, at least as long as the LDP is in power (December 2018), if not longer. Chart 19Revise The Constitution? Yes.##br## End Pacifism? Maybe. Chart 20Japanese No Longer ##br##Savers Who Fear Inflation Bottom Line: Abe's downfall is not assured, and would portend the end of Abenomics in name only. The next LDP government would maintain Abenomics, as it is driven by structurally limited options. Fade any selloff in Japanese equities. However, in the long run, Abenomics may prove a failure in terms of defeating deflation. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 4 As a reminder to the uninitiated readers, Breitbart is a conservative magazine that has been a platform for a slew of unorthodox right-wing views more in line with modern nationalist European political movements than the American conservative movement. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 6 Please see BCA U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," dated July 17, 2017, available at usis.bcaresearch.com. 7 Please see BCA U.S. Bond Strategy Weekly Report, "Every Which Way But Loose," dated July 18, 2017, available at usbs.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. 10 Please see BCA China Investment Strategy Weekly Reports, "Questions From The Road," dated July 1, 2015, and "Policy Mistakes And A Silver Lining," dated October 7, 2015, available at cis.bcaresearch.com. 11 Please see Gabriel Wildau, "China bank overseer launches 'regulatory windstorm,'" Financial Times, April 18, 2017, available at www.ft.com. 12 Please see Jun Mai, "Guess who's not invited to China's key Communist Party congress," South China Morning Post, July 23, 2017, available at www.scmp.com. 13 Please see BCA Foreign Exchange Strategy Weekly Report, "A Soft-Spoken Yellen," dated July 14, 2017, available at fes.bcaresearch.com. 14 Please see footnote 11 above. 15 The last two dissenters, Takehiro Sato and Takehide Kiuchi, stepped down when their terms expired on July 23, 2017. They were replaced by Goshi Kataoka and Hitoshi Suzuki, who are expected to support Governor Haruhiko Kuroda's dovish approach. Now all nine policy board members have been appointed by the Abe administration. Please see "Two new Bank of Japan policymakers join board," Japan Times, July 24, 2017, available at www.japantimes.co.jp.

Highlights The RBA will not hike as quickly as markets expect. Weak wage growth and high underemployment suggest plenty of spare capacity. Inflation is only barely at the bottom of the central bank's range. Massive household debt levels will make it difficult for consumers to handle higher interest rates. Australian banks, although relatively healthy, are still enormously exposed to Australian housing and interest-only mortgages. House prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Maintain a neutral exposure to Australian government bonds, but enter into a 2-year/10-year Australian government bond yield curve flattener. Feature Chart 1Diverging Trends In##BR##The Australian Economy Australia remains one of the more difficult bond markets on which to take a decisive investment stance at the moment. The recent Moody's downgrade of Australian banks has put the spotlight back on the housing boom Down Under. With home prices continuing to climb - despite the introduction of macro-prudential measures on mortgage lending and with household indebtedness reaching exorbitant levels - investors are becoming increasingly concerned over a potential housing crash that could have spillover effects on the Australian banking system (Chart 1). At the same time, the domestic economy continues to suffer a hangover from the end of the mining boom earlier this decade, with excess capacity keeping inflation pressures subdued. Naturally, this has put the Reserve Bank of Australia (RBA) in a difficult position. Interest rate cuts in response to low inflation would add further fuel to the housing bubble. On the other hand, any attempt to try and normalize the current accommodative monetary policy settings with rate hikes could trigger an unwanted surge in the Australian dollar and prompt a correction in house prices. The latter could lead to financial instability and raise recession risks with consumers already dealing with negative real wage growth, low savings and massive debt loads. In this Special Report, we examine Australia's monetary policy trajectory, analyze its concentrated banking sector and the potential risks from a downturn in house prices, and revisit our positioning on Australian government debt. Our conclusions still lead us to stick with a neutral duration stance and country allocation on Australian debt, but with a bias towards a flatter government bond yield curve. RBA On Hold... For Now Chart 2Aussie Bonds Caught##BR##In The Global Selloff Earlier this month, the RBA decided to leave the cash rate unchanged at 1.5%. The central bank maintained its fairly neutral rhetoric, though they did cite that the "broad-based pick-up in the global economy is continuing." The central bank upgraded its economic forecasts, with real GDP growth now projected to reach slightly above 3% over the next two years. The minutes from that July 4 monetary policy meeting revealed that a discussion over the ideal level of the real cash rate took place.1 The conclusion was that equilibrium inflation-adjusted rate is now around 1%, meaning that the "neutral" nominal rate is 3.5% after adding an inflation expectation of 2.5% (the middle of the RBA inflation target band). That implies that the RBA has lots of catching up to do on interest rates once the next tightening cycle begins. The timing of that discussion on real rates came shortly after the rebound in global bond yields that began after policymakers in other countries, most notably the European Central Bank and the Bank of Canada, began hinting that a move to dial back the emergency monetary easings of 2015/16 was about to begin (Chart 2). With the RBA possibly sending a similar message, investors responded by raising interest rate expectations and bidding up the Australian dollar (AUD). 30bps of RBA hikes are now priced in over the next year, while our proxy for the market-implied pricing of the terminal (i.e. equilibrium) cash rate - the 5-year AUD overnight index swap rate, 5-years forward - shot up to just over 3%. We believe that this market repricing of potential RBA rate hikes is too optimistic. Australian monetary policy must remain highly accommodative for some time. Our more dovish case is based on our assessment of the RBA's policy mandates, which include full employment, price stability and the 'welfare of the Australian people'. Because of Australia's heavy economic exposure to iron ore prices, its largest export, we also include an outlook on the commodity to aid in our forecast of RBA policy. Employment: The latest readings on the Australian labor market have shown marked improvement so far in 2017 (Chart 3). The unemployment rate now sits at 5.6%. Employment growth is accelerating while the participation rate has edged higher in recent months. The National Australia Bank business confidence index is steadily improving, while job vacancies are at a five-year high. In the statement released after the June monetary policy meeting, RBA governor Philip Lowe stated that "forward-looking indicators point to continued growth in employment in the period ahead." Chart 3Labor Demand##BR##Picking Up... Chart 4...But All Signs Point To Lots##BR##Of Spare Labor Capacity While Governor Lowe also noted that the overall employment picture is 'mixed' in some aspects, we are far more pessimistic (Chart 4). The underemployment rate has been rising and now sits only slightly below its almost 50-year high of 8.8%.2 Part-time workers as a percentage of total employment has experienced a structural increase to nearly 33%, while hours worked have declined. Additionally, nominal wages have been flat and real wages are declining. This suggests that there is plenty of slack in labor markets and that Australia is still far from full employment, even with the headline jobless rate sitting slightly below the OECD's current NAIRU estimate of 5.9%.3 Inflation: Core inflation has been slowing since 2014 and only reached an anemic 1.45% in the first quarter of 2017 (Chart 5). Although headline inflation has rebounded over the past year, at 2.1% it remains only at the bottom of the RBA's 2-3% target range. Additionally, the downtrend in inflation expectations for 2017 appears to be intact. Chart 5Inflation Staying Within The RBA 2-3% Target Chart 6Australian Consumer Spending Slowing Weak productivity growth, leading to lackluster wage growth, is keeping overall inflation subdued. The trade-weighted currency has rallied since June, presenting an additional headwind for consumer prices. Even if the recovery in headline inflation persists and starts to pass through to core readings, policymakers will likely err on the side of caution. A higher realized inflation rate will be tolerated in the near term to ensure expectations stay well within the 2-3% target band - the RBA's definition of "price stability" - before any interest rate increases are considered. Consumer: Australian households face a challenging environment. Real wages are declining, with the wage cost index in a downtrend since 2011. Real retail spending growth has been slowing and is nearing negative territory, while consumer sentiment is quite pessimistic (Chart 6). As income growth is lacking, consumers have had to dip into savings to maintain consumption, with the savings rate collapsing from 10% to 5% over the last few years. Part of that decline is likely due to the rising cost of "essentials" spending, such as utilities, health care, education and transportation. The inflation rates for those sectors have been outpacing overall headline and core readings (Chart 7), suggesting that Australian households are saving less just to "make ends meet." Chart 7Spending More On The "Essentials" Overall, Australian consumers remain incredibly indebted. The household debt-to-income ratio is nearing 200% - the fourth highest figure among the OECD countries.4 Households have been able to handle the massive debt loads (so far) due to record-low interest rates, which have allowed debt service ratios to fall in line with long-term averages. However, hiking interest rates against this backdrop of highly leveraged consumers - especially given the huge exposure of Australian household balance sheets to overvalued house prices - could severely test the 'economic prosperity and welfare of the Australian people' element of the RBA's mandates. In other words, the RBA would need to see decisive signs that the economy was pushing up against inflationary capacity constraints before embarking on a tightening cycle, for fear of the spillover effects of pricking the housing bubble too soon (as we discuss later in this report). Iron Ore: Historically, Australia's growth has been tightly linked to the performance of industrial commodities, in particular iron ore which represents nearly 20% of total Australian exports. Our commodity strategists are neutral on iron ore on a cyclical horizon and bearish on a strategic basis. Chinese iron ore import growth has recently ticked up, but should remain subdued as Chinese inventories are still high (Chart 8). Chinese property construction activity, which accounts for roughly 35% of total Chinese steel demand, remains depressed. Globally, iron ore supply is set to increase throughout the year as many mining projects will come on stream. On a longer-term basis, Chinese demand for metals will likely slow due to the ongoing structural economic shift away from excessive reliance on infrastructure investment and house-building to an economy based on consumption and services. Summing it all up, none of the RBA's policy mandates is being threatened in a way that should force policymakers to begin shifting to a less dovish stance. There is little evidence that Australia has reached full employment, inflation and inflation expectations remain within the RBA target band, growth momentum remains moderate and the housing bubble remains an existential risk to the future health of the economy. Additionally, Australian policymakers will want to keep rates as low as possible to ensure that a weaker currency helps prop up exports, support the economy in its transition away from the heavy reliance on mining investment. Real GDP growth fell below 2% and the output gap is still far in negative territory, suggesting plenty of slack (Chart 9). Our own Australian Central Bank Monitor has rolled over and is now barely in the "tight policy required" zone (bottom panel). Projected fiscal drag over the next few years will also dampen growth. RBA growth forecasts appear highly optimistic relative to median economist estimates. All of these factors point to a delay in rate hikes. Chart 8No Big Boost To Iron Ore Prices From China Chart 9No Pressure On The RBA To Hike Rates Bottom Line: Markets are overpricing the potential for RBA tightening. There is still spare capacity in labor markets, inflation is subdued and consumers cannot handle higher rates. Monitoring The Banks In June, Moody's downgraded all Australian banks, citing a "rise in household leverage and the rising prevalence of interest-only and investment loans" (Chart 10). The downgrade raised concern among investors, with banks being the largest component of the Australian equity market, and short positions have noticeably risen. Despite subdued income growth and enormous household debt levels, escalating house prices have supported consumption through the wealth effect, but this is clearly unsustainable. Political pressures are also building, as evidenced by the introduction of a bank levy in South Australia. Chart 10A Relentless Climb In Household Debt The Chairman of the Australian Prudential Regulation Authority (APRA), Wayne Byres, wants to make bank capital levels "unquestionably strong." His recent comments indicate that Australian banks will need to raise capital before 2020 to adhere to global standards, with some estimates reaching as high as $20bn (in USD). This process is crucial for instilling confidence in markets that banks can meet these targets through organic capital generation or dividend re-investment plans. As the increased capital required is relatively small - only 2% of the capital base of the Australian banks - it should not be difficult to raise that amount. The greatest risk to the financial system is still the exposure to Australian housing. For the four major banks, Australian housing loans make up slightly over 50% of their lending mix, far greater than for U.S. banks prior to the Great Financial Crisis of 2008 (Chart 11). Of those loans, approximately 40% are non-traditional (interest-only, sub-prime, reverse mortgages). Several macro-prudential measures have been implemented by Australian financial regulators to decrease risks within the banking sector. The regulations have been focused on interest-only loans, which are more vulnerable to rate rises. Such loans are riskier, typically shorter in maturity and requiring larger deposit amounts. Banks are tightening their lending standards for these loans and risk weights will likely be increased, thereby requiring more capital. Additionally, the standard variable rate on interest-only loans has increased by 30-35bps and APRA has imposed a 30% cap on interest-only loans as a percentage of new loans. This will cause a meaningful decline in the risk profile of banks' mortgage books, as consumers with interest-only loans will shift to less expensive principal-plus-interest loans. Another source of risk is the Australian banks' increasing reliance on offshore short-term wholesale funding. When credit growth outpaces deposit growth, which has been the case, banks need to balance the equation through increased wholesale funding. This raises the potential for a liquidity crunch, as capital may be unavailable during a crisis. Credit growth to the private sector is slowing, though, reducing the immediate need for this type of funding. Additionally, authorities are prompting banks to substitute away from the heavy reliance on short-term wholesale funding through the implementation of a net stable funding ratio. This is defined as the available amount of stable funding (i.e. core deposits, equity and long-term wholesale funding) over the required regulatory level of stable funding. Banks will have until 2018 to increase this ratio above 100%. As a result, long-term wholesale debt issuance rose sharply in 2016 and that amount is projected to be relatively similar for 2017. Overall, current metrics suggest that Australian banks are fairly healthy, even before the additional capital requirements. Tier 1 capital ratios have gradually increased since 2007 and are fairly strong, non-performing loans are subdued and net interest margins are rising (Chart 12). In fact, Tier 1 ratios are substantially higher in Australia than they were in the U.S. prior to the Global Financial Crisis. Return-on-assets and return-on-capital have bounced slightly, although increasing capital will certainly dampen the earnings prospects for the Australian banks. Chart 11Australian Banks Heavily Exposed##BR##To Risky Mortgage Lending Chart 12Aussie Banks In##BR##Good Shape Right Now... Since the Moody's downgrade, credit default swap spreads for Australian banks have actually declined to near the 2014 lows, suggesting markets are not concerned about the risk of future bank stresses. We remain concerned, however. Macro-prudential measures on mortgage loan sizes and higher capital requirements are certainly welcome and will reduce perceived risks within the banking sector. However, these measures have done little to curb the rise in Australian house prices. Given their huge exposure to Australian housing, the banks will likely not be able to withstand a meaningful decline in house values - the outlook for which depends critically on the RBA's future monetary policy path. Bottom Line: Australia bank metrics are fairly healthy but they will need to raise more capital. This should not be too problematic. However, the banks' massive exposure to Australian housing, elevated number of interest-only mortgage loans and heavy reliance on short-term wholesale funding present substantial risks. Even if the bank capital levels are 'unquestionably strong,' they will not be enough to withstand a meaningful downturn in house prices. When Will The Housing Bubble Burst? House prices in Australia have nearly quadrupled since 2000. With the exception of Perth, house prices in the other major cities have continued their massive run-up over the last year, suggesting macro-prudential measures have done little to cool the market (Chart 13). Price gains have been supported by robust demand, both domestic and foreign. However, the steady rise in debt-fueled speculation (i.e. loans for investment purposes), the magnitude of the price increases, and the lack of any correction in over 25 years, suggest Australian housing is indeed in the midst of a bubble. On the supply side, steadily rising completions over the past decade have not curbed price gains (Chart 14). While construction has slowed since its peak at the end of 2016 and building approvals have declined, we find the argument that there has been a shortage in supply to be fairly weak. In fact, the rate of dwelling completions has outpaced population growth since 2012 and dwelling completions per 1,000 people are much higher in Australia than its G7 counterparts. Chart 13...Just Don't Prick##BR##The Housing Bubble Chart 14Supply Not Rising Enough To##BR##Slow House Price Growth History teaches us that bubbles never deflate calmly. Nevertheless, we view the likelihood of a systemic crash over the next 6-12 months as highly unlikely. While growth estimates may not meet the RBA's lofty goals, Australia will also not experience its first recession in over 25 years, which would crimp housing demand. The two most likely candidates to act as a catalyst for a housing downturn are therefore: a slowdown in capital inflows from Chinese property buyers and/or a shift to restrictive monetary policy from the RBA. It will not require a complete halt in capital inflows from China, simply a considerable slowdown, for the Australian housing market to come under pressure. While there is always a possibility for Chinese authorities to clamp down on outflows, particularly if the RMB comes under pressure, we view this as fairly unlikely. Current capital outflows have eased a bit and a long-term goal is to deregulate the capital account. Continued capital liberalization in China will aid in maintaining capital flows into Australian housing. Additionally, the millionaire class in China is growing and the private sector wants to diversify its assets. While Australian house prices are expensive, prices are far more affordable than those metropolitan areas such as Hong Kong, indicating Chinese money will continue to drift into Australian real estate. Chart 15A Long Way From Restrictive Policy Rates The more likely candidate for a bursting of the housing bubble is through the monetary policy channel. In the case of the U.S., multiple Fed rate hikes in the mid-2000s pushed monetary conditions into restrictive territory, prompting the housing crash. As we previously argued, the RBA will likely stay on hold for an extended period due to a lack of serious inflation pressures. Yet even if the RBA were to begin tightening sooner than we expect, it will take multiple rate hikes before monetary conditions become even close to restrictive. Using a simple measure of the equilibrium RBA cash rate, like a combination of Australian potential GDP growth and a five-year moving average of headline CPI inflation or the Taylor Rule formulation that we introduced in a recent Weekly Report, it is clear that the RBA is a long way from a restrictive policy stance (Chart 15).5 Bottom Line: Australian house prices have nearly quadrupled since 2000 and exhibit the characteristics of a bubble. Still, it will likely take considerable monetary tightening before the bubble bursts. We do not think this will occur anytime soon. Investment Implications We currently hold a neutral recommended stance on Australian government debt, both in terms of duration exposure and country allocation in global fixed income portfolios. Australian bond yields are above the lows seen in 2016 but have yet to break out of the structural downtrend with the benchmark 10-year now at 2.67% (Chart 16). We hesitate to go outright overweight on Australian debt in our model bond portfolio, however, even with our relatively dovish view on the RBA's future policy moves. Without any slowing in house prices, and with realized and expected inflation having clearly bottomed after last year's downturn, a big move lower in Australian bond yields is unlikely. At best, Australian yields will not rise by as much as we expect to see in the U.S. or Euro Area over the next 6-12 months. At the same time, if that view pans out, the Australian currency will likely underperform which will erode into the returns of an overweight Australian bond position (either through currency hedging costs or the outright losses on unhedged currency exposure). We do, however, see an opportunity to enter into an Australian 2-year/10-year yield curve flattening position (Chart 17). As previously mentioned, the short end of the curve will be anchored by an inactive central bank. The long end, however, faces multiple downward pressures. Macro-prudential measures and political pressures will continue to dampen credit growth. While we believe there is scope for realized inflation to grind a bit higher in the coming quarters, longer-term inflation expectations are likely to remain well-anchored. Additionally, the economic surprise index is elevated after several positive data releases and has plenty of scope for disappointment, which will limit any rise in longer-dated bond yields. Chart 16No Bear Market##BR##In Australian Bonds Chart 17Enter A 2yr/10yr##BR##Australian Curve Flattener The added benefit of entering a curve flattener is that the trade will likely work if our RBA view turns out to be wrong in a hawkish direction. If the RBA does indeed begin to hike rates sooner than we expect to deal with an improving economy or to begin deflating the housing bubble, this should put flattening pressure on the curve as the market prices in additional future rate increases. Only in the case of a breakout in longer-term inflation expectations that bear-steepens the curve, or a severe economic downturn that prompts RBA rate cuts and bull-steepens the curve, will a flattening trade underperform. Given our views on Australian growth and inflation, we see more likely scenarios where the curve flattens than steepens, particularly versus the only modest amount of flattening currently priced in the forwards. Bottom Line: Enter into a 2-year/10-year Australian government bond yield curve flattener. The short end of the curve will be anchored by an inactive central bank. On the long end, slowing credit growth, fiscal drag and an elevated economic surprise index will put downward pressure on yields. Patrick Trinh, Associate Editor Patrick@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 http://www.rba.gov.au/monetary-policy/rba-board-minutes/2017/2017-07-04.html 2 The "underemployed" is defined as full-time workers on reduced hours for economic reasons and part-time workers who would like, and are available, to work more hours. 3 NAIRU = Non-Accelerating Inflation Rate Of Unemployment. 4 https://data.oecd.org/hha/household-debt.htm 5 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017. Available at gfis.bcaresearch.com.