Policy

Highlights The GOP's failure to repeal Obamacare could rev up the Republicans' motivation to move forward on tax cuts. Fed policymakers are taking financial stability seriously. Constructive conditions for consumer spending. Margin expansion continues in early Q2 earnings results. Feature Tax Cuts Still On The Table The Republicans' failure to pass their health care legislation is leading the markets to doubt the prospect for tax cuts. This may be premature but, contrary to conventional wisdom, it may actually increase the chances of tax cuts. Ironically, the inability to jettison Obamacare may turn out to be a blessing for President Trump and the Republican Party. According to the Congressional Budget Office, by 2026, 22 million fewer Americans would have health care if the legislation had been enacted compared with the status quo. The Senate bill also would have led to substantial cuts to Medicaid and deep reductions to insurance subsidies for poor and middle-class families, many of whom voted for Trump. 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. Implications For The Fed Expansionary fiscal policy next year would generate difficulties for the FOMC. The June CPI report underscored that inflation is not a problem for now. Nonetheless, we highlighted in last week's report that pipeline inflationary pressures are gradually building. The unemployment rate is already below the Fed's estimate of the full employment level. Chart 1Inside The Fed's Forecasts... Moreover, unemployment will continue to fall 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. 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 (Chart 1). The implication is that, unless real GDP growth slows, the unemployment rate is soon likely to reach lows not seen since 2000. The FOMC hawks would become even more worried that the Fed is taking too large a risk with inflation and financial stability (see below). Fiscal stimulus in 2018 would place the FOMC even further behind the curve. Policymakers would be forced to tighten aggressively to bump up the unemployment rate. The Fed would hope for a soft landing, but the more likely result is a recession in 2019. That said, it is too early for investors to position for a recession.1 Bonds rallied and the dollar weakened anew following the collapse of the Senate's healthcare bill on the view that hopes for fiscal stimulus are all but dead. We still believe that bond yields and the dollar have more upside potential, even in the absence of fresh fiscal stimulus. Last week's report2 highlighted that a global monetary policy recalibration is under way because central bankers have decided that "emergency" levels of monetary accommodation are no longer required. Moreover, the maximum level of policy divergence has not yet been reached between the Fed and other major central banks, which means that the dollar will have one last leg higher. The U.S. stock market has weathered the fiscal disappointment, seemingly moving out of sync with dollar and bond market action in the past several months. The equity market appears to have been given a "free pass" because earnings have been very supportive. The combination of robust earnings growth, steady real GDP growth near 2%, and low bond yields, all have been bullish for stocks. It will be tougher sledding when profit growth peaks. Fortunately, the earnings backdrop is still constructive at the moment (see below). A Third Mandate? Financial stability has become a third mandate for the Fed, and is one of the reasons the hawks want to keep tightening despite the fact that the FOMC has not yet met the inflation target. The topic has been mentioned by either Fed staff or FOMC members in 27 of the 39 meetings since September 2012. Fed Chair Yellen has elevated financial stability during her tenure, leading discussions or staff briefings in 19 of the 27 meetings she has presided over. The topic merited only passing mention in Fed deliberations prior to 2012. At the June meeting, Fed staff characterized the "financial vulnerabilities of the U.S. financial system" as moderate on balance.3 This assessment has not changed since the Fed began to offer opinions on the health of the financial system at its September 2013 meeting. However, the Fed does not provide a financial stability grade at every meeting. In December 2013, Fed staff described financial conditions as moderate, but its next judgment (also moderate) was only in January 2016. Since then, Fed staff has provided an assessment of financial stability in half of the 12 subsequent meetings. Another indication that Fed policymakers are paying particular attention to financial market risk is that the issue has become a key part of the Monetary Policy Report (MPR).4 Before the onset of the GFC, financial stability warranted only a few paragraphs in the MPR, but since 2013 the report has included a special section on the topic. Chart 2FOMC Closely Monitoring Financial Stability The four primary areas that the Fed monitors to assess financial stability are: Vulnerabilities stemming from maturity and liquidity transformation in the financial sector (Chart 2, panel 1); Valuation pressures across a range of assets, including Treasury securities, equities, corporate bonds and commercial real estate (panel 2); Leverage in the household and business sectors (panel 5); and Regulatory burden (not shown). Some FOMC members are worried that if rates are not normalized soon, then valuation will become even more stretched in bond and equity markets, which could potentially lead to financial stability issues. This is a reason why a few of the central bankers want to hike rates even though inflation is still too low. This group believes it is better to tighten slowly, rather than wait and raises rates sharply in the future when financial valuations may be even more stretched. Nonetheless, others at the Fed are concerned that higher rates may trigger an equity correction, which if significant enough, would spark a slowdown in the U.S. economy via the wealth channel. In this case, greater financial instability would push the Fed to pause its rate hike regime prematurely. We intend to return to this scenario in a future Weekly Report. The monetary authority is also concerned by negative term premiums in the bond market. We expect only minimal impact on Treasury bond yields linked to the reduction in the Fed's balance sheet.5 That said, a big sell-off in bond prices that leads to a sudden correction in equity prices or a widening of credit spreads would tighten financial conditions, impact the real economy and prompt the Fed to rethink its path for the fed funds rate and its balance sheet. Bottom Line: The conditions that foster financial stability matter to the central bank almost as much as maintaining low and stable inflation, and full employment. The doves want to see inflation rise closer to the 2% target before tightening even more. The hawks worry that the relationship could be non-linear, which means that a further undershoot of unemployment below estimates of full employment could suddenly generate a surge in inflation. At a minimum, an undershoot could boost risks to financial stability by promoting excess risk-taking in the financial markets. Conditions Still Favor The Consumer June's reading on retail sales released in mid-July was disappointing, but the conditions that cultivated increased consumer spending are still in place. Core retail sales dipped by 0.1% month-over-month in June, and both the 3-month and 12-month rates of change have been on a downward trajectory since the start of the year (Chart 3, panel 1). Moreover, auto sales have stagnated near all-time highs in recent months, adding to the market's consumer concerns (panel 2). The only positive is that consumer spending looks better in real terms because inflation has moderated (panel 3). Nominal retail sales have softened, but inflation-adjusted spending is what feeds into the construction of GDP. Even so, conditions are in place for a rebound in spending in the coming months. Consumer confidence readings are still near cycle peaks; home values are elevated and rising; household net worth is at an all-time high and expanding rapidly, financial conditions are easy, and accelerating income growth is supported by the tightening labor market. When these economic circumstances prevailed in the past, consumer spending almost always sped up (Chart 4). Chart 3Soft Patch In Retail Sales##BR##And Inflation Continues Chart 4Conditions Conducive For##BR##Consumer Spending Bottom Line: The soft patch in consumer spending is lingering longer than expected, which challenges our view that U.S. economic growth will be stronger in the second half of the year relative to the first half average. Nevertheless, we anticipate that GDP growth will permit economic output to hit the Fed's low target for the year and keep the monetary authority on track to tighten policy at a faster pace than is discounted in the bond market. The resulting bond sell-off will not derail the equity bull run as long as profits remain supportive. Q2 Earnings Update: Margin Expansion Continues Chart 5Positive Earnings Surprises Continue The Q2 earnings reporting season is off to a strong start, with both EPS and sales running well ahead of consensus expectations as forecasted in our July 3 preview. Moreover, the counter trend rally in profit margins is still in place. Just under 20% of companies have reported results so far with 74% of companies beating consensus EPS projections, right at the long-term average of 70% (Chart 5). In addition, 74% have posted Q2 revenues that exceeded expectations. The surprise factor for Q2 stands at 5% for EPS and 1% for sales. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, the initial results imply that Q2 will see another quarter of margin expansion. Average earnings growth (Q2 2017 versus Q2 2016) is strong at 9% with revenue growth at 5%. The BCA Earnings model predicts EPS growth to hit roughly 18% later this year on a 4-quarter moving total basis, before moderating in 2018 (Chart 6). Measured on this basis, S&P 500 EPS growth so far in Q2 is 18%, compared with 12% in Q1. The strength in earnings and revenue is broad based (Table 1). Earnings per share are up in Q2 2017 versus Q2 2016 in 10 of 11 sectors; the lone exception is the utilities sector. EPS results are particularly strong in energy, technology and financials. Energy revenues surged by 15% in Q2 versus a year ago. Sales gains in technology (7%), materials (6%), utilities (5%), and real estate (5%), are notable. The upward trajectory of EPS estimates for 2017 and 2018 (Chart 7) since the start of 2017 is encouraging. We will provide an update on the Q2 earnings season in the August 7 Weekly Report. Chart 6Strong EPS##BR##Growth Ahead Table 1S&P 500:##BR##Q2 2017 Results* Chart 7Estimates For '17 & '18 Have Moved##BR##Higher Since Start Of The Year Bottom Line: EPS growth will continue to accelerate through the end of 2017 and into early 2018, aided by a period of margin expansion and decent top-line growth. The elevated level of ISM sets the stage for EPS growth to gather speed in the second half of 2017. Firm readings on ISM are an indication that our bullish profit story for 2017 is still intact. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report "Waiting For The Turn", dated June 26, 2017. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report "Global Monetary Policy Recalibration", dated July 17, 2017. Available at usis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/fomcminutes20170614.htm 4 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 5 Please see BCA's U.S. Bond Strategy Weekly Report "Two Challenges For U.S. Policymakers", dated May 23, 2017. Available at usbs.bcaresearch.com.

Highlights The Fed is behind the curve in raising rates, as is the Bank of Canada, the Reserve Bank of Australia, the Reserve Bank of New Zealand, and the Swedish Riksbank. In contrast, the Bank of Japan, the ECB, and the Swiss National Bank have little need to tighten monetary policy. Accordingly, investors should favor USD, CAD, SEK, NZD, and to a lesser extent, AUD. EUR, CHF, and JPY will weaken. GBP will trade sideways. Short-term momentum could push EUR/USD to 1.18, but the euro will ultimately reach parity against the dollar next year, as the Fed is forced to accelerate the pace of rate hikes. Stay structurally long DXY. Go long SEK/CHF. We are closing our longstanding overweight positions in Australian and New Zealand government bonds for a handsome profit. Remain overweight global equities for now, but be prepared to turn bearish in the second half of 2018. Feature The Fed: It's Time To Get A Bit More Hawkish In our December 2015 report "The Fed Makes An Unforced Error," we made the case that the Federal Reserve would regret its decision to tighten monetary policy.1 Subsequent events validated this view: U.S. growth sagged in the first half of 2016, leading to a sharp flattening in the yield curve. It would be another 12 months before the Fed raised rates again. As bond prices and the economic data evolved over the course of 2016, our recommendations changed accordingly. On July 5th, we published a note entitled "The End Of The 35-Year Bond Bull Market" arguing that it was time to take profits on long duration positions.2 As luck would have it, this was the exact same date that the 10-year Treasury yield hit a record closing low of 1.37%. Fast forward to the present and investors are once again debating the next steps that central banks are likely to take. However, unlike in 2015, a strong case can be made that the Fed is now behind the curve in raising rates, rather than ahead of it. There are three reasons for this: There is less slack now than in 2015. The unemployment rate stands at 4.4%, down from 5% in December 2015. The broader U-6 unemployment rate has fallen even more, from 9.9% to 8.6%. Other measures of labor market slack are also closing in on their past business-cycle lows (Table 1). Table 1Comparing Current Labor Market Slack With Past Cycles The neutral interest rate has likely risen somewhat over the past 18 months (Chart 1). Household debt has continued to decline as a share of disposable income. The share of national income going to labor has increased. Wage growth among lower-income workers who tend to spend most of their paychecks has accelerated. All this should give consumers the wherewithal to spend more, warranting higher interest rates. Bank balance sheets have also continued to improve, as evidenced by the recent stress test results. In addition, fiscal policy has eased modestly and could ease even more if Congress is able to pass legislation cutting taxes later this year or in early 2018. Financial conditions have eased significantly since the start of the year, which should boost growth in the second half of this year (Chart 2). This is in sharp contrast to 2015, a year when financial conditions tightened sharply. Easier financial conditions are boosting credit growth. The annualized 3-month change in bank credit has accelerated from 1.1% in April to 4.2% at present. (Chart 3). Chart 1Households Have The Wherewithal To Spend More Chart 2Financial Conditions Have Eased Chart 3Credit Growth Has Picked Up 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%. If that were to happen, the unemployment rate would end up being nearly a full percentage point below the Fed's estimate of NAIRU. It is possible, of course, that the true value of NAIRU is lower than official estimates suggest. Older workers change jobs less frequently, and so an aging workforce tends to produce less frictional unemployment. The internet has also improved the ability of companies to fill vacancies with suitable workers. On the flipside, declining geographical mobility and falling demand for low-skilled labor may have raised structural unemployment. On balance, we are skeptical that the current estimate of NAIRU of 4.7% - already one percentage point below its post-1960 average (Chart 4) - is significantly overstated. A tighter U.S. labor market will put upward pressure on wages. While recent wage data has been on the soft side, our wage tracker is still growing twice as fast as in 2010 (Chart 5). Indeed, for all the talk about how wage growth is "inexplicably" slow, real wages have been rising more quickly than productivity for three straight years now - the longest stretch since the late 1990s (Chart 6). Chart 4NAIRU Is Low By Historic Standards Chart 5A Stronger Labor Market Will Lead To Faster Wage Growth Chart 6Real Wages Now Increasing Faster Than Productivity Inflation: A Lagging Indicator When will accelerating wage growth translate into sharply higher price inflation? Probably not this year. Historically, inflation has been the mother-of-all lagging indicators. Core inflation peaked at 2.5% in August 2008, eight months after the start of the recession. In fact, core inflation has topped out in every single business cycle over the past 40 years only after the expansion has ended and the recession begun (Chart 7). Likewise, core inflation typically bottoms several years after the economic recovery is underway. This suggests that inflation could stay subdued for the next 12 months as the labor market slowly overheats, before moving higher in the second half of 2018. Chart 7Inflation Is A Lagging Indicator If the Fed drags its feet in raising interest rates, it will be difficult to achieve a soft landing. Stabilizing the economy is akin to landing a plane: You don't just need to know the speed at which you have to hit the runway, you also have to time your descent in order to touch the ground at precisely the right speed. Even if the Fed knew where the neutral interest rate stood (which it doesn't), tightening monetary policy too late could end up pushing the unemployment rate to such a low level that it has nowhere to go but up. And as we have shown before, once the unemployment rate starts rising, it generally keeps rising, owing to the presence of numerous negative feedback loops.3 The Fed has arguably already fallen into the trap of waiting too long. If so, gradual rate hikes this year will give way to more aggressive hikes late next year, setting the stage for a recession in 2019. The Bank Of Canada Turns Hawkish On the other side of the 45th parallel, the Bank of Canada raised rates last week and signaled that further hikes lie in store. The BoC revised up its GDP growth forecasts for 2017 and 2018. It also indicated that the output gap would close later this year, rather than next year as it had earlier projected. The Bank of Canada's newfound optimism was bolstered by the most recent Business Outlook Survey, which pointed to accelerating growth, dwindling spare industrial capacity, and an increasingly tight labor market (Chart 8). The moose in the living room is the Canadian housing market (Chart 9). Central bankers are generally reluctant to use the blunt tool of tighter monetary policy to target excessive property prices. However, when stricter macroprudential regulations fail to do the job, the standard prescription is to tighten monetary policy slowly but early. The Bank of Canada has done the former but not the latter. Consequently, as my colleague Jonathan LaBerge argued in last week's Special Report, the coming housing bust is likely to be a nasty affair.4 This will be the price the Bank of Canada pays for being behind the curve. Chart 8Canadian Growth Picture Is Upbeat Chart 9Housing Bubbles Abound For now, we remain long the Canadian dollar in our currency recommendations. We are expressing this view by being long CAD/EUR, a trade that has gained 3.5% in the nine weeks since we initiated it. We also recommend being underweight Canadian government bonds within a global fixed-income portfolio. It is important to stress, however, that these are 12-month views. Most Canadian mortgages are floating rate. Higher borrowing costs will likely trigger a housing bust late next year or in 2019, forcing the Bank of Canada to slow or even reverse the pace of rate hikes. The RBA And RBNZ ... Behind The Curve Too Australia and New Zealand have also been grappling with dangerously overvalued housing markets, and just as in Canada, the RBA and RBNZ have been behind the curve in responding to the brewing excesses. That is starting to change. The Reserve Bank of Australia struck a hawkish tone in the July 4 meeting minutes released this week, sending the Aussie dollar to a 26-month high against the greenback. The RBA highlighted the improvement in business conditions and a tightening labor market. It also indicated that the "neutral cash rate" was 3.5%, two points higher than the rate of 1.5%. Australia's terms of trade have been recovering of late and this should support the economy as well as the Aussie dollar (Chart 10). The RBNZ is even further behind the curve than the RBA (Chart 11). Nominal GDP is growing at over 6% and retail sales are expanding at nearly 8%. Population growth has risen sharply in recent years due to increased immigration, leading to greater demand for housing. The government has increased infrastructure spending and cut taxes. The unemployment rate has fallen back to an 8-year low of 4.9%, while the terms of trade is approaching record-high levels. Chart 10RBA Behind The Curve... Chart 11... And RBNZ Too? With all this in mind, we are closing our longstanding overweight positions in Australian and New Zealand government bonds for gains of 59.5% and 74.2%, respectively.5 Riksbank: End Of NIRP? The Swedish repo rate stands at -0.5%, despite the fact that the output gap has moved into positive territory (Chart 12). Inflation is still slightly below target, but is moving higher. The Riksbank is taking notice of the changing economic environment. The central bank backed away from its easing bias at its most recent policy meeting. The facts on the ground support this decision. Sweden's GDP is now 0.7% above potential and the economy continues to strengthen. The Riksbank's resource utilization indicator points to a sharp acceleration in Swedish inflation in the coming quarters. Nonfinancial private credit has reached 237% of GDP, up from 106% in 2000. If the Riksbank falls too far behind the curve, it will be forced to jack up rates very aggressively down the road, reviving the specter of the debt crisis of the early 1990s. The ECB, SNB, And BoJ: Take It Easy Whereas a strong case can be made that the central banks discussed above are behind the curve in normalizing monetary policy, the same cannot be said for the ECB, Swiss National Bank, or Bank of Japan. 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 (Chart 13). Moreover, as we discussed two weeks ago, the neutral rate in the euro area remains very depressed.6 Thus, even if the euro area economy were close to full employment, the ECB would still not have much scope to raise rates. Chart 12NIRP In Sweden: R.I.P. Chart 13Euro Area: Labor Market Slack Still High Outside Of Germany In this light, investors have gotten too optimistic about the ability of the ECB to tighten monetary policy. While the ECB will further taper asset purchases as early as this autumn, sustained rate hikes are still a few years away. Mario Draghi explicitly said during his press conference yesterday that "the last thing that the governing council may want is actually an unwanted tightening of the financing conditions." This is in sharp contrast to the Fed, which is trying to tighten financial conditions by raising rates. Swiss monetary conditions are far from accommodative, despite a policy rate that remains buried in negative territory (Chart 14). Core inflation is close to zero and wage growth is anemic. An overvalued currency has offset the benefits from lower interest rates. Given the SNB's policy of intervening in the currency markets to keep EUR/CHF within a reasonably tight range, the recent appreciation of the euro will further add to the deflationary pressures weighing on the Swiss economy. Investors should position for a weaker franc (and euro) in the months ahead. Go long SEK/CHF (Chart 15). Chart 14The Swiss Economy Still Needs Low Rates Chart 15Long SEK/CHF Similar to the ECB and the SNB, the Bank of Japan is in no position to tighten monetary policy. Core inflation has fallen back to zero and medium-to-long-term inflation expectations have dipped so far this year (Chart 16). The annual shunto wage negotiations this summer produced little in the way of salary hikes. And even if inflation were to rise, the government would likely want to tighten fiscal policy before contemplating removing the monetary punch bowl. The Bank Of England: A Tough Call If one didn't know what transpired last June, the case for tighter monetary policy in the U.K. would be fairly straightforward. The unemployment rate is at a 9-year low and inflation is well above target. The trade-weighted pound has weakened by 21% since November 2015, which in most cases, would translate into stronger growth in the years ahead. Reflecting these points, our Central Bank Monitors show that the U.K. is more in need of tighter money than any other major developed economy (Chart 17). Chart 16BoJ: In No Position To Tighten Chart 17The Message From Our Central Bank Monitors Brexit negotiations are likely to cast a pall over the economy, however. The EU will be forced to take a tough line with the U.K., for fear that the Brexit vote could prompt other countries to follow's Britain's lead. BCA's geopolitical strategists ultimately expect a "hard Brexit" to be averted, but things may need to be brought to the precipice before that happens. The pound is cheap and so we do not expect it to weaken significantly from current levels. Nevertheless, the upside for both sterling and gilt yields will remain constrained until political uncertainty abates. Investment Conclusions As a rule of thumb, investors should favor currencies in economies whose central banks are behind the curve. Such central banks are likely to find themselves in a position where they have to scramble to tighten monetary policy. We noted on July 7th that short-term momentum favors the euro and that we would not be surprised if EUR/USD reaches 1.18 over the coming weeks. Looking further ahead, the appreciation of the euro in the first half of this year will weigh on growth in the remainder of 2017 and into early 2018. This will force the ECB to cool its heels. In contrast, U.S. growth should accelerate. Against the backdrop of diminished spare capacity, this will prompt the Fed to turn more hawkish. We expect EUR/USD to fall to 1.05 by year-end, and reach parity next year as the Fed ramps up the pace of rate hikes. The market is betting that the Fed will deliver fewer rate hikes than implied by the 'dots'. Our hunch is that the Fed will deliver more hikes than what its forecast suggests, especially starting early next year when inflation is liable to accelerate. Bullish sentiment towards the dollar has collapsed. Investors should turn contrarian and position for a stronger greenback over the next 12 months. In addition to the dollar, we like the Swedish krona, Canadian dollar, and New Zealand dollar. The Aussie dollar should also perform reasonably well, provided that the Chinese economy continues to hold up, as we expect it will. The Japanese yen remains our least favorite currency. Despite the dollar selloff, USD/JPY has managed to gain 3% since mid-April. As the Fed and a number of other central banks raise rates, the spread in yields between foreign government bonds and JGBs will widen. This will push down the yen, helping Japanese stocks in the process. As far as overall risk sentiment is concerned, another rule of thumb says that stocks rarely fall on a sustained basis outside of recessions (Chart 18). We do not expect a recession in the U.S. or elsewhere until 2019. This implies that investors should maintain an overweight position in global equities for now, favoring cyclical sectors over defensive ones. Chart 18Stocks Rarely Fall On A Sustained Basis Outside Of Recessions Peter Berezin, Global Chief Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Fed Makes An Unforced Error," dated December 18, 2015, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com 3 Please see Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gis.bcaresearch.com. 4 Please see Global Investment Strategy Special Report, "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com. 5 Calculated as the total excess return on the 10-year bond index relative to global government benchmark since inception in 2009, foreign-currency hedged since 2014. The 10-year yield for New Zealand government bonds has dropped from 4.28% at the time of inception to 2.94% today. The 10-year yield for Australian government bonds has fallen from 4.10% to 2.74% over this period. 6 Please see Global Investment Strategy Weekly Report, "Draghi's Dilemma," dated July 7, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights China's strong second-quarter growth numbers released early this week confirmed the synchronized global growth upturn within the major economies. Our model is predicting an imminent increase in the PBoC's benchmark lending rate. Higher rates in China are reflective rather than restrictive. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. The latest MFWC pledges "re-regulation" of the financial industry and remains committed to developing capital markets. Increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space. Feature The Bank of Canada hiked its policy rate by 25 basis points last week, the second major central bank to tighten after the Federal Reserve in the current cycle. While it is unclear whether central bankers maintain secret communication channels, effectively there appears to be a "coordinated recalibration" of monetary policies among major central banks, due largely to a synchronized growth upturn within the major economies. China's strong second-quarter growth numbers released early this week fit with this broad theme. There are rising odds that the People's Bank of China (PBoC) will join the proverbial global party with rate hikes. In addition, the Chinese authorities have pledged a tougher stance on the financial industry. Reflective Or Restrictive? China's latest data have shown across-the-board strength of late. Most indicators have surprised to the upside, rectifying our positive assessment.1 With the latest growth numbers, our model is predicting an imminent increase in the PBoC's benchmark lending rate (Chart 1). The model follows a modified version of "Taylor's Rule," in which external factors are also considered for open economies. In China's case, both improvement in growth and the Fed's interest rate hikes have played a strong role in setting the stage for higher policy rates in China. The model currently predicts 50 to 75 basis points in rate hikes by the PBoC. Historically, our interest rate model has done a reasonably good job in capturing the major turning points in China's policy rate cycles. This time around, the country's interest rate reforms may have complicated the model's predicting power. In short, the PBoC is in the process of diminishing the importance of the benchmark lending rate, while promoting market-based interest rates. The central bank has theoretically fully liberalized commercial bank interest rates since 2015, and therefore it is unclear whether it will abandon benchmark policy rates, which is viewed as an outdated tool. Instead, the PBoC has been trying to build an interest rate "corridor" in which it uses monetary and liquidity measures to guide market interest rates. The upper band of the interest rate corridor appears to be the interest rates of the PBoC's lending facilities - the cost for financial institutions to borrow from the central bank - while the lower band is the interest rate the PBoC pays on commercial banks' excess reserves (Chart 2). In this vein, the 6-month Medium Term Lending Facilities (MLF) interest rate has already been raised by 20 basis points since late last year, and interbank rates have been guided higher. Chart 1Rising Odds Of PBoC Rate Hikes Chart 2Interest Rate Corridor' ##br##Has Been Lifted Higher Chart 3Bank Loan Rate Is On The Rise Nonetheless, the upturn in our interest rate model justifies higher rates engineered by the PBoC. Regardless of whether the PBoC explicitly raises its policy lending rate, interest rates in China have already moved higher (Chart 3). Tighter liquidity and higher bond yields since late 2016 suggest that average bank lending rates should have increased by probably 50 basis points in recent months. Higher rates in China are a reflection of stronger growth rather than policy tightening to tame business activity, at least for now. After all, China's nominal GDP growth has rebounded from 6.4% in late 2015 to 11.1% in the second quarter of 2017 - a sharp turnaround in nominal business activity that calls for higher interest rates. Similarly, recent hawkish - or less dovish - rhetoric from other central banks all reflect improving growth where "emergency" levels of monetary accommodation are no longer needed (Chart 4). With the exception of Japan, BCA Central Bank Monitors, which measure pressure on central bankers to raise or reduce interest rates, have mostly climbed above zero of late, underscoring the need for tighter money among most developed countries. By the same token, it is premature to conclude that any policy tightening by the PBoC will lead to major growth problems in China. Chart 4Emergency' Levels Of Accommodation No Longer Needed Where does the RMB fit in? The PBoC's tightening bias suggests there is less incentive to target a lower exchange rate, both against the dollar and in trade-weighted terms. The central bank will continue to intervene to smooth out volatility. From investors' perspectives, the risk-return profile of taking a direct bet on the RMB is not attractive in either direction: we doubt there is meaningful upside in the RMB against the dollar in the near term, but the odds of significant RMB/USD depreciation have been further reduced. In other words, the RMB/USD exchange rate is still largely dominated by broader dollar performance, and the RMB is not a "high beta" currency to play the dollar. In short, we maintain our positive view on China's growth outlook, as discussed in greater detail in last week's bulletin. The PBoC will likely maintain a tightening bias, but this should not lead to major growth disappointments. Financial Reforms And Markets As growth has mostly surprised to the upside, policymakers' focus appears to have shifted to controlling financial risks, as highlighted by the key messages from the 5th National Financial Work Conference (NFWC) this past weekend. The NFWC convenes twice a decade, and usually sets the policy tone for the following years. Compared with the previous meeting five years ago that featured "deepening reforms and promoting development" as the key theme of the financial industry, the current session clearly strikes a more conservative tone. Top leadership declared that the financial sector must serve the needs of the "real economy," and that preventing systemic financial risks is the government's "eternal theme." Importantly, a cabinet level committee has been established to coordinate regulatory oversight on the financial industry - a task currently shared between the central bank and three regulators. The overall message from the latest NFWC is consistent with the regulatory crackdown on financial excesses since late last year.2 Overall, we share policymakers' sentiment that China's financial sector deregulation in recent years has gone too far.3 The dramatic leverage-fueled equity market boom-bust cycle in 2015 offered a crude awakening to the authorities against imprudent financial deregulation. Meanwhile, reform measures also ushered in a proliferation of institutions that prolonged financial intermediation channels. Without proper regulatory coordination, the authorities' attempts to reduce excesses has typically pushed speculative activity off the books of financial institutions, making it even more difficult to monitor and regulate. In fact, regulations on the financial sector have already been tightened of late. Derivatives, internet-based financing firms and asset-backed securities have all been put under much tighter regulatory scrutiny. The macro-prudential assessment (MPA) on financial institutions has been adopted since earlier this year - the latest MFWC suggests that "re-regulation" of the financial industry will continue in the coming years. The long-term impact of tighter control over the financial sector on the economy and financial markets remains to be seen. On one hand, imprudent financial deregulation and prolonged financial intermediation channels have done little to address the financing needs of small private enterprises, but have amplified risks and raised funding costs for the overall corporate sector - a suboptimal outcome that needs to be corrected. On the other hand, China's vast domestic savings need to be properly intermediated to the economy. We have long held the view that so long as the banking sector and debt instruments play the dominant role in financial intermediation, the accumulation of debt in the overall economy is all but inevitable.4 In this vein, any attempt to block financial intermediation aimed at "deleveraging" will prove both ineffective and counterproductive, with unintended consequences. An easier bet is that the authorities will remain committed to developing capital markets, both equities and corporate bonds, to provide alternative funding sources for the corporate sector. Procedures for initial public offerings (IPOs) and debt issuances will be simplified. The share of debt and equities in total social financing will continue to grow from a structural point of view (Chart 5). From investors' perspective, increasing supplies of equities through IPOs will put some downward pressure on stock prices - especially in the domestic small cap space, where multiples are unsustainably high and will continue to be de-rated (Chart 6). There are certainly some compelling growth stories among small caps that are worth cherry-picking, but overall investors should remain cautious for this asset class. Chart 5Debt And Equity Issuance##br## On A Structural Uptrend Chart 6Domestic Small Caps##br## Will Continue To Derate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China Outlook: A Mid-Year Revisit," dated July 13, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: Financial Crackdown And Market Implications," dated May 18, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Legacies Of 2015," dated December 16, 2015, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate Sweden's Riksbank. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar. Bond investors should underweight Swedish government bonds versus a European or global benchmark, currency hedged. Equity investors should remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. The risk of persistent inflation will rise only after the next severe global downturn. Feature "Is the 2% inflation target still a very realistic aim?" - Ewald Nowotny, ECB Governing Council member As the ECB Governing Council gathers for its latest monetary policy meeting, some voices within its ranks are starting to question the ECB's first commandment: the 2% inflation target. Respected and influential ECB Governing Council member, Ewald Nowotny, has asked whether there should "be an easing of the 2% inflation goal in the sense of setting a range instead of a clear-cut target." Across the Baltic Sea, Sweden's Riksbank is one step ahead. Recently, it suggested (re)introducing a variation band of 1% either side of the 2% inflation target1 to acknowledge that persistent 2% inflation is very difficult, or impossible, to achieve (Chart of the Week). More concerning, the single-minded pursuit of 2% inflation creates risks and instabilities. The Riksbank's inflation target has forced it into an absurd position: with inflation undershooting for over five years, the policy interest rate is now at -0.5% when Swedish GDP growth was recently running at a world-beating 4.5% clip (Chart I-2). Chart I-1Mission Impossible:##br## 2% Inflation Chart I-2Absurd: Interest Rate At -0.5% ##br##When Growth Is At 4.5% Hence, Riksbank Governor, Stefan Ingves, recently proposed that "central banks should also have the explicit responsibility for financial stability." The former governor of the Bank of Japan, Masaaki Shirkawa agrees. "My worry with setting a precise number (of 2%) is that it can crowd out other very important considerations, such as financial stability." What's So Special About 2% Inflation Anyway? Given the almost religious significance of the 2% inflation target for central banks, you would think that there is a well-established theoretical and empirical basis both for inflation targeting and for the 2% number. But you would be wrong. As we explained two years ago in our special report Mission Impossible: 2% Inflation,2 inflation targeting only became established in the 1990s, and the magic 2% number was pulled out of the air. Chart I-3The Riksbank Has Undershot ##br##Its 2% Inflation Target For 5 Years At the Federal Reserve's July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1% (because measured inflation slightly overstates true inflation.) But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1%, the zero-bound of interest rates would prevent "real interest rates becoming negative on the rare occasions when required to counter a recession." Yellen's pragmatism won the day, and Greenspan summarized "we have now all agreed on 2%" Meanwhile in Europe, the ECB's original inflation target of below 2% was close to Greenspan's proposal of 0-1%. But in 2003 the ECB changed its inflation target to its current "below but close to 2%". The reason, according to Mario Draghi: "The founding fathers of the ECB thought about the adjustment within the euro area, the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they have to readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2%." Hence, the Fed, ECB and other central banks are targeting inflation at a low but arbitrary number, 2%, to always allow some leeway for negative real rates; and in the case of the ECB, to allow easier convergence among disparate euro area economies. But as the Riksbank and other central banks have now acknowledged, trying to hit and hold inflation at a point target of 2% is both futile and dangerous (Chart I-3). Why 2% Inflation Is A Mission Impossible The crux of the issue is that inflation is a notoriously non-linear phenomenon. A defining feature of a non-linear phenomenon is that you cannot just turn it up or down like the volume dial on your music system. Non-linear phenomena experience sudden and violent phase-shifts from stability to instability, making it very difficult to hit and hold a point target like 2%. To experience this difficulty for yourself, try pulling a brick across a table using an elastic band. Initially, the brick doesn't move because of the friction with the table. But at a tipping point the brick does move, and the friction simultaneously decreases, self-reinforcing the brick's acceleration. Meanwhile, your pull on the elastic continues to increase as you react with a time-lag. The result is that this non-linear system suddenly phase-shifts from stability - the brick doesn't move - to violent instability - the brick hits you in the face! Try as hard as you might, it is near-impossible to pull the brick across the table at a constant speed of, say, 2mph. A very similar dynamic applies to inflation. The system suddenly phase-shifts from stability - near-zero inflation - to violent instability. It is near-impossible to keep inflation at an arbitrary constant of, say, 2%. To understand why, consider the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. Theoretically and empirically, both M and V are notoriously non-linear phenomena (Chart I-4, Chart I-5, Chart I-6, Chart I-7) - because they are subject to the same conditions as the brick pulled by an elastic band: inertia, then self-reinforcement with delayed controlling feedback. Chart I-4The Velocity Of Money... Chart I-5...Is A Non-Linear Phenomenon Chart I-6The Money Multiplier... Chart I-7...Is A Non-Linear Phenomenon As policymakers try to take inflation away from its natural state of near-zero, nothing happens at first. But at a tipping point, the self-reinforcement of inflation expectations becomes explosive. Whereupon, the money supply, M, gaps up because it becomes rational for banks to lend as much as possible. And its velocity, V, also gaps up because it becomes rational to spend the money - both newly created and pre-existing balances - as quickly as possible. Hence, the product MV experiences an even sharper non-linearity. Well-intentioned policymakers would think they could apply a controlling feedback to MV. But how? Economic and monetary data are noisy, imprecise and take time to collect and parse. As we have shown, inappropriate and/or delayed feedback just adds to the system's instability. Seen in this light, inflation-targeting in the 1990s worked because central banks were just helping economies move from an unnatural state - uncontrolled inflation - towards a natural state - price stability (Table I-1 and Chart I-8). But now that economies have reached a natural near-zero inflation rate, point targeting an unnatural inflation rate is both futile and dangerous. Table I-1For 700 Years U.K. Inflation ##br##Averaged Near-Zero Chart I-8Excluding Wars, Persistent Inflation Was ##br##Very Unusual... Until The Late 20th Century The Investment Implications The ECB's Nowotny argues that "the 2% inflation target should include a certain flexibility." The Riksbank's Ingves agrees, and adds that extreme and unprecedented loose monetary policy endangers financial stability. Central banks tend not to volte-face as it damages their credibility. But to us, it is clear that the ECB and Riksbank are switching their focus from sub-2% inflation to their economies' robust growth. And to the risk that ultra-accommodative policy poses to financial stability and market distortion. Hence, the era of divergent monetary policies between the ECB and the Fed is over. Re-convergence has a lot further to go. As the ECB ends its ultra-accommodation, it will also liberate the Riksbank whose policy has inevitably mirrored Frankfurt - for fear of a sharp appreciation of the Swedish krone versus the euro. Our currency mantra this year has been "euro first, pound second, dollar third." The strategy has performed extremely well, and into this mix we can add the Swedish krone. Go long Swedish krone/dollar as an alternative or addition to long euro/dollar (Chart I-9). Chart I-9Long SEK/USD Is An Alternative ##br##To Long EUR/USD Chart I-10Underweight Swedish Bonds Is An Alternative To Underweight German Bunds The bond market corollary is to underweight Swedish government bonds - just like German bunds - versus a European or global benchmark, currency hedged (Chart I-10). The equity market implication is to remain overweight European banks and retailers versus U.S. banks and retailers, currency unhedged. Finally, given that inflation could ultimately phase-shift to violent instability, when should we worry about it? Not yet. To expand the broad money supply, someone has to borrow money. So if policymakers really want to create rampant inflation, the government has to borrow and spend money at will,3 with the central bank creating it. In other words, the central bank loses its independence and fiscal policy becomes irresponsibly loose. The risk of this remains low until the next severe downturn - when policymakers may be forced into desperate measures for a desperate situation. Until then, own some bonds. Our preference is Spanish Bonos and U.S. T-bonds. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 The Swedish FSA has said that the Riksbank should delay the change until a parliament review of Riksbank policy rules is completed in about 2 years. 2 Published on August 20, 2015 and available at eis.bcaresearch.com. 3 For example, by giving all public sector workers a 50% pay rise! Fractal Trading Model* The sell-off in Spanish media (Mediaset Espana Comunicacion) is technically overdone. This week's trade is to go long Mediaset Espana Comunicacion versus the market with a 5% profit-target and symmetric stop-loss. In other trades, long FTSE100/short IBEX35 hit its 4% profit-target, while short EUR/USD hit its 2% stop-loss For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Chinese political risks are heating back up; The 19th National Party Congress will replenish President Xi's political capital; Xi will escalate financial deleveraging and reboot his reform agenda in 2018; Yet the Chinese leadership is becoming more populist - holding reforms back; Volatility is going up; go long Chinese equities versus EM, and long big banks versus others. Feature China's economy grew at a faster-than-expected 6.9% rate in the second quarter (Chart 1), the result of easing financial conditions, healthy external demand, and domestic stimulus efforts that have enabled the country to shake off a range of serious risks since 2015. Chart 1As Good As It Gets Chart 2Exports And Monetary Conditions = Reflation The nominal rate of growth is at the top of what one can reasonably expect out of China today; the upside is limited. Stimulus is likely to wane, while the RMB, exports, and financial conditions are likely to be less supportive going forward (Chart 2). Moreover, the latest improvements came at the expense of China's structural reform agenda, which would rebalance growth toward consumption and services while encouraging private entrepreneurship and cutting back state-owned enterprises (SOEs) (Chart 3). As a result, risks are skewed to the downside. If China's total government and quasi-government fiscal-and-credit impulse rolls over, the recent improvements in industrial profits and domestic demand will come under threat (Chart 4). No surprise then that Chinese economic policy uncertainty remains elevated despite the growth recovery and stifling of capital outflows (Chart 5). Chart 3A Setback To##br## Economic Rebalancing Chart 4A Weaker Fiscal/Credit##br## Impulse Would Threaten Profits Chart 5Policy Uncertainty##br## Remains High The critical question going forward is: How will policymakers respond? Will they continue on the current path of waxing and waning stimulus combined with ad hoc reform efforts? Or will they attempt aggressive structural reforms to try to break out of the current cycle and escape the dreaded middle income trap?1 Between now and March of next year, China's political leaders will make a series of crucial decisions that have the potential to reshape the country's future over the long run. Though it is impossible to predict the precise outcome of the Communist Party's 19th National Party Congress - the crucial "midterm" leadership reshuffle set to take place in late October or November - there are nevertheless structural factors that will constrain the options available to the new leaders. Why Does The Party Congress Matter? The paradox of China's recovery from the turbulence of 2015-16 is that it coincided with the stagnation of President Xi Jinping's ambitious reform agenda, outlined to great fanfare at the 18th Central Committee's Third Plenum in 2013. Moreover, the impending 19th National Party Congress has implied that China would be even more vigilant than usual in maintaining stability. As we have argued, this meant that there would be neither dramatic reflation nor dramatic reform this year, which has (so far) been the case (Chart 6). Chart 6No Aggressive Stimulus Prior To Five-Year Party Congresses Now the party congress is approaching. In August, top leaders will convene at Beidaihe, a small seaside tourist village, to hammer out the final roster of the Chinese leadership for the next five years. Later the party congress delegates will mostly ratify this roster as well as any changes to the party's constitution. The historic average turnover of leaders in the Central Committee is significant, at about 60%. And this time around, almost the entire Politburo Standing Committee (PSC), the supreme decision-making body in China, will retire. A new PSC will literally emerge from behind a curtain for the world to see for the first time. China will have a substantially new set of decision-makers. Xi Jinping, who will give a report on where the party stands, will remain the "core" leader. The post-Mao system of power transition is relatively young and not as institutionalized as one might think. Still, some clear rules and norms are in place. In even-numbered years, party congresses mark a changeover in the top leaders (Hu Jintao and Wen Jiabao in 2002, Xi Jinping and Li Keqiang in 2012), while in odd years they have served as a "midterm" reshuffle (as under Jiang Zemin in 1997, Hu in 2007, and now Xi). Crucially, the midterm reshuffle marks the point at which a leader "consolidates" his power over the party and state, after which he has a freer hand to push his policy agenda. The meeting is often preceded by the removal of key rivals, the promotion of key protégés, and the launching of a leader's priority policies. Witness the sudden ousting of Sun Zhengcai, Chongqing party boss, who was until this week the likeliest candidate to succeed Li Keqiang as premier in 2022.2 The question is political capital Xi will have after the congress. There is no chance of him becoming a lame duck, but there is potential for him to be checked if his followers make a poor showing on the PSC, the 25-member Politburo, and the 300-member Central Committee.3 China watchers will pore over the new membership rosters. Here are the important issues at stake: Institutionalization: Will Chinese politics become more or less institutionalized and predictable? Of particular importance is whether Xi retains existing age limits, term limits, the size of party bodies.4 Any drastic changes would suggest that Chinese power is becoming more personalized, "charismatic," and dictatorial.5 That would feed rumors that Xi intends to stay in power beyond his term limit of 2022. Succession: Will Xi and Premier Li Keqiang promote successors to take over their positions in 2022? They will be expected to elevate their favorites to the PSC, just as they were elevated by their predecessors in 2007.6 If the new PSC does not include two conspicuously younger officials who are clearly being groomed to take over the country in 2022, then political uncertainty will spike. It will suggest that Xi is following in Vladimir Putin's and Recep Erdogan's footsteps. Re-centralization: The size of the Politburo and PSC have fluctuated over the years. In 2012, Xi notably reduced the PSC from nine to seven members, which was the norm in the 1990s. This move was seen as a re-centralization of power after the 2002-12 nine-member PSC came to be seen as slower-moving, indecisive, and less effective. Now there is speculation that Xi will again reduce the PSC to five members, further concentrating power. We think this unlikely but the result would be in keeping with the trend of re-centralization. Factionalization: China only has one party, but the party is divided into factions. The Communist Youth League (CCYL) faction is the most coherent. It includes current Premier Li Keqiang, former President Hu Jintao, and at least four of the ten most likely candidates to ascend to the PSC this fall. It is also called simply the "Hu faction" (see Diagram 1) and is broadly associated with populist policies. By contrast, Xi Jinping, in addition to being part of an elite group of "princelings," or sons of revolutionary founders, is forming his own clique. It is very roughly allied with other "elitists" from former President Jiang Zemin's faction (hence the label "Jiang/Xi faction" in Diagram 1). Xi has recently criticized the CCYL and cut its funding - he is also believed to have taken the economic portfolio away from Li Keqiang. Hence the predominance of Xi's or Hu's faction on the PSC and Politburo will be important. And if Xi were to replace Li, that would be a sign of extreme factionalization and political risk. Diagram 1Lineup Of New Politburo Standing Committee Yet To Take Shape - Factions Evenly Balanced? These issues can be debated ad nauseam, but for investors the chief takeaways are as follows: Chinese politics are not institutionalized: While we expect that Xi will largely adhere to party norms, we also expect him to make some tweaks. Unless he suffers a shocking setback at the party congress (very low probability), he is already lined up to be the most powerful leader in China through the 2020s. That is true even if he steps down from all formal positions as scheduled in 2022. Why? Because Chinese leaders - especially "core" leaders like Xi - continue to wield great power behind the scenes.7 In other words, many of China's underlying tendencies over the past five years (e.g. ideological purity, foreign policy ambition) will be with us for quite some time. Succession is what matters: We expect Xi to promote a successor. If he fails to do so, he will appear to be a true strongman who may stay in office after 2022. If the party congress points in that direction, then China's consensual political norms of the past thirty years will be in jeopardy. Rumors will say that Xi plans to revive the "chairman" position that Mao Zedong held and thus rule indefinitely. The factional balance in China will be upset and internal power struggle will ignite. Western governments will see China moving toward dictatorship. Capital flight pressure will intensify. Re-centralization will continue: China is in a re-centralization phase regardless of whether the PSC has five or seven members. Xi has charted this course and we expect it largely to continue due to his focus on regime security and international prestige. What matters is whether Xi is outnumbered by a rival faction on the PSC, since that could water down his policies or implementation. Factions do not predict policies: Factions reveal differences in the party that could weaken policy or stability, but they are limited in terms of predicting policy orientation. Xi has delayed difficult structural economic reforms with stimulus and promoted socially accommodative policies like his predecessor Hu Jintao.8 As such early expectations that Xi would be pro-market have dissipated. The real difference is that Xi has removed formidable enemies, giving him greater flexibility than Hu ever had. He may choose to use that flexibility for painful reforms in future, but he has notably refrained from doing so thus far. Chart 7Balance Of Institutions On China's Politburo A victory for the CCYL would be an "upset" for Xi, hindering his dominance, but would also be status quo for China as a whole. It would call into question Xi's political capital and ability to drive through his preferred policies. China would be seen as less economically promising, though possibly more politically mature. Xi's effectiveness in his first five years leads us to believe that this will not happen. We think he will secure control of the top policymaking bodies. Yet, as stated above, we also think Xi will broadly adhere to party norms and not lay the groundwork to become "leader for life." Why? The Communist Party has developed an informal but empirically verifiable history of balancing the members of the top leadership so that different institutions, regions, and skill-sets are represented. Hence the representation of leaders on the Politburo with key backgrounds in the party bureaucracy, the state bureaucracy, the regional governments, and the military have been remarkably stable since the 1980s (Chart 7). The balance is even more jealously guarded on the PSC than on the Politburo. Hence, the party congress is most likely to be a determiner of which way the balance tilts (more on that below), rather than whether the balance is entirely overthrown. Our expectation is probably the best short-term political outcome for financial markets: Xi enhances his political capital through 2022, but does not jeopardize the stability of the Chinese political system by resurrecting a Maoist "cult of personality" and embroiling the country in a future succession crisis. The country is thus more politically mature and (potentially) more economically promising. Bottom Line: Chinese politics are not institutionalized. Dramatic changes are taking place as we go to press; more are likely to occur before and after the party congress. Nevertheless, we expect Xi to uphold most of the party's rules even as he clinches full control of the party for the next five-year term. He will push the envelope but not break it. This is marginally positive for Chinese H-shares. What Comes Afterwards? The party congress provides an important infusion of political capital with which policymakers can try to get things done. For instance, after the 1997 congress, Jiang launched a massive "reform and restructuring" campaign of banks and state-owned enterprises (SOEs) that led to a spike in unemployment and bankruptcies to purge the system of inefficiencies (Chart 8). These policies ultimately transformed China - by one estimate they contributed about 20% of China's aggregate increase in total factor productivity through 2007.9 We expect the Xi administration to reinvigorate its policy agenda after this fall. The first five years of his presidency have centered on power consolidation - i.e. the sweeping anti-corruption campaign, breaking the fiscal and judicial independence of the provinces, and party purge. This campaign is likely to continue to some extent, but it has peaked in intensity (Chart 9) and the party congress should settle many of the most important power struggles, at least for a time. Chart 8China Embraced Creative Destruction In 1990s Chart 9Anti-Corruption Campaign Has Peaked Hence the central leadership's policy effectiveness should intensify in 2018. This is significant because Xi's reform agenda is incredibly ambitious. Our clients will remember that, in a deliberate echo of Deng Xiaoping's famous "reform and opening up" measures launched at the Third Plenum in 1978, Xi Jinping announced a raft of major reforms at the latest Third Plenum in 2013.10 The intention was to push forward the next wave of China's development and make market forces "decisive" in China's economy, namely by: rebalancing growth toward consumers, services, and private investors; deregulating upstream and downstream markets; reforming the fiscal system to give local governments sustainable finances; injecting private capital, competition and market discipline into the state-owned corporate sector; and stabilizing the business environment and broader society by fighting pollution and establishing the rule of law. As mentioned, this agenda has since been compromised, with Xi reverting to infrastructure spending and credit growth to avoid confronting the socio-political blowback of painful adjustments. With limited reforms, total factor productivity has continued on its post-GFC decline throughout Xi's term (Chart 10). Xi has also gone easy on SOEs, the weakest link in China's economy, maintaining the time-tried policy of rolling up inefficient ones into bigger conglomerates rather than letting them fail. The market has not perceived any loss of policy support for SOEs (Chart 11). Chart 10Productivity Weak In Xi's First Term Chart 11SOE Reforms Put On Hold Will the party congress change any of this? Will Xi be less pragmatic - i.e. more concerned with building a legacy as a historic reformer - in the coming five years? We cannot predict the precise membership of the next PSC or Politburo - especially given the furious horse-trading taking place after Sun Zhengcai's fall. But looking at key trends in the PSC's membership in recent decades, and assuming the top five likeliest candidates for 2017, the following trends become apparent (see Charts 12A & 12B): Chart 12ALeadership Characteristics Of ##br##The Politburo Standing Committee Chart 12BLeadership Characteristics Of ##br##The Politburo Standing Committee From technocrats to generalists: The "fourth generation" of Chinese leaders (Hu Jintao's generation) will finally rotate out of top posts this year. This is the last generation to have gone to college prior to the Cultural Revolution (1966-76), when schools and universities were disrupted, and to have largely studied natural sciences or engineering. Xi Jinping's "fifth generation" - and those beneath it - tend to come from educational backgrounds that are less technical and scientific and more legal and humanistic.11 The rise of the humanities may translate to a more ideologically doctrinaire outlook (pro-Communist Party, anti-West, anti-liberal) among the leadership, as opposed to the practicality of Deng Xiaoping and Jiang Zemin. Rule by provincial chieftains: Leaders with executive experience either as governors or party secretaries of the provinces have taken up an ever-greater share of the PSC and Politburo. This suggests that leaders have made tough decisions and have a broad conception of China that encompasses its vast regional, demographic, and economic disparities. They have dealt closely with poverty, ethnic minorities, border and security issues, and social instability. They are presumably less afraid to make decisions, or to crack heads, than central bureaucrats. The central government knows best: The share of leaders with experience at the top of the state bureaucracy is also rising. This means that leaders have experience administering key government agencies and ministries. They are not, however, "technocrats," as defined above - they are simply politicians capable of handling a policy portfolio that applies across the country. Fewer soldiers and business executives: PSC members with military experience have declined since Deng Xiaoping's era. Meanwhile, PSC members with experience as executives of state-owned enterprises have vanished since the days that one of them (Jiang Zemin) led China. But this does not portend sweeping privatization and liberalization.12 The bottom line is that China is being ruled more and more by politicians and less by business leaders and generals. This should also portend greater ideological purity and loyalty to the Communist Party. The heartland's revenge: Leaders who hail from the thickly populated and poorer provinces of central China have recently outnumbered those from the wealthy coastal provinces. But while PSC leaders increasingly come from the interior, their executive experience is still mostly in rich coastal areas. They straddle - and maybe know how to balance - the country's stark regional divide. In essence, China's political elite is gradually shifting toward greater "populism." The Han Chinese heartland has reasserted control of the Communist Party to which it gave birth in 1921. China's leaders, as a result of their provincial governing experience, are increasingly primed to maintain socio-political stability through redistribution or force rather than to promote economic efficiency via competition and liberalization (Chart 13). Chart 13More Social Spending Needed Further, these leaders have grown more aloof from the hard sciences and business acumen that gave rise to China's industrial prowess and are more intent on supporting the Communist Party's foundational myths and regime control - as well as keeping the country's rapid social and technological development under that control. What does this mean for Xi Jinping's second term? Xi is seen as an "elitist" both in his policy preferences - the demand for greater economic competition, efficiency, and technological advances - and in his personal background as a princeling. Yet these preferences will likely be compromised in his second term, as in his first, because the economic drivers of the "populist" trend will persist. Insofar as leadership characteristics are a reliable predictor, the radical liberalizing agenda of the Third Plenum - soon to be supplanted by another Third Plenum in 2018 - will only briefly benefit from an infusion of new energy, say in 2018-19, before being moderated, postponed, or watered-down. The leadership is increasingly aware of the need to maintain minimum levels of growth, development, and income redistribution for the sake of stability. The creative destruction of the late 1990s is no longer an option. Xi will still make an attempt to revive his reforms - and therein lies a risk to short-run growth, as China's cyclical growth is simultaneously set to slow in 2018. But he will fail to launch a transformative new period of productivity growth in China over the long run. Bottom Line: The final line-up of the Politburo and PSC will enable us to revise the above sketch of China's elite with new data. But the main trends and implications are unlikely to be altered. Not only is Xi Jinping aiming to stabilize and preserve the regime and re-centralize power, but so too is the Communist Party. Xi's reform agenda will undoubtedly be rebooted after the party congress - with non-negligible risks to short-term growth - but Xi will not ride roughshod over these institutional constraints. At least, not for very long. Whither China? The structural constraints that will stymie Xi's new reform push are well known. Capital formation has been well above the range staked out by other emerging economies during similar phases of national development (Chart 14). This is a source of instability: the investment-led economic model has expired and yet the country has not weaned itself off of capital-intensive policies. China's debt load and debt-servicing costs have exploded upward both because of the inefficiencies of the state sector (SOEs and state banks) and because local governments rely on SOEs (and their own shady financing vehicles) to generate growth. Household debt is low but rising rapidly (Chart 15). Chart 14Excess Investment Is A Real Problem Chart 15Corporate Debt: The Achilles Heel The central government's surprising "deleveraging campaign" this year - which was softened to avoid mistakes ahead of the party congress - shows that China's leaders do not expect the view that the country's financial risks are negligible due to the large pool of savings. Instead, this year's financial crackdown serves as a dress-rehearsal for what is likely to be a much stricter crackdown on the financial sector as Xi reboots reforms in 2018. Financial tightening alone is a major aspect of restarting the reform agenda. Tighter controls on banks and leverage will translate into greater market discipline. This will in turn maintain the pressure on the sector most in need of change - the SOEs. The key question is how much of an appetite Xi has for bankruptcies and unemployment, since traditionally Chinese governments have not had much. Today's manufacturing employment indicators are weak despite the past two years' stimulus and growth recovery (Chart 16). The Xi administration will push forward with "supply side reforms" meant to weed out excess capacity - including at least some redundant workers13 - but this is precisely where any reformist intentions are likely to be compromised after the initial burst. The Communist Party has also placed greater emphasis on improving living standards and per capita disposable income, which will further limit the regime's appetite for self-imposed deleveraging (Chart 17). The hundredth anniversary of the Communist Party in 2021 will mark another politically sensitive calendar year and hence another reason for the party to backtrack after a spell of greater economic discipline. Xi will want to leave on a high note in 2022. Furthermore, excessive tightening would pose enormous risks for Xi's outward-looking economic and foreign policy agendas: not only the highly touted international development projects under the Belt and Road Initiative (OBOR), which require extensive Chinese investment, but also China's military rise in a region that is increasingly militarily competitive (Chart 18). Chart 16Employment Weak Despite Stimulus Chart 17Communist Party Expects Higher Incomes Chart 18Another Reason To Avoid Economic Slowdown Bottom Line: The Xi administration will renew its reform drive - particularly by curbing leverage, shadow banking, and local government debt. Growth risks are to the downside. But Beijing will eventually backtrack and re-stimulate, even as early as 2018, leaving the reform agenda in limbo once again. Investment Implications China's fundamental transition has already occurred. The demographic profile of the country no longer favors cheap labor or an ever-larger pool of savings that state authorities can easily direct into productivity-enhancing basic investments (Chart 19). The cost of capital is set to rise in the long run and that will put sustained pressure on the inefficient parts of the economy. "Reform" will become more an issue of withholding financial assistance, which the government will eventually be forced to grant out of concern for stability. As the pool of savings declines, the government faces the unprecedented challenge of moderating the wealth disparities that widened so rapidly during the boom years and that threaten regime stability (Chart 20). Chart 19The Savings Glut Is Coming To An End Chart 20Inequality: A Liability For The Party This will involve increasing the redistributive effect of taxes - which is remarkably low in China, and which in turn will generate higher levels of political tension between the haves and have nots, both households and regions. The Communist Party is only beginning to navigate these difficulties, which will stir up resentment among the large and ambitious middle class. Yet the middle class must be encouraged to thrive, as the rebalance of the Chinese economy cannot rest solely on the decline of investment. For that to occur, there needs to be a change in household, government, and corporate relations such that the government absorbs the excess debt created by corporations and instills greater efficiency among them, while devoting more resources to social wellbeing, thus enabling households to reduce precautionary savings. So far, Chinese households continue to save up for a rainy day (Chart 21), which leaves economic growth at the mercy of corporate borrowing and exports, the very dependencies that the Xi administration aims to reduce. Unfortunately for Xi, the chance to turn attention to these internal problems will coincide with bigger international challenges - especially tensions with the United States. We expect Sino-American distrust to worsen as long as China continues its more aggressive foreign policy and tries to carve out a sphere of influence in Asia. This is not a policy reliant on Xi's preferences alone but rather on China's growing domestic economic and security needs. In the event that Xi attempts to stay in power beyond 2022 - which we consider a low probability outcome - we expect U.S.-China confrontations to occur sooner than otherwise. Our long-term theme of global multipolarity will receive a steroid injection. There is no clear trend for Chinese H-shares around party congresses - sometimes they rally, sometimes they sell off (Chart 22). China's fiscal/credit impulse has ticked up and the coming slowdown may take time to develop, so we would not be surprised to see a rally leading into or following this year's congress. Chinese H-shares are cheap relative to their peers. Chart 21Chinese Still Saving For A Rainy Day Chart 22China Rallies Versus EM In Times Of Reform On the other hand, China's economic structure is worse than Xi found it. If he grabs the bull by the horns - as we think he will do - markets will sell off for fear of growth disappointments and policy mistakes, at least until investors are convinced it is safe to buy into China's long-term efficiency gains from reform. We recommend going long Chinese equities relative to EM. Xi's renewed reform drive will be attractive to EM dedicated investors in the context of un-reforming EMs like South Africa, Turkey, and Brazil, while EM will suffer from the negative short-term growth impact of Chinese reforms. This trade performed well during the major reforms of 1997-2002 and after the Third Plenum in 2014-15. Certainly we would bet against the continuation of extreme low volatility in Chinese assets, as measured by the CBOE China ETF Volatility Index. Both China's foreign and domestic political risks are understated. Finally, we recommend investors go tactically long Chinese Big Five banks versus small and medium-sized banks, a trade initiated by our fellow BCA Emerging Markets Strategy in October for a gain of 7.7% (Chart 23). Our EM Equity Sector Strategy has also lent credence to this view.14 The larger banks are better provisioned and prepared for credit losses and the financial tightening that we expect to come. Chart 23Big Banks Can Weather The Storm This trade has lost some altitude over the past month as a result of the perception that Chinese authorities would scale back their financial crackdown. However, the National Financial Work Conference held over the weekend of July 14-16 signaled that the Xi administration will expand its deleveraging campaign not only throughout the financial sector but also to SOEs and local governments to rein in China's formidable systemic risks. The new Financial Stability and Development Committee is likely to be more significant than market participants realize - Xi will have new political capital after this fall and is already shifting his attention to the sector. Moreover the announcement that the People's Bank of China will take a greater oversight role in the financial sector and for systemically important institutions is especially significant in light of the impending retirement of Governor Zhou Xiaochuan, which will usher in a new chapter in the PBoC's governance. Fortifying the country against financial risk is a regime security issue, as well as a basis for eventual financial reform and liberalization, and we expect the coming regulatory tightening to have far-reaching consequences. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 The "middle income trap" is a concept in economics describing developing countries that fail to make the transition into developed economies, despite showing rapid developmental progress for a time, and thus remaining stuck in the "middle income" GDP per capita range. Please see Indermit Gill and Homi Kharas et al, "An East Asian Renaissance: Ideas For Economic Growth," World Bank (2007), available at siteresources.worldbank.org. For a recent review of the literature, please see Linda Glawe and Helmut Wagner, "The middle-income trap - definitions, theories and countries concerned: a literature survey," MPRA Paper 71196, dated May 13, 2016, available at mpra.ub.uni-muenchen.de. 2 The dismissal of Beijing Mayor Chen Xitong, for example, is seen as evidence of Jiang Zemin's consolidation of power ahead of the 15th National Party Congress, while the fall from grace of Shanghai Party Secretary Chen Liangyu in 2006 is seen as proof of Hu Jintao's consolidation ahead of the 17th Party Congress in 2007. 3 Indeed judging solely by the cyclical rotation of Chinese leaders according to generation and faction, Hu Jintao's acolytes are favored to outnumber Jiang Zemin's and Xi Jinping's in the 2017 reshuffle. Please see BCA Geopolitical Strategy, "China: Two Factions, One Party," dated September 2012, available at gps.bcaresearch.com. However, Xi's effectiveness and good luck since coming to power lead us to believe that he will secure his followers on the PSC and Politburo this year: please see BCA Geopolitical Strategy Strategic Outlook 2017, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 For instance, this time around there are rumors that Xi will keep his anti-corruption chief, Wang Qishan, on the PSC beyond the standard retirement age, and that he may even go so far as to oust Premier Li Keqiang. Such drastic changes are unlikely, particularly the latter, but certainly not unthinkable. 5 For our long-term investment theme of "charismatic leadership," please see our Strategic Outlook cited in note 3 above. 6 Please see Alice L. Miller, "China's New Party Leadership," Hoover Institution, China Leadership Monitor 23 (Winter 2008), available at www.hoover.org. For this discussion of factions please also see Willy Wo-Lap Lam, “The Eclipse of the Communist Youth League and the Rise of the Zhejiang Clique,” Jamestown Foundation, May 11, 2016. 7 For instance, Jiang Zemin has continued to be a powerbroker to this day: Xi's vaunted anti-corruption campaign over the past five years has largely aimed at rooting out the influence of Jiang's faction. This includes the ouster of Sun Zhengcai this past week. And that is thirteen years after Jiang gave up a formal post! 8 Note that Xi rose to power as a princeling and member of Jiang Zemin's faction, as opposed to Hu Jintao and the CCYL. Yet Xi combined with Hu to oust the princeling Bo Xilai, and his anti-corruption campaign has largely focused on eradicating Jiang's influence. 9 Please see Chang-Tai Hsieh and Zheng (Michael) Song, “Grasp the Large, Let Go of the Small: The Transformation of the State Sector in China,” Brookings Papers on Economic Activity, March 19 2015, available at www.brookings.edu. At the seventeenth party congress in 2007, Hu also launched major reforms, aiming to reduce income inequality, urban-rural disparities, and lack of development in western China, but his efforts were cut short by the global financial crisis. Please see Hu Jintao, "Hold High the Great Banner of Socialism with Chinese Characteristics and Strive for New Victories in Building a Moderately Prosperous Society," Report to the 17th National Congress of the Communist Party of China, October 15, 2007, available at www.china.org.cn. 10 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013; and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. Please also see BCA China Investment Strategy, "Understanding China's Master Plan," dated November 20, 2013, available at cis.bcaresearch.com. 11 There are obviously pros and cons to this change: the industrial era required leaders with technical skills; the modern era requires services, branding, and innovation. But, in the Chinese context, the humanities are not focused on critical thinking and questioning authority to the same extent as in the West. 12 In fact, Xi Jinping's recent promotions have re-emphasized SOE managers and his policies have supported SOEs. Please see Cheng Li and Lucy Xu, "The rise of state-owned enterprise executives in China's provincial leadership," Brookings, February 22, 2017, available at www.brookings.edu. 13 Even the official unemployment measure, which hardly ever moves, is slated to rise from 4.02% to 4.5% this year. Please see BCA China Investment Strategy Weekly Report, "Messages From The People's Congress," dated March 9, 2017, available at cis.bcaresearch.com. 14 Please see BCA Emerging Market Strategy Special Report, "Chinese Banks' Ominous Shadow," dated June 15, 2016, available at ems.bcaresearch.com. Please see also BCA EM Equity Sector Strategy Portfolio Update, "Ranking Model And China Banks," dated July 18, 2017, available at emes.bcaresearch.com. Appendix

Highlights Monetary Policy: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. TIPS: We attribute this year's decline in breakevens to the combination of disappointing realized inflation and the fact that they had appeared too wide on our TIPS Financial Model. Inflation: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Feature Chart 1Bond Bear Takes A Pause Globally, a shift toward less accommodative monetary policy remains the dominant market theme. However, the U.S. bond selloff did pause last week following some disappointing macro data and comments from Fed policymakers that were interpreted as dovish. The market is now discounting 30 bps of rate hikes during the next 12 months, down slightly from the recent peak of 36 bps (Chart 1). The dovish comments came from Governor Lael Brainard in a July 11 speech1 and were echoed one day later by Fed Chair Janet Yellen in her semi-annual testimony to Congress.2 Both comments related to the stance of monetary policy in relation to its neutral (or equilibrium) level. In my view, the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term. If that is the case, we would not have much more additional work to do on moving to a neutral stance. - Fed Governor Lael Brainard Because the neutral rate is currently quite low by historical standards, the federal funds rate would not have to rise all that much further to get to a neutral policy stance. - Fed Chair Janet Yellen Contextualizing "Neutral" Contrary to how many have interpreted the above remarks, neither Chair Yellen nor Governor Brainard meant to suggest that the rate hike cycle is close to finished. In fact, Yellen went on to say in her testimony that: ...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... This is the first important piece of context needed to understand how the Fed views the neutral rate. The Fed views the neutral rate as variable, and sees it increasing over time. This becomes clear when we look at the Fed's Summary of Economic Projections and note that 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. Second, the Fed is likely tracking the real neutral fed funds rate using an estimate created by Laubach and Williams (LW).3 Chart 2 shows this estimate of the neutral rate alongside the real federal funds rate - deflated using 12-month trailing core PCE. We observe that the real fed funds rate has risen sharply during the past seven months, in part because the Fed lifted rates three times but also because inflation weakened. Chart 2Real Fed Funds Rate Getting Closer To Neutral We calculate that if the Fed lifts rates once more this year and core inflation stays flat, then the real fed funds rate would end 2017 at 0.02%, 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. In sum, the LW neutral rate is a useful tool for assessing the path of Fed policy. If the real fed funds rate gets too close to neutral, then the Fed will probably need to see inflation rise before it delivers another hike. This would appear to be the situation we are in at the moment. We continue to expect that the Fed will start to unwind its balance sheet in September, but will need to see some signs that core inflation is increasing before lifting rates again. Our forecast still calls for higher core inflation during the next few months and another Fed rate hike in December (see section titled "Inflation: Chalk Up Another Bad Month" below). A related issue is why the Fed thinks the neutral rate will rise during the next few years. In arguments that date back to Ben Bernanke's tenure,4 the Fed maintains that headwinds related to household deleveraging and balance sheet repair have depressed the neutral rate since the Great Recession and financial crisis. There is some evidence to support this stance. The LW neutral rate correlates quite strongly with the growth rate of household debt (Chart 3). Although the neutral rate hasn't kept pace so far this cycle, household debt is growing off an unusually low base (Chart 3, bottom panel) and that may mean it takes longer for the neutral rate to rise. There is one final important application for the neutral fed funds rate, and it relates to the timing of the corporate credit cycle (Chart 4). Typically, excess returns to corporate bonds do not start to decline until the following three criteria are met: Chart 3Household Leverage And The Neutral Rate Chart 4Neutral Rate Important For Credit Cycle Deteriorating corporate balance sheet health (Chart 4, panel 2) Restrictive monetary policy i.e. the fed funds rate above its neutral level (Chart 4, panel 3) Tightening bank lending standards (Chart 4, bottom panel) Notice that in the prior two cycles the real fed funds rate actually rose above the LW neutral level before our Corporate Health Monitor started to signal deteriorating corporate health. In contrast, corporate balance sheets have already aggressively added leverage this cycle and accommodative policy is the sole support for spreads. In this environment, we view inflation and the stance of Fed policy as the most important factors determining the medium term outlook for corporate bond returns.5 Policy Wildcard: A New Fed Chair In 2018 One potential wrinkle in our outlook for monetary policy is that Janet Yellen's term as Fed Chair will end in February 2018. If history is any guide, we should expect to learn the identity of the new Fed Chair sometime this fall. While we would not completely rule out the possibility that Janet Yellen is re-appointed, recently, the chatter is that Gary Cohn, the Chairman of President Trump's National Economic Committee, is the frontrunner for the position (see Box). Box 1: Fed Chairs Since 1970 Gary Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Since the late 1970s, Presidents have tended to select the Fed Chair based on their trust relationship with a candidate (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Arthur Burns (Chair from 1970 - 1978) was head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978 - 1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987 - 2006) served as the Chair of Ronald Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014 - present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team. Paul Volcker (1979 - 1987) was the lone exception to this rule, he worked for Nixon, but not Carter, before becoming Fed Chair. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volcker, Greenspan and Bernanke were all reappointed to lead the Fed by Presidents from opposing political parties. Chart 5Yellen Vs. Summers Drove Markets In 2013 To see how the timing of the Fed Chair appointment can matter for markets in the short-term, we need only look back to the autumn of 2013 when two candidates - Larry Summers and Janet Yellen - were in the running for the position. Rightly or wrongly, Summers was viewed as the more hawkish candidate and once 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 expectation of a more dovish Fed (Chart 5). Bottom Line: The Fed is still on track to start winding down its balance sheet in September, and will lift rates again in December if inflation starts to move higher. If the Fed continues to lift rates in the face of low inflation, then the real fed funds could soon overtake its estimated neutral level. What's Driving The TIPS Breakeven Rate? We maintain an overweight position in TIPS relative to nominal Treasury securities on the view that long-maturity TIPS breakeven inflation rates will eventually settle into a range between 2.4% and 2.5%, once core inflation gets back to the Fed's 2% target. At the time of publication the 10-year TIPS breakeven inflation rate was 1.76%. In that sense, we view the medium to longer-run driver of TIPS breakevens as the path of inflation itself. However, we also acknowledge that breakevens are highly correlated with other financial asset prices, which can explain many of the near-term moves (Chart 6). In fact, our TIPS Financial Model - a model of the 10-year TIPS breakeven rate based on the oil price, the dollar and the stock-to-bond total return ratio - was flagging that breakevens were far too wide earlier this year (Chart 6, panel 1). Through this lens, the year-to-date decline in breakevens can be attributed simply to overvaluation being wrung out of the market. Digging a little deeper into the model, we find that breakevens have maintained their strong positive correlation with energy prices this year (Chart 6, panel 2), while non-energy commodity prices exhibit a weaker positive correlation (Chart 6, panel 3). Interestingly, the negative correlation between breakevens and the trade-weighted dollar has broken down during the past year (Chart 6, bottom panel). If dollar weakness persists, we would eventually expect it to translate into higher realized inflation - via higher import prices - and also wider breakevens. Other pipeline inflation measures, which tend to correlate with breakevens, are sending mixed signals. Core PPI inflation for intermediate goods remains elevated (Chart 7, panel 2), while the supplier deliveries component of the ISM manufacturing survey is trending higher (Chart 7, panel 3). The prices paid component of the ISM manufacturing survey has followed breakevens lower (Chart 7, bottom panel). Chart 6TIPS Breakevens: Financial Drivers Chart 7TIPS Breakevens: Pipeline Inflation Drivers Bottom Line: We attribute this year's decline in breakevens to the combination of weak realized inflation data (Chart 7, panel 1) and the fact that they had appeared too wide on our Financial Model. Going forward, we expect TIPS breakevens to increase as the realized inflation data bounce back. Inflation: Chalk Up Another Bad Month Core CPI increased just 0.12% month-over-month in June, marking the fourth consecutive downside surprise. The year-over-year growth rate also moderated from 1.74% to 1.71%, and the weakness was once again broad based across the four major components (Chart 8). The cost of shelter continues to decelerate from a high level, and our model - based largely on the rental vacancy rate - forecasts further moderation in the months ahead (Chart 8, panel 1). Core goods prices continue to deflate, though dollar weakness should filter through to higher core goods prices in the coming months (Chart 8, panel 2). In last week's report we showed that non-oil import prices have already moved higher in response to the weaker exchange rate.6 The big drag on inflation in recent months has been the failure of core services inflation (excluding shelter and medical care) to respond to rising wage pressures. The third panel of Chart 8 shows that core services inflation (excluding shelter and medical care) correlates strongly with the employment cost index. Further, the employment cost index itself has been accelerating since 2010 alongside improvement in the prime-age employment-to-population ratio (Chart 9). Chart 8Core CPI Components Chart 9Wages Will Grow As Labor Market Heals We expect wages will continue to accelerate as the labor market remains on a steadily improving path. Eventually this will bleed into core services inflation, as it has in the past. In the near term, the employment cost index for the second quarter will be a crucial input for the direction of both inflation and monetary policy. It will be released on July 28. Bottom Line: Core inflation disappointed once again in June. The pass-through from a depreciating dollar and accelerating wages should cause this weakness to reverse in the months ahead. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/brainard20170711a.htm 2 https://www.federalreserve.gov/newsevents/testimony/yellen20170712a.htm 3 Laubach, Thomas, and John C. Williams. 2003. "Measuring the Natural Rate of Interest," Review of Economics and Statistics, 85(4), November, 1063-1070. 4 https://www.federalreserve.gov/newsevents/speech/bernanke20121120a.htm 5 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights DM Rates Strategy: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. U.S. Corporate Bond Liquidity: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Feature Chart of the Week2013 Revisited Developed Market (DM) policymakers continue to push towards a less accommodative monetary stance. Last week, the Bank of Canada (BoC) became the second central bank to hike rates this year, following the Fed's earlier tightenings. The European Central Bank (ECB) continues to signal a move to reduce the pace of its asset purchases, likely to be announced at the September policy meeting. A very public debate has opened up among the members of the Bank of England (BoE) policy committee against the stagflationary backdrop of high inflation and cooling growth. This current backdrop is reminiscent of the 2013 synchronized global economic upturn that also put pressure on policymakers to become less accommodative according to our Central Bank Monitors (Chart of the Week). That year was terrible for government bonds, but spread product held in well given the solid growth backdrop. A big difference now is that there is greater evidence of diminished economic slack (lower unemployment rates, higher capacity utilization) than in 2013, so the underlying inflation pressures should be greater. Realized inflation rates remain subdued in most countries (excluding the U.K.), but central bankers are attributing that to temporary factors that should soon fade. That forecast may prove to be wrong, which risks a potential policy mistake if interest rates move up too much or too fast. For now, however, central banks are in charge and bond investors should position accordingly by limiting duration exposure and overweighting growth-sensitive assets like corporate bonds versus sovereign debt. A Country-By-Country Summary Of Our Interest Rate Views With central banks now in the process of adjusting policy settings to varying degrees, financial markets are starting to show a greater level of diversification than in previous years. This can be seen in the moves in bond yields, equity markets and currencies since the speech by ECB President Mario Draghi on June 27 that ignited the latest bond sell-off (Chart 2). The largest yield moves have occurred in the Euro Area, U.K., Canada and Australia, which have also coincided with currency strength and equity market underperformance in those countries. As the markets now try to sort out the growing divergences between monetary policies, this has opened up opportunities for diversification of duration exposures, country allocation and yield curve strategies. This week, we present a brief summary of our individual country recommendations for the remainder of the year. United States: underweight duration, underweight country allocation, steeper yield curve, long inflation protection The Fed remains on track for a move to begin reducing its balance sheet at the September FOMC meeting, with another rate hike expected in December. The inflation data of late has started to raise concern among some FOMC members about how many more interest rate increases will be necessary for this tightening cycle. We expect U.S. growth to show solid improvement over the latter half of 2017, and for this current downdraft in realized inflation to soon bottom out led by tightening labor markets and the lagged impact of this year's decline in the U.S. dollar. Treasury yields will continue to grind higher in the months ahead, led more by rising inflation expectations that will bear-steepen the yield curve. (Chart 3) Chart 2Market Moves Since Draghi's Portugal Speech Chart 3U.S. Rates Strategy Summary Germany: underweight duration, underweight country allocation, steeper yield curve, long inflation protection France: underweight duration, underweight country allocation, steeper yield curve, long inflation protection Italy: underweight duration, underweight country allocation (versus Spain), steeper yield curve The ECB is clearly signaling that a taper of its asset purchase program will begin in 2018. The Wall Street Journal reported last week that Mario Draghi will speak at the upcoming Fed Jackson Hole conference in late August.1 Similar to his speech at the ECB Forum in late June, this will likely be another opportunity for Draghi to prepare financial markets and other central bankers for the ECB's policy shift. We expect an announcement of a "Fed-like" tapering of bond purchases that will begin in January and end sometime in the fourth quarter of 2018. A rate hike is still some time away, most likely in the first half of 2019 at the earliest. The ECB will want to see more signs of lower unemployment and sustainable higher core Euro Area inflation before contemplating higher short-term interest rates - especially given the likely positive impact on the euro from such a move that would risk an unwanted tightening of financial conditions. There is far more risk in longer-dated bond yields to reprice via higher term premia and/or inflation expectations, thus we are recommending a bearish stance not only on European duration and country allocation, but also a bias toward steeper yield curves (Chart 4 & Chart 5). Tapering will also put upward pressure on Peripheral European yields and spreads, particularly in Italy, as risk premiums normalize away from the tight levels seen during the ECB asset purchase program. We do not anticipate a rout in Italian debt given the current improvements in the domestic economy and the positive moves seen in consolidating and recapitalizing the troubled Italian banking sector. However, we do see continued underperformance of Italian debt versus Spanish sovereigns, thus we are maintaining an overweight stance on Spain versus Italy in our model bond portfolio (Chart 6). Chart 4Germany Rates Strategy Summary Chart 5France Rates Strategy Summary Chart 6Italy & Spain Strategy Summary U.K.: underweight duration, neutral country allocation, neutral yield curve We have been maintaining a neutral allocation to U.K. Gilts, but with an underweight duration exposure and a curve steepening bias (Chart 7). The growing rift among the members of the BoE Monetary Policy Committee does suggest that there could be more two-way risk in U.K. interest rates than at any time seen since last year's Brexit vote. The BoE responded to that political surprise with rate cuts and a new round of asset purchases, even though the U.K. economy was operating at full employment at the time and inflation pressures were rising. Now, the chickens have come home to roost for the BoE, with inflation remaining stubbornly high despite signs of slowing growth (Chart 8). With real wage growth slowing substantially and household saving rates at very low levels, the risk of a consumer spending slowdown - that the BoE was flagging earlier in the year - is increasing. Chart 7U.K. Rates Strategy Summary Chart 8Stagflation In The U.K. Given the ongoing uncertainties from the upcoming Brexit negotiations that will likely continue to weight on business confidence and investment spending, and with consumption likely to continue losing steam, we see little case for the BoE to seriously consider a rate hike before year-end. We are only recommending a neutral stance on Gilts, though, as realized inflation continues to run well above the BoE's target, supported by the stubbornly soft British pound. We continue to recommend a steepening bias on the Gilt curve until there is more decisive evidence that U.K. inflation is rolling over. Japan: overweight duration, maximum overweight country allocation, neutral yield curve and neutral inflation protection We continue to recommend a maximum overweight on Japanese government bonds (JGBs). JGBs are a low-beta market with the BoJ still targeting a 0% level on the benchmark 10-year yield, even as other global bond markets sell off. The BoJ has been particularly aggressive in capping any rise in JGB yields of late, offering to buy 10-year bonds in unlimited size and also increasing its purchases at shorter maturities (Chart 9). With Japanese inflation still struggling to stay in positive territory, even with the economy estimated to be operating at full employment, the BoJ will do the only thing it can do to put a floor under inflation - keep JGB yields at low levels to trigger a new wave of yen weakness and, hopefully, some imported inflation pressures via the currency. Against this backdrop, JGBs will continue to outperform other DM bond markets during this move towards strong growth and less accommodative monetary policies outside of Japan. Stay overweight Japan against global hedged bond benchmarks. Canada: underweight duration, underweight country allocation, flatter yield curve, long inflation protection We moved our Canadian country allocation to underweight last week in advance of the BoC's expected rate hike, but we had been recommending bearish Canadian trades (curve flatteners and spread wideners versus U.S. Treasuries) in our Tactical Overlay Trade Portfolio for much of the year so far.2 The BoC's 180-degree policy shift over the past month has taken many investors by surprise, but the very strong upturn in the Canadian economy is forcing the BoC into action. With the BoC now projecting the Canadian output gap to be closed this year, expect another one, even two, rate hikes by the end of 2017. This will put additional upward pressure on Canadian bond yields and bear-flatten the Canadian government bond yield curve (Chart 10). Australia: neutral duration, neutral country allocation, neutral curve Australia has been one of the trickier markets on which to have a strong opinion, given the combination of a tight labor market, low inflation, mixed readings on domestic demand and heavy exposure to China's economy. This has led us to be neutral across the board on Australian bonds (Chart 11). We will be covering the outlook for Australia in a Special Report to be published next week, in which we will re-examine our current Australia recommendations. Chart 9Japan Rates Strategy Summary Chart 10Canada Rates Strategy Summary Chart 11Australia Rates Strategy Summary Bottom Line: Many central banks are responding to the strong global economic backdrop by signaling not only a shift in the bias of monetary policy, but actual changes in interest rates or asset purchases. We continue to recommend a below-benchmark overall portfolio stance, but with more diverse views on country allocation: underweight the U.S., Euro Area, & Canada; maximum overweight on Japan; and neutral on the U.K. and Australia. Expect steeper yield curves in the U.S., Euro Area and U.K., and continued flattening in Canada. An Update On The State Of U.S. Corporate Bond Market Liquidity In the Fed's latest Monetary Policy Report, presented by Janet Yellen to the U.S. Congress last week, an entire section was devoted to the state of U.S. corporate bond market liquidity.3 The Fed's conclusion was that, according to many commonly used metrics like average bid/ask spreads, corporate debt has not become more difficult to trade in recent years. This goes against the intuition of many bond investors who have perceived a deterioration of liquidity in corporate credit markets since the 2008 Financial Crisis. The Fed likely felt compelled to dedicate three pages of its Monetary Policy Report to a topic as mundane as bond market functionality as a defense of its current regulatory framework for U.S. banks. The Fed has taken a lot of flak from major U.S. financial institutions, conservative free-market politicians and, since last November, the Trump White House over the "heavy-handed" rules shackling the banks. Chart 12U.S. Dealers Don't Matter Regulations such as the Volcker Rule and the Supplementary Leverage Ratio have almost certainly reduced the odds of another financial crisis caused by undercapitalized banks speculating in risky assets. Yet the critics continue to point out that banks which are more worried about meeting regulatory targets are less able to make loans or, in the case of investment banks, make markets in risky assets like corporate debt. This is important for bond investors given the sharply reduced footprint of investment banks in corporate debt markets. The Fed's data on primary dealer positioning in corporates shows a massive decline from the pre-crisis peak in 2007 of $280bn to only $20bn this year (Chart 12). Over the same period, the size of the U.S. corporate bond market has more than tripled to $6.5 trillion (using the market capitalization of the Barclays Investment Grade and High-Yield indices as a proxy). On the surface, that indicates that dealers held 10% of "the market" at the peak. Now, dealer inventories barely represent only 0.3% of corporate debt outstanding. While that is low, it is not much lower than the share of corporates held by dealers in the early 2000s. When looking at the full span of the available data, the huge dealer footprint in the U.S. corporate bond market in the years prior to the Financial Crisis was the exception and not the norm. Like most other market participants in those years, the investment banks were seduced by the extended period of low macro and market volatility and ended up taking too much risk on their balance sheets. Now, dealers are much more cautious when trading with clients, acting more as an "agent" that matches buyers and sellers for individual trades and less as a "principal" that holds the bonds themselves. The smaller presence of dealers could create a liquidity problem for corporate debt, especially if dealers in their usual role as market-makers cannot be there to absorb the selling pressure from investors during market sell-offs. Yet corporate bond markets have functioned well since the dark days of the Lehman crisis. According to data from SIFMA, average daily trading volumes in the U.S. corporate bond market rose from a low in 2008 of $14bn to $30bn in 2016 (Chart 13). Corporate bond issuance has surged as well, but corporate bond turnover - total annualized trading volumes relative to total bonds outstanding - has improved by nearly 35% since the 2008 low. In addition, the reduced dealer presence has not resulted in any unusual widening of typical relationships like the basis between Credit Default Swaps and corporate bond spreads (bottom panel). The Fed noted this in its Monetary Policy Report as a sign that market liquidity was not impaired since there were not many "unrealized arbitrage opportunities". It is evident that other market participants have picked up the slack from the dealers in U.S. corporate bond trading. Exchange Traded Funds (ETFs) are the obvious candidate, led by the popular iShares HYG and the SPDR JNK funds that have a combined $30bn in assets under management. According to the Fed's database on the Financial Accounts of the United States (formerly known as the Flow of Funds), the share of corporate bonds held by all retail funds, including ETFs, soared from 6.5% in 2008 to nearly 19% in Q1 of this year (Chart 14). This nearly offset the decline in the share of corporates held directly by households, as individual investors shifted their preferences toward the ease of trading corporate debt ETFs over individual bonds. Chart 13U.S. Corporate Bond Market Turnover Has Improved Chart 14Shifting Ownership Patterns For U.S. Corporates Importantly, institutional investors like insurance companies and pension funds have seen their influence in corporate bond markets increase, as they now hold a combined 35% of corporate debt, up from 26% in 2008 (bottom two panels). These groups will likely control an even greater share of the corporate bond market in the years to come with the growing usage of so-called "all-to-all" electronic trading platforms like MarketAxess or Bloomberg that allow users to trade directly with each other. All-to-all has already established a major market footprint, as activity on MarketAxess now represents 16% of all trading volume in U.S. Investment Grade corporates and 34% for High-Yield, according to The Economist.4 This is a hugely important development. If more professional bond investors can now transact directly with one another, this helps to alleviate any reduction in market liquidity caused by a smaller dealer presence in the market. Even with so much evidence pointing to no serious liquidity problems in U.S. corporate debt, some worrisome issues remain. Chart 15Market Performance Leads Fund Inflows,##BR##Not Vice Versa Average trade sizes in corporates are smaller now compared to pre-crisis levels - perhaps as much as 20% smaller according to estimates by the New York Fed.5 This is likely the result of the reduced risk-taking by the dealers and the growing share of direct electronic trading. This creates an effect where it may feel like liquidity is impaired since it now takes longer to execute a large bond trade, even though transaction costs for individual trades have not been increasing, on average. Corporate bond ETFs are easier to trade than the underlying bonds held in the ETFs themselves. This has worried many investors who fear that a corporate bond market downturn could turn into a much larger rout if rapid ETF redemptions cause "fire sales" of the bonds held in the ETFs to quickly raise cash. Admittedly, the unique ETF structure - where the shares of the ETF are traded and not the underlying bonds, similar to a closed-end mutual fund - has not yet been tested in a true credit bear market. However, there have been several episodes of "risk-off" bond sell-offs over the past few years, most notably for High-Yield ETFs during the 2014/15 oil bear market, which did not result in any disorderly disruption of corporate bond markets. If anything, the historical experience of U.S. corporate bond mutual funds shows that net flows into funds tend to follow, and not lead, the performance of markets (Chart 15). This may exaggerate bond market moves at turning points but, in general, outflows are a symptom, not a cause, of corporate bond downturns. Net-net, we agree with the assessment of the Fed that corporate bond market liquidity shows little sign of impairment and does not represent a threat to market stability. Bottom Line: There are few signs of diminished liquidity in U.S. corporate bond markets, despite the sharply reduced inventories of primary dealers. ETFs and institutional investors have picked up the slack from the dealers, as has electronic trading directly between market participants. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.wsj.com/articles/draghi-may-address-future-of-ecb-stimulus-at-jackson-hole-1499944342 2 Please see BCA Global Fixed Income Strategy Weekly Report, "Dangerous Duration", dated July 11 2017, available at gfis.bcaresearch.com. 3 https://www.federalreserve.gov/monetarypolicy/files/20170707_mprfullreport.pdf 4 https://www.economist.com/news/finance-and-economics/21721208-greater-automation-promises-more-liquidity-investors-digitisation-shakes-up 5 http://libertystreeteconomics.newyorkfed.org/2015/10/has-us-corporate-bond-market-liquidity-deteriorated.html 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 BCA's Central Bank Monitors support the case for less stimulus. Yellen's "dovish" testimony does not change our Fed call. The BCA Beige Book Monitor and related indicators support our view on the economy and Fed. Maximum central bank policy divergence has not been reached. Too early to predict Trump's replacement for Yellen. Now that economic surprise index has bottomed, risk assets can outperform as the metric mean reverts. Some wage measures are accelerating as the economy approaches full employment. Feature Chart 1Sell-Off In Global Bond Markets##BR##Triggered By Central Bank Talk Global bond investors were shocked in June when central bankers announced at the ECB's Forum on Central Banking what appeared to be a global recalibration of monetary policy. Until that time, investors had been lulled into a false sense of security that growth headwinds would prevent the Fed from hiking by more than once a year and keep the other major central banks on hold "indefinitely." The heads of the Bank of England (BoE), the Bank of Canada (BoC) and the Riksbank all took a less dovish tone, as they signaled less need for ultra-stimulative policies because the threat of deflation had diminished. Together with some better-than-expected U.S. economic data, this shift in tone led to a sharp sell-off in global bond markets (Chart 1). The BoC followed up last week by kicking off a prolonged tightening cycle. The central bank now expects the Canadian economy to reach full employment and hit the BoC's inflation targets by mid-2018, which is much earlier than expected. The global bond mini-rout actually began before the ECB Forum, when the ECB President gave a very upbeat description of the underlying strength of the Euro Area economy. BCA's Global Fixed Income Strategy service highlights that the Euro Area 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. Draghi's comments confirm that the ECB will announce this fall that a further tapering of its asset purchase program will take place in early 2018. The message that "emergency" levels of monetary accommodation are no longer needed is confirmed by our Central Bank Monitors (CB), which measure pressure on central bankers to raise or lower interest rates (Chart 2). The Monitors became less useful when rates hit the zero bound and quantitative easing became popular, but the measures are relevant again. All of our CB Monitors are in "tighter policy required" territory except for Japan (although even that one appears on the verge of breaking above the critical zero line). The Monitors have been rising due more to their growth than their inflation components. Bond investors may be startled by the ECB's posture because inflation remains well below target in all the major economies except the U.K. What is most worrying is the recent deceleration in U.S. inflation, where the economy is very close to or at full employment. Almost all of the major central banks point to temporary factors that will soon fade, which would allow inflation to escalate toward the target. Our Aggregate Inflation 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 3). 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 2All In The "Tighter Policy Required" Zone Chart 3BCA Aggregate Inflation Indicators These and other indicators support our view that core consumer price inflation will grind higher in the coming months in most of the advanced economies, including the U.S. Admittedly, all models and indicators have been poor predictors of inflation in this recovery. Nonetheless, historical relationships might begin to re-establish now that capacity utilization is rising and labor market slack has moderated significantly. Did Yellen Turn Dovish? June's FOMC minutes indicated that the consensus among Fed policymakers is willing to "look through" low inflation and maintain the current timetable on rate hikes. Yellen's Congressional testimony last week 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." The Fed asserts there are two neutral interest rates: short-term and long-term. Yellen argued that the actual policy rate is close to the short-term 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 Chair is at risk of confusing investors by discussing the concept of two neutral rates, although this may have been to head off demands by some Congressional lawmakers that the Fed should follow a mechanical policy rule when setting policy (such as the Taylor Rule). Nonetheless, the important point is that Yellen is not saying that the actual policy rate is close to the peak for the cycle. Yellen's testimony has not altered our Fed call for this year: balance sheet runoff beginning in the fall, 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. We expect more rate hikes in 2018/19 than are discounted in the bond market. That said, the soft June CPI data challenges our view that inflation will move higher in the second half. The bottom line is that the backdrop has turned decidedly 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. Global bond yields have already taken a step up in recent weeks, but they will have to rise further to catch up with the solid pace of global growth and diminishing economic slack. Duration should be kept short. The Beige Book: Another Inflation Anomaly The Beige Book released on July 12 supports the Fed's base case outlook for the economy and inflation. It also keeps the Fed on track to begin to trim its balance sheet in September and boost rates by another 25 basis points in December. Our quantitative approach2 to the qualitative data in the Beige Book points to an acceleration in GDP and inflation, less business unease from a rising U.S. dollar, and ongoing improvement in real estate, both commercial and residential (Chart 4). Chart 4Beige Book Monitors Support Fed's Outlook##BR##On Economy And Inflation At 62%, the BCA Beige Book Monitor remained near its cycle highs in July, providing more confirmation that the economy rebounded in Q2 after a desultory Q1. The July 12 Beige Book covered the period from late May through June 30. Based on the Beige Book, the dollar should not be much of an issue in Q2 earnings season. The greenback seems to have faded as a concern for small businesses and bankers, which is in sharp contrast to 2015 and early 2016 when mentions of a strong dollar in the Beige Book surged. The Q2 earnings reporting season will provide corporate managements with another forum to express their views of currency impact on their operations. Business uncertainty over government policy (fiscal, regulatory and health) remained elevated in the most recent Beige Book (not shown). The implication is that the business community is mindful of the lack of progress by Washington policymakers on Trump's agenda. Our analysis of the Beige Book also shows that real estate was still stout as Q2 ended. This implies that both residential and commercial real estate, the former a source of strength in Q1, will add to growth again in Q2. Moreover, the latest reading on the BCA Real Estate Monitor further widened the gap between the BCA Beige Book Real Estate Monitor and the relative performance of REITS to the S&P 500. Nonetheless, BCA's U.S. Equity Strategy service recently downgraded REITS to neutral,3 citing our expectation of higher Treasury yields, modest rent growth, some cracks in CRE credit quality, and tightening standards for bank lending in the CRE marketplace. Echoing the market's disagreement with the Fed on inflation, the big disconnect in the Beige Book showed up in the number of inflation words. Inflation words hit a new peak in July, in sharp contrast with the recent soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The Beige Book backs the Fed's assertion that the economy will expand around 2% this year and inflation will move higher in the coming months, supporting a gradual removal of policy accommodation. Uncertainty in Washington is distressing, but worries over the dollar seem to be fading. Max Policy Divergence Has Not Been Reached What about the dollar? Tighter Fed policy is dollar-bullish on its own, but some of the major central banks are also starting to remove the monetary punchbowl as well. Recent dollar action suggests that investors have decided that the peak Fed/ECB policy divergence is now behind us. We do not agree. The ECB may be tapering, but raising interest rates is a long way off because there is still a lot of economic slack in the Eurozone. In contrast, the Fed is increasingly concerned that allowing the unemployment rate to fall further below its estimate of full-employment risks too large an overshoot of the 2% target. We still believe that market pricing for the fed funds rate is too benign. 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. The major exception is the Canadian dollar, which we expect to appreciate versus the greenback. Does Gary Cohn Have What It Takes? A key wildcard in the financial outlook is the Fed Chair's replacement. Yellen's term as Chair will end in February 2018 and the markets have not yet shown any concerns about her potential replacement. The current frontrunner is Gary Cohn, the Chairman of President Trump's National Economic Committee; his appointment would conform to some historical precedents but violate others. Our March 6 Weekly Report4 provides a list of potential Fed appointees and also provides some background on the potential for the Fed to become more politicized under Trump. Since the late 1970s, Presidents have selected the Fed Chair based on their trust relationship with a candidate. Arthur Burns (Chair from 1970-1978) was the head of President Eisenhower's Council of Economic Advisors (CEA) and was a special counselor to President Nixon. William Miller (1978-1979) worked for the presidential campaigns of Hubert Humphrey and Jimmy Carter. Alan Greenspan (1987-2006) served as the Chair of President Reagan's Social Security Commission in the early 1980s, was the Chair of President Ford's CEA and advised President Nixon's campaign in 1968. Ben Bernanke (2006-2014) was George W. Bush's chief economist in 2005 and 2006 before Bush chose him to lead the Fed. Janet Yellen (2014-present) was Chair of Bill Clinton's CEA in the late 1990s, when she worked with many of Obama's economic team members. Paul Volcker (1979-1987) was the lone exception to this rule; he worked for Nixon, but not Carter, before becoming Fed Chair (Table 1). Table 1Characteristics Of Fed Chairs Since 1970 Cohn does not have any experience as a central banker, but that does not preclude him from holding the position. Volcker, Bernanke and Yellen, all held posts in the Federal Reserve System before their appointments as Chair. However, Miller was an outside director for the Boston Fed, and Burns and Greenspan had no prior experience at the monetary authority. Party identification is one area where Gary Cohn would stand out. Since at least 1970, the party affiliation of a new Fed Chair has matched that of the President. However, Presidents have crossed party lines to reappoint sitting Fed Chairmen to additional terms. Volker, Greenspan and Bernanke were reappointed to lead the Fed by Presidents from opposing political parties. The timing of Trump's announcement on Yellen's replacement may be critical. In the summer of 2013, names were already being floated by the Obama White House (and mainly rejected) by markets, before he finally settled on Yellen. The official announcement came in early October 2013. In August 2009, President Obama reappointed Bernanke for a second four-year term. Bernanke was initially nominated to be Fed Chair by George W. Bush in October of 2005. If the appointment comes in October and the nominee is perceived to be hawkish, the risk is that markets may begin to price in the regime change sometime in the next few months. Our U.S. Bond Strategy service argued in a recent report5 that rate hike expectations may already be ramping up, while the data on the economy and inflation begin to beat expectations again. Bottom Line: It is too early for the markets to be concerned about the next Fed Chair and their policies. The names mentioned in the summer may not be the ones offered the job in the fall. Surprise Index Finally Bottomed Out The June employment report marked a turning point for the Citigroup surprise index, following an extended period of disappointment that depressed the dollar and bond yields. The June reports on CPI and retail sales were disappointing, but June industrial production exceeded expectations. What does this mean for relative asset returns? After 86 days, expectations moved low enough to allow economic reality to begin to run ahead. It took as few as 8 business days (in 2009) and as many as 164 (2015) for the surprise index to return to the zero line, an average of 52 days (Chart 5). Chart 5Risk Assets Tend To Outperform As Economic Surprise Index Rebounds Mean-reversions in the surprise index following troughs have generally been good for risk assets in this recovery (Table 2). We have identified 11 periods since late 2009 when the surprise index bottomed out and then moved up toward zero. In 8 of those episodes, the total return on stocks was higher than 10-year Treasuries. Equities beat Treasuries by an average of 286 bps across all 11 periods, with a median outperformance of 400 basis points. Table 2U.S. Financial Market Performance As Economic Surprise Index Rises The total return on investment-grade corporate debt outperformed Treasuries in 6 of 11 episodes. In those six instances, investment grade credit outperformed on average by 132 bps. Nonetheless over all 11 episodes, the excess return was 0%. In contrast, high-yield bonds beat Treasuries in 7 of the 11 periods, with a median outperformance of 188 basis points. Similarly, small caps beat large caps 72% of the time as the economic surprise index moved back toward the zero line. The median outperformance of small over large in all 11 periods was 124 basis points. The performance of commodities was mixed as economic surprises climbed. Gold rose in 6 of the 11 times, but fell in 5. Oil prices posted increases in only 5 of the 11, but the median return for oil after economic surprise bottomed was -2.7%. Bottom Line: Economic expectations that ramped up post-election have now declined and allowed the economic surprise index to trough. The implication for investors is that risk assets tend to outperform as the economic surprise index moves back to zero. This supports our tactical views of stocks over bonds, small over large caps, and credit over Treasury. What's Up With Wages? The June jobs report released in early July6 only added to the market's fears that the Phillips Curve is dead because wage growth softened even as the labor market tightened. Unfortunately, no Fed officials including Yellen have addressed the topic in depth recently. The market does not believe the Fed when it says that the tighter labor market is pushing up wages. We see it another way. Chart 6 shows that wage inflation has accelerated since mid-to-late 2012, but some measures of wages have made more progress than others. Chart 7 and Chart 8 reinforce that, setting aside the rollover in average hourly earnings (AHE), wage inflation is accelerating, albeit modestly. Chart 6Plenty Of Signs That##BR##Wages Are Accelerating Chart 7Compositional Effects Do Not##BR##Explain Recent Rollover Chart 8Acceleration In Hours Worked Should##BR##Lead To Faster Wage Growth The Employment Cost Index (ECI) excluding bonuses (Chart 6, panel 1) is our favorite measure of labor compensation. It has accelerated steadily since 2010. It adjusts for compositional changes in the labor market (unlike the average hourly earnings measure) and is the broadest and most comprehensive wage metric. Its drawbacks are that it is released with a long lag. For example, the Q2 ECI data will not be released until the end of July. The AHE data is already available for June and Q2. On the other hand, unit labor costs (ULC) (panel 2) have stagnated for the past five years. Data starts in 1947, so it has the most history of any of the wage measures. However, it is even more delayed than the ECI: it is released five weeks after the end of the quarter. Moreover, these data are subject to revisions and tend to be more volatile than other wages measures, which makes it difficult to identify a change in trend. Productivity, which is used to construct ULC, is also very difficult to estimate. A recent BIS report7 notes that there is evidence that the relationship between ULC and labor market slack has diminished over time, but that ULC is a better measure of inflationary pressures than AHE. Median usual weekly earnings (panel 3) have also accelerated. This is not a pure wage measure; it combines hourly pay and hours worked and, therefore, is a good proxy for incomes. Income growth has picked up the pace, providing a solid underpinning for consumer spending. Panel 4 shows compensation per hour worked. It, too, has stalled and is subject to the same strengths and weakness as ULC because it is part of the quarterly Productivity and Costs report. This metric has run near 2% with no trend. Finally, average hourly earnings (panel 5) have sped up since 2012, but rolled over in late 2016. This wage gauge gets most of the market's attention although it is only one of many measures that the Fed watches. AHE is a timely data set, released alongside monthly payroll numbers. It includes average earnings of private non-farm production and non-supervisory positions. The major disadvantage of this measure is that hourly wage earners represent only about 58% of workers and do not account for trends in salaried jobs. Earnings do not include bonus pay or employee benefits. The data are available beginning only in 2006. In Chart 7, we created an "equally-weighted" AHE measure to adjust for shifts in the composition of the labor market, but we found that the recent deceleration is not linked to compositional effects. Since wage growth bottomed out in late 2012, the compositional shifts slightly lowered wage inflation on average, but the growth rates today are roughly the same. The Atlanta Fed wage tracker (not shown) is in a distinct uptrend. The Tracker has the advantage that it is not biased by compositional shifts. Chart 8 shows our update to a study by the Kansas City Fed8 that found only a few industries (mostly in the goods-producing sector of the economy) have accounted for most of the rise in wages, notably manufacturing, construction and wholesale trade. Financial services, retail, professional and business services, and leisure and hospitality - all service sector industries - were the laggards. The report shows that although earnings growth has fallen behind in service-oriented industries since 2015, hours worked have seen faster growth than in the goods-producing sector. We concur with the author that labor demand was strong in the past few years in areas that have not experienced much wage growth. As the labor market continues to tighten, wages in these industries may accelerate, but patience will be required. Bottom Line: The various measures of wage inflation provide a mixed picture. Taken as a group, however, we believe that wage growth has indeed accelerated as the labor market has tightened. The acceleration has admittedly been modest, but it is only recently that unemployment reached a full employment level. The real test for the Phillips curve will be in the coming quarters as the economy moves further into "excess labor demand" territory. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see BCA's 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 U.S. Investment Strategy Weekly Report "The Great Debate Continues", dated April 17, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report "SPX 3000?, dated July 10, 2017. Available at uses.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report "Trump And The Fed", dated March 6, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Bond Strategy Weekly Report "Summer Snapback", dated July 11, 2017. Available at usbs.bcaresearch.com 6 Please see U.S. Investment Strategy Weekly Report "Sizing up the Second Half", dated July 10, 2017. Available at usis.bcaresearch.com. 7 Monetary policy: inching towards normalization", Bank for International Settlements (BIS), 25 June 2017. 8 Wage Leaders and Laggards: Decomposing The Growth In Average Hourly Earnings", Willem Van Zandweghe, Federal Reserve Bank of Kansas City, February 15, 2017.

Dear Client, I am visiting clients this week, and as such there will be no Weekly Report. Instead, we are sending you this Special Report written by my colleague Jonathan LaBerge. Jonathan argues that while the recent acceleration of the Canadian economy is genuine, the rise in Canadian household debt-to-income over the past 16 years has been so large that a credit-driven downturn in spending is now virtually unavoidable over the long run. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights The recent economic improvement in Canada is genuine. In isolation, this supports the Bank of Canada's decision to gradually raise interest rates. However, over the long run, the historical experience suggests that the substantial leverage of Canadian households will ultimately cause a serious credit-driven downturn. Several myths about Canada's housing market have obscured the true extent of its credit market imbalances, heightening the risk that policymakers will ultimately overplay their hand when tightening monetary conditions. There are multiple potential triggers that could eventually spark a credit-driven downturn in Canada, but none of them seem likely to have a major impact on the economy over the coming 6-12 months. Favor a pro-cyclical stance over the coming year, but look to shift to a bearish structural view at some point beyond the immediate investment horizon. Feature Several developments over the past few months have altered the outlook for the Canadian economy. However, these events have not had a consistent impact on the narrative for Canadian assets. Whereas a sharp rebound in real GDP growth and a hawkish pivot from the Bank of Canada have been signs of a strengthening economy, the crisis surrounding Home Capital Group (a Canadian non-bank mortgage lender) was an ominous sign for many investors concerned about the deeply imbalanced Canadian housing market.1 In this report we argue that the cyclical improvement in the Canadian economy is legitimate, and that the Bank of Canada is likely to move forward with gradual policy tightening following Wednesday's move. However, the rise in Canadian household debt-to-income over the past 16 years has been so large that a credit-driven downturn in spending is now virtually unavoidable over the long run, rather than a risk. We highlight how, in many ways, the imbalances in the Canadian housing market are even worse than the market narrative would suggest. We also provide a checklist of factors to monitor in order to judge when Canada's day of reckoning will arrive. For now, it does not appear to be imminent. From an investment standpoint, our conclusions imply that investors should pursue a "two-staged" approach when allocating to Canadian assets. Over the coming 6-12 months, a cyclical improvement in the economy means that Canadian risky asset prices and government bond yields are likely to rise, and we believe that this stage is worth playing. But over the secular horizon, the reverse is likely to unfold, meaning that a rally in Canadian assets over the coming year will create excellent "selling conditions" for investors looking to position for a bearish structural view. Economic Momentum Is Spurring Tighter Monetary Policy... The Bank of Canada is now back on a path towards tighter monetary policy, and a close examination of the Canadian economy, as well as our outlook for global oil inventories, supports the BoC's view: Real consumer spending picked up significantly in Q1, rising from 2.7% to 3.1% on a year-over-year basis. Chart 1 highlights that the rise in real spending has been supported by a rebound in employment growth and consumer confidence (the latter is at a 9-year high). On the employment side, Chart 1 also shows that the acceleration in job growth is not limited to provinces that are strongly associated with oil sands production. In fact, the chart shows that employment in Canada excluding Alberta and Saskatchewan has been in an uptrend since mid-2014, when fiscal and monetary policy began to respond to the shock from a collapse in the price of oil. All Canadian employment cylinders are now firing, given the job recovery in oil sands provinces. Real Canadian gross fixed capital formation turned positive in Q1 after a significant decline into negative territory, and a simple model based on business confidence, oil prices, and the Canadian dollar (stripped of its correlation with oil) suggests that it will continue to accelerate modestly over the coming year (Chart 2). Chart 1Genuine Signs Of A Stronger Economy Chart 2Further Gains In Investment Likely Chart 3 shows a model for oil prices, based on global industrial production, oil production, OECD oil inventories, and oil consumption in the major countries and China. If OPEC is successful in reducing inventories to their 5-year moving average, as BCA's commodity strategists expect, the model implies that oil prices will rise materially. This is likely to provide a tailwind for the Canadian economy, at least in nominal terms. While the pace of tightening is likely to be gradual because of the weakness in Canadian core inflation, Chart 4 suggests that the decline in inflation over the past few months may simply represent the correction towards more fundamentally-justified levels. The chart shows a model of core inflation based on lagged real core consumer spending and the Canadian dollar (as a proxy for imported inflation/deflation), and highlights that actual inflation has overshot the model value over the past three years. But the chart also shows that the fundamentally-justified level of core inflation remains in an uptrend, suggesting that recent weakness is likely temporary and is thus not an impediment to higher policy rates over the coming year. Chart 3Falling Inventories Will Be Bullish For Oil Chart 4The Dip In Core Inflation Is Temporary Bottom Line: The recent economic improvement in Canada is genuine and, in isolation, supports the Bank of Canada's decision to gradually raise interest rates. ...But It Will All Likely End In Tears Chart 5Higher Household Leverage Than In The U.S. Pre-Crisis While we agree that the Bank of Canada is on a path to gradually raise interest rates over the coming year and that the economy is currently in good shape, the odds are good that tighter policy (and/or other factors) will eventually inflict considerable damage to the Canadian economy via the housing market and its impact on highly leveraged consumers. In this regard, the pickup in Canadian economic growth likely represents a happy moment in an otherwise sad story. Chart 5 compares Canada's mortgage debt-to-disposable income, total household debt-to-GDP, and the total household debt service ratio to that of the U.S. The chart neatly illustrates the fundamental basis for a bearish secular outlook for the Canadian economy, which is that household debt levels have risen enormously since 2000, to a level that is worse today than in the U.S. in 2007. "So what?" ask some investors. Household debt levels vary significantly across countries, meaning that an elevated level of household debt-to-income does not necessarily spell economic doom. Chart 6 counters this point by showing the relationship between the historical change in household debt-to-GDP (y-axis) versus the starting point for the ratio (x-axis) during episodes of significant household leveraging. The change in debt-to-GDP is shown as a 10-year average of the year-over-year change in the ratio, in order to compare Canada's recent debt binge with other long-term booms in credit. In terms of very significant increases in household credit-to-GDP from an already above-average level, Chart 6 shows that Canada's experience (an average yearly increase of 3.3%) has been among the most severe cases. The chart also shows that while there are a few exceptions, other observations in the neighborhood of Canada's have had a strong tendency to be associated with harsh economic consequences once the credit binge has come to an end. In particular, while the chart shows that the countries at the center of the euro area sovereign debt crisis saw a more rapid rise in household debt-to-GDP than observed in Canada, this occurred from a lower base. When measuring the total change in household debt-to-GDP, Canada has experienced almost the same magnitude rise from 2000 to today as what occurred in Spain and Portugal during the last economic cycle. In terms of a comparison with the U.S., Chart 7 presents a long-term perspective on the inverse relationship between household credit growth and real per capita consumption in the U.S. The chart highlights that 10-year upcycles in household debt-to-GDP correlate well, with a lag, to 10-year downcycles in real per capita spending. Periods where the relationship is less tight have tended to be associated with less severe increases in household debt-to-GDP, suggesting that investors can be more confident that debt growth will eventually negatively impact consumer spending the stronger the credit binge has been. Chart 6The Historical Experience Of Household Leveraging Does Not Paint A Pretty Picture For Canada Chart 7Upcycles In Household Leveraging Correspond To Downcycles In Real Spending As a final point, Chart 7 underscores a sobering fact: The U.S. has only seen two instances of a 3% or greater average annual rise in household debt-to-GDP over the course of a decade: the first was in the 1920s, and the second was from 1998 to 2007. Clearly, in both cases the rise in debt ended very poorly for the U.S. economy. This, along with the prevalence of serious debt crises following credit binges similar in magnitude to Canada's experience, makes it clear that a credit-driven downturn in spending is a highly probable event for the Canadian economy over the long run, rather than a risk. Bottom Line: The available historical evidence suggests that the substantial leveraging of Canadian households that has already occurred will ultimately cause a serious credit-driven downturn. Debunking Some Housing Market Myths: It's Worse Than You Think Chart 816 Years Of Too-Easy Money The risk that the Bank of Canada will eventually "over-tighten" is magnified by the fact that there is still an ongoing debate within Canada about whether any housing market imbalances even exist. Many market participants still employ several arguments about the Canadian housing market that, at first blush, appear to mitigate the risk of serious long-term consequences of Canada's debt boom. But these arguments are flawed, and an in-depth review of these fallacies highlights the economic risk of higher interest rates. Myth #1 - Sustainable Demand And Affordability The first myth about Canada's housing market is that the rise in house prices and household debt is sustainable because of how long the boom has lasted without consequence. However, besides the ominous historical experience highlighted in Charts 6 and 7 above, Chart 8 makes it clear that the substantial build-up in Canadian household debt since 2000 has occurred primarily due to too-easy monetary policy, rather than legitimate housing market fundamentals. The chart presents Canadian household debt-to-GDP versus the Bank of Canada's target for the overnight rate. The dotted line in panel 2 is a Canadian version of the well-known Taylor rule of monetary policy, with panel 3 showing the difference between the actual policy rate and that prescribed by the rule. The chart shows that the rise in household debt-to-GDP began precisely when the policy rate fell below the Taylor rule, and that this gap has persisted for the past 16 years. We acknowledge that the Bank of Canada felt it was necessary to keep interest rates relatively low during the last economic cycle because of the persistent strength in the Canadian dollar (which acts to restrain exports). But whatever drag on growth that occurred from a strong currency was not large enough to prevent low interest rates from sparking an enormous rise in household leverage. Myth #2 - No Foreign Money Effect The second myth about the Canadian housing market is that there is no substantial effect on house prices from foreign money and that, by extension, foreign transaction taxes should be discouraged. To us, the issue is not the specific residency status of a particular buyer, but rather whether the housing market is being supported by an inflow of foreign capital. While data limitations make it difficult to prove with certainty that Canada has been struck with a tidal wave of capital from China (with Hong Kong acting as the conduit), Charts 9 and 10 show that the circumstantial evidence is overwhelming. The story that emerges from the charts is that the peak in Chinese real GDP growth in 2010 marked the beginning of significant capital outflow from the country, which appears to have moved through Hong Kong, and was perhaps accelerated by Xi Jinping's crackdown on cronyism that began in 2013. Panel 2 of Chart 9 shows that the average absolute value of Hong Kong's "net errors and omissions" line from the balance of payments spiked after mid-2010,2 as did Canada's "other investment liabilities" with a lag. Chart 10 shows that this period also saw a sharp rise in visitor arrivals to Canada from China and Hong Kong, a rise in the share of Canadian bank loans to nonresidents, and a meteoric rise in house prices in Vancouver and Toronto. Chart 11 presents data from Global Financial Integrity, a Washington-based think tank that tracks illicit financial flows globally. While the data is only available with a lag, the chart shows that GFI's estimate of illicit financial outflows from China has risen significantly following the global financial crisis, which is consistent with the narrative presented in Charts 9 and 10. Chart 9Very Strong Circumstantial Evidence... Chart 10...Of Foreign Capital Inflows Chart 11Clear Evidence Of Chinese Capital Flight Myth #3 - Tight Supply The third myth concerning Canadian housing is the argument that housing supply is tight, which justifies the exponential move in house prices. First, it should be noted that while residential investment as a share of GDP was indeed low in the late-1990s, it rose back to its long-term average within the first three years of the housing boom, and has recently risen to a 27-year high (Chart 12). A similar trend can be observed in housing starts and the number of unsold housing inventories. As such, it seems difficult to make the case that the extraordinary rise in house prices and household debt that we have observed over the past 16 years is ultimately due to scarce housing supply. Chart 13 makes this point more saliently, by presenting a scatterplot of the median house price-to-income ratio versus the population density of several major global markets. Ultimately, in any true market economy, genuine housing supply constraints must be related to high density or else there would be ample room to build additional housing units. Two points are noteworthy: Chart 12There Is No Supply Problem Chart 13'There's Nowhere To Build!': Yeah, Right! The median house price-to-income ratio for Toronto and Vancouver deviate enormously from the level that would be implied by their density given the relationship across global housing markets. Based purely on this analysis of relative density, Toronto and Vancouver house prices are 80% and 140% overvalued, respectively. Around the globe, the housing markets that appear to be the most overvalued relative to population density appear to be the geographically closest to China (Vancouver, Australia, Hong Kong, and the West Coast of the U.S.), which echoes our conclusions about foreign capital inflow above. Myth #4 - A Healthier Canadian Household Debt Distribution The fourth myth concerning Canadian housing is the idea that the household debt binge that we have observed has been a "healthier" rise than what occurred in the U.S. during the last economic cycle. The argument is that the rise in debt in the U.S. from 2001 - 2007 predominantly occurred among "subprime" borrowers, and that this is not occurring in Canada. Comparing Canada to the U.S. last cycle is difficult due to the lack of data on the distribution of Canadian household debt-to-income ratios by income percentile. However, some inferences can be drawn from the OECD's wealth distribution database, and they suggest that Canadian household debt is, in fact, quite concentrated. Chart 14 presents the relationship between the number of households with debt and the median debt-to-income ratio of indebted households, from 2010 to 2012 (depending on the observation). The chart shows that while only about half of Canadian households are indebted (in line with the average of the countries shown and below that of the U.S.), among those with debt the median debt-to-income ratio is substantially higher than most other countries. This is also reflected in Chart 15, which shows that Canada has a high rank of significantly indebted households as a share of all indebted households,3 more so that the U.S. Investors should note that Canada's rank today is likely to be higher than that shown in Chart 15, given that several other highly indebted countries (such as the Netherlands and Portugal) have actually experienced household deleveraging since 2010. Chart 14High Concentration... Chart 15...Of Household Indebtedness Myth #5 - The "CMHC Backstop" The fifth and final myth concerning Canadian housing is the fact that the economy is not significantly exposed to a housing market downturn because of the Canada Mortgage and Housing Corporation's mortgage insurance coverage protects Canadian banks. It is true that the CMHC can act as a backstop for the economy by helping to mitigate mortgage default losses. But Chart 16 highlights that there have been some substantial changes over the past few years in the CMHC's footprint in the mortgage market that casts significant doubt on whether it would be able to materially blunt the losses that are likely to occur from systemic mortgage defaults. First, the chart shows that while half of mortgages in Canada had CMHC insurance coverage in 2010, this has fallen by 14 percentage points in just six years (to 36%). This means that almost 2/3rds of Canadian mortgages are not CMHC-insured. Second, while the CMHC has been aggressive in building equity over the past several years (perhaps in anticipation of a significant housing bust!), this equity buffer is still small relative to its total loans (9%) and is fractional as a share of total Canadian residential mortgage credit (1.5%). As such, while we agree that the CMHC is an effective backstop against idiosyncratic risk in the mortgage market, it is simply too small to act as a credible buffer against large-scale losses. Bottom Line: Several myths about Canada's housing market have obscured the true extent of its credit market imbalances, heightening the risk that policymakers will ultimately overplay their hand when tightening monetary conditions. When Will The Party Come To An End? From our perspective, the most likely catalysts for a credit-driven downturn in spending are a reversal of the factors that drove the rise in household debt in the first place. Chart 17 presents a three-phase view of the rise in household debt-to-income since 2000, and summarizes the major drivers of rising leverage in each phase given our analysis above: persistently easy monetary policy (phase I), fiscal and monetary easing (phase II), and foreign capital inflow (phase III). Given this, higher interest rates, fiscal drag, and/or a shock to foreign capital would appear to be the most likely triggers for a credit-driven downturn: Chart 16A Substantially Lower CMHC Footprint Chart 17The Major Drivers Of Rising Household Leverage Higher Interest Rates: Tighter monetary policy is an obvious (and most likely) trigger for a major reversal in the Canadian housing market. It is not yet clear how aggressively the Bank of Canada will raise interest rates over the coming 6-12 months, but Chart 18 highlights that the household debt service ratio will quickly rise to a new high even if the Bank of Canada hikes rates by 150 bps over a two-year period, owing to the relatively short maturity of Canadian mortgage contract terms. Still, the chart shows that this does not occur until mid-2019 at the earliest. Fiscal Drag: IMF forecasts for Canada's cyclically-adjusted primary balance suggest that government spending and investment will remain a positive contributor to growth into next year (Chart 19). But beginning in 2019, fiscal policy is forecast to become a persistent drag on growth, and it is even possible that the sharp deceleration in fiscal thrust set to occur next year could act as the proximate cause of serious problems in the Canadian housing market. Chart 18Not An Imminent Threat, But Watch Out Chart 19Fiscal Drag Set To Begin In 2019 Chart 20Macroprudential Measures Didn't Kill The Vancouver Housing Market A Domestically-Driven Shock To Foreign Capital Inflow: Some investors have pointed with concern to dramatic declines in the sales-to-listings ratios in Vancouver and Toronto following foreign taxation announcements in these markets. We agree that the impact of new or existing macroprudential measures may eventually cause a severe fallout in the housing market, but for now the experience of Vancouver suggests that such an event is not imminent. Chart 20 presents the 3- and 12-month rate of change in Vancouver house prices, with the vertical line denoting the announcement of the foreign transaction tax. While it is clear that the tax sharply slowed the rate of appreciation in Vancouver house prices, it did not cause an outright decline (the 3-month rate of change only briefly turned negative before returning to positive territory). Cyclically, we would become more concerned were we to observe a combination of additional restrictions on foreign capital inflow, higher minimum down payment thresholds for houses priced at or below median levels, and a significantly lower allowable gross/total debt service ratio. An Externally-Driven Shock To Foreign Capital Inflow: We noted earlier in the report that there is strong circumstantial evidence showing that Canada's property market is benefiting from large capital inflows from China, with Hong Kong acting as the conduit. Given this, the Canadian housing market could be subject to a shock from exogenous changes in the flow of this capital, perhaps triggered by cyclical changes in China's economy or, more likely, actions by Chinese policymakers to materially slow the pace of capital flight. While it is very difficult on a high frequency basis to track whether the impact of foreign capital on Canada's housing market is growing or weakening, the indicators shown in Charts 9 and 10 on page 9 form the basis of our monitoring effort. The list above has focused on potential triggers that are specific to the factors that led to the build-up in Canadian household debt. Clearly there are additional macro factors that could trigger the onset of a major debt payback period in Canada, and chief among these would be the next U.S. or global recession. For example, we recently noted how continued tightening from the Fed could set the stage for a U.S. recession in 2019, which could easily trigger either a prolonged period of stagnant Canadian growth or an active deleveraging event.4 Bottom Line: There are multiple potential triggers that could eventually spark a credit-driven downturn in Canada, but none of them seem likely to have a major impact on the economy over the coming 6-12 months. Investment Implications Canadian household leverage has risen enormously over the past 16 years, and a detailed analysis of Canada's housing market shows that an eventual credit-driven downturn in spending is a highly probable event for the Canadian economy over the long run (rather than a risk). However, among the most probable triggers for a serious housing market shock, only higher interest rates are set to occur over the coming year. Given that monetary tightening will be gradual in its pace, it does not seem probable that a major downturn in spending is imminent. From an investment standpoint, these conclusions imply the following stance towards Canadian dollar assets over the coming 6-12 months: Overweight the Canadian dollar: The cyclical improvement in the Canadian economy, along with our bullish view on oil prices, suggests that the Canadian dollar is set to appreciate over the coming year. We acknowledge that our constructive view on oil prices is contrarian and that, for now, we are ahead of the market. Continued weakness in oil prices remains the chief risk to a bullish stance on the CAD. But our detailed analysis of the global oil market strongly implies that the current level of oil inventories is too high and is set to draw materially over the coming months, which will be undoubtedly positive for oil prices barring the development of a major global demand shock. Maintain Canadian equities on upgrade watch: Canadian equities have materially underperformed their global peers over the past six years, due to fairly significant de-rating from overvalued levels as well as a downtrend in relative 12-month forward earnings (mostly vs the U.S.; Chart 21). Relative performance in common-currency terms has also been hurt by a declining Canadian dollar. Looking out over the next year, there are at least some tentative signs to be optimistic about Canadian stocks. First, Chart 22 highlights that Canadian stocks are now moderately cheap relative to their global peers based on a composite valuation indicator. Second, our expectation of an uptrend in oil prices would likely bolster relative forward earnings, and could act as a re-rating catalyst for the broad market. Chart 21Multiples And Earnings Have Worked Against Canadian Stocks Chart 22No Longer Expensive Underweight Canadian bonds within a hedged global fixed-income portfolio: Canadian government bonds have recently underperformed their global peers, and this trend is likely to continue in response to tighter monetary policy. Over the longer term, the likelihood of a major credit-driven downturn in spending means that the secular investment implications for Canada are precisely the opposite of that described above. This means that investors should pursue a "two-staged" approach to investing in Canadian assets. The fact that the Canadian economy is currently accelerating and a significant reversal in the Canadian housing market does not seem to be imminent means that there is an opportunity for Canadian assets to potentially outperform (or underperform in the case of government bonds) over the coming 6-12 months. Such a period of cyclical improvement would likely (temporarily) dampen investor concerns about a major housing market correction, creating much better "selling conditions" for Canadian risky assets than from current levels. We acknowledge that the "two-stage" nature of this strategy is nuanced, and we have provided a checklist of potential triggers for the housing market in this report so that investors can gauge the likelihood that a material payback period is about to begin. We will continue to monitor both the cyclical improvement in the Canadian economy and the magnitude of imbalances in the household sector, and will provide investors with regular updates as they develop. Stay tuned! Bottom Line: Investors should pursue a "two-staged" approach when allocating to Canadian assets. Favor a pro-cyclical stance over the coming 6-12 months, but look to shift to a bearish structural view at some point beyond the immediate investment horizon. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix A A Quick Recap Of Home Capital: Not A Systemic Issue In April, the share price of Home Capital Group (a Canadian non-bank mortgage lender) collapsed by 75% in response to a major liquidity crisis for the firm. The crisis ultimately stemmed from a set of mortgage loans with falsified income documentation, which to many outside observers was strongly reminiscent of the aberrant practices of U.S. subprime lending institutions during the last cycle that eventually spawned the global financial crisis. However, as highlighted below, Home Capital Group's problems were largely idiosyncratic (i.e., not systemic) in nature: Home Capital's business model involves lending to Canadians who lack a stable credit history, but who are generally otherwise creditworthy (commonly referred to as "near-prime" borrowers). Since these borrowers subsequently build a credit history by staying current on their mortgage loans with Home Capital, they often switch to a big-five bank after the term of the loan is complete. As such, Home Capital faces substantial client retention challenges, which is an idiosyncratic income statement problem rather than a balance sheet problem with systemic implications. To combat the tendency of its loan book to shrink, in 2014 Home Capital increased the size of its sales force by partnering with a set of established mortgage brokers. Some of the loans that had been originated by these brokers had falsified income documentation, which led to an internal investigation. Following the investigation, the company failed to disclose the results to investors during a period where the company's operating performance was impacted by the fraud. This eventually led to enforcement action from the Ontario Securities Commission. The disclosure of enforcement, along with several other events (such as the termination of its CEO in late-March) severely eroded investor confidence in the firm and essentially caused a bank run. From a macro perspective, there are two important takeaways from this series of events. First, it is important to note that Home Capital experienced a liquidity rather than a solvency crisis. While the former can, of course, lead to the latter, the run on Home Capital did not occur because of deteriorating loan performance, unlike what occurred in the U.S. with the subprime market. Indeed, Home Capital's first quarter results show that net impaired loans as a percent of gross loans have continued to trend lower over the past several quarters (Chart A1). Second, the fact that Home Capital's mortgage book tends to shrink underscores the underlying creditworthiness of at least some of its borrowers, because these households would probably not be able to shift their mortgages to the big-five banks if loan qualification was an issue. As a final point, Chart A2 presents some perspective about the apparent prevalence of mortgage fraud in Canada by showing the number of U.S. mortgage loan fraud suspicious activity reports (SARs) in the lead-up to the subprime financial crisis. The chart not only shows the sharp rise in the number of SARs from 2002-2003 to 2007-2008, but it also shows that the volume of reports numbered in the tens of thousands. By contrast, Canadian news stories reporting on a rise in the number of mortgage fraud complaints in Canada quote a trivially small number of cases. For example, a recent article from the Vancouver Sun stated that British Colombia's Financial Institutions Commission statistics "show complaints roughly doubled from 109 in 2013 to about 200 in 2016, and about a third of complaints allege loan application fraud."5 Chart A1No Deterioration In Loan Performance Chart A2No Evidence That This Is Happening In Canada While it is technically correct to state that this is a doubling in the rate of fraud cases, it is from what appears to be an extremely small base. Adjusting by a factor of 10 to account for the difference in population, Canada would need to see 3,000-to-6,000 cases of mortgage fraud per year in order to be comparable to what occurred in the U.S. in the latter half of the housing market bubble. There is simply no evidence that mortgage fraud on this scale of magnitude is occurring. 1 See Appendix A on page 19 for a review of the Home Capital debacle and why concerns of systemic mortgage fraud are quite likely overblown. 2 If Hong Kong has been a conduit for capital flight from China, the flow of capital would only temporarily show up in Hong Kong's balance of payments. For example, one quarter of significant capital inflow might be followed by a quarter of significant capital outflow as the money enters from China and exits towards the rest of the world. As such, we use the absolute value of Hong Kong's net errors and omissions line to see whether the magnitude of the flow has increased. 3 Defined as having a debt-to-income ratio in excess of 3. 4 Please see Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 5 Sam Cooper, "Regulator Tracks The Rise In Mortgage Fraud Complaints In B.C. As House Prices Jump," Vancouver Sun, June 19, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Yellen pointed out that the U.S. R-star is low but that it will rise as temporary depressing factors pass. The Fed is determined to push rates toward 3% over time. The euro area R-star is substantially lower than that of the U.S., limiting the capacity of the ECB to follow the Fed's path and pace. Traders are massively long the euro. Abe's woes do not signal the end of Abenomics, in fact they point toward more stimulus. The BoC has hiked and will keep doing so, continue to favor the CAD. Feature Janet Yellen offered both a fascinating and telling glimpse on the Federal Reserve's thinking this week. She argued that the equilibrium fed funds rate is currently very depressed, which is limiting the pace at which the FOMC can increase interest rates before plunging the economy into recession. However, she also noted that the Fed anticipates equilibrium interest rates will continue to rise over time, which means the actual fed funds rate has more upside on a multi-year horizon, despite what will be a slow pace of increases. With this additional information on the Fed's mindset, investors should be even more comfortable in their assessment that the period of maximum policy divergence between the euro area and the U.S. is behind us, which justified bullish bets on the euro. However, the broader picture is a bit more complex. Different Equilibria The idea that the neutral fed funds rate is still low but rising explains why the Fed is still pegging its terminal rate at 3%. Currently, the Laubach and Williams formulation of the neutral real fed funds rate (also known as R-star) is at 0.4%, while the current real fed funds rate stands at -0.5%, which implies 0.9% upside in real rates over the next two years or so (Chart I-1). Moreover, if as we expect core inflation moves back toward 2% over the Fed's forecast horizon, the upside to rates would be closer to 150 basis points. In the euro area, however, the same long-term R-star stands at -0.1%, depressed by lower population growth, a higher savings rate and lower structural productivity gains. Since the real policy rate is at -0.7%, this signifies that the gap between the actual real policy rate and its equilibrium is a smaller 0.6% (Chart I-2). This means that euro area rates have much less upside than U.S. ones before generating a deleterious impact on growth. Chart I-1U.S. R-Star Vs. Policy Rates Chart I-2Euro Area R-Star Vs. Policy Rates It is easy to argue that R-star differences are nice theoretical concepts, with little practical implications for currency investors. After all, interest rate differentials at the long end of the curve are clearly a function of the relative GDP per capita between the euro area and the U.S. (Chart I-3). These same GDP-dynamics also have an impact - albeit a less tight one - on EUR/USD. Chart I-3Yield Differentials And Relative GDP Chart I-4How R-Star And GDP Tango Yet, R-star spreads do affect growth differentials between the euro area and the U.S. As Chart I-4 illustrates, when the euro area real policy rate crosses above its equilibrium, euro area real GDP per capita growth sags soon after. The same holds true for the U.S. This suggests the capacity of European GDP per capita to outperform that of the U.S. is currently limited, or at the very least needs rates in Europe to remain quite low relative to the U.S., anchored lower by the depressed level of the R-star in Europe vis-a-vis the U.S. Moreover, the recent outperformance of European GDP per capita relative to the U.S. has a lot to do with the poor performance of U.S. GDP in 2016. However, U.S. GDP should firm in the coming quarters, particularly since household income levels are well supported. As Chart I-5 shows, based on an average of the pay-related and hiring-related components of the NFIB small businesses survey, the aggregate wages and salaries received by U.S. households are set to accelerate, both in nominal and real terms. This represents a boost to aggregate income and should support consumption, or almost 70% of the U.S. economy. Additionally, the rebound in U.S. capex should continue. Both the NFIB and the various regional Fed capex intention surveys remain healthy. This, along with labor market tightness, should be accretive to per capita GDP. As Chart I-6 shows, a composite indicator based on the NFIB survey capex and "jobs hard to fill" components is very strong, which historically has led to an acceleration of real-GDP-per capita growth. Chart I-5U.S. Household Income Will Accelerate Chart I-6U.S. Real GDP Per Capita Will Strengthen As a result, we are inclined to bet on a renewal of strength in the U.S. economy, which will support R-star there and help the Fed hike rates by more than the 43 basis points currently anticipated over the next 24 months. Bottom Line: The U.S. long-term equilibrium real fed funds rate is low, but remains substantially higher than the R-star in the euro area. This suggests that U.S. rates have more upside than European ones. Moreover, the outlook for U.S. per capita GDP is healthy, while that of Europe will continue to require low rates to remain on an upward path. Tactical Considerations Around EUR/USD EUR/USD is well bid, and our base case scenario remains that the 1.15 to 1.16 zone will be retested. However, some technical indicators have made us leery to chase this move, and might even prevent this target zone from ever being breached. To begin with, the number of long speculative bets on the euro has hit a record high, while the number of short bets has collapsed (Chart I-7). Net long speculative positions are not at a record high yet, but are in the upper echelons of the distribution of the past 17 years. Interestingly - and some would argue almost mechanically - while speculators' optimist or pessimist extremes can be used as contrarian indicators, commercial traders tend to be disproportionally short or long the euro at the appropriate time - i.e., when the euro is set to plummet or rally, respectively. Theoretically, commercial and non-commercial traders' positions should be in perfect balance as they are counterparties to one another, but in practice this is rarely the case. Because of this observation, we decided to amplify the message of both series by subtracting the net long commercial positions from net long non-commercial ones. This indicator tends to work best at highlighting tops in EUR/USD. The current reading has been indicative of an upcoming period of weakness in this pair (Chart I-8). The only exception was in 2007, a period when unlike today, the Fed was cutting rates while the ECB policy rate was being lifted all the way to July 2008. Chart I-7Record Longs In The Euro Chart I-8Aggregate Positioning Points To A Lower Euro Moreover, the buying pressure on EUR/USD may be exhausting itself. Wednesday, despite a seemingly dovish message from Fed Chair Yellen and despite stronger-than-anticipated industrial production numbers out of the euro area, EUR/USD weakened 0.6% instead of appreciating. In fact, our European Investment Strategy Senior Vice President Dhaval Joshi's Fractal Dimension indicator - a measure of group-think in the market - is now at 1.25, a level that also warns of an imminent trend change (Chart I-9).1 Chart I-9A Risk Of Reversal As a result, we do not yet think it is time to be betting aggressively on a fall in EUR/USD, especially as next week's ECB meeting might give an occasion for President Mario Draghi to re-affirm his optimism, giving the euro its final push toward 1.15-1.16. However, nimble traders should begin building small short positions in the euro on the optic of expanding their bets if the EUR/USD gathers downward momentum. Bottom Line: The euro may well hit the 1.15-1.16 range, but positioning in EUR/USD is currently extremely overstretched, and the euro's trading action suggests that groupthink has become prevalent, confirming the message of positioning. This means the euro is at risk. Nimble traders should begin building small short positions in EUR/USD, but it is not yet time to bet aggressively on this pair. Shinzo's Troubles Are Not The Demise Of Abenomics Japanese Prime Minister Shinzo Abe's popularity has been in freefall in recent weeks, hitting the most dismal levels of his current premiership (Chart I-10). The flogging received by the LDP in the recent Tokyo Metropolitan Assembly election is indeed being perceived as a rejection of the party's policy stance since 2012. Does this represent the coup de grace that will end Abenomics? We doubt it. The key behind the recent dip in Abe's popularity is not his economic policy but his move away from it. Instead, his focus on changing the pacifist constitution of post-war Japan is the source of the LDP's and Abe's woes, as this topic remains anathema with the Japanese public. Moreover, we are not willing to bet on the demise of the LDP. The Tokyo election was a one-off event. The new Tomin First no Kai (Tokyoites First) party that is now the largest force in the regional assembly is led by the very popular Tokyo governor Yuriko Koike, and will rely on the pacifist Komeito to control the Tokyo Metropolitan Assembly. At the national level, the DPJ remains in tatters, and no potential new party is in place to carry the torch of the opposition. Japan is still effectively a one-party democracy. So what are the market implications of these political developments? We expect a doubling down by Abe on economic stimulus. If Abe ever wants a passing chance to have, let alone win, a referendum to increase Japan's militarism, the economy needs to be stronger than it is. Thus, we think this boot of unpopularity will be key to unlocking more fiscal stimulus out of Tokyo. When more fiscal stimulus finally does materialize, if it boosts growth, it will also lift long-term inflation expectations (Chart I-11). Chart I-10Abe's Plummeting##br## Popularity Chart I-11If Fiscal Stimulus Is Implemented ##br##CPI Expectations Will Rise... In this context, we would expect continued pressure on the Bank of Japan to remain one of the two most dovish central banks in the G10, as to not undo the benefits of fiscal stimulus. Moreover, the BoJ cannot remove stimulus, as realized CPI excluding food and energy remains in negative territory. Tokyo's CPI report, which offers a one-month lead on the national release, shows that core inflation is still in negative territory. National summer wage negotiations point to negative wage growth next year, making a revival of domestically generated inflation a remote event without an easing of financial conditions (Chart I-12). Additionally, the recent rollover in the leading diffusion index suggests the economic upswing may already be fading (Chart I-13). Continued BoJ support and higher inflation expectations would hurt Japanese real yields and handicap the yen. Chart I-12...But That Will Also Require Easy Monetary##br## And Financial Conditions Chart I-13A Slowdown ##br##In Japan The recent upswing in global bond yields is thus likely to continue to weigh on the yen, leading to a higher USD/JPY. As this week illustrated, rising global yields are forcing the BoJ to increase its amount of JGB purchases to cap the upside in Japanese 10-year yields. Tactically, USD/JPY has been in an upswing, but has hit an important resistance close to 114.5. A few more days of weakness could ensue, but such weakness should be used by investors to sell the yen. Bottom Line: Abe's political problems do not represent the end of Abenomics. Instead, they illustrate the Japanese public's lack of appetite toward abandoning Japan's post-war pacifism. If Abe is serious about holding a referendum on this topic, he will have to support growth going forward - which implies higher fiscal stimulus and inflation expectations. Meanwhile, the absence of inflation in Japan continues to hamstring the BoJ in keeping policy extremely supportive, limiting the upside to nominal interest rates across the Japanese yield curve. Real rate differentials will continue to support USD/JPY. Use any weakness in this pair to buy the dollar versus the yen. Canada: Poloz Delivers The Bank of Canada on Wednesday increased interest rates by 25 basis points to 0.75%, the first central bank to follow the Fed's lead. Our analysis two weeks ago suggested that the BoC was faced with some of the most supportive conditions in the world to follow the Fed's path.2 More interesting than the decision itself was the accompanying quarterly Monetary Policy Report. In the report, the BoC moved forward its estimation of the closure of the output gap from 2018 to 2017. Additionally, despite expecting a slowdown in household consumption in 2018, the BoC upgraded its GDP forecast by 0.2% in 2017 and 0.1% in 2018, to 2.8% and 2%, respectively. Obviously, the market took note of these views, with USD/CAD falling three big figures on the news. The tone of the report was quite bullish on the Canadian economy, highlighting robust as well as broad-based growth and increasing signs of vanishing slack. In fact, the message reiterated that of the summer Business Outlook Survey, which showed strong growth, growing difficulty meeting demand, and growing and intensifying labor shortages (Chart I-14). As a result, the BoC expects the weak Canadian CPI to rebound, after the transitory effects of low food inflation, automobile rebates, and Ontario's electricity subsidies dissipate. We are inclined to agree with this assessment. At 2% per annum, Canadian employment growth is robust and the unemployment rate has fallen significantly. Now that oil prices have stabilized, employment is improving, suggesting that even the weakest regions of the economy are participating in the party. Additionally, our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth (Chart I-15). Chart I-14Canada Is Booming And Slack Is Shrinking Chart I-15Strong Data Across The Board USD/CAD continues to trade at a discount to real interest rate differentials, signaling further upside on the CAD. Also, while investors have begun to curtail their shorts on the loonie, there do remain enough stale shorts for the CAD advance to persevere. We continue to prefer playing the CAD's strength on its crosses such as versus the AUD and the EUR, as the risk profile seems cleaner on these pairs than versus the USD. Short EUR/CAD looks particularly attractive. Our long CAD/NOK trade is near its target, and we are closing this position. Bottom Line: The Bank of Canada has not only hiked rates, but it has also highlighted that the Canadian economy is strong and inching closer to full capacity. The market has taken note, with the loonie rallying violently. The CAD has more upside going forward, especially against the euro and the AUD. We are booking profits on our long CAD/NOK position. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see European Investment Strategy Special Report titled, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 2 Please see Foreign Exchange Strategy And Global Alpha Sector Strategy Special Report titled, "Who Hikes Next?", dated June 30, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback has largely been flat this week, despite Yellen's statements regarding rate hikes and balance sheet normalization at her Congressional Testimony, even if, 10-year yields went down. U.S. economic data has a soft tone: NFIB Business Optimism Index came in lower than expected at 103.6, reflecting broad-based softness in the details of the survey; JOLTS job openings also came in lower than expected at 5.666 mn; Initial jobless claims underperformed expectations, coming in at 247,000; Additionally, continuing jobless claims were higher than expected at 1.945 mn. While data remains mixed, the Fed is still intent on tightening policy. The dollar will follow suit, especially if inflation moves as the Fed expects. Report Links: Who Hikes Next? - June 30, 2017 Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Data out of Europe this week was reasonably strong: Both exports and imports increased at a 1.4% and 1.2% monthly pace, respectively; The current account beat expectations; Industrial production increased by 4%, more than the expected 3.6%; However, despite this upbeat data, the euro remained largely flat this week. This behavior is justified from a technical perspective: the RSI is close to overbought levels; the MACD line is rolling over and closing the gap with the signal line; the number of speculators with long positions is at its highest level ever. The considerable weakness in EUR/SEK and EUR/NOK on Thursday shows underlying weakness in the euro. This decreases the likelihood that EUR/USD breaches the 1.15-1.16 zone. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Labor cash earnings yearly growth outperformed expectations and grew from last month, coming in at 0.7%. However, machinery orders yearly growth was far below expectations, coming in at 0.6%. In spite of the selloff in the dollar, USD/JPY has rallied by more than 1% since last week, stopping its ascent after hitting a key technical level at 114.5. We continue to be yen bears, even in the face of the declining popularity of Shinzo Abe: the champion for expansionary fiscal policy in Japan. Instead, we are confident that Abe will double down on fiscal spending as his decline in popularity has been precisely because he has strayed away from this key policy pillar which made him so popular. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Updating Our Intermediate Timing Models - April 28, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Halifax House prices grew by only 2.6% YoY, underperforming expectations of 3.1%. Industrial Production contracted by 0.2% year-on-year, also underperforming expectations. While the unemployment rate decreased, coming in at 4.5% and also beating expectations, average earning growth fell to 1.8%. After appreciating by almost 2% this week, and reaching 0.895, EUR/GBP has come down to 0.885, but the pound is likely to have short term downside against the euro. Furthermore, GBP/USD is also likely to have downside, as the pound is not as attractive as it was in the beginning of the year from a valuation standpoint. Indeed, sentiment has turned much more positive on the outcome of Brexit, which means that the significant discount in the pound has disappeared. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD has seen a broad-based increase this week, except for against the CAD. This increase has largely been a factor of Chinese data, although domestic conditions also played a role: Chinese exports and imports both increased at a 11.3% and 17.2% annual pace, respectively; China's trade balance in June was USD 42.77 bn, better than expected; Chinese new loans came in at RMB 1,540 bn; NAB Business Conditions and Confidence both beat expectations; However, investment lending for homes is still contracting at 1.4%, albeit at a lesser than expected pace of 2.3%; Also, home loans are increasing at a lesser than expected pace of 1%. We retain our view of the inherent weakness in the Australian economy, which will restrict the RBA from changing its view. This will weigh on the AUD in the near future. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 AUD/NZD has rallied by almost 1.3% since last week. This in part, was the market reaction to an approved housing infrastructure fund by Prime Minister Bill English worth NZ$1 Billion aimed at increasing the supply of housing in the country. This measure provides the RBNZ with some breathing room, as it is a policy aimed at cooling housing market, which has prices growing at a 14% rate. The increase in housing supply alleviates the pent up demand generated by the dramatic increase in population in New Zealand in recent years. The RBNZ is unlikely to join the BoC and the Fed this year, as they remain cautious, and have opted for macro prudential measures to eliminate any imbalances in the economy. Stay short the NZD against the dollar and the yen. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canada followed the footsteps of its partner in the south, joining the U.S. as the only two central banks in the G10 space raising interest rates. The Bank of Canada highlighted that "the adjustment to lower oil prices is largely complete" and that "both the goods and services sectors are expanding". Alberta's economy validates this stance as all sectors of the economy are growing at a very brisk pace. The BoC estimates that the output gap will now close at the end of 2017, instead of the previous forecast of the first half of 2018, further escalating their hawkish rhetoric. The press release noted that the recent restrain in inflationary pressures will be transitory, as "excess capacity is absorbed". Recent data corroborates this view with strong employment data and stronger than expected housing starts. USD/CAD declined 1.3% at the end of the day of the hike, and outperformed all other currencies. Report Links: Bad Breadth - July 7, 2017 Who Hikes Next? - June 30, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Unemployment remains very low, coming in at 3.2% However, producer and import prices contracted by 0.1% year-on-year, coming below expectations and decreasing from the previous month. The low unemployment number is not the only indicator that shows a tight labor market, as employment is also growing at an astonishing 5% yearly rate. However, this tightness in the labor market is not translating to higher wages, as wages are growing at a paltry 0.6%, anchored by strong deflationary forces. Thus, the SNB will continue with their ultra-dovish monetary policy and with their interventions in the currency market. Nevertheless, we will monitor if the recent plunge in the CHF against the euro creates any kind of inflationary dynamics in the economy, and causes the SNB to rethink their stance. Report Links: Who Hikes Next? - June 30, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Manufacturing output contracted by 0.3%, falling sharply from last month number. Additionally, although both core and headline inflation came above expectations at 1.6% and 1.9% respectively, they still fell from last month reading. The Krone has appreciated sharply the past week, with USD/NOK falling by 1.45% and EUR/NOK falling by 1.15%. This has been a result of the rebound in oil prices caused by the massive draws in inventories the past couple of weeks. Indeed, last week's number, which showed an inventory draw of 7.6 million barrels was the biggest since 2011. Overall, we expect that OPEC should be able to continue managing supply, and therefore, oil should rise until the end of the year. This will be negative for EUR/NOK. Report Links: Who Hikes Next? - June 30, 2017 A Market Update: June 23, 2017 Exploring Risks To Our DXY View - May 26, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Riksbank's change in rhetoric was perfectly timed, as Sweden's economy is increasingly showing signs of strength. Data has outperformed these past two weeks: Manufacturing PMI came in at 62.4, beating expectations of 59.8; Industrial production increased at a 8% annual pace in May; Inflation in Sweden is firming, coming in at 1.7% in June and beating expectations. The SEK appreciated 0.7% against EUR, and 0.6% against USD. Markets are pricing in stronger growth and a further escalation of hawkish rhetoric from the central bank, especially as Stefan Ingves as tabulated to leave this Riksbank in a few months. Part of the reason for Sweden's strength is also a stronger European economy. With Germany leading the pack, Sweden's largest export partner is also lifting the largest Scandinavian economy. Report Links: Who Hikes Next? - June 30, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades