Policy

Highlights China's recent growth moderation is due to marginally tighter monetary conditions. There is no case for severe policy tightening that could lead to a material growth relapse. There are plenty of signs the economy could continue to run hotter on almost all fronts. The downside risk in the economy remains fairly low, even if annual growth rates of various macro variables do not continue to accelerate. Feature Chart 1Tighter Monetary Conditions ##br##Led To Growth Moderation Our team was in China over the past two weeks, talking to investors and exchanging views with our local contacts for some on-the-ground reconnaissance. Investors appeared more upbeat on China's cyclical outlook than during our recent past trips, but generally speaking conviction remained low, and concern on some structural issues - particularly credit and the housing market - remained deeply rooted. Investors' more upbeat sentiment on growth reflected China's cyclical recovery since early last year, but the rapidly-emerging consensus appeared to be that the growth acceleration peaked in the first quarter, and the economy is facing growing downward pressure, even though few investors seem worried about a chaotic "hard landing" at the moment. Collectively, investors appeared largely preoccupied with downside risks and mindful of negative surprises, while the upside risks were not really discussed. China's latest PMI numbers released this week seemed to validate the consensus view of an imminent growth top. Most major components of the PMI surveys in both the manufacturing and service sectors had setbacks, which were also reflected in softer commodities prices (Chart 1).1 A key reason for the growth moderation is likely the performance of the RMB. We have long argued that the RMB's depreciation has been a key reflationary force for China, which boosted producer prices, enhanced profit margins and reduced the real cost of funding.2 By the same token, the pace of RMB depreciation has moderated in recent months, removing some reflationary impulses within the economy. However, it is important to note that China's worsening growth deterioration in previous years was in part attributable to sharp RMB appreciation, a replay of which is highly unlikely going forward (Chart 2). The RMB appreciated by almost 30% between 2012 and 2015, a massive deflationary shock to the economy. Currently, the trade-weighted RMB is still depreciating, albeit at a slower pace, and real interest rates deflated by PPI are still negative. In other words, although tighter on the margin, monetary conditions are still fairly stimulative, which should continue to help the economy improve. On the fiscal front, the government significantly reduced fiscal stimulus toward the end of last year, but quickly reversed course (Chart 3).3 Both direct fiscal spending and infrastructure investment have picked up notably, and its impact will continue to ripple through the broader economy. Moreover, China's fiscal spending tends to be pro-cyclical: growth recovery typically boosts fiscal revenues, which gives the government more financial resources for fiscal expenditures, and vice versa. Unless the government steps on the brakes, there is no case for a sudden retrenchment in fiscal stimulus soon. Chart 2China: But Monetary Conditions ##br##Remain Fairly Stimulative Chart 3... Meets Waning Fiscal Stimulus China: ##br##Fiscal Retrenchment Has Been Reversed In short, China's policy setting remains expansionary, a major departure from previous years when the Chinese economy was under the heavy weight of policy tightening while external demand also weakened. Looking forward, there is little chance that the Chinese authorities will commit similar policy mistakes that could lead to a major growth downturn. Chart 4China: More Upside In Exports? Barring a major policy mistake of aggressive tightening, Chinese growth should remain buoyant. In fact, there are plenty of signs the economy could continue to run hotter on almost all fronts: Exports are likely to continue to accelerate, according to our model, barring disruptions from major external shocks such as election surprises in Europe and /or broad protectionist measures from the Trump administration (Chart 4). America's latest anti-dumping measures on some Chinese steel products are irrelevant from a big picture point of view, as U.S. steel imports from China only account for a mere 1% of Chinese steel output.4 The upturn in the profit cycle will likely boost investment, particularly among private industrial enterprises (Chart 5). Rising profits and higher output prices indicate tighter capacity utilization, which would in turn encourage capital spending. The prolonged downturn in China's capital spending cycle has likely come to an end. Domestic consumption may further benefit from improvement in the labor market, which is lifting both income and confidence. This is particularly important for large-ticket consumer durable goods such as automobiles and household appliances. Housing construction will likely continue to improve, driven by strong demand. The most recent central bank survey showed that households' home-buying intentions jumped to an all-time high in the last quarter, underscoring a massive increase in pent-up demand (Chart 6). Developers are also warming to increasing supply - and land purchases have resumed positive growth in recent months after a prolonged slump. Tighter housing policies in major cities will prevent a massive boom, but will not short-circuit the recovery. Chart 5China: Private Capex Should Have Bottomed Chart 6China: A Sharp Recovery In Housing Demand All in all, we reiterate our view that the downside risk in the Chinese economy is low from a cyclical perspective, even if annual growth rates of various macro variables do not continue to accelerate. Growth figures to be released in the coming weeks will become noisy, but we lean against being overly bearish. Overall, business activity will remain fairly robust, and a major relapse in growth is unlikely. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead" dated April 6, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "2016: A Choppy Bottoming" dated January 6, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening" dated February 16, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Reflecting On The Trump-Xi Summit" dated April 13, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The headwinds against commodity currencies are still brewing, the selloff is not over. Global liquidity conditions are deteriorating and EM growth will disappoint. The valuation cushion in commodity currencies and EM plays is not large enough to compensate for the red flags emanating from financial markets. The euro is peaking. A capitulation by shorts is likely early next week. A move to 1.12 should be used to sell EUR/USD. Feature Commodity currencies have had a tough nine weeks, weakening by 5% in aggregate, helping boost our short commodity currency trade returns to 3.8%. At this juncture, the key questions on investors' minds is whether or not this trend will deepen and if this selloff will remain playable. We believe the answer to both questions is yes. A Less Friendly Global Backdrop When observed in aggregate, the past 12 months represented a fertile ground for commodity currencies to perform well as both global liquidity and growth conditions were on one of the most powerful upswings in the past two decades, lifting risk assets in the process (Chart I-1). Chart I-1The Zenith Is Passing Global Liquidity Is Drying When we look at the global liquidity picture, the improvement seems to be over, especially as the Fed, the key anchor to the global cost of money, is more confidently embracing its switch toward a tighter monetary policy. It is true that U.S. Q1 data has been punky at best; however, like the Fed, we think this phenomenon will prove to be temporary. Recently, much ink has been spilled over the weakness in the auto sector. However, when cyclical spending is looked at in aggregate, the picture is not as dire and even encourages moderate optimism. Driven by both corporate and housing investment, cyclical sectors have been growing as a share of GDP (Chart I-2). This highlights that poor auto sales may have been a sector specific development and do not necessarily provide an accurate read on the state of household finances. Chart I-2Autos Do Not Paint The Full Picture For The U.S. Cyclical Spending Is Firm... Moreover, the outlook for household income is still positive. Our indicator for aggregate household disposable income continues to point north (Chart I-3). As we have highlighted in recent publications, various employment surveys are suggesting that job growth should improve in the coming months.1 Also, this week's productivity and labor cost report showed that compensation is increasing at a nearly 4% annual pace. This healthy outlook for household income, combined with the consumer's healthy balance sheets - debt to disposable income stands near 14 year lows while debt-servicing ratios are still near 40 year lows - and elevated confidence suggests that house purchases can expand. With the inventory of vacant homes standing at 11 year lows, this positive backdrop, along with the improving household-formation rate, is likely to prompt additional housing starts, lifting residential investment (Chart I-4). Chart I-3Bright U.S. Household ##br##Income Prospects Chart I-4As Households Get Formed,##br## Housing Starts To Pick up For the corporate sector, the strength in survey data is also likely to result in growing capex (Chart I-5). Not only have "soft" data historically been a good leading indicator of "hard" data, but the outlook for profit growth has also improved substantially. Profit growth is the needed ingredient to realize the positive expectation of business leaders embedded in "soft" data. Profit itself is very often dictated by the trend in nominal revenue growth. The fall in profits in 2016 mostly reflected the fall in nominal GDP growth to 2.5%, which produced a level of revenue growth historically associated with recessions (Chart I-6). As such, the recent rebound in nominal GDP growth, suggests that through the power of operating leverage, profit should also continue to grow, supporting capex in the process. Chart I-5Business Confidence Points ##br##To Better Growth And Capex... Chart I-6...Especially As A Key Profit##br## Driver Is Improving With the most cyclical sector of the U.S. economy still on an upswing, the Fed will continue to increase rates, at least more aggressively than the 45 basis points of tightening priced into the OIS curve over the next 12 months. With liquidity being sucked into the U.S. economic machine, international dollar-based liquidity, which is already in a downtrend, is likely to deteriorate further (Chart I-7). Moreover, global yield curves, which were steepening until earlier this year, have begun flattening again, highlighting that the tightening in global liquidity conditions is biting (Chart I-8). This will represent a continuation of the expanding handicap against global growth, and EM growth in particular. Chart I-7Global Dollar Liquidity Is Already Poor Chart I-8A Symptom Of The Tightening In Liquidity Global Growth Conditions Are Also Past Their Best, Especially In EM Global growth conditions are already showing a few troubling signs, potentially exerted by the tightening in global liquidity. To begin with, while our global leading economic indicator is still pointing north, its own diffusion index - the number of nations with improving LEIs versus those with deteriorating ones - has already rolled over. Normally, this represents a reliable signal that growth will soon peak (Chart I-9). For commodity currencies, the key growth consideration is EM growth. Here too, the outlook looks precarious. The impulse to EM growth tends to emerge from China as Chinese imports have been the key fuel to boost exports, investments, and incomes across a wide swath of EM nations. Chinese developments suggest that Chinese growth, while not about to crater, may be slowing. Chinese monetary conditions have been tightening abruptly (Chart I-10, top panel). Moreover, this tightening seems to be already yielding some results. The issuance of bonds by smaller financial firms has been plunging, which tends to lead the growth in aggregate total social financing (Chart I-10, bottom panel). This is because the grease in the shadow banking system becomes scarcer as the cost of financing rises. Chart I-9Deteriorating Growth##br## Outlook Chart I-10Chinese Monetary Conditions ##br##Are Tightening This situation could continue. Some of the rise in Chinese interbank rates to two-year highs reflects the fact that easing capital outflows have meant that the PBoC can tighten monetary policy through other means. However, the recent focus by the Beijing and president Xi Jinping on financial stability and bubble prevention, suggests that there is a real will to see tighter policy implemented. This means that the decline in total credit growth in China should become more pronounced. As a result, this will weigh on the country's industrial activity, a risk already highlighted by the decline in Manufacturing PMIs (Chart I-11). Additionally, this decline in credit growth tends to be a harbinger of lower nominal GDP growth, and most importantly for EM and commodity producers, a foreboding warning for Chinese imports (Chart I-12). Chart I-11China Industrial ##br##Growth Worry Chart I-12Slowing Chinese Credit Impulse ##br##Will Weigh On EM Growth Financial markets are already flashing red signals. The Canadian Venture exchange and various coal plays have historically displayed a tight correlation with Chinese GDP growth.2 Today, they are breaking below key trend lines that have defined their bull markets since the February 2016 troughs (Chart I-13). This message is corroborated by the recent weakness in copper, iron ore, and oil prices. Additionally, the price of platinum relative to that of gold is also breaking down. While the VW scandal has a role to play, this breakdown is also a symptom of the pain on growth created by the tightening in global liquidity conditions. In the past, the message from this ratio have ultimately been heeded by EM stock prices, suggesting that the recent divergence is likely to be resolved with weaker EM asset prices (Chart I-14). Confirming this risk, the sectoral breadth of EM equities has also deteriorated, and is already at levels that in the past have marked the end of stock advances (Chart I-15). At the very least, the narrowing of the EM bull market should prompt investors in EM-related plays to pause and reflect. Chart I-13Two Worrisome Breakdowns##br## On Chinese Plays Chart I-14Platinum's Dark##br## Omen For EM Chart I-15The Falling Participation ##br##In The EM Rally This moment of reflection seems especially warranted as EM assets do not have much cushion for unanticipated growth disappointment. The implied volatility on EM stocks is near cycle lows, so are EM sovereign CDS and corporate spreads (Chart I-16). This picture is mimicked by commodity currencies. Even after the recent bout of weakness, the aggregate risk-reversal in options points to a limited amount of concern, and therefore, a growing risk of negative surprises (Chart I-17). Chart I-16Little Cushion##br## In EM Assets Chart I-17Commodity Currency Options##br## Turn Optimistic As Well If commodity currencies have already depreciated in the face of a slightly soft dollar and perky EM asset prices, we worry that further weaknesses will emerge if the dollar strengthens again and EM assets self-off on the back of less liquidity and more EM growth disappointment. If the price of platinum relative to that of gold was a signal for EM assets, it is also a good indicator of additional stress in the commodity-currency space (Chart I-18). Chart I-18Platinum Raises Concerns ##br##For Commodity Currencies As Well We remain committed to our trade of shorting a basket of commodity currencies. AUD is the most expensive and most exposed to the Chinese tightening of the group, but that doesn't mean much. The Canadian housing market seems to be under increased scrutiny thanks to the combined assault of rising taxes on non-residents and growing worries about mortgage fraud, which is deepening the underperformance of Canadian banks relative to their U.S. counterparts. If this two-front attack continues, the housing market, the engine of the domestic economy, may also prove to weaken faster than we anticipated. Finally, the New Zealand dollar too is expensive even if domestic economic developments suggest that its fair value may be understated by most PPP metrics. Bottom Line: The outlook for the U.S. economy remains good, but this will deepen the tightening in global liquidity. When combined with the tightening of monetary conditions in China, this suggests that global industrial activity and EM growth in particular could disappoint, especially as cracks in the financial system are beginning to appear. Moreover, EM assets and commodity currencies do not yet offer enough of a valuation cushion to fade this risk. Stay short commodity currencies. Macron In = Buy The Euro? The euro has rallied a 3.6% since early April, mostly on the back of Emmanuel Macron's electoral victories. Obviously, the last big hurdle is arriving this weekend with the second round. The En Marche! candidate still leads Marine Le Pen by a 20% margin. Wednesday's bellicose debate is unlikely to overturn this significant lead. The Front National candidate's lack of substance seems to have weighed against her in flash polls. If anything, her performance might have prompted some undecided Mélanchon voters to abstain or cast a "vote blanc" this weekend instead of picking her. This was her loss, not Macron's win. Does this mean that the euro has much upside? A quick rally toward 1.12 early next week still seems reasonable. New polls are beginning to show that En March! might perform much better than anticipated in the legislative election. Also, the center-right Les Républicains should also perform very well, resulting in the most right wing, pro-market Assemblée Nationale in nearly 50 years. While these polls are much too early to have any reliability, they may influence the interpretation by traders of Sunday's presidential election. However, we would remain inclined to fade any such rally. As we highlighted last week in a Special Report, our EUR/USD intermediate-term timing model shows that the euro is becoming expensive tactically, and that much good news is now in the euro's prices (Chart I-19).3 Additionally, investors have been excited by the rebound in core CPI in the euro area, a development interpreted as giving a carte-blanche to the ECB to hike rates sooner than was anticipated a few months ago. Indeed, currently, the first hike by the ECB is estimated to materialize in 27 months, versus the more than 60 months anticipated in July 2016. We doubt that market participants will bring the first rate hike closer to the present, a necessary development to prompt the euro to rally given our view on the Fed's tightening stance. We expect the rebound in the European core CPI to prove transient. Not only does European wage dynamics remain very poor outside of Germany, our country-based core CPI diffusion index has rolled over and points to a decelerating euro area core CPI (Chart I-20). Chart I-19EUR/USD: ##br##Good News In The Price Chart I-20European Core CPI Rebound ##br##Should Prove Transient Additionally, as we argued four weeks ago, tightening Chinese monetary conditions and EM growth shocks weigh more heavily on European growth than they do on the U.S.4 As such, our EM view implies that the euro area's positive economic surprises might soon deteriorate. Therefore, the favorable growth differential between Europe and the U.S. could be at its zenith. Shorting the euro today may prove dangerous, as a violent pop next week is very possible if the last euro shorts capitulate on a positive electoral outcome. Instead, we recommend investors sell EUR/USD if this pair hits 1.12 next week. Moreover, for risk management reasons, despite our view on the AUD, we are closing our long EUR/AUD position at a 6.9% gain this week. Bottom Line: Emmanuel Macron's likely victory this weekend could prompt a last wave of euro purchases. However, we are inclined to sell the euro as economic differentials between the common currency area and the U.S. are at their apex. Moreover, European core CPI is likely to weaken in the coming quarters, removing another excuse for investors to bid up the euro. Close long EUR/AUD. A Few Words On The Yen The yen has sold-off furiously in recent weeks. The tension with North Korea and the rise in the probability of a Fed hike in June to more than 90% have been poisons for the JPY. We are reluctant to close our yen longs just yet. Our anticipation that EM stresses will become particularly acute in the coming months should help the yen across the board. That being said, going forward, we recommend investors be more aggressive on shorting NZD/JPY than USD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled “The Last Innings Of The Dollar Correction”, dated April 21, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report titled "Healthcare Or Not, Risks Remain", dated March 24, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report titled "Updating Our Intermediate Timing Models", dated April 28, 2017, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The Fed decided to keep the federal funds rate unchanged at the 0.75% - 1% range. The Committee highlighted the Q1 GDP weakness as transitory, as the labor market has tightened more since their last meeting, inflation is reaching its 2% target, and business investment is firming. Continuing and initial jobless claims both beat expectations; However, ISM Manufacturing PMI came in less than expected at 54.8; PCE continues to fluctuate around the 2% target, coming in at 1.8% from 2.1%; ISM Prices Paid came in at 68.5, beating expectations. Furthermore, the Committee expects that "near-term risks to the economic outlook appear roughly balanced", and that "economic activity will expand at a moderate pace". The market is now pricing in a 93.8% probability of a hike. We therefore expect the dollar to continue its appreciation after the French elections. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Macron's lead over Le Pen has risen after the heated debate between the two rival candidates. We believe these dynamics were a key bullish support for the euro in the run up to elections as the possibility of a Le Pen victory is being completely priced out. Adding to this optimism is a plethora of positive data from Europe. Business and consumer confidences have both pick up. German HICP came in at 2% yoy; Overall euro area headline CPI came in at 1.9%, and core at 1.2%. Nevertheless, labor market data in the peripheries, as well as the overall euro area, was disappointing. We believe this highlights substantial slack in the economy, and will keep the ECB from increasing rates any time soon. We expect the euro to climb in the short run, but the longer-run outlook remains bleak. Look to short EUR/USD at 1.12. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Economic data in Japan has been positive this past week: The unemployment rate went down to 2.8%, outperforming expectations. Retail trade annual growth came in 2.1%, also outperforming expectations. The jobs offer-to-applicants ratio came in at 1.45. This last number is significant, as this ratio has reached it 1990 peak, and it provides strong evidence that the Japanese labor market is very tight. Eventually, this tight labor market will exert pressures on wage inflation. In an environment like Japan, where nominal rates are capped, rising inflation would mean a collapse in real rates and consequently a collapse on the yen. Thus, we are maintaining our bearish view on the yen on a cyclical basis. On a tactical basis, we continue to be positive on the yen, given that a risk-off period in EM seems imminent. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 In spite of the tougher rhetoric coming from Brussels recently, the pound has maintained resilient and has even gain against the U.S. dollar. Indeed, recent data from the U.K. has been positive: Markit Services PMI came in at 55.8, outperforming expectations. Meanwhile, Markit Manufacturing PMI came in at 57.3, crushing expectations. Additionally, both consumer credit and M4 money supply growth also outperformed. Overall we continue to be positive on the pound, particularly against the euro, as we believe that expectations on Britain are too pessimistic, while the ability for the ECB to turn hawkish limited given that peripheral economies are still too weak to sustain tighter monetary conditions. Against the U.S. dollar the pound will have limited upside from now, given that it has already appreciated substantially. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5%. The Bank also stated that its "forecasts for the Australian economy are little changed." It remains of the opinion that the low interest rate environment continues to support the outlook. This will also be a crucial ingredient to generate a positive outcome in the labor market in the foreseeable future. This past month has been very negative for the antipodean currency, with copper and iron ore prices displaying a similar behavior, losing almost 10% and 25% of their values since February, respectively. With China tightening monetary policy, and dissipating government spending soon to impact the Chinese economy, we remain bearish on AUD. In brighter news, the Bank's trimmed mean CPI measure increased by 1.9% on an annual basis, beating expectations of 1.8%. This is definitely a positive, but economic slack elsewhere could limit this development. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data for New Zealand was very positive this week: The participation rate came in at 70.6%, outperforming expectations. Employment growth outperformed expectations substantially in the first quarter of 2017, coming in at 1.2%. The unemployment rate also outperformed coming in at 4.9% This recent data confirms our belief that inflationary pressures in New Zealand are stronger than what the RBNZ would lead you to believe. Indeed, non-tradable inflation, which measures domestically produced inflation is at its highest since 2014. Eventually, this will lead the RBNZ to abandon its neutral bias and embrace a more hawkish one, lifting the NZD in the process, particularly against the AUD. Against the U.S. dollar the kiwi dollar will likely have further downside, as the tightening in monetary conditions in China should weigh on commodity prices. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has once again succumbed to fleeting oil prices, depreciating to a 1-year low. U.S. crude inventories have recently been declining by less than expected and production in Libya has been increasing. Moreover, headline inflation dropped 0.5% from its January high of 2.1%. The Bank of Canada acknowledged the weak core CPI data in its last monetary policy meeting, but instead chose to focus on stronger economic data to change their stance to neutral. As the weakness in oil prices proves temporary due to another likely OPEC cut, headline inflation should pick up again. However, labor market conditions and economic activity remain questionable based on the weakness of recent data: retail sales are contracting 0.6% on a monthly basis, and the raw materials price index dropped 1.6%. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Real retail sales growth came in at 2.1%, crushing expectations. However, Aprils PMI underperformed coming in at 57.4 against expectations of 58.3. Additionally, the KOF leading indicator came in at 106, al coming below expectations. EUR/CHF now stands at its highest level since late 2017 and while data has not been beating expectations it still very upbeat. We believe that conditions are slowly being put into place for the SNB to abandon its implied floor, given that core inflation is approaching its long term average. Therefore, once the French elections are over, EUR/CHF will become an attractive short, given that the euro will once again trade on economic fundamentals rather than political risks. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The krone continues to depreciate sharply. This comes as no surprise given that oil is now down 13% in 2017. Overall we expect that oil currencies will outperform metal currencies given that oil prices will have less sensitivity to EM liquidity and economic conditions. That being said, it is hard to be too bullish on oil if China slows anew, even if one believe that the OPEC deal will stay in place . This means that USD/NOK could have additional upside. On a longer term basis, there has been a slight improvement in Norwegian data, as nominal retail sales are growing at a staggering 10% pace, while real retail sales are growing at more than 2%, which are a 5-year and a 2-year high respectively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The April Monetary Policy meeting delivered an unexpected decision, with members deciding to extend asset purchases till the end of the year, while delaying the forecast for a rate hike to mid-2018. Recent inflationary fluctuations and weak commodity prices support the Riksbank's actions. Forecasts for both inflation and the repo rate were lowered for 2018 and 2019. The Riksbank highlighted that "to support the upturn in inflation, monetary policy needs to be somewhat more expansionary", and is prepared to be more aggressive if need be. This increasingly dovish rhetoric by the Riksbank contrasts markedly with the FOMC's hawkish tilt, a dichotomy that will prove bearish for the krona relative to the greenback. Implications for EUR/SEK are a little more blurred, as the ECB will also remain dovish for the foreseeable future. However, Sweden's attentive and cautious stance on its currency's strength will cap any downside in EUR/SEK. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Ongoing monetary tightening in China poses a substantial threat to EM risk assets. Yet financial markets remain highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Business conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The pillars of the EM business cycle are China, commodities, and their own domestic credit cycle, rather than the U.S. and Europe. Continue shorting/underweighting the Malaysian currency, stocks and sovereign credit. Feature Chart I-1China: Ongoing Liquidity Tightening There is one major underappreciated risk in global financial markets: China's gradual yet unrelenting monetary tightening. Though slow and measured, this policy tightening constitutes a significant risk, particularly for emerging markets. The basis is that it could trigger a disproportionally large negative effect on Chinese growth because it is taking place amid a lingering credit bubble in China.1 Mainland interbank rates and onshore corporate bond yields have risen as the People's Bank of China (PBoC) has reduced its net liquidity injections via open market operations (Chart I-1, top panel). The PBoC's monetary tightening is bound to reduce money/credit growth in China. The bottom panel of Chart I-1 demonstrates that changes in the central bank's claims on commercial banks lead by 3 months asset growth at commercial banks. Diminished liquidity injections by the PBoC will soon push commercial banks to reduce the pace of their balance sheet expansion. Asset growth/loan origination among policy banks2 has already slowed (Chart I-2). On top of this, China's regulatory tightening aimed at curbing speculative (high-risk) financial activity will also curtail commercial banks' loan origination. For example, bank regulators are forcing banks to bring off-balance-sheet assets onto their balance sheets. As a result, money/credit growth is set to decelerate meaningfully. This, in turn, will cause another slump in this credit-addicted economy. It is very probable that the mini-business cycle in China has already reached its peak - our credit and fiscal impulse heralds further drop in the manufacturing PMI (Chart I-3). Chart I-2Commercial Banks And Policy ##br##Banks' Loan Growth To Slow Further Chart I-3China's Growth Has Rolled Over While China's monetary tightening is not a direct risk to domestic demand in the U.S. or Europe, it poses an imminent risk to commodities prices and EM risk assets. Consistent with slowing Chinese manufacturing output growth, commodities prices trading in mainland China have lately tanked. Bottom Line: BCA's Emerging Markets Strategy team maintains that ongoing monetary tightening in China poses substantial risks to EM risk assets and commodities. Yet financial markets remain complacent. Perplexing Complacency It is very perplexing that EM risk assets have so far ignored the risks stemming from China's tightening and renewed relapse in commodities prices. It seems portfolio allocation into risk assets, including those in the EM universe, is pushing prices higher irrespective of a major relapse in forward-looking indicators for both China and EM growth. EM stocks, currencies and credit spreads have decoupled from a number of indicators with which they historically had a high correlation: In recent weeks, we have brought to investors' attention that an unsustainable gap has been opening between the commodities currencies index - an equal-weighted average of AUD, NZD and CAD - and both EM exchange rates and EM share prices in local currency terms (Chart I-4A & Chart I-4B). Chart I-4AHeed The Message From Commodities Currencies Chart I-4BHeed The Message From ##br##Commodities Currencies Not only have commodities currencies decisively rolled over, but also commodities prices have begun sliding. Historically, EM risk assets in general and the sovereign credit market in particular have always sold off when commodities prices have drifted lower (Chart I-5). EM equity volatility is back to its lows (Chart I-6). This corroborates reigning complacency in the marketplace. Chart I-5Commodities Prices And ##br##EM Sovereign Spreads Chart I-6A Sign Of Complacency EM sovereign and corporate spreads have also fallen to their narrowest levels in recent years (Chart I-7). Notably, our valuation model for EM corporate bonds - which is constructed based on our EM Corporate Financial Health Index - posits that EM corporate credit is very expensive (Chart I-8). Chart I-7EM Sovereign And Corporate Spreads Chart I-8EM Corporate Credit Is Expensive Finally, EM local currency bond yield spreads over U.S. Treasurys have also dropped a lot, signifying complacency on the part of EM investors (Chart I-9). Chart I-9EM Local Bond Yield Spreads ##br##Over U.S. Treasurys Are Low Bottom Line: EM financial markets are not cheap, and investors are highly complacent. Mind the gap between EM risk assets and commodities currencies/various commodities prices. Can EM Decouple From China? An oft-asked and relevant question is whether EM ex-China can decouple from China itself. Not for the time being, in our view. On the contrary, as we argued in last week's report titled Toward A Desynchronized World,3 China's slowdown will weigh on the majority of the EM investable equity, currency and credit markets. As a result, growth conditions in EM ex-China will diverge from the U.S. and European economies and recouple to the downside with China's growth. The three pillars of EM ex-China growth are commodities, China and their domestic credit cycles. The primary link is via commodities. As China's growth decelerates and its imports relapse, commodities prices will plunge (Chart I-10). Latin America, Africa, the Middle East, Russia, Malaysia and Indonesia are set to experience negative terms-of-trade shocks as commodities prices deflate. As a result, their currencies will depreciate and growth will suffer. Although Mexico is leveraged to the U.S., oil prices still matter for it. This leaves non-commodities producing economies in Asia and central Europe. The latter is too small to matter for EM benchmarks. Central Europe correlates with Europe's business cycle rather than EM. In emerging Asia, Korea and Taiwan - the largest equity market cap weights after China in the MSCI EM index - sell much more to China than to the U.S. and Europe combined. Korea's shipments to China account for 25% of total exports while those to the U.S. and Europe combined make up 22%. For Taiwan the numbers are 27% and 20%, respectively. Thailand sells to China as much as it does to the U.S. This by and large leaves only three mainstream EM economies that are not substantially exposed to China: India, the Philippines and Turkey (Table I-1). Indian and Philippine stocks are expensive, and these nations confront their own unique problems. Turkey in turn is facing major political, economic and financial predicaments. Chart I-10Industrial Metals Prices To head Lower Table I-1Export To China And U.S. In short, among mainstream EM countries, there are very few plays not exposed to China or commodities and offer a reasonable risk/return profile. Investors also often ask if commodities importing economies in Asia can rally in absolute terms when and as commodities prices drop. Chart I-11 illustrates the Korean and Taiwanese equity indexes have historically (in the past 20 years) been strongly correlated with oil and industrial metals prices. The reason is that commodity price swings partially reflect global growth conditions. Being heavily dependent on exports, Korea and Taiwan are highly sensitive to fluctuations in global growth. We expect global trade to slow down anew, driven by weakness in China/EM imports, even if U.S. and European demand remains resilient. We elaborated on this theme in last week's report.4 Therefore, Korean and Taiwanese export shipments are set to slow as well. We are not bearish on Korean and Taiwanese domestic demand - we are in fact overweight these bourses within the EM equity universe, with a focus on technology and domestic sectors. That said, consumer and business spending in these economies is relatively small in a global context to make a difference for other EM markets. In addition, given these economies' mature phase of development, the pace of their income and domestic demand growth will be moderate. Many EM countries have experienced excessive credit growth in the past 15 years, but their banking systems have not restructured - i.e. banks have not sufficiently provisioned for non-performing loans. Until they do so, domestic loan growth remains at risk of weakening. There has been modest deleveraging in Brazil, Russia and India (Chart I-12). However, there is no evidence that these economies have embarked on a new credit cycle. Chart I-11Korean And Taiwanese Stocks ##br##Correlate With Commodities Chart I-12Some Moderate Deleveraging ##br##In Brazil, Russia And India Case in point are Indian state-owned banks: their experience shows that deleveraging can be more protracted and painful than one might initially expect. The reason is that it takes time for banks to acknowledge non-performing loans, be recapitalized and get ready to boost loan growth again. In addition, Brazil and Russia are still commodities plays at the mercy of commodities price dynamics. Besides, Brazil needs to undergo painful fiscal adjustment/reforms. In other developing countries, bank loan growth remains elevated and bank loan-to-GDP ratios continue to rise (Chart I-13). In these economies, credit retrenchment and even a mild deleveraging has not yet occurred. Prominently, as EM currencies come under downward pressure, interest rates in many economies running current account deficits will be pressured higher. This will lead to a slowdown in bank credit growth and will depress demand. Finally, if it were not for the pick-up in Chinese imports, the EM ex-China business cycle and commodities prices would not have ameliorated in the past 12 months. Notably, excluding China, Korea and Taiwan, developing nations' retail sales volumes and new vehicle sales remain dormant (Chart I-14). Similarly, there has not been much recovery in capital spending and, consistently, imports of capital goods in EM ex-China, Korea and Taiwan (Chart I-15). Chart I-13No Deleveraging In Many EMs Chart I-14EM Ex-China, Korea And Taiwan: ##br##Stabilization But No Revival Chart I-15EM Ex-China, Korea And Taiwan: ##br##Not Much Of Recovery As credit growth slows or fails to pick up in these economies, domestic demand recovery will be tepid, and will certainly disappoint market expectations. Bottom Line: Given budding divergence between U.S./Europe and Chinese growth, EM ex-China growth will fail to recover and will surprise to the downside. The basis is that the pillars of the EM's business cycle are China, commodities and their own domestic credit cycle, rather than the U.S. and Europe. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Reports from October 26, 2016, November, 23 2016, and January 18, 2017, the links are available on page 16. 2 Policy banks are China Development Bank, Agricultural Development Bank and Export-Import Bank of China. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. 4 Please refer to the Emerging Markets Strategy Weekly Report titled, "Toward A Desynchronized World", dated April 26, 2017, link available on page 16. Malaysia: Not Out Of The Woods Arenewed relapse in Chinese growth later this year coupled with lower commodities prices will once again expose Malaysia's vulnerabilities. Notably, 26% of Malaysia's exports are related to commodities - mainly crude oil, natural gas, petroleum products and palm oil. Another downleg in the ringgit's value along with lower commodities prices will cause domestic interest rates to rise. However, Malaysia is in no position to tolerate higher interest rates. Leverage has risen considerably in the past ten years in Malaysia, and is very high (Chart II-1A). Indeed, the country has one of the highest debt-servicing costs in the EM universe, according to BIS data (Chart II-1B). Chart II-1A...And Debt Servicing Costs Chart II-1BHigh Leverage... If the Malaysian central bank attempts to cap interest rates by injecting local currency liquidity into the system, the ringgit will plunge even further. Chart II-2 shows that in recent years local interbank rates have tended to rise when the central bank curtailed its net liquidity injection. If on the other hand the Bank Negara of Malaysia (BNM) does not inject liquidity into the banking/financial system, interest rates will rise as the currency depreciates. Interestingly, despite strong inflows into EM generally, the BNM has continued to inject local liquidity into the economy - albeit at a slower pace than in recent years - to keep local rates tame (Chart II-2). Additionally, despite the significant growth slowdown that has occurred in the past two years in Malaysia, banks' NPLs have not risen much (Chart II-3). As banks start acknowledging loan losses and setting provisions for them, their profitability will decline, capital will be eroded, and loan origination will fall. Chart II-2BNM Has Been Injecting Liquidity ##br##To Control Interest Rates Chart II-3Malaysian Banks Haven't ##br##Acknowledged Enough Losses Yet Meanwhile, even though global trade and commodities prices have picked in the past 15 months, Malaysia's economy has failed to recover. This reflects the country's underlying economic vulnerability as the borrowing/credit spree of the past decade has come to a halt: Commercial and passenger vehicle sales are shrinking. Retail trade and employment are also still anemic. Property sales volumes and housing construction approvals are collapsing (Chart II-4). Capital expenditures are depressed (Chart II-4, bottom panel). On the external side, the semiconductor/electronics sector has boomed in Asia since early 2016, but Malaysia has failed to benefit much. Indeed, the recovery in Malaysia's electronics sector has been weak compared to other technology hubs such as Taiwan and Korea. This confirms why Malaysia has been losing market share in electronics products to Korea, Taiwan and the Philippines (Chart II-5). Chart II-4Cyclical Growth Remains Anemic Chart II-5Malaysia Is Losing Tech Market ##br##Share To Its Asian Competitors Bottom Line: Continue shorting MYR versus the U.S. dollar and the Russian ruble. Equity investors should continue to underweight Malaysian stocks within an EM equity portfolio. Relative value traders should maintain our long Russian / short Malaysia equity trade. Buy/hold Malaysian CDS or underweight this sovereign credit market within an EM credit portfolio. Ayman Kawtharani, Associate Editor aymank@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights ECB: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. France-Germany Spreads: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Feature Investors have navigated a minefield of political headline risks over the past few weeks. From French politics to North Korean missile launches, from Donald Trump's tax cuts to Theresa May's snap U.K election, uncertainty abounds. Yet risk assets remain unscathed. That can be mostly be chalked up to the strength of the global cyclical economic upturn, which has boosted corporate profits in the developed world and lifted equity and credit market valuations. The continued accommodative monetary stance of the major central banks is also helping investors see through the political noise, although the winds there are shifting (Chart of the Week). Chart of the WeekCyclical Upturn Remains Intact In the U.S., financial conditions have eased since the Fed's "dovish hike" in March, and too few rate increases are now discounted with leading indicators pointing to a reacceleration of growth after the soft Q1 print. Across the Atlantic, the European Central Bank (ECB) is having an increasingly open debate about the ongoing need for an exceptionally dovish policy stance given the robust (by European standards) economic expansion. A lack of inflation will keep the Bank of Japan in hyper-easy mode for longer, but the data is presenting a more mixed message for other developed economy central banks like the Bank of Canada and the Bank of England. We continue to see the current level of global bond yields as priced too low given the ongoing cyclical growth and inflation pressures. A pro-growth fixed income investment stance, with below-benchmark portfolio duration and overweight allocations to corporate credit versus sovereign debt (favoring the U.S.), is still appropriate. ECB Outlook: Language Change Coming In June, Policy Change Coming In September Last week's ECB meeting offered few surprises, on the surface. The official statement sounded a cautious note, discussing downside risks to the Euro Area economy from global factors (i.e. trade policy vis-à-vis the U.S. and U.K., geopolitical uncertainty), and that there is still not enough evidence suggesting that inflation was sustainably on course to return to the ECB's 2% target. In the post-meeting press conference, however, the questions aimed at ECB President Mario Draghi turned into an almost farcical dissection of every word in the official statement. Like this exchange, taken directly from the press conference transcript:1 Question: If I got it right, there's one sentence missing in the statement, and this is the sentence, "There are no signs yet of a convincing upward trend in underlying inflation." What is the reason? No? Have I got it wrong? Draghi: No, you're right in a sense that there is one sentence less, but this one is there. On page 2 you have: "Moreover, the ongoing volatility in headline inflation underlines the need..." Constâncio: "...yet to show a convincing upward trend." Draghi: "...convincing upward trend." If you read the end of page 1, beginning of page 2... Question: So there is no change in your assessment of the underlying inflation trend? That was finally the question. Draghi: That is there. No, the one that is not equal exactly like in the last statement is the balance of risks sentence, which repeated twice that the risks remained tilted on the downside in the last statement, and you can find it only once on the second page. That's the difference. Chart 2ECB Policies Are Working... It is clear that the ECB Governing Council is now stuck in a very difficult position. The domestic Euro Area economic data continues to show a very solid pace of expansion that is soaking up spare capacity, supported by the highly accommodative ECB monetary policies of large-scale asset purchases and rock-bottom interest rates (Chart 2). Yet both wage growth and core inflation remain subdued, suggesting that there is no rush to send any signal that a shift in monetary policy settings is on the horizon - even though the market is aware that the current ECB asset purchase program is set to expire at year-end. The political calendar is playing a role here, as the ECB has not wanted to create additional market volatility by discussing any potential tapering of asset purchases or interest rate hikes during the French election campaign. But with the pro-euro candidate now well-placed to win the French Presidency this Sunday, the market's focus will shift away from ''President Le Pen" disaster scenarios towards timing the ECB's next policy move. The latest round of Euro Area inflation data, released last Friday, showed that the sharp drop in inflation in March was a statistical aberration. Headline HICP inflation (on a year-over-year basis) rose to 1.9% in April from 1.5%, while core inflation jumped to 1.2% from 0.7% - the highest level in almost four years. An acceleration in core inflation now would be consistent with the evidence seen in the Euro Area jobs data, with the unemployment rate steadily falling towards the "full employment" level of 8% (Chart 3). This also fits with the ECB's latest projections that show core inflation returning to just under 2% by 2019. Already, markets are starting to get more jittery about a potential change in the ECB's policy stance in the coming months. Realized bond volatility at the front-end of the German yield curve has risen to the highest level since 2013, although our "months-to-hike" measure is still at 25 months, suggesting that the next ECB rate hike will not occur until 2019 (Chart 4). That pricing makes sense, in our view, as the ECB is likely to taper its asset purchases before considering any interest rate increase. Chart 3...Perhaps Now Too Well? Chart 4Tightening Pressures Building Draghi and other senior members of the ECB (like Chief Economist Peter Praet) have reiterated that exact forward guidance of sequencing - tapering before rate hikes - in recent weeks, citing a desire to not cause an unwanted tightening of financial conditions too soon. That sounds to us like code language for "we do not want to hike rates and cause the euro to appreciate sharply", which is more likely to happen, with greater magnitude, after an increase in policy rates than a taper of bond purchases. We continue to expect that the ECB will move toward a less accommodative monetary stance over the next year, starting with a tapering of asset purchases followed by rate hikes. The initial signal for that will come at the June meeting where a new set of ECB staff economic projections will be prepared, followed by an announcement in September that tapering will begin in early 2018. Rate hikes will not begin until after the tapering ends, likely not until late 2018 or early 2019. This sequencing could change, however, if core inflation was to rise more rapidly than the ECB currently projects, with a rate hike happening sooner in that case. In terms of bond strategy, we recommend curve steepeners in core European government bond markets as an initial way to position for a less accommodative ECB. We anticipate moving to an underweight allocation stance to core Europe (both Germany and France) at some point before the June ECB meeting. We would like to see higher U.S. Treasury yields before making that change, as we expect Treasury-Bund spreads to narrow as the ECB tapers. With the market not pricing in enough rate hikes into the U.S. curve, in our view, we see the Treasury-Bund spread moving wider first as Treasuries reprice, before narrowing after the ECB taper is announced. Bottom Line: The ECB is still on track to move to a less accommodative policy stance over the next year. Hints of this will be given at the June policy meeting, while a 2018 asset purchase taper announcement will be made at the September meeting. Rate hikes will follow the taper, unless core inflation surges faster than expected. Position for steeper core Euro Area government curves now, and a narrowing of the U.S. Treasury-German Bund spread in the second half of this year. OAT-Bund Spreads Are Now Fairly Valued Last week, we closed our recommended long 10-year French OAT vs. 10-year German Bund Tactical Overlay trade following the first round of the French presidential election, at a profit of 1.3%.2 While we view the chances of Marine Le Pen winning this Sunday's run-off vote versus Emmanuel Macron as remote, betting on additional spread tightening from the current level of 53bps does not offer an attractive risk/reward opportunity. To judge this, we performed a scenario analysis to determine a probability-adjusted level of the OAT-Bund spread under the two tail events of a Macron or Le Pen victory. In the first scenario, we assigned a 15% probability to Le Pen winning the election, as currently indicated by online betting markets (Chart 5). In the second, we increased the probability to a more pessimistic 40%, which is Le Pen's current level of support in head-to-head opinion polls. We then came up with OAT-Bund spread projections for a victory by either candidate. If Le Pen were to pull off the upset and win the presidency, this would re-ignite fears of a potential Eurozone breakup given her anti-euro stance. Fears of a "Frexit" would likely push the OAT-Bund spread up to at least the same level (around 190bps) reached during the peak of the Euro debt crisis in late 2011 when euro breakup risk was at extreme levels. Even that spread level, however, may not adequately compensate for France's worsening fiscal backdrop, with France's debt/GDP ratio now 40% larger, relative to Germany's, than during the Euro debt crisis (Chart 6). Chart 5Macron Is The Favorite To Win Chart 6No Value In Staying Long France Vs Germany As a simple way to account for this, we increased the spread target for a Le Pen victory scenario by 1.4 times to account for the increased stock of French sovereign debt, which is all denominated in euros, that would be at risk of default if France was to pull out of the euro. This gives an upside spread target for a Le Pen victory of 266bps. In the event that the poll numbers prove correct, as they did in the first round of the election, and Macron wins as expected, this market-friendly result would prompt the OAT-Bund spread to decline further. Our estimate for a downside spread target after a Macron win is 36bps, which is the average level during 2015-2016 before the rise in uncertainty surrounding the elections. Again, this is adjusted upward in order to reflect changes in the relative debt-to-GDP ratios for France and Germany, with the former nearly 10% higher versus the latter over the past two years. Table 1Probability-Weighted OAT-Bund ##br## Spread Scenarios Using these spread targets and our base case election odds (85% chance of a Macron victory), we come up with a probability-adjusted spread of 71bps (Table 1). Using the head-to-head probabilities from the polling data (60% chance of a Macron win), the expected spread is 128bps. With the current OAT-Bund spread at 53bps, well below either projection, we conclude that the potential reward of holding onto a long OAT/short Bund position for a Macron victory does not adequately compensate for the non-zero probability that Le Pen pulls out the win this Sunday. Bottom Line: France-Germany bond spreads are now too narrow relative to the probability-weighted outcomes of this Sunday's final round of the French presidential election. Even with a Macron victory highly likely, we do not recommend long positions in French OATs versus German Bunds. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Global Fixed Income Strategy patrick@bcaresearch.com 1 https://www.ecb.europa.eu/press/pressconf/2017/html/ecb.is170427.en.html 2 Please see BCA Global Fixed Income Strategy Weekly Report "Global Bond Yields On The Move, Higher", dated April 25, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Geopolitical tensions eased last week, but there are still a few near term hurdles to clear. Domestic policy uncertainty remains. Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. A gradual Fed may be the right response to the recent run of mixed economic data. Housing and housing-related investments led the global economy into the last recession. Housing is still on the mend. The housing sector will contribute about 0.2 percentage points and 0.5 percentage points to real GDP growth in 2017 and 2018, respectively. Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. Feature U.S. equity prices neared record highs and Treasury yields bounced off of their late-March low last week as near term international and domestic political risk melted away in the minds of investors. We continue to expect U.S. equities to beat bonds this year. Oil prices continue to trade near $50/bbl, and the dollar held steady amid all the news-good and bad. Both have upside over the remainder of 2017. In today's report, we examine the following key issues for investors: Since the end of the Great Recession, geopolitical risks have ebbed and flowed, and 2017 has proven to be no different. Are political risks over, or just over for now? How does the recent run of mixed U.S. data influence the Fed, and what does this mean for risky asset prices? Housing and housing-related investments led the global economy into the last recession. Where do we stand now? Are Geopolitical Concerns Over? North Korea failed to test another nuke after a nerve rattling Easter Weekend. The leadup to the presidential election in South Korea on May 9 may have motivated a part (or most) of the uptick in belligerence that we are seeing from North Korea. All leading candidates are more likely to try diplomacy and economic engagement with North Korea than to maintain the past ten years of conservative efforts to strengthen military deterrence via stronger alliances with the U.S. and Japan. In the euro area, the good news is that the polls in the first round of the French election (April 23) were correct. The bad news is that there is still another election. Macron and Le Pen face off on this Sunday (May 7), and markets are betting that the polls will be correct again given Macron's 20 point lead over Le Pen. The June parliamentary elections in France should be a non-event for U.S. financial markets; we still see Italy - where most voters favor Eurosceptic parties - as the biggest risk on the geopolitical scene in the next year or so. In the U.K., the ruling Tories look to add to their majority in June's parliamentary election, which will provide British Prime Minister Theresa May with a stronger hand to negotiate with Europe and increases the odds of a less extreme Brexit outcome (Chart 1). Chart ICGeopolitical Risk Is Ebbing...For Now Chart 1BGeopolitical Risk Is Ebbing...For Now Chart 1AGeopolitical Risk Is Ebbing...For Now There was good news and bad news on the domestic policy front last week as well. The release of the long awaited Trump tax plan and the passage of a spending bill by Congress to avert a government shutdown (at least until later this week) helped to remove some domestic political uncertainty. The bad news is that the plan was more tax cut than tax reform. The one page plan lacked detail and still has to pass muster with the House GOP. The Trump Administration may have started a trade war with Canada (over lumber) and sent trial balloons about pulling out of NAFTA (despite walking back from this position soon after). Is this "negotiator" Trump or something worse? The bad news is that tax reform, trade wars, dynamic scoring, and yes, even Obamacare will be with us until late Summer/early Fall. The good news is that the border adjustment tax may not be. The takeaway for investors is that while geopolitical concerns have not disappeared, they have ebbed, and this will support the relative performance of U.S. equities over 10-year government bonds over the coming year. Italy (not North Korea, France, or Germany) remains the biggest geopolitical risk on the horizon, but the next election there isn't until early-2018. Domestically, Trump's pro-growth agenda is advancing at a pace that is slower than many investors would prefer, but it is advancing, which we believe will continue to support a pro-cyclical asset allocation stance. Bottom Line: Geopolitical concerns have not disappeared, but they have ebbed materially to the benefit of risky asset prices. Investors should stay overweight U.S. stocks vs 10-year government bonds within a multi-asset portfolio. Mixed Data Warrants A Gradual Fed Investors still can't seem to reconcile the disconnect between weak "hard" data and solid "soft" data. The recent uptick in initial claims and the soft Q1 GDP data are the most recent examples. Investors should recall that claims are inherently noisy; a rise in claims of more than 75,000 over a 6-month period is typically needed to signal a recession. Chart 2 makes it clear that the latest wiggles on claims are not sending a recessionary signal. Chart 2Claims Are Not Even Close To Sending A Recession Signal Friday's GDP report highlighted that growth in Q1 was soft again. As we noted in last week's report, GDP growth in Q1 averaged -0.1% over the last 10 years. Q2 growth has averaged more than 2%. Q1 growth has been below Q2 in 8 of the last 10 years. 2017 is shaping up to be a repeat performance. Defense spending - identified by the Cleveland Fed as a key culprit in the unwanted seasonal weakness in Q1 GDP - fell 4% in Q1, subtracting 0.2% from growth. Inventories were also singled out by the Cleveland Fed, and they shaved 0.9% off of GDP in Q1. We expect to see a snapback in all three components of growth (GDP, defense spending and inventories) in Q2. Business capital spending, and housing were bright spots in Q1 (Chart 3). Corporate earnings are the ultimate piece of hard data. Equity prices track earnings growth over the long term. With 288 members of the S&P 500 reporting, 77% have beaten expectations on the bottom line. Healthcare, financials and technology lead the way. Weakness was evident in defensives. More impressive is the 7.1% gain in revenues in Q1 so far (Table 1). But overall, corporations appear to have pricing power. The ECI accelerated in Q1 to +2.4% year-over-year from +2.2%, but remain relatively subdued. This implies that margins will hold up, which will continue to support our view that stocks will beat bonds this year. With no Fed Chair Yellen press conference, a new set of dot plots or a new economic forecast, markets will have to be content with just the FOMC statement this week. A speech by Fed Vice Chair Fischer will be closely watched for signals about the June FOMC meeting. The market has been too quick to price out rate hikes in 2017. Expectations for rate hikes in 2018 have all but disappeared (Chart 4). We expect this gap will close - in favor of the Fed for both 2017 and 2018. We expect Treasury yields and inflation to head higher this year, despite recent soft readings on March CPI. The March PCE deflator - also due this week-is key. Chart 3Markets Shouldn't Be Surprised By Weak##br## Q1 GDP, Or What Caused It Table 1S&P 500: ##br##Q1 2017 Results* Chart 4Still Plenty Of Disagreement Between Fed ##br##And Market; Both Expect Gradual Hikes Though Bottom Line: We continue to expect the hard data to catch up to the soft data in the coming months. Financial markets have overreacted to the weak data and have been too quick to price out Fed rate hikes this year and next. The Fed is taking a gradual approach to rate hikes for a reason; the data-hard or soft-doesn't warrant an aggressive Fed. But a gradual Fed and solid profit growth strongly favor an allocation towards stocks over bonds this year. Housing: Set To Keep A "Slow-Burn" Expansion Burning Housing is one sector of the economy that stands to look relatively good over the coming few years, with some important implications for housing-related asset performance. The monthly Bank Credit Analyst recently published some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment in the labor market, similar to what has occurred since the Great Recession. Chart 5 compares the current cycle (dotted lines) with the average of the 1980s and 1990s long expansions (solid lines). The cycles are all lined up with the beginning of the expansion, indicated by the first vertical line. These long "slow burn" recoveries also extended well beyond the point at which the economy first reached full employment (called late-cycle phases, shaded in Chart 5). Inflation pressures were slower to emerge in these types of recoveries, allowing the Fed to proceed cautiously when normalizing interest rates. Interestingly, earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. We are not making the case that returns will be anywhere near this level in the coming years. The starting point for valuation, for example, is much more extended than it was in previous long cycles. There are also plenty of possible sources of shocks that could end the expansion abruptly. Nonetheless, it is not going to die simply of old age. In the absence of any major shocks, this expansion may continue for a while yet. One reason is that there are no major areas of overspending that would make the economy highly vulnerable. This includes the housing sector, where investment has lagged previous slow-burn recoveries by a wide margin. A lagging housing market is not surprising given the bloated inventory of vacant homes that had to be absorbed in this cycle. The good news is that overhang appears to now be gone. The stock of unsold new and existing homes has returned to low levels by historical standards (inventories of new homes are in fact now rising, after plunging between 2006 and 2012; Chart 6). Chart 5The Current Cycle Is ##br##A "Slow Burn" Expansion Chart 6The Overhang From Housing##br## Inventories Is Gone Other positive factors include the following: Lending standards haven't eased much, but FICO scores have increased sharply, meaning that more renters now qualify for loans and thus might move from rental unit to a single family home (which generates more GDP per unit). This factor was highlighted in a recent Special Report on housing.1 Affordability is favorable, and the cost of owning is cheap relative to the cost of renting. The home-ownership rate has returned to its long-term average (Chart 6, bottom panel). If the pre-Lehman bubble in the homeownership rate has been unwound, it removes a headwind for construction activity because renting favors multi-family construction that produces less GDP per unit than single family homes. The supply of foreclosed homes onto the market has withered along with the foreclosure rate. This might not affect construction activity because it represents families simply swapping homes for other ones, but it supports home prices. Importantly, household formation is still recovering from a period in which young adults stayed with their parents for longer than normal for economic reasons. The tightening in the labor market and cyclical rebound in real disposable income growth is allowing millennials to finally move out, boosting the demand for new housing stock (Chart 7). Chart 8 presents a simple way of estimating the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the remaining gap implies an extra 540,000 housing units. Chart 7Income Growth Is Helping Young Americans To Leave The Nest Chart 8A Catch-Up Housing Construction Will Occur If This Gap Closes The equilibrium number of housing starts that cover underlying population growth plus the units lost to scrappage is estimated to be about 1.4 million annually. If the household formation 'catch up' occurs over the next two years, adding another 250,000 units per year, total demand could be 1.6 to 1.7 million in each of the next two years. This compares to the just-released March housing starts level of 1.2 million. If starts rise smoothly from today's level to 1.7 million at the end of 2018, then the housing sector will contribute about 0.2 percentage points and 0.5 percentage point to real GDP growth in 2017 and 2018, respectively (Chart 9). Chart 9A Housing Catch-Up Will Boost GDP Growth For the economy, the implication is that this already-aged expansion phase could persist for a couple of more years as long as it is not hit by a negative shock and inflationary pressures remain quiescent, allowing the Fed to proceed slowly. Bottom Line: Housing starts remain well below the equilibrium level implied by underlying household formation, and a "catch up" phase could help keep the current "slow burn" expansion burning over the coming years. Favor Housing-Related Assets The above analysis also has some favorable implications for housing-related financial assets. We originally examined the implications of a rebound in home construction in 2012, during the early phase of the recovery in housing starts.2 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables, and concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario over the following year (and beyond). We have updated our original analysis in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Second, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of homes following the crisis period on housing-related asset returns. Table 2 presents the list of housing-related assets that we examined,3 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables do contain useful information, with the exception of the two noted above. The rightmost column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset, which varies from a low of 13% to a high of 20%. Table 2Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2016) Charts 10 and 11 present a set of relatively conservative assumptions for the key housing market variables shown in Table 2, based on a rise in housing starts modestly above the scrappage rate that we noted in the previous section. We assume that house price appreciation and housing affordability moderate due to further rate hikes from the Fed, that the already-elevated homebuilders' confidence index stays flat, that refi applications remain low due to the uptrend in mortgage rates, and that purchase applications rise in lockstep with housing starts. Chart 10A Set Of Conservative Assumptions... Chart 11...For Key Housing Market Variables Finally, Table 3 illustrates the predicted excess returns over the coming 12-months of the housing-related assets that we examined, along with the annualized excess returns in 2016 and over the entire sample period for the purposes of comparison. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 3Excess Returns Of Housing-Related Assets* (%) The analysis presented above highlights several important conclusions for investors: The predictive power of key housing market variables has been smaller over the course of this economic expansion than in the past economic cycle (including the recession of 2008-2009), suggesting that housing market developments were more important during the downturn than they have been during the recovery. Still, housing market data is an important driver of excess returns for housing-related assets. All of the housing-related assets that we examined are expected to outperform their respective benchmarks over the coming year, even given the relatively conservative assumptions that we have made about the pace of gains in the housing market. For the three corporate bond assets shown in Tables 2 and 3, our model predicts outperformance even relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. With the exception of S&P 500 homebuilders and banks, the model's predicted excess returns are lower over the coming year than they have been on an annualized basis since the onset of the recovery, highlighting that housing-related assets have front-run at least some of the expected normalization in the housing market over the coming few years. However, a full rise to our equilibrium estimate of 1.7 million starts over the coming two years could potentially lead to even larger outperformance than the model would predict. Charts 12 and 13 do not suggest that valuation will be an impediment to the outperformance of housing-related assets. Chart 12Valuation Won't Be An Impediment... Chart 13...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance over the coming 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform even given conservative assumptions about the former. 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 Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com 2 Please see U.S. Investment Strategy Weekly Report U-3 Or U-6?", dated February 13, 2012, available at usis.bcaresearch.com 3 Note that we have excluded fixed and floating rate home equity loan ABS from our list of housing-related assets owing to a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market

Highlights Lean against depressed and euphoric interest rate expectations. The ECB will remove or fade the negative deposit rate, with an outside chance that it happens this year. The U.K. economy will determine the nature of Brexit - not the other way round. The snap General Election doesn't change anything. Expect an ongoing narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. Expect the following order of currency performance: euro first, pound second, dollar third. Expect the FTSE100 to outperform the Eurostoxx50. Feature The interplay between interest rate expectations - in the U.K., U.S. and euro area - is one of the most important factors in explaining what has happened, what is happening, and what will happen, to financial markets. Chart of the WeekBrexit Depression Has Unwound; ##br##Trump Euphoria Hasn't... Yet Interest rate expectations convincingly explain the movements in the U.S. T-bond/German bund yield spread, the U.S. T-bond/U.K. gilt yield spread, euro/dollar, and pound/dollar. Thereby, they also explain FTSE100/Eurostoxx50 relative performance which is just an (inverse) currency play. Chart I-2, Chart I-3, Chart I-4, Chart I-5 and Chart I-6 should leave readers in absolutely no doubt. Chart I-2Interest Rate Expectations Explain The ##br##T-Bond/German Bund Yield Spread Chart I-3Interest Rate Expectations Explain The##br## T-Bond/U.K. Gilt Yield Spread Chart I-4Interest Rate Expectations ##br##Explain Euro/Dollar Chart I-5Interest Rate Expectations##br## Explain Pound/Dollar Chart I-6Pound/Euro (Inversely) Explains ##br##FTSE100/Eurostoxx50 Lean Against Depressed And Euphoric Interest Rate Expectations Last year's shock victories for Brexit and Trump dramatically swung the market mood towards the U.K. and U.S. economies. After Brexit, the knee-jerk response was depression; after Trump, the knee-jerk response was euphoria. But extreme mood swings to depression and euphoria are rarely justified, and ultimately tend to unwind. Responding to last year's dramatic mood swings, U.K. and U.S. interest rate policy - both actual and expected - moved very sharply in opposite directions. Following the Brexit vote, the BoE cut the base rate by a quarter percent, and the rate expected two years out plunged by three quarters of a percent. In contrast, following the Trump victory, the Federal Reserve twice hiked the Fed funds rate by a quarter percent, and the rate expected two years out surged by more than a percent. Meanwhile, throughout all this activity, the ECB repo rate and deposit rate were anchored at zero and -0.4% respectively, and the interest rate expected two years out remained in negative territory. Fast forward to today, and the U.K. interest rate expected two years out has fully unwound the Brexit vote depression - the expected BoE policy rate two years out stands exactly where it stood before the EU Referendum. In contrast, the expected Fed policy rate two years out retains its Trump euphoria (Chart of the Week). Meanwhile, the expected ECB policy rate two years out remains anchored close to the realistic limit of negativity. To reiterate, the extreme market moods of depression and euphoria are rarely justified, and tend to unwind. On this basis, we can say that policy rate expectations in relative terms now have the scope to: Get less depressed in the euro area. Remain broadly unchanged in the U.K. Get less euphoric in the U.S.1 Hence, on a 12-month horizon, expect a continued narrowing in the U.S. T-bond/German bund yield spread and U.S. T-bond/U.K. gilt yield spread. For currencies, expect the following order of performance: euro first, pound second, dollar third. And therefore, expect the FTSE100 to outperform the Eurostoxx50. Brexit: A Reductionist View Many millions of words have been written about Brexit, and we suspect that many millions more will be written. But true to our reductionist philosophy, we can reduce those millions of words to a single sentence. Brexit was, is, and always will be, about the trade-off between national sovereignty and access to the European single market. Irrespective of the vote to leave the EU and the start of the divorce proceedings, the full spectrum of possibilities in this trade-off is still open to the U.K. At one extreme the U.K. could get a full divorce, and thereby regain absolute national sovereignty in all areas including law and immigration. But in this full divorce, the EU27 would regard the U.K. as a complete outsider whose status is little different to say, Russia. At the other extreme, the U.K. could near enough replicate its current economic and political relationship with the EU27 in a 'pseudo-marriage'. Technically, the U.K. would be divorced, but practically, there would be only minor differences to being married. Although the U.K. would lose its official place at the EU top table, in all likelihood the EU27 would still listen to the British voice given the U.K.'s size and global standing. But in this pseudo-marriage the EU27 would exact a cost: the U.K. could not regain any national sovereignty. All points on the spectrum between a full divorce and a pseudo-marriage are now available to the U.K. The relationship that the U.K. ends up with depends on the trade-off that the British public - and therefore its political representatives in the government and parliament - will accept. In turn, this will depend on the evolution of the economy and standards of living. A strong economy will embolden the British public to want something close to a full divorce. Conversely, a weakening economy might be blamed, rightly or wrongly, on Brexit. In which case, public opinion would shift towards something closer to a pseudo-marriage. Therefore, the causality runs from the economy to Brexit, not from Brexit to the economy. The U.K. economy will determine where the U.K. ends up on the Brexit spectrum - at least, in terms of the initial deal. The snap General Election doesn't change anything. Nor is the General Election a game changer for the pound. The preceding section demonstrated that relative interest rate expectations - rather than Brexit per se - are driving the pound. We expect the BoE to remain relatively inactive because empirically, U.K. real consumption is hyper-sensitive (inversely) to inflation. When inflation is too high, real consumption growth is undermined, making it difficult to hike rates; and when inflation is too low, real consumption tends to grow strongly, making it difficult to cut rates (Chart I-7). This ties the hands of the BoE, and explains why the post EU Referendum emergency rate cut has been the BoE's only interest rate change since early 2009! Chart I-7Why The Bank Of England's Hands Are Tied While rate expectations can get less depressed in the euro area, and less euphoric in the U.S., they are likely to change least in the U.K. Hence, we like the pound less than the euro; but we like the pound more than the dollar. Role Playing On The ECB Governing Council We are writing ahead of the ECB policy meeting, but we do not anticipate any substantive announcements - given that we are only half way through the French Presidential Election. In the absence of major developments, the euro's strong recent advance might take a tactical breather. But what then? Some people argue that ECB policy should be based not on the aggregate euro area economy, but instead on the weaker links in the euro area economy. These arguments have some merit, as the ECB - unlike other central banks - has to contend with a permanent existential threat. On this basis, let's finish this week with a role playing exercise. Imagine you're on the ECB Governing Council, and the weak link that worries you is euro area bank fragility, particularly in some of the southern member states. Your own (ECB) analysis, illustrated in Chart I-8, shows that extreme accommodative monetary policy has had a negligible net impact on bank profitability. The QE component has probably been a mild net positive - admittedly, a flatter yield has dragged down banks' net interest margins; but it has also generated profits in banks' bond portfolios; and in so far as QE has boosted economic growth, it has reduced bank charge-offs. Chart I-8What Is The Point Of The ECB's Negative Deposit Rate? But the negative deposit rate - charging banks for excess liquidity - has been a clear drag on bank profitability. And there is little evidence that it has encouraged lending. What would you do? Even if the ECB is setting policy for the euro area weak links, the central bank's own analysis suggests that it should remove, or at least fade, the negative deposit rate. Our central expectation is for this to happen early next year, with an outside chance that it is even sooner. With expectations for ECB policy rates still anchored close to the realistic limit of negativity, the euro exchange rate has cyclical upside. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Assuming that the U.S. government does not approve inappropriate fiscal stimulus. Fractal Trading Model* This week's trade is to go long the FTSE100 versus the IBEX35 with a profit target and stop loss of 4%. 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-9 * 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 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. 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 Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. There are also some worrying signs in our global forward-looking growth indicators for 2018, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. first-quarter economic data. They also went too far in pricing out U.S. fiscal action. It is positive for risk assets that centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. Italian elections could be troublesome, but that is a story for next year. The fact that China finally appears willing to apply pressure to Pyongyang is good news. North Korea might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. Disappointing U.S. Q1 real GDP growth largely reflects weather and seasonal adjustment factors. The deceleration in bank credit growth is also temporary. The window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals remain constructive. Importantly, signs of improving pricing power in the U.S. corporate sector are finally emerging, which should allow margins to expand somewhat in the coming quarters. The bond rally has depressed yields to a level that makes fixed-income instruments highly vulnerable to a reversal of the factors that sparked the rally. Market expectations for the fed funds rate are far too benign. The ECB will announce the next tapering step later this year, and may remove the negative deposit rate. But the central bank will not be in a position to lift the refi rate for some time. Yield spreads will shift in a way that allows one last upleg in the U.S. dollar. The recent pullback in oil prices will not last, as OPEC and Russia manage global stockpiles lower this year. Feature Chart I-1Reflation Trades Returning? Traders and investors gave up on the global reflation story in early April, sending the 10-year U.S. Treasury yield below the year's trading range. Missile strikes, European elections and U.S. saber rattling regarding North Korea lifted the allure of safe havens such as government bonds (Chart I-1). At the same time, the Fed was unwilling to revise up the 'dot plot', doubts grew over the ability of the Trump Administration to deliver any stimulus and U.S. data releases disappointed. The major equity indexes held up well against the onslaught of bad news, but looked increasingly vulnerable as April wore on. The market gloom was overdone in our view, and it appears that financial markets have now returned to a 'risk on' phase. It is difficult to forecast the ebb and flow of geopolitical news so we cannot rule out another bout of risk aversion. Nonetheless, the global economic backdrop remains upbeat and tensions regarding North Korea have eased. President Trump also unveiled his Administration's tax reform plan, raising hopes of a fiscal boost to the economy. Moreover, investors have read too much into the distorted U.S. first quarter data, and our corporate pricing power indicators support our constructive earnings view in 2017. There are clouds hanging over the outlook for 2018, but the backdrop will favor risk assets for most of this year. Investors should remain overweight equities versus bonds and cash, and bullish the dollar. Geopolitics Weigh On Risk Tolerance President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. The fact that China finally appears willing to apply pressure to Pyongyang is good news. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. The safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances. Chart I-2Macron Appears Set For Victory Turning to Europe, investors breathed a sigh of relief following the first round of the French Presidential election. The pre-election polls turned out to be correct, and our Geopolitical Team has no reason to doubt the polls regarding the second round (Chart I-2). We expect Macron to sweep to victory on May 7 because Le Pen will struggle to get any voters from the candidates exiting the race. What should investors expect of a Macron presidency? A combination of President Macron and a right-leaning National Assembly should be able to accomplish some reforms. Several prominent center-right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister. This is positive for the markets as it means that French economic policy will be run by the center-right, with an ultra-Europhile as president. Over in the U.K., the big news in April was Prime Minister Theresa May's decision to hold a snap election, which reduces the risk of a "hard Brexit". The current slim 12-seat majority that the Conservatives hold in Parliament has made May highly dependent on a small band of hardline Tories who would rather see negotiations break down than acquiesce to any of the EU's demands, including that the U.K. pay the remaining £60 billion portion of its contribution to the EU's 2014-20 budget. If the Conservatives are able to increase their seats in Parliament - as current opinion polls suggest is likely - May will have greater flexibility in reaching an agreement with Brussels and will face less of a risk that Parliament shoots down the final deal. U.S. Fiscal Policy: Positive For 2017, But Long-Term Negative Chart I-3Long-Term U.S. Budget Pressures The drama will be no less interesting in Washington in the coming weeks. As we go to press, Congress is struggling to pass a bill to keep the U.S. government running through the end of fiscal year 2017 (the deadline is the end of April). We expect a deal will get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. Both events could see temporary safe-haven flows into Treasurys. However, markets may have gone too far in pricing-out tax cuts or fiscal stimulus. For example, high tax-rate companies have given back all of their post-election equity gains. Even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. "Dynamic scoring" will be used to support the argument that the tax cuts will self-funding through faster growth. We also expect that Trump will get his way on at least a modest amount of infrastructure spending. The so-called Trump trades may wither again in 2018, but we see a window this year in which the stock-to-bond total return ratio lifts as growth expectations rebound. Looking further ahead, it seems likely that the U.S. budget deficit is headed significantly higher. Health care and pension cost pressures related to population aging are well known (Chart I-3). A recent Special Report by BCA's Martin Barnes highlighted that "it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlement programs and preventing a massive rise in the budget deficit."1 There is simply not enough non-defense discretionary spending to cut. Larger U.S. Federal budget deficits could lead to a widening fiscal risk premium in Treasury yields, although that may take years to show up. Perhaps more importantly, the U.S. government sector will be a larger drain on the global pool of available savings in the coming years. We highlight in this month's Special Report, beginning on page 20, that there are several key macro inflection points under way that will temper the "global savings glut" and begin to place upward pressure on global bond yields. A Temporary Soft Patch Or Something Worse? The first quarter GDP report for the U.S. is due out as we go to press, and growth is widely expected to be quite weak. The retail sales and PCE consumer spending data have fed concerns that the U.S. economy is running out of gas, despite the surge in the survey data such as the ISM. We believe that growth fears are overdone. Financial markets should be accustomed to weak readings on first quarter GDP. Over the past 22 years, the first quarter has been the weakest of the four on 12 occasions, or 55% of the time. Second quarter GDP growth has been faster than Q1 growth 70% of the time. A large part of the depressed Q1 GDP growth rate and lackluster "hard data" readings likely reflect poor seasonal adjustment and weather distortions. The "soft" survey data are more consistent with the labor market. Aggregate hours worked managed to increase by 1.5% at an annualized rate in Q1. If GDP growth really was barely above zero, this would imply an outright decline in the level of labor productivity. Even in a world where structural productivity growth is lower than it was in the past, this strikes us as rather implausible. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have pulled back from their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in the weather-impacted "hard" data in May and June. What about the slowdown in commercial and industrial loan growth and corporate bond issuance late in 2016 and into early 2017? This is a worry, but it partly reflects the lagged effects of the contraction in capital spending in the energy patch. C&I loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that the defaults have waned, this process will soon go into reverse. Higher profits more recently have permitted these firms to pay back old bank loans, while also enabling them to finance new capital expenditures using internally-generated funds. In addition, the rising appetite for corporate debt has allowed more companies to access the bond market. According to Bloomberg, the U.S. leveraged-loan market saw $434 bn in issuance in Q1, the highest level on record (Chart I-4). The rest we chalk up to uncertainty surrounding the U.S. election. The recent spikes in the political uncertainty index correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November. There has been a close correlation between these spikes and the deceleration in C&I loan growth. CEOs are also holding back on capex in anticipation of new tax breaks from Congress. The good news is that bond issuance has rebounded strongly in January and February of this year (Chart I-5). The soft March U.S. CPI release also appeared to be quirky, showing a rare decline in the core price level in March (Chart I-6). However, the March reading followed two months of extremely strong gains and it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Chart I-4U.S. Bank Credit Slowdown Is Temporary Chart I-5U.S. Corporate Bond Issuance Is Rebounding Chart I-6U.S. Inflation: Sogginess Won't Last Global Economic Data Still Upbeat For the major industrialized economies as a group, the so-called "hard" data are moving in line with the "soft" survey data for the most part. For example, retail sales growth continues to accelerate, reaching 4½% in February on a year-over-year basis (Chart I-7). This follows the sharp improvement in consumer confidence. Manufacturing production growth is also accelerating to the upside, in line with the PMIs. The global manufacturing sector is rebounding smartly after last year's recession that was driven by the collapse in oil prices and a global inventory correction. Readers may be excused for jumping to the conclusion that the rebound is largely in the energy space, but this is not true. Production growth in the energy sector is close to zero on a year-over-year basis, and is negative on a 3-month rate of change basis (Chart I-8). The growth pickup has been in the other major sectors, including consumer-related goods, capital goods and technology. In the U.S., non-energy production has boomed over the six months to March (Chart I-9). Chart I-7Global Pick-Up On Track Chart I-8Manufacturing Rebound Is Not About Energy Chart I-9U.S.: Non-Energy Production Surging The weak spot on the global data front has been capital goods orders (Chart I-7). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near zero or slightly negative for all three. These data are perplexing because they are at odds with an acceleration in the production of capital goods (noted above) and a pickup in capital goods imports for 20 economies (Chart I-7, third panel). Improving CEO sentiment, accelerating profit growth and activity surveys all suggest that capital goods orders will catch up in the coming months. That said, one risk to our positive capex outlook in the U.S. is that the Republicans fail to deliver on their promises. This is not our base case, but current capex plans could be cancelled or put on indefinite hold were there to be no corporate tax cuts or immediate expensing of capital spending. As for China, the economic data are holding up well and deflationary pressures have eased. Fears of a debt crisis have also ebbed somewhat. That said, fiscal and monetary stimulus is fading and it is a worrying sign that money and credit growth have decelerated because they tend to lead production. Our China experts believe that growth will be solid in the first half of the year, but they would not be surprised to see a deceleration in real GDP growth in the second half that would weigh on commodity prices. Bond Market Vulnerable To Fed Re-Rating A rebound in the U.S. activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A May rate hike is unlikely, but we would not rule out June. The bond market is vulnerable to a re-rating of the path for the fed funds rate because only 45 basis points of tightening is priced for the next 12 months. This is far too low if growth rebounds as we expect. The FOMC also announced that it intends to start shrinking its balance sheet later this year by ceasing to reinvest both its MBS and Treasury holdings. Our bond strategists do not think this by itself will have much of an impact on Treasurys because yields will continue to be closely tied to realized inflation and the expected number of rate hikes during the next 12 months (Chart I-10). Fed policymakers are trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. It is a different story for mortgage-backed securities, however, where spreads will be pressured wider by the lack of Fed purchases. All four of our main forward-looking global economic indicators appear to have topped out, except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past (Chart I-11). Nonetheless, all four are still consistent with robust growth. They would have to weaken significantly before they warned of a sustained bond bull market. Chart I-10Shrinking Fed Balance Sheet: ##br##Bearish For Bonds? Chart I-11Leading Indicators: ##br##Some Worrying Signs The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is the most concerning at the moment. The LEIs for two major economies and two emerging economies dipped slightly in February, such that roughly half of the country LEIs rose and half fell in the month. While it is too early to hit the panic button, the diffusion index is worth watching closely; a decline below 50 for several months would indicate that a peak in the GLEI is approaching. The bottom line is that global bond yields have overshot on the downside: underlying U.S. growth is not as weak as the Q1 figures suggest; market expectations for the fed funds rate are too benign; the Republicans will push ahead with tax cuts and infrastructure spending; the global economy has healthy momentum, and the majority of the items on our Duration Checklist suggest that the bond bear market will resume; the ECB will announce another tapering of its asset purchase program this autumn, placing upward pressure on the term premium in bond yields across the major markets; and the Treasury and bund markets no longer appear as oversold as they did after the rapid run-up in yields following last November's U.S. elections. Large short positions have largely unwound. For the U.S., we expect that the 10-year yield to rise to the upper end of the recent 2.3%-2.6% trading range in the next couple of months, before eventually breaking out on the way to the 2.8%-3% area by year-end. We recommend keeping duration short of benchmarks within fixed-income portfolios. One Last Leg In The Dollar Bull Market Chart I-12ECB In No Hurry To Lift Rates While we see upside for the money market curve in the U.S., the same cannot be said in the Eurozone. The economic data have undoubtedly been robust. The composite PMI is booming and capital goods orders are in a clear uptrend. Led by gains in both manufacturing and services, the composite PMI rose from 56.4 in March to 56.7 in April, a six-year high. The current PMI reading is easily consistent with over 2.0% real GDP growth (Chart I-12). This compares favorably to the sub-1% estimates of trend growth in the euro area. Private sector credit growth reached 2½% earlier this year, the fastest pace since July 2009. Despite this good news, the ECB is in no rush to lift interest rates. The central bank will taper its asset purchase program further in 2018, but ECB President Draghi has made it clear that he will not raise the refi rate until well after all asset purchases have been completed, which probably will not be until late 2019 at the earliest (although the ECB could eliminate the negative deposit rate to ease the pressure on banks). Unemployment is still a problem in Spain and Italy, while core CPI inflation fell back to just 0.7% in March. The euro could strengthen further in the near term if Macron wins the second round of the French elections, easing euro break-up fears. Nonetheless, we expect the euro to trend lower on a medium-term horizon versus the dollar as rate expectations move further in favor of the greenback. Some real rate divergence is already priced into money and currency markets, but there is room for forward real spreads to widen further, possibly pushing the euro to parity versus the dollar before this cycle is over. We are also bullish the dollar versus the yen for similar reasons. On a broad trade-weighted basis, we still expect the dollar to rally by another 10%. Positive Signs For U.S. Corporate Pricing Power Chart I-13U.S. Corporations Gaining Pricing Power Turning to the equity market, it is still early days for Q1 U.S. earnings, but the results so far are positive for a pro-risk asset allocation. After a disappointing Q4, positive Q1 earnings surprises for the S&P 500 are on track to match their highest level in two years, with revenue surprises also materially higher than previous quarters. At the industry level, banks and capital goods companies stand out: the former registered an earnings beat of nearly 8%, and it was nearly 12% for the latter. We highlighted the positive 2017 outlook for U.S. corporate profits in our March 2017 Monthly Report. Earnings growth is in a catch-up phase following last year's profit recession, which was related to energy prices and a temporary slowdown in nominal GDP growth relative to aggregate labor costs. Proprietary indicators from our sister publication, the U.S. Equity Sectors Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart I-13). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly-based across industries (as shown by the diffusion index in the chart). As a side note, the Profit Proxy provides some evidence that recent softness in core CPI inflation will not last. Second, the upward march of wage growth appears to be taking a breather (Chart I-13). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching perpetually-optimistic bottom-up estimates for 2017 (Chart I-14). Many companies have supported per share profits in this expansion via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart I-15 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same is true for GDP. Chart I-14U.S. Profit Model Is Very Upbeat Chart I-15U.S. Corporate Finance Cycle Comparison Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity issuance since 2009, which includes the impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions (positive values shown in Chart I-15 represent net equity withdrawals). CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Nonetheless, buybacks have boosted EPS growth by almost 2% over the past year according to our proxy (Chart I-16). We expect this tailwind to continue given the positive reading from our Capital Structure Preference Indicator (third panel). Firms have a financial incentive to issue debt and buy back shares when the indicator is above zero. Stronger global growth should continue to power an acceleration in corporate earnings outside the U.S. over the remainder of the year. Chart I-17 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Our profit indicators remain constructive for the U.S., Eurozone and Japan. Chart I-16Incentive To Buy Back ##br##Stock Remains Strong Chart I-17Global Profit ##br##Growth On The Upswing It is disconcerting that the rally in oil prices has faltered in recent days as investors worry that increased U.S. shale production will thwart OPEC's plans to trim bloated inventories. A breakdown in oil prices could spark a major correction in the broader equity market. Indeed, commercial oil inventories finished the first quarter with a minimal draw. The aim of last year's agreement between OPEC and Russia to remove some 1.8mn b/d of oil production from the market in 2017 H1 was to get visible inventories down to five-year average levels. They are well short of that goal. Without trimming stockpiles to more normal levels, storage capacity remains too close to topping out, which raises the risk of another price collapse. This is an extremely high-risk scenario for states like Saudi Arabia, Russia and their allies, which are heavily dependent on oil-export revenues to fund government budgets and much of the private sector. This is the reason why our commodity strategists expect the OPEC/Russia production cuts to be extended when OPEC meets on May 25. This will significantly raise the odds that OECD commercial oil stocks will be drawn down to more normal levels. We expect WTI and Brent to trade on either side of $60/bbl by December, and to average $55/bbl to 2020. Investment Conclusions Financial markets have returned to 'risk on' in late April, after becoming overly gloomy on the growth, political and policy outlooks in recent months. Admittedly, some of the U.S. data have been disappointing given the extremely upbeat survey numbers. There are also some worrying signs in our global forward-looking growth indicators, and Chinese policy is tightening. Nonetheless, investors read too much into the distorted U.S. economic data in the first quarter. They also went too far in pricing out U.S. fiscal action. As for European political risk, centrist candidate Macron is poised to win the French election and we do not see much risk for markets lurking in the German election. There are legitimate reasons to be concerned about the economic and profit outlook in 2018. Nonetheless, we believe that the window for reflation trades will remain open for most of this year because the underlying economic and profit fundamentals are constructive. The passage of market-friendly fiscal policies in the U.S. later in 2017 will be icing on the cake. Perhaps more importantly, we are finally seeing signs that pricing power in the U.S. corporate sector is improving, allowing margins to expand somewhat in the coming quarters. Our profit models remain upbeat for the major advanced economies and for China. It has been frustrating for those investors looking for an equity buying opportunity. Despite the surge in defensive assets such as gold and Treasurys, the major equity bourses did not correct by much. Value remains stretched in all of the risk asset classes. Nonetheless, investors should stay positioned for another upleg in the stock-to-bond total return ratio in the coming months. Perhaps the largest risk lies in the bond market. The rally has depressed yields to a level that makes bonds highly vulnerable to a reversal of the factors that sparked the rally. Within an underweight allocation to fixed-income in balanced portfolios, investors should overweight investment- and speculative-grade corporate bonds in the U.S. and U.K. We are more cautious on Eurozone corporates as the ECB's support for that sector will moderate. Looking ahead to next year, our bond strategists foresee a shift to underweight credit given the advanced nature of the releveraging cycle in the U.S. corporate sector. Our other recommendations include: Within global government bond portfolios, overweight JGBs and underweight Treasurys. Gilts and core Eurozone bonds are at benchmark. Underweight the periphery of Europe. Overweight European and Japanese equities versus the U.S. in currency-hedged terms. Continue to favor defensive over cyclical equity sectors in the U.S. for now, but a shift may be required later this year. Overweight the dollar versus the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market. Recent underperformance is a buying opportunity. Value has improved and cyclical conditions favor small caps. Stay exposed to oil-related assets, and favor oil to base metals within commodity portfolios. Mark McClellan Senior Vice President The Bank Credit Analyst April 27, 2017 Next Report: May 25, 2017 1 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies and Fantasies," dated April 5, 207, available at bca.bcaresearch.com II. Beware Inflection Points In The Secular Drivers Of Global Bonds The fundamental drivers of the low rate world are considered by many to be structural, and thus likely to keep global equilibrium bond yields quite depressed by historical standards for years to come. However, some of the factors behind ultra-low interest rates have waned, while others have reached an inflection point. The age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. Global investment needs will wane along with population aging, but the majority of the effect on equilibrium interest rates is in the past. In contrast, the demographic effects that will depress desired savings are still to come. The net impact will be bond-bearish. Moreover, the massive positive labor supply shock, following the integration of China and Eastern Europe into the world's effective labor force, is over. Indeed, this shock is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power, sparking a shift toward using more capital in the production process and thereby placing upward pressure on global real bond yields. It is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. This could be inflationary if it disrupts global supply chains. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. As for China, the fundamental drivers of its savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Technological advance will remain a headwind for real wage gains, but at least the transition to a world that is less labor-abundant will boost workers' ability to negotiate a larger share of the income pie. We are not making the case that real global bond yields are going to quickly revert to pre-Lehman averages. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations for bond yields are too low. Investors should have a bond-bearish bias on a medium- and long-term horizon. In the September 2016 The Bank Credit Analyst, we summarized the key drivers behind the major global macroeconomic disequilibria that have resulted in deflationary pressure, policy extremism, dismal productivity, and the lowest bond yields in recorded history (Chart II-1). The disequilibria include income inequality, the depressed wage share of GDP, lackluster capital spending, and excessive savings. Chart II-1Global Disequilibria The fundamental drivers of the low bond yield world are now well documented and understood by investors. These drivers generally are considered to be structural, and thus likely to keep global equilibrium bond yields and interest rates at historically low levels for years to come according to the consensus. Based on discussions with BCA clients, it appears that many have either "bought into" the secular stagnation thesis or, at a minimum, have adopted the view that growth headwinds preclude any meaningful rise in bond yields. However, bond investors might have been lulled into a false sense of security. Yields will not return to pre-Lehman norms anytime soon, but some of the factors behind the low-yield world have waned, while others have reached an inflection point. Most importantly, the age structure of world population is transitioning from a period in which aging added to the global pool of savings to one in which aging will begin to drain that pool. We have reached the tipping point. Equilibrium real bond yields will gradually move higher as a result. But before we discuss what is changing, it is important to review the drivers of today's macro disequilibria. Several of them predate the Great Financial Crisis, including demographic trends, technological advances, and the integration of China's massive workforce and excess savings into the global economy. Ultra-Low Rates: How Did We Get Here? (A) Demographics And Global Savings Chart II-2Global Shifts In The Saving ##br##And Investment Curves The so-called Global Savings Glut has been a bullish structural force for bonds for the past couple of decades. We won't go through all of the forces behind the glut, but a key factor is population aging in the advanced economies. Ex-ante desired savings rose as baby boomers entered their high-income years. The Great Financial Crisis only served to reinforce the desire to save, given the setback in the value of boomers' retirement nest eggs.1 The corporate sector also began to save more following the crisis. Even more importantly, the surge in China's trade surplus since the 1990s had to be recycled into the global pool of savings. While China's rate of investment was very high, its propensity to save increased even faster, resulting in a swollen external surplus and a massive net outflow of capital. Other emerging economies also made the adjustment from net importers of capital to net exporters following the Asian crisis in the late 1990s. By leaning into currency appreciation, these countries built up huge foreign exchange reserves that had to be recycled abroad. In theory, savings must equal investment at the global level and real interest rates shift to ensure this equilibrium (Chart II-2). China's excess savings, together with a greater desire to save in the developed countries, represented a shift in the saving schedule to the right. The result was downward pressure on global interest rates. (B) Demographics And Global Capital Spending Demographics and China's integration also affected the investment side of the equation. A slower pace of labor force growth in the developed countries resulted in a permanently lower level of capital spending relative to GDP. Slower consumer spending growth, as a result of a more moderate expansion in the working-age population, meant a reduced appetite for new factories, malls, and apartment buildings. Chart II-3 shows that the growth rate of global capital spending that is required to maintain a given capital-to-output ratio has dropped substantially, due to the dramatic slowdown in the growth of the world's working-age population.2 Keep in mind that this estimate refers only to the demographic component of investment spending. Actual capital expenditure growth will not be as weak as Chart II-3 suggests because firms will want to adopt new technologies for competitive or environmental reasons. Nonetheless, the point is that the structural tailwind for global capex from the post-war baby boom has disappeared. Chart II-3Demographics Are A Structural Headwind For Global Capex (C) Labor Supply Shock And Global Capital Spending While the working-age population ratio peaked in the developed countries years ago, it is a different story at the global level (Chart II-4). The integration of the Chinese and Eastern European workforces into the global labor pool during the 1990s and 2000s resulted in an effective doubling of global labor supply in a short period of time. Relative prices must adjust in the face of such a large boost in the supply of labor relative to capital. The sudden abundance of cheap labor depressed real wages from what they otherwise would have been, thus incentivizing firms to use more labor and less capital at the margin. The combination of slower working-age population growth in the advanced economies and a surge in the global labor force resulted in a decline in desired global capital spending. In terms of Chart II-2, the leftward shift of the investment schedule reinforced the impact of the savings impulse in placing downward pressure on global interest rates. (D) Labor Supply Shock And Income Inequality The wave of cheap labor also aggravated the trend toward greater inequality in the advanced economies and the downward trend in labor's share of the income pie (Chart II-5). In theory, a surge in the supply of labor is a positive "supply shock" that benefits both developed and developing countries. However, a recent report by David Autor and Gordon Hanson3 highlighted that trade agreements in the past were incremental and largely involved countries with similar income levels. The sudden entry of China to the global trade arena, involving a massive addition to the effective global stock of labor, was altogether different. The report does not argue that trade has become a "bad" thing. Rather, it points out that the adjustment costs imposed on the advanced economies were huge and long-lasting, as Chinese firms destroyed entire industries in developed countries. The lingering adjustment phase contributed to greater inequality in the major countries. Management was able to use the threat of outsourcing to gain the upper hand in wage negotiations. The result has been a rise in the share of income going to high-income earners in the Advanced Economies, at the expense of low- and middle-income earners (Chart II-6). The same is true, although to a lesser extent, in the emerging world. Chart II-4Working-Age Population Ratios Have Peaked Chart II-5Labor Share Of Income Has Dropped Chart II-6Hollowing Out Greater inequality, in turn, has weighed on aggregate demand and equilibrium interest rates because a larger share of total income flowed to the "rich" who tend to save more than the low- and middle-income classes. (E) The Dark Side Of Technology Advances in technology also contributed to rising inequality. In theory, new technologies hurt some workers in the short term, but benefit most workers in the long run because they raise national income. However, there is evidence that past major technological shocks were associated with a "hollowing out" or U-shaped pattern of employment. Low- and high-skilled employment increased, but the proportion of mid-skilled workers tended to shrink. Wages for both low- and mid-skilled labor did not keep up with those that were highly-skilled, leading to wider income disparity. Today, technology appears to be resulting in faster, wider and deeper degrees of hollowing-out than in previous periods of massive technological change. This may be because machines are not just replacing manual human tasks, but cognitive ones too. A recent IMF report made the case that technology and global integration played a dominant role in labor's declining fortunes. Technology alone explains about half of the drop in the labor share of income in the developed countries since 1980.4 Falling prices for capital goods, information and communications technology in particular, have facilitated the expansion of global value chains as firms unbundled production into many tasks that were distributed around the world in a way that minimized production costs. Chart II-7 highlights that the falling price of capital goods in the advanced economies went hand-in-hand with rising participation in global supply chains since 1990. Falling capital goods prices also accelerated the automation of routine tasks, contributing especially to job destruction in the developed (high-wage) economies. In other words, firms in the developed world either replaced workers with machinery in areas where technology permitted, or outsourced jobs to lower-wage countries in areas that remained labor-intensive. Both trends undermined labor's bargaining power, depressed labor's share of income, and contributed to inequality. The effects of technology, global integration, population aging and China's economic integration are demonstrated in Chart II-8. The world working-age-to-total population ratio rose sharply beginning in the late 1990s. This resulted in an upward trend in China's investment/GDP ratio, and a downward trend in the G7. The upward trend in the G7 capital stock-per-capita ratio began to slow as a result, before experiencing an unprecedented contraction after the Great Recession and Financial Crisis. Chart II-7Economic Integration And ##br##Falling Capital Goods Prices Chart II-8Macro Impact Of ##br##Labor Supply Shock The result has been a deflationary global backdrop characterized by demand deficiency and poor potential real GDP growth, both of which have depressed equilibrium global interest rates over the past 20 to 25 years. Transition Phase Chart II-9Working-Age Population ##br##To Shrink In G7 And China It would appear easy to conclude that these trends will be with us for another few decades because the demographic trends will not change anytime soon. Nonetheless, on closer inspection the global economy is transitioning from a period when cyclical economic pressures and all of the structural trends were pushing equilibrium interest rates in the same direction, to a period in which the economic cycle is becoming less bond-friendly and some of the secular drivers of low interest rates are gradually changing direction. First, the massive labor supply shock of the past few decades is over. The world working-age population ratio has peaked according to United Nations estimates. This ratio is already declining in the major advanced economies and is in the process of topping out in China. The absolute number of working-age people will shrink in China and the G7 countries over the next five years, although it will continue to grow at a low rate for the world as a whole (Chart II-9). Unions are unlikely to make a major comeback, but a backdrop that is less labor-abundant should gradually restore some worker bargaining power, especially as economies regain full employment. The resulting upward pressure on real wages will support capital spending as firms substitute toward capital and away from (increasingly expensive) labor. Consumer demand will also receive a boost if inequality moderates and the labor share of income begins to rise. Globalization On The Back Foot Chart II-10Globalization Peaking? Second, it is too early to declare globalization dead, but the neo-liberal trading world order that has been in place for decades is under attack. Global exports appear to have peaked relative to GDP and average tariffs have ticked higher (Chart II-10). The World Trade Organization has announced that the number of new trade restrictions or impediments outweighed the number of trade liberalizing initiatives in 2016. The U.K. appears willing to sacrifice trade for limits to the free movement of people. The new U.S. Administration has ditched the Trans-Pacific Partnership (TPP) and is threatening to impose punitive tariffs on some trading partners. Anti-globalization policies could paradoxically be positive for capital spending, at least for a few years. If the U.S. were to impose high tariffs on China, for example, it would make a part of the Chinese capital stock redundant overnight. In order for the global economy to produce the same amount of goods and services as before, the U.S. and other countries would need to invest more. Any unwinding of globalization would also be inflationary as it would disrupt international supply chains. Demographics And Saving: From Tailwind To Headwind... Third, the impact of savings in the major advanced economies and China on global interest rates will change direction as well. In the developed world, aggregate household savings will come under downward pressure as boomers increasingly shift into retirement. Economists are fond of employing the so-called life-cycle theory of consumer spending. According to this theory, consumers tend to smooth out lifetime spending by accumulating assets during the working years in order to maintain a certain living standard after retirement. The U.N. National Transfer Accounts Project has gathered data on spending and labor income by age cohort at a point in time. Chart II-11 presents the data for China and three of the major advanced economies. Chart II-11Income And Consumption By Age Cohort The data for the advanced economies suggest that spending tends to rise sharply from a low level between birth and about 15 years of age. It continues to rise, albeit at a more modest pace, through the working years. Other studies have found that consumer spending falls during retirement. Nonetheless, these studies generally include only private spending and therefore do not include health care that is provided by the government. The data presented in Chart II-11 show that, if government-provided health care is included, personal spending rises sharply toward the end of life. The profile is somewhat different in China. Spending rises quickly from birth to about 20 years of age, and is roughly flat thereafter. Indeed, consumption edges lower after 75-80 years of age. These data allow us to project the impact of changing demographics on the average household saving rate in the coming years, assuming that the income and spending profiles shown in Chart II-11 are unchanged. We start by calculating the average saving rate across age cohorts given today's age structure. We then recalculate the average saving rate each year moving forward in time. The resulting saving rate changes along with the age structure of the population. The results are shown in Chart II-12. The saving rates for all four economies have been indexed at zero in 2016 for comparison purposes. The aggregate saving rate declines in all cases, falling between 4 and 8 percentage points between 2016 and 2030. Germany sees the largest drop of the four countries. Chart II-12Aging Will Undermine Aggregate Saving The simulations are meant to be suggestive, rather than a precise forecast, because the savings profile across age cohorts will adjust over time. Moreover, governments will no doubt raise taxes to cover the rising cost of health care, providing a partial offset in terms of the national saving rate.5 Nonetheless, the simulations highlight that the major economies are past the point where the baby boom generation is adding to the global savings pool at a faster pace than retirees are drawing from it. The age structure in the major advanced economies is far enough advanced that the rapid increase in the retirement rate will place substantial downward pressure on aggregate household savings in the coming years. It is well known that population aging will also undermine government budgets. Rising health care costs are already captured in our household saving rate projection because the data for household spending includes health care even if it is provided by the public sector. However, public pension schemes will also be a problem. To the extent that politicians are slow to trim pension benefits and/or raise taxes, public pension plans will be a growing drain on national savings. Could younger, less developed economies offset some of the demographic trends in China and the Advanced Economies? Numerically speaking, a more effective use of underutilized populations in Africa and India could go a long way. Nevertheless, deep-seated structural problems would have to be addressed and, even then, it is difficult to see either of these regions turning into the next "China story" given the current backlash against globalization and immigration. ...And The Capex Story Is Largely Behind Us Demographic trends also imply less capital spending relative to GDP, as discussed above. In terms of the impact on global equilibrium interest rates, it then becomes a race between falling saving and investment rates. Chart II-13Demographics And Capex Requirements Some analysts point to the Japanese experience because it is the leading edge in terms of global aging. Bond yields have been extremely low for many years even as the household saving rate collapsed, suggesting that ex-ante investment spending shifted by more than ex-ante savings. Nonetheless, Japan may not be a good example because the deterioration in the country's demographics coincided with burst bubbles in both real estate and stocks that hamstrung Japanese banks for decades. A series of policy mistakes made things worse. Economic theory is not clear on the net effect of demographics on savings and investment. The academic empirical evidence is inconclusive as well. However, a detailed IMF study of 30 OECD countries analyzed the demographic impact on a number of macroeconomic variables, including savings and investment.6 They estimated separate demographic effects for the old-age dependency ratio and the working-age population ratio. Applying the IMF's estimated model coefficients to projected changes in both of these ratios over the next decade suggests that the decline in ex-ante savings will exceed the ex-ante drop in capex requirements by about 1 percentage point of GDP. This is a non-trivial shift. Moreover, our simulations highlight that timing is important. The outlook for the household saving rate depends on the changing age structure of the population and the distribution of saving rates across age cohorts. Thus, the average saving rate will trend down as populations continue to age over the coming decades. In contrast, the impact of demographics on capital spending requirements is related to the change in the growth rate of the working-age population. Chart II-13 once again presents our estimates for the demographic component of capital spending. The top panel presents the world capex/GDP ratio that is necessary to maintain a constant capital/output ratio, and the bottom panel shows the change in that ratio. The important point is that the downward adjustment in world capex/GDP related to aging is now largely behind us because most of the deceleration in the growth rate of the working-age population is done. This is in contrast to the household saving rate adjustment where all of the adjustment is still to come. China Is Transitioning Too Chart II-14China's Savings Rates Have Peaked... China must be treated separately from the developed countries because of its unique structural issues. As discussed above, household savings increased dramatically beginning in the mid-1990s (Chart II-14). This trend reflected a number of factors, including: the rising share of the working-age population; a drop in the fertility rate, following the introduction of the one-child policy in the late 1970s that allowed households to spend less on raising children and save more for retirement; health care reform in the early 1990s required households to bear a larger share of health care spending; and job security was also undermined by reform of the state-owned enterprises (SOE) in the late 1990s, leading to increased precautionary savings to cover possible bouts of unemployment. These savings tailwinds have turned around in recent years and the household saving rate appears to have peaked. China's contribution to the global pool of savings has already moderated significantly, as measured by the current account surplus. The surplus has withered from about 9% in 2008 to 2½% in 2016. A recent IMF study makes the case that China's national saving rate will continue to decline. The IMF estimates that for every one percentage-point rise in the old-age dependency ratio, the aggregate household saving rate will fall by 0.4-1 percentage points. In addition, the need for precautionary savings is expected to ease along with improvements in the social safety net, achieved through higher government spending on health care. The household saving rate will fall by three percentage points by 2021 according to the IMF (Chart II-15). Competitive pressure and an aging population will also reduce the saving rates of the corporate and government sectors. Chart II-15...Suggesting That External Surplus Will Shrink Of course, investment as a share of GDP is projected to moderate too, reflecting a rebalancing of the economy away from exports and capital spending toward household consumption. The IMF expects that savings will moderate slightly faster than investment, leading to a narrowing in the current account surplus to almost zero by 2021. A lot of assumptions go into this type of forecast such that we must take it with a large grain of salt. Nonetheless, the fundamental drivers of China's savings capacity appear to rule out a return to the days when the country was generating a substantial amount of excess savings. Moreover, a return to large current account surpluses would likely require significant currency depreciation, which is a political non-starter given U.S. angst over trade. The risk is that China's excess savings will be less, not more, in five year's time. Tech Is A Wildcard It is extremely difficult to forecast the impact of technological advancement on the global economy. We cannot say with any conviction that the tech-related effects of "hollowing out", "winner-take-all" and the "skills premium" will moderate in the coming years. Nonetheless, these effects have occurred alongside a surge in the world's labor force and rapid globalization of supply chains, both of which reinforced the erosion of employee bargaining power. Looking ahead, technology will still be a headwind for some employees, but at least the transition from a world of excess labor to one that is more labor-scarce will boost workers' ability to negotiate a larger share of the income pie. We will explore the impact of technology on productivity, inflation, growth, and bond yields in a companion report to be published in the next issue. Conclusion: The main points we made in this report are summarized in Table II-1. All of the structural factors driving real bond yields were working in the same (bullish) direction over the past 30-40 years. Looking ahead, it is uncertain how technological improvement will affect bond prices, but we expect that the others will shift (or have already shifted) to either neutral or outright bond-bearish. Table II-1Key Secular Drivers No doubt, our views that globalization and inequality have peaked, and that the labor share of income has bottomed, are speculative. These factors may not place much upward pressure on equilibrium yields. Nonetheless, it seems likely that the demographic effect that has depressed capital spending demand is well advanced. We see it shifting from a positive factor for bond prices to a neutral factor in the coming years. It is also clear that the massive positive labor supply shock is over, and is heading into reverse as the global working-age population ratio falls. This may improve labor's bargaining power and the resulting boost consumer spending will be negative for bonds. This may also spark a shift toward using more capital in the production process and thereby place additional upward pressure on global real bond yields. Admittedly, however, this last point requires more research because theory and empirical evidence on it are not clear. Perhaps most importantly, the aging of the population in the advanced economies has reached a tipping point; retirees will drain more from the pool of savings than the working-age population will add to it in the coming years. We have concentrated on real equilibrium bond yields in this report because it is the part of nominal yields that is the most depressed relative to historical norms. The inflation component is only a little below a level that is consistent with central banks meeting their 2% inflation targets in the medium term. There is a risk that inflation will overshoot these targets, leading to a possible surge in long-term inflation expectations that turbocharges the bond bear market. This is certainly possible, as highlighted by a recent Global Investment Strategy Quarterly Strategy Outlook.7 Pain in bond markets would be magnified in this case, especially if central banks are forced to aggressively defend their targets. Please note that we are not making the case that real global bond yields will quickly revert to pre-Lehman averages. It will take time for the bond-bullish structural factors to unwind. It will also take time for inflation to gain any momentum, even in the United States. Global yields could even drop back to previous lows in the event of another recession. Nonetheless, from a long-term perspective, current market expectations suggest that investors have adopted an overly benign view on the outlook for yields. For example, implied real short-term rates remain negative until 2021 in the U.S. and 2026 in the Eurozone, while they stay negative out to 2030 in the U.K. (Chart II-16). We doubt that short-term rates will be negative for that long, given the structural factors discussed above. Chart II-16Market Expects Negative Short-Term Rates For A Long Time Another way of looking at this is presented in Chart II-17. The market expects the 10-year Treasury yield in ten years to be only slightly above today's spot yield, which itself is not far above the lowest levels ever recorded. Market expectations are equally depressed for the 5-year forward rate for the U.S. and the other major economies. Chart II-17Forward Rates Very Low Vs. History The implication is that investors should have a bond-bearish bias on a medium- and long-term horizon. Mark McClellan Senior Vice President The Bank Credit Analyst 1 It is true that observed household savings rates fell in some of the advanced economies, such as the United States, at a time when aging should have boosted savings from the mid-1990s to the mid-2000s. This argues against a strong demographic effect on savings. However, keep in mind that we are discussing desired (or ex-ante) savings. Ex-post, savings can go in the opposite direction because of other influencing factors. As discussed below, global savings must equal investment, which means that shifts in desired capital spending demand matter for the ex-post level of savings. 2 Arithmetically, if world trend GDP growth slows by one percentage point, then investment spending would need to drop by about 3½ percentage points of GDP to keep the capital/output ratio stable. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "The China Shock: Learning from Labor-Market Adjustment to Large Changes in Trade," Annual Review of Economics, Vol. 8, pp. 205-240 (October 2016). 4 Please see "Understanding The Downward Trend In Labor Income Shares," Chapter 3 in the IMF World Economic Outlook (April 2017). 5 In other words, while the household savings rate, as defined here to include health care spending by governments on behalf of households, will decline, any associated tax increases will blunt the impact on national savings (i.e. savings across the household, government and business sectors). 6 Jong-Won Yoon, Jinill Kim, and Jungjin Lee, "Impact Of Demographic Changes On Inflation And The Macroeconomy," IMF Working Paper no. 14/210 (November 2014). 7 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. III. Indicators And Reference Charts The modest correction in April did not improve equity valuation by much in any of the major markets. Our U.S. valuation metric is still hovering just below the +1 sigma mark, above which would signal extreme overvaluation. Measures such as the Shiller P/E ratio are flashing red on valuation, but our indicator takes into consideration 11 different valuation measures. Technically, the U.S. equity market still has upward momentum, while our Monetary indicator is neutral for stocks. The Speculation index indicates some froth, although our Composite Sentiment indicator has cooled off, suggesting that fewer investors are bullish. The U.S. net revisions ratio is hovering near zero, but it is bullish that the earnings surprise index jumped over the past month. First-quarter earnings season in the U.S. has got off to a good start, while the global earnings revisions ratio has moved into positive territory for the first time in six years (see the Overview section). Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500, although it is now so elevated that it suggests that there could be little 'dry power' left to buy the market. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. In contrast to the U.S., the WTP indicators for both the Eurozone and Japan are rising from a low level. This suggests that a rotation into these equity markets is underway and has some ways to go. We remain overweight both the Eurozone and Japanese markets relative to the U.S. on a currency-hedged basis. April's rally in the U.S. bond market dragged valuation close to neutral. However, we believe that the market is underestimating the amount of Fed rate hikes that are likely over the next year. Now that oversold technical conditions have been absorbed, this opens the door the next upleg in yields. Bonds typically move into 'inexpensive' territory before the monetary cycle is over. The trade-weighted dollar remains quite overvalued on a PPP basis, although less so by other measures. Technically, the dollar has shifted down this year to meet support at the 200-day moving average and overbought conditions have largely, but not totally, been worked off. We still believe there is more upside for the dollar, despite lofty valuation readings, due to macro divergences. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market And ##br##Earnings: Relative Performance Chart III-7Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning ECONOMY Chart III-27U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Highlights Markets will survive late spring and summer unscathed; Macron will win the French election; Trump's agenda is not going down in flames; U.K. snap polls support our sanguine view on Brexit; Fade the rally in Treasuries and bet against unwinding of Trump reflation; Stay tactically long EUR/USD, long the pound, and long French industrials vs. German. Feature One of the oldest adages of Wall Street is to "sell in May and go away." Data reinforce the conventional wisdom, with a strategy of staying on the sidelines during the summer months clearly outperforming the alternative of staying long every month (Chart 1). Chart 1Sell In May And Go Away Should investors adopt the same approach in 2017? Certainly the risks are skewed to the downside due to investor complacency and a busy political schedule: Complacency: Investor complacency has been spectacularly elevated ahead of Q2 this year. Our colleague Anastasios Avgeriou of BCA's Global Alpha Sector Strategy, who has been flagging warning signs since early February, lists four measures of complacency that peaked in April (Chart 2).1 The SKEW index, controlled for by the VIX, rose above 12 early in April, warning that at least a tactical pullback is at hand. The Yale U.S. one year institutional confidence index hit an all-time high of 98.68% in February. Similarly, the Minneapolis Fed's market-based probability of a 20%+ correction in the S&P 500 dropped to below 10%, a level last seen during the peak of the previous bull market in 2007 (bottom panel).2 Political Schedule: April and May have an unusually high number of high-profile deadlines, meetings, and elections packed into a tight space: April 26: U.S. President Donald Trump is expected to announce key details of his long-awaited tax reform plan; April 28: The U.S. government's stopgap funding measure, the continuing resolution, will expire - leading to a government shutdown if no replacement is passed; April 29: The EU Council will hold its "Brexit Summit" to either approve, amend, or reject Council President Donald Tusk's proposed negotiation guidelines;3 May 7: The second round of the French presidential election will be held; May 9: An extraordinary presidential election will take place in South Korea; Mid-May: U.S. President Donald Trump will present his full budget proposal, including tax plans, spending cuts, and growth projections; May 19: Iran holds its presidential election; May 25: The OPEC meeting in Vienna will determine whether to extend the current production-cut agreement. In this Weekly Report, we focus on the three most immediate risks to the markets: the second-round of French presidential election, U.S. domestic politics, and the upcoming election in the U.K. We will also address downside risk to oil prices in an upcoming joint report, to publish tomorrow, with BCA's Commodity & Energy Strategy. Our conclusion is that while risks are indeed skewed to the downside by the mere combination of investor complacency and volume of potential tail-risks, the market will likely emerge from the summer doldrums unscathed. As such, any market downturns are an opportunity to buy on dips. As we recently warned, however, the real risks will emerge in 2018.4 France: Fin? Centrist Emmanuel Macron has won the first round of the French presidential election with a narrow victory over nationalist Marine Le Pen (Table 1). As expected, the two will now contest the second round on May 7. France will subsequently hold a two-round legislative election on June 11 and 18. Chart 2Complacency At A Peak Table 1France: First-Round Election Results Investors learned three things from the first round of the French presidential election: Polls are right: Repeat after us: polls are not wrong, pundits are.5 Neither the Brexit referendum nor the U.S. presidential election came as a huge surprise to those who read polls objectively. In both cases, the outcome was inside the margin of error. Hopefully, the first round of the French presidential election will set aside the notion that all polls are useless and therefore investors are better off interpreting chicken entrails for election forecasting. In fact, polls in France have not significantly underestimated Marine Le Pen's nationalist party - Front National - since the 2002 election (Chart 3). Le Pen has no momentum: Le Pen consistently polled in the high 20s throughout late 2016 and 2017, but ended with only 21.43% of the vote on April 23 (Chart 4). In fact, she only narrowly improved on her 2012 performance of 17.9%, which is astounding considering everything that has happened in France since then (terrorist attacks in particular). Macron has meanwhile nearly doubled his polling from late 2016. French voters are angry: Protest and anti-establishment candidates came away with 49.62% of the vote (Chart 5). Chart 3FN Rarely Outperforms Its Polling Chart 4Le Pen's Momentum Is Gone Chart 5French Voters Are Angry... What to make of these three lessons? First, if lessons A and B are correct, then Le Pen is toast on May 7 (Chart 6).6 According to a poll conducted from April 17 to 21, Le Pen will struggle to get any voters from Mélenchon and Socialist candidate Benoît Hamon (Chart 7). This should not be surprising to anyone who knows France and its history: the left and the right just do not get along. We construct a "Le Pen best case scenario" out of the data by giving her all the voters who said they would abstain in the second round. Let's say that they were lying and are secret Le Pen supporters. She still loses (Chart 8)! Chart 6...But Not That Angry Chart 7Most Voters Will Swing To Macron Chart 8The No-Shows Can't Win It For Le Pen But surely a major terrorist attack could turn it around for Le Pen, right? Wrong. Macron is not pro-terrorist. Why would the French turn to a Russian-financed nationalist with no clear plan on how to prevent terrorism or stop refugee flows into Europe other than to close French borders?7 (And that description is not fake news!)8 They wouldn't. And there is empirical evidence to prove that French voters see through Le Pen's empty rhetoric. We highly recommend our clients read our February report titled "The French Revolution" where we conducted a careful study of the 2015 December regional elections.9 These elections occurred only 23 days following the November 2015 terrorist attacks in Paris and at the height of that year's migration crisis. It was as if the fates conspired with Le Pen's Front National (FN) to create a perfect storm. And yet the election was a crushing loss for the nationalists who came away with nothing in the second round. Chart 9French Public Supports The EU And Euro But hold on a minute. Are the French really about to elect a former investment banker for president even though 50% of them are "angry," as suggested by our lesson C? Well, yes. The "anger" is complicated. Mélenchon received a lot of the disgruntled Socialist Party voters who jumped the Hamon ship after it sunk during the latter's woefully uninspiring debate performances. These are not hard-core Euroskeptic voters. In fact, both Mélenchon and Le Pen moderated their Euroskepticism in the run up to this election to broaden their base of support. Le Pen promised that she would abide by the results of a referendum on the EU even if it went against her will, as polls currently suggest it would (Chart 9). And Mélenchon suggested that exiting the EU would only be his "Plan B," in case his plan to renegotiate the Treaty of the EU failed. What should investors expect of a Macron presidency? While the "French Thatcherite" François Fillon may have been more welcome to the markets than Macron, we think that a combination of President Macron and right-leaning National Assembly could accomplish some reforms. Polling for the legislative elections in June is scarce, but Le Pen's party is highly unlikely to outperform Le Pen herself. Judging by the December 2015 regional elections and Fillon's pre-scandal polling, the center-right Les Républicains are likely to win at least a plurality of seats in the legislative elections. Several prominent center right figures have already come out in support of Macron, perhaps to throw their name in the ring for the next prime minister.10 This is highly positive for the markets as it means that French economic policy will be run by the center right, with an ultra-Europhile as president. Bottom Line: Nothing is over until it is over. Le Pen obviously still has a chance to win given that she is one of the two people running in the French election. However, given current polling, Macron is highly likely to become the next president of France. Hold tactical long EUR/USD and strategic long French industrial equities / short German industrial equities. But start thinking about closing long euro positions. The U.S.: From Math To Magic There are three reasons for global investors to worry about U.S. politics at the moment: Government shutdown: The U.S. government will face a shutdown on April 28 if the continuing resolution (CR) is not extended (via another CR) or if an omnibus funding bill is not passed. The risk for investors is that Senate Democrats could filibuster an omnibus bill that contains a conservative "poison pill" such as funding the wall on the border with Mexico or defunding Planned Parenthood. This would result in a partial government shutdown. Our view is that there is no time to find a long-term solution and the Republicans will have to extend current spending levels via short-term CRs, possibly until the end of the fiscal year on October 1. Given that the government has already been funded for half of the current fiscal year via short-term CRs, it may be the only way that Republicans can avoid a showdown with Democrats in the Senate. Obamacare repeal and replacement: The Senate and the House passed a budget resolution on January 13 that included "reconciliation instructions" allowing for the repeal of Obamacare in an eventual reconciliation bill.11 The reconciliation procedure allows measures that impact government spending and revenue - budgetary matters - to pass through Congress with a simple majority, i.e. without the need for 60 votes to defeat a filibuster in the Senate.12 These instructions are believed to "expire" at the end of May or thereabouts, giving Republicans one more month to replace Obamacare without causing greater traffic jams down the road.13 There are two hurdles to this process. First, the Tea Party-linked "Freedom Caucus" opposed the original Obamacare proposal and needs to be placated with provisions that may put off centrist Republicans in the Senate. Second, both the original Paul Ryan plan and the soon-to-be-revealed alternative are likely to be challenged by the Democrats under the reconciliation rules.14 Trump at first appeared willing to walk away from repealing Obamacare - which seemed to make sense given that the bill he endorsed imposes a roughly $700 billion burden on U.S. households (Chart 10). However, he has since decided that he needs the bill's roughly $320 billion in savings over ten years in order to pay for the "hyuge" tax cuts he has promised.15 Tax reform: Also coming into focus in April and May is tax reform. The White House is set to release key tax-reform details as we go to publication. Further, Trump has to deliver his full FY2018 budget in mid-May. Unlike the budget Trump released in mid-March, the May edition will include the tax proposals, measures on "mandatory" or entitlement spending, and growth projections. Concurrently, Congress has to start working on its budget resolution for FY2018, which, as mentioned, will enable using reconciliation to pass the tax bill with a mere 51 votes in the Senate. Again, the Freedom Caucus is a potential hurdle. Investors fear they will demand that any tax bill be strictly revenue neutral and thus foul up the legislative process. Chart 10Obamacare Repeal Hits Households Confused yet? You are not alone! We have noticed from client meetings and the financial media a growing obsession with details of upcoming reforms and the arcane congressional rules that will govern the legislative process. This is a mistake. Investors should step back and focus on the big picture: Trump is an economic populist who wants to see a higher rate of nominal GDP growth; Republicans are a party that favors tax cuts; Legislative rules are meant to be broken. As such, the key question is whether President Trump can bend the will of the Freedom Caucus, which plays the role of the antagonist in his efforts to clear all three hurdles listed above. We have no reason to believe that he cannot. In fact, all signs are pointing to the Freedom Caucus playing ball with the White House: Rhetoric has changed: Mark Meadows (R- North Carolina), Chairman of the Freedom Caucus, has confirmed that he is not demanding revenue-neutral tax reform plan and that he is open to a compromise on Obamacare. The Freedom Caucus is reportedly getting closer to accepting a health-care bill that passes the deadly issues to the states, allowing state legislatures to make their own decision on whether to remove the most popular regulatory requirements of Obamacare. Politically, this is a brilliant move. It allows both the Tea Party and moderate Republicans to declare victory by claiming that they upheld "state rights" - a core conservative principle - while giving conservative governors and state legislatures the option of eroding Obamacare at a state level. Moderates in the Senate, the theory goes, will not have to shoot down the new health bill for fear of a popular backlash since they presumably reside in states that will opt to keep the Obamacare measures in question (essential health benefits, community ratings, etc). The bill is by no means guaranteed to pass, but the point is that the Freedom Caucus has changed its tune after having been blamed for failing to repeal Obamacare, when repeal was one of the main reasons they were elected in the first place. Trump retains political capital: President Trump's polling with Republican voters has improved since the strike against Syria (Chart 11). He retains political capital with GOP voters and is therefore still a threat to the Freedom Caucus if he should campaign against them in the 2018 midterm primaries. The electoral threat is real: The Tea Party-favored candidate in Georgia's special election on June 20, Bob Gray, came in third place with just over 10% of the vote.16 Notably, a Trump-linked super PAC fielded campaign ads against Gray, helping propel the moderate candidate - Karen Handel - to the run-off against the Democratic challenger. While the media has obsessed about the surprise performance by Jon Ossoff, the first Democrat to make the district competitive since 1978, we are certain that House Freedom Caucus members have taken notice of Gray's fate. The message from the White House is clear: don't mess with Donald Trump. Trump will use carrots as well as sticks with the Freedom Caucus. To that end, we wish to remind our clients of "dynamic scoring," the macroeconomic modeling tool based on the work of economist Arthur Laffer (of the "Laffer curve" fame). The idea is that the headline government revenue loss of tax cuts fails to take into account the growth-generating consequences ("macroeconomic feedback") of the cuts, consequences that actually add to revenues. In other words, "tax cuts pay for themselves." Republican legislators have been using dynamic scoring to justify deficit-busting tax cuts for decades. And there is some truth to their claim that tax cuts generate revenue. For instance, while it is true that President Bush's White house vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 12). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 13). And we are being conservative in those numbers. Chart 11Trump In Line With##br## GOP Predecessors Chart 12Bush Was Right,##br## CBO Was Wrong! Chart 13Dynamic Scoring Will Offset About 10% ##br##Of Revenues Lost To Tax Cuts Treasury Secretary Steven Mnuchin was anything but conservative when he explicitly told investors to expect a tax reform plan paid for largely by dynamic scoring. Speaking on the sidelines of the IMF and World Bank spring meetings in Washington, Mnuchin said, Some of the lowering in (tax) rates is going to be offset by less deductions and simpler taxes, but the majority of it will be made up by what we believe is fundamentally growth and dynamic scoring. We have been arguing since November that investors should expect tax cuts that rely on dynamic scoring to justify their deficit-busting effects.17 Mnuchin's comments, after several hints from other legislators, confirm that this is indeed the plan. For the Freedom Caucus, dynamic scoring provides a defense against the accusation that their tax cuts increase the budget deficit. That said, data clearly shows that voters care less about deficits - their concerns have subsided with the deficits themselves (Chart 14).18 It remains to be seen whether Trump's team expects for dynamic scoring to do all the heavy lifting in justifying tax cuts or whether real tax reforms are still on the agenda. Even assuming Trump rejects the House GOP's border adjustment tax (which is apparently hanging onto life by a thread), he can offset revenue losses by repatriating companies' foreign earnings, moderating tax cuts for high-income earners, and closing loopholes. These offsets would add to whatever he saves from repealing Obamacare and cutting regulations.19 Chart 14Americans Not So Worried About Deficits Now Chart 15Trump Lags Average Predecessor Ultimately, Republicans of all stripes know that if they fail to produce some legislative "wins" then they will be left with nothing to campaign on in the midterm elections except for their affiliation with President Trump's very poor nationwide approval rating (Chart 15). The current polling foreshadows a 36-seat slaughter in the upcoming midterm elections for the Republicans in the House (Chart 16). This would give Democrats a majority. Several clients have asked us if this makes tax reform less likely. We do not think so. It simply means that Republicans have 18 months to pass their most treasured policies - and much less time if they want the economic growth spurt to help them get reelected. They may not have an opportunity like this for decades. Bottom Line: Investors should step back and focus on the big picture: Trump remains popular with GOP voters, the Freedom Caucus understands this threat, and - to quote Pink Floyd - magic makes the world go round. Investors should fade the rally in Treasurys, as our colleague Peter Berezin of BCA's Global Investment Strategy recently recommended. We are sticking with our "Trump reflation" 2-year/30-year Treasury curve steepener and initiating a recommendation that clients go short the January 2018 fed funds futures contract (Chart 17).20 Chart 16Republicans Heading For Huge Defeat In 2018 Chart 17Short Jan '18 Fed Funds Futures Brexit: Early Elections Reinforce Our GBP Call British Prime Minister Theresa May's decision to hold early elections vindicates our view that the political risks of Brexit peaked - and GBP bottomed - in mid-January when May declared that her country would leave the EU's common market (Chart 18).21 At that time, May frontloaded the worst expectations of negotiations while simultaneously removing the most contentious issue: common market access. With the U.K. decisively "out," i.e. not trying to take the EU's market while rejecting its people, the EU had less of a reason to make an example of the U.K. to other countries whose Euroskeptics might think they could pick and choose what they want from the bloc. Now May and the Tories are on track for a big electoral win that will not only confirm her government's strategy but also give her more maneuverability to handle the negotiations: May's Personal Mandate: May is a "takeover" prime minister - she emerged as leader in the party reshuffle after her predecessor David Cameron's resignation following the "Leave" outcome of the referendum. Takeover prime ministers are historically weaker than "elected" prime ministers and do not last as long in office - on average they rule for 3.3 years, as opposed to six for their elected peers (Chart 19). In other words, May's position was tenuous. This was especially likely to be the case as the country entered the rocky period of formal exit in 2019 and general elections in 2020. Her struggles in turn could have threatened the Brexit deal or her party's control. At the same time, May has received a bigger "bounce" in popular opinion after assuming office than other takeover prime ministers have done (Chart 20), partly as a result of the rally-around-the-flag effect after the referendum shock. Thus, it was eminently sensible to seek public approval of her leadership at this time. Chart 18GBP Bottomed When U.K. ##br##Forswore Common Market Chart 19Theresa May Faced##br## A Short Tenure Chart 20May Received ##br##A Brexit Boost A Thin Majority: The Conservative Party has also rallied post-referendum, especially in contrast with the divided Labour Party, under Jeremy Corbyn, that will hit its lowest point since 1918 if it performs according to current polling (Chart 21). Yet the government has a thin majority in parliament of only 17 seats, among the thinnest majorities in recent decades (Chart 22). This is a liability heading into the parliamentary vote on the final exit deal with the EU in 2019, raising the menace of a "Brexit cliff" in which the U.K.'s two-year negotiating period could expire without any EU deal at all. That would be an unmitigated disaster. With a greater majority, May will be able to cow the other parties further and whip her own party's backbenchers into shape. There was also a festering scandal about the Conservative Party's 2015 fundraising that could trigger a number of by-elections jeopardizing the thin majority.22 2022 is better than 2020: The Tories also faced the prospect of running for re-election in 2020, one year after Brexit actually occurs. By that time negative economic effects (not to mention any cyclical downturn) are more likely to be felt by the public than today. The Tories would also have to face the public immediately after any embarrassing compromises in the EU negotiations. Although Labour is currently in free fall - as illustrated by the astounding loss to the Tories in the by-election in Copeland in February23 - the next two years provide opportunities for revival. The negotiations may be messy, the economy will suffer as reality sets in,24 and the union itself may come under threat from a second Scottish referendum.25 Hence the new election timeline will suit the Tories better than the old, giving them till 2022 to cement Brexit itself and address some of the effects of the aftermath before facing voters. Chart 21Labour In The Doldrums Chart 22Tories Want A Bigger Majority To Manage Brexit Few doubt that May's timing is impeccable. There can be backlash from election opportunism and voter fatigue, but May's popular approval and the national atmosphere do not suggest it will be significant. Pollsters project from current opinion polls that she will secure a 100-seat majority or greater, and since 1997 party-preference polling has become more, not less, predictive of parliamentary seats after elections. Moreover our extremely conservative estimate based exclusively on opportunities that the Tories have to snatch seats from rivals at odds with the Brexit referendum suggests that they cannot do worse than to add 11 seats to their majority (Table 2). Table 2Minimal Scenario Gives Tories 11 New Seats For Their Majority In turn, a bigger majority more securely linked to Theresa May's leadership will bring greater maneuverability in the EU talks and assurance that she can get her final deal through parliament - even if it is an ugly one. How do the elections affect the EU? Contrary to the posturing on both sides, the early election will send a further electoral confirmation to the EU that the U.K. is dead-set on leaving and that the EU cannot deliberately negotiate a bad deal in hopes that the U.K. will change its mind. It could hardly hope to overturn domestic politics and elicit a reversal on Brexit after a third national electoral outcome in favor of leaving the union. Yet the EU saw the writing on the wall already. EU Council President Tusk's negotiating guidelines are not vindictive.26 The EU is opening the possibility of a multi-year transition period after the formal 2019 exit date and acknowledging the need under Article 50 of the Lisbon Treaty to take account of the future relationship, i.e. to provide a framework for a trade deal. The City of London stands to lose the most, but the guidelines are so far fairly tame outside of the financial sector. Moreover, we do not expect a harder line to emerge from the EU Council meeting on April 29. Already the Dutch, Irish, and Danish have called for negotiations on a trade agreement to begin promptly, essentially agreeing with Britain's urgent timeline.27 True, the probability that Macron will be the next French president - along with a likely shift toward a more outspoken Europhile stance in Germany after elections in September - presents the prospect of a "clash" with May's triumphant Tories. Macron has called for a "strict approach" to negotiations, has threatened to model his pro-market reforms in France in such a way as to steal "banks, talents, researchers, academics" from the U.K., and has suggested that the U.K. can at best hope for a deal comparable to Canada's Free Trade Agreement with the EU. That would set a low bar for the U.K.'s all-important services exports (Chart 23). However, Macron is an establishment player who will not significantly change France's position in the negotiations from what it would have been otherwise. (A Le Pen presidency obviously would mark a change by throwing the EU into chaos, but it is highly unlikely.) France is going to demand with the rest of the EU that the U.K. pay its dues (namely a 60 billion-euro budget contribution), but it is not in the interest of France or the EU to impose, effectively, a British recession - not while they seek to cultivate their own economic recoveries. Moreover, wreaking vengeance would not necessarily discourage Euroskeptics on the continent. With Le Pen mortally wounded, the significant Euroskeptic threat lies in Italy, where an imperious approach to Brexit from Germany and France may not be well received (Chart 24). Chart 23Services Are Key For The U.K. Chart 24Punishing The U.K. May Not Dissuade Italy Bottom Line: May's early election helps remove additional political risk by giving her party more maneuverability in negotiations and a greater ability to "make do" with what the Europeans give. Though this is highly unlikely to lead to a "soft Brexit" (common market access, customs union membership, subordination to the European Court of Justice), it is much more likely to prevent Britain from sailing off into a "no deal" abyss. To be clear, we can still see scenarios in which a reversal of Brexit is possible, as discussed previously,28 but they are very low probability. The snap election enables May's government to be flexible in the negotiations and accept some difficult truths in the final deal, which will reinforce the existing tendency of the EU to avoid causing a destabilizing "punitive" break. Both sides of the Channel are positioning for a relatively market-friendly outcome. We maintain our view that the pound has bottomed. Our short USD/GBP recommendation is up 2.85% since March 29 and short EUR/GBP is up 0.14% since January 25. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Alpha Sector Strategy Weekly Report, "Eerie Calm," dated February 10, 2017, available at gss.bcaresearch.com. 2 Please see BCA Global Alpha Sector Strategy Weekly Report, "Caveat Emptor," dated March 24, 2017, available at gss.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 6 French toast in fact... we'll be here all night folks! 7 The reason this plan does not make sense is because most perpetrators of terrorist attacks in France have been French or European citizens. Le Pen's plan amounts to closing the barn door after the horse has bolted. 8 Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at bloomberg.com. 9 Please see BCA Geopolitical Strategy and Foreign Exchange Strategy Special Report, "The French Revolution," dated February 3, 2017, available at gps.bcaresearch.com. 10 Former conservative prime ministers Jean-Pierre Raffarin and Alain Juppé, as well as other prominent members of Les Républicains have already announced that they would support Macron in the second round. 11 Please see "S. Con. Res. 3 - A concurrent resolution setting forth the congressional budget for the United States Government for fiscal year 2017," United States Congress, available at www.congress.gov. 12 For a great summary of the arcane procedure, please see "Introduction to Budget 'Reconciliation,'" dated November 9, 2016, available at cbpp.org. 13 If Republicans choose to delay beyond May, they will have to delay producing the fiscal year 2018 budget resolution. This is possible but introduces problems for next year's budget appropriations and the tax reform measures which will depend on the yet-to-be-written FY2018 budget resolution's reconciliation instructions. "The reconciliation legislation that the GOP is using to partially repeal and replace the ACA has a half-life. It will expire when Congress begins drafting the fiscal 2018 budget blueprint, which will likely be sometime in May. So if Republicans want to resurrect the AHCA and avoid the need for bipartisan votes in the Senate, they will have to vote on the bill within the next several weeks." Please see Baker and Hostetler LLP, "GOP Struggles To Revive Health Bill," Lexology, April 7, 2017, available at www.lexology.com. 14 In short, reconciliation can only be used to pass bills that impact spending and revenue. As such, any changes to Obamacare that do not impact fiscal matters could be found inadmissible by the Senate parliamentarian and thus could defeat the entire bill. There is of course always the "nuclear option" of simply ignoring the ruling of the Senate parliamentarian, but it is not clear whether the Senate GOP would want to go "Kim Jong-Un" twice in the same year! 15 Please see Congressional Budget Office, "American Health Care Act," March 13, 2017, available at www.cbo.gov. 16 Georgia's sixth congressional district is holding this special election to fill the seat left vacant by Tom Price, the new Secretary of Health and Human Services, as appointed by Trump. 17 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 18 Wouldn't dynamic scoring fail to pass the "smell test" with the CBO? Yes, it would. The CBO will likely ignore Republican "magic" and apply actual "math" to the tax proposal. However, this is not an impediment to passing tax reform as the reconciliation rules can still be used as long as the legislation expires after ten years. This is how President George W. Bush passed tax cuts in 2001. 19 A study by the conservative American Action Forum suggests that Trump's regulatory cuts may save $260 billion over ten years. This is a likely source of savings to justify tax cuts, and Trump is only getting warmed up when it comes to deregulation! For the study, please see Sam Batkins, "Fiscal Benefits Of The CRA, Regulatory Reform," April 20, 2017, available at www.americanactionforum.org. 20 Please see BCA Global Investment Strategy Weekly Report, "Fade The Rally In Treasurys," dated April 21, 2017, available at gis.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 22 Please see "Conservatives fined £70,000 over expenses by election watchdog," Channel 4 News, March 16, 2017, available at www.channel4.com. 23 The Conservatives won the Copeland seat for the first time since 1982 after the Labour MP Jamie Reed's resignation there. 24 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 27 Please see "Brexit Shouldn't Delay Trade Talks Too Long, Say Leaders," Bloomberg, April 21, 2017, available at www.bloomberg.com. 28 See note 26 above. Geopolitical Calendar

Highlights Duration: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS: Although we still expect TIPS breakevens to widen as inflation rises, this week we review possible arguments for why breakevens might have shifted to a permanently lower post-crisis equilibrium. Remain overweight TIPS versus nominal Treasuries. Corporate Valuation: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Feature Chart 1Yields Lower Since March FOMC In last week's report we argued that recent bond market strength was caused by a politically-induced flight-to-quality. In particular, we noted that the term structure of implied equity volatility had inverted - investors were paying more to hedge equity positions over a 1-month horizon than over a 3-month horizon. But political tensions have eased somewhat during the past week. President Trump promised to unveil his administration's tax reform plan this Wednesday, and the first round of the French election resulted in centrist candidate Emmanuel Macron securing a significant advantage over far-right candidate Marine Le Pen. As a consequence, 1-month implied equity vol fell back below 3-month vol, and the bond rally ebbed with the 10-year Treasury yield edging up to 2.29% from 2.17% at this time last week. Nonetheless, bond yields are still far below the levels seen following the last FOMC meeting in mid-March. Since that meeting, the 10-year Treasury yield has fallen 27 bps, split between a 12 bps decline in the real yield and a 15 bps drop in the cost of inflation compensation (Chart 1). Real Yields Are Too Low As shown in the top panel of Chart 1, the 10-year real yield is tightly linked to the number of rate hikes discounted in the overnight index swap curve during the next 12 months. Further, the drop in both of these series since mid-March occurred alongside a string of economic data disappointments, as evidenced by the sharp fall in the Economic Surprise Index (Chart 2). Our assessment, however, is that the mean reversion in the surprise index represents excessively optimistic expectations rather than a trend change in the pace of U.S. growth. Chart 2Disappointments Are Discounted To test this theory, we looked at the New York Fed's Nowcast for Q1 GDP growth and noted that it has been revised lower from 2.96% (as of March 24) to 2.65% (as of April 20). We observed that the data releases responsible for the bulk of the downward revision were: Real consumer spending Retail sales and food services Import & Export growth Housing starts As can be seen in Chart 3, with the exception of real consumer spending, all of the other data disappointments represent small corrections from elevated levels. As for real consumer spending, we noted last week that the recent weakness is probably explained by problems with Q1 seasonal adjustments.1 Taking a step back, U.S. growth still appears to be on solid footing. The BCA Beige Book Monitor, introduced last week by our U.S. Investment Strategy service,2 scans the Federal Reserve's Beige Book3 for the words "strong" and "weak" (and their derivatives like stronger, weakened, etc...). The Monitor is the number of "strong" words less the number of "weak" words, and it has been an excellent coincident indicator of GDP growth since the mid-1990s (Chart 4). At present, the Beige Book Monitor is sending a robust signal for U.S. growth. Similarly, despite supposed weakness in housing starts and trade data, our preferred leading indicators point to continued strength in both the residential investment and net export components of GDP (Chart 4, bottom 2 panels). Chart 3What Weak Data? Chart 4Growth Still Looks Strong Bottom Line: The market is now priced for only 30 bps of rate hikes between now and the end of the year, despite little evidence that growth is actually slowing. We still expect the Fed will lift rates by at least 50 bps between now and the end of the year. Stay at below-benchmark duration and remain short the January 2018 Fed Funds Futures contract. TIPS Breakevens: How Far From Fair Value? As was mentioned above, the cost of 10-year inflation compensation has also declined since mid-March alongside some weakness in the headline non-seasonally adjusted Consumer Price Index (see Chart 1). Our Financial Model of TIPS Breakevens - which models the 10-year TIPS breakeven rate using the stock-to-bond total return ratio, the price of oil and the trade-weighted dollar - attributes the recent decline to weakness in the stock-to-bond ratio and the fact that the 10-year breakeven rate was already quite elevated compared to our model's fair value (Chart 5). The 10-year breakeven rate is still somewhat wide compared to our model's fair value, but much less so. We remain overweight TIPS versus nominal Treasuries on the view that growth will be strong enough to keep measures of core inflation on a steady upward trajectory, eventually converging with the Fed's 2% inflation target. The fair value reading from our TIPS Financial Model should also trend gradually higher in this environment. Historically, core PCE inflation anchored around the Fed's 2% inflation target has corresponded with a 5y5y TIPS breakeven inflation rate in the range of 2.4% to 2.5% (current value 1.89%) and a 5y5y CPI swap rate between 2.8% and 2.9% (current value = 2.31%) (Chart 6). These remain our target levels for TIPS breakevens and CPI swaps, respectively. Chart 5TIPS Financial Model Chart 6Still Below Target However, we must also consider the possibility that these target ranges, based on the mid-2000s, may no longer be applicable. Put differently, it is possible that the market for inflation protection underwent a structural shift following the financial crisis and the appropriate level for long-maturity TIPS breakeven rates when core PCE is anchored around 2% might now be lower. A Structurally Lower Inflation Risk Premium? It is common to think of the 10-year TIPS breakeven inflation rate as: TIPS Breakeven Inflation = Inflation Expectations + Inflation Risk Premium The inflation risk premium is the extra return required by nominal bond investors to bear the risk that future inflation will differ from expected inflation. In theory, this premium can be influenced by uncertainty about the inflation outlook, but also by structural factors that make it more or less attractive to include TIPS in a portfolio. For example, any asset that is negatively correlated with equities is more valuable as a hedge in the context of an overall portfolio and investors should demand less of a risk premium to hold that asset. As one recent Fed paper4 noted, the correlation between long-maturity TIPS breakeven rates and equities has shifted from being negative in the 1980s to being sharply positive in recent years. This means that TIPS have become less valuable as a hedge against equity positions. All else equal, this should increase the yield that investors demand to hold TIPS and thus lower the TIPS breakeven inflation rate. We acknowledge the strong positive correlation between equities and TIPS breakevens, but are inclined to view it as more of a cyclical phenomenon. Chart 7 shows that the correlation between inflation expectations5 and equities was negative when inflation was above the Fed's 2% target in the 1980s and also that the correlation becomes more positive when the Fed eases and more negative when the Fed tightens (Chart 7, bottom panel). Chart 7Correlation Between Breakevens & Equities Is Cyclical In other words, when inflation is low the Fed has an incentive to maintain an accommodative monetary policy. It does not react strongly when inflation rises, and this supports increases in both inflation expectations and equity prices. However, when inflation becomes too high, the correlation between inflation expectations and equity prices shifts because higher inflation now signals a more rapid pace of Fed tightening which tends to depress equities. It therefore seems likely that the correlation between TIPS breakevens and equity prices will weaken as inflation rises and the Fed tightens policy. So we do not view this as a compelling reason for why TIPS breakevens might be permanently lower. Structural Limits To Arbitrage? A potentially more interesting line of argument comes from a 2010 paper by Fleckenstein, Longstaff and Lustig.6 In this paper, the authors document a persistent arbitrage opportunity between TIPS and nominal Treasury bonds. Investors can earn risk-free returns using inflation swaps and TIPS to replicate the cash flows from a nominal Treasury bond. The authors also find that this arbitrage opportunity biases TIPS breakeven rates lower, and that this bias worsens in times of increased financial market volatility. Chart 8Repo Market Less Efficient Specifically, the authors demonstrate that the size of the downward bias in TIPS breakevens increases as repo market fails trend higher. The rationale being that repo fails occur when market participants are unable to acquire specific Treasury collateral. This is taken as a signal that the supply of government bonds is constrained, which makes it more difficult to take advantage of the arbitrage between TIPS and nominal Treasuries. Interestingly, repo fails have been trending higher since the financial crisis as repo market activity has been reduced by strict post-crisis regulations (Chart 8). The case has been made that new regulations - specifically the Supplementary Leverage Ratio which forces dealer banks to set aside a fixed amount of capital for any assets they hold, regardless of riskiness - have caused dealers to shy away from low margin businesses such as making markets in repo.7 It is conceivable that reduced activity in the repo market has resulted in less available collateral and increased fails. If this is the new state of affairs, then it is possible that TIPS breakevens will be permanently lower in the post-crisis world because lack of liquidity in the repo market has reduced the attractiveness of arbitraging the difference between nominal and real yields. So far, we are reluctant to draw any sweeping conclusions from this analysis. In fact, if the Fed believes that the fair value for long-maturity TIPS breakevens is between 2.4% and 2.5%, then does the "limits to arbitrage" argument even matter? Also, Manmohan Singh of the IMF has argued that the act of the Fed unwinding its balance sheet would free up balance sheet space for dealer banks, mitigating some of the regulatory burden and leading to a more efficient repo market.8 If this is correct, then repo fails could decline as the Fed starts to let its balance sheet run down, a process that is likely to start later this year. For now, we consider the theory of a permanently lower equilibrium for TIPS breakevens a risk to our view that merits further research in the coming weeks. Corporate Bond Valuation Update With the release of the Moody's Default Report for March we were able to update our High-Yield Default-Adjusted Spread (Chart 9). Our Default-Adjusted Spread is equal to the average option-adjusted spread from the Bloomberg Barclays High-Yield index less a 12-month forecast of default losses. That 12-month forecast is based on Moody's baseline forecast for the speculative grade default rate and our own forecast of the recovery rate. Chart 9Default-Adjusted Spread Moody's data show that the speculative grade default rate was 4.7% for the 12 months ending in March, and the baseline forecast calls for it to fall to 3% during the next 12 months. Using this forecast we calculate that the current Default-Adjusted Spread is 228 bps. Our analysis shows that excess returns for both Investment Grade and High-Yield corporate bonds are usually positive unless the Default-Adjusted Spread is below 100 bps. The relationship between excess returns and the Default-Adjusted Spread for both Investment Grade and High-Yield corporates is shown graphically in Charts 10 & 11 and also in Tables 1 & 2. Chart 1012-Month Excess Investment Grade Returns ##br##Vs. Ex-Ante Default-Adjusted Spread (2003 - Present) Chart 1112-Month Excess High-Yield Returns Versus Ex-Ante ##br##Default-Adjusted Spread (2003-Present) Table 112-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Given our relatively optimistic outlook for U.S. growth, we tend to view current valuation levels as attractive and see scope for spread tightening during the next few months. However, the weakening state of corporate balance sheets means spreads are at risk once inflation starts to bite and monetary policy turns less accommodative, possibly as early as next year.9 Bottom Line: Our Default-Adjusted Spread remains at reasonably attractive levels, suggesting that corporate spreads will tighten in the coming months if the economic recovery remains on track. Remain overweight corporate bonds within U.S. fixed income portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Fade The Flight To Safety", dated April 18, 2017, available at usbs.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 According to the Fed, the Beige Book provides "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." 4 Chen, Andrew Y., Eric C. Engstrom, and Olesya V. Grishchenko (2016). "Has the inflation risk premium fallen? Is it now negative?," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, April 4, 2016, http://dx.doi.org/10.17016/2380-7172.1720 5 In order to benefit from more back-data, in Chart 7 we use the Cleveland Fed's measure of inflation expectations rather than TIPS breakeven rates. Details about the Cleveland Fed's methodology can be found here: https://www.clevelandfed.org/en/our-research/indicators-and-data/inflation-expectations.aspx 6 Fleckenstein, Matthias, Francis A. Longstaff, and Hanno Lustig (2010). "Why Does the Treasury Issue TIPS? The TIPS-Treasury Bond Puzzle", NBER Working Paper No. 16358. September 2010. JEL No. E6,G12,G14. http://www.nber.org/papers/w16358 7 https://www.forbes.com/sites/lbsbusinessstrategyreview/2016/03/11/why-are-big-banks-offering-less-liquidity-to-bond-markets/#64286f5729de 8 https://ftalphaville.ft.com/2017/04/24/2187716/guest-post-why-shrinking-the-fed-balance-sheet-may-have-an-easing-effect/ 9 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The U.S. dollar correction is entering its last innings as investors now only discount marginally more than one rate hike by the Fed over the next 12 months. The last leg of the USD's weakness is likely to be prompted by technical and political factors. Beyond this, the outlook for the U.S. economy remains healthy, yet investors have pared down their expectations, suggesting that positive surprises should emerge. The conciliatory tone of the so-called currency manipulator report suggests that the hopes of a Plaza 2.0 accord should get dashed. EUR/GBP has downside. Feature The dollar continues to decline. Doubts about President Trump's pro-growth agenda and higher borrowing costs are creating worries about future economic growth. Treasury Secretary Mnuchin's admonition that fiscal reform may be delayed only added fuel to the fire. The reality is a bit more nuanced than this. The global economy just experienced one of its most broad-based periods of improvement in decades. Earlier this year, our global economic and financial diffusion index, based on 106 indicators, hit its highest level since 1999 (Chart I-1). This upswing caused global growth expectations to surge, as highlighted by large moves in the global and U.S. stock-to-bond ratios. Chart I-1Broad-Based Economic Upswing Has Lifted Growth Expectations Still, such a pace of improvement is hard to maintain. The handicap is even greater given one of the sharpest increases in global borrowing costs of the past thirty years. Thus, an almost unavoidable growth disappointment is currently underway, as illustrated by the sudden swoon in global economic surprises. As negative surprises accumulate, it is natural for investors to tame their growth expectations, and in the process, to have pulled down their expectations for the level of the Fed funds rate 12 months out (Chart I-2). Unsurprisingly, the dollar has corrected in the process. Going forward, the flattening yield curve and weak inflation expectations could cause market expectations for the Fed Funds rate to fall further (Chart I-3). A downgrade in Fed expectations could push the DXY toward 97 - particularly given that the greenback currently stands at a crucial support (Chart I-4). Chart I-2A Full Rate Hike Has Been ##br##Purged From Expectations Chart I-3The Source Of ##br##The Worry Chart I-4Dollar At ##br##Crucial Spot Moreover, while our dollar capitulation index is already flirting with oversold readings, it can remain in that territory for extended periods of time. In fact, as long as this indicator stays below its 13-week moving average, the dollar tends to remain under downward pressure (Chart I-5). This would suggest that the window of weakness in the dollar has yet to be closed and that a break toward 98-97 in DXY is still very likely. Chart I-5Momentum Still A Headwind For The Dollar Outside of growth considerations, politics could also contribute to a last wave of selling in the dollar against the euro. Macron, the centrist candidate for the French presidency, is currently polling 25% of voting intentions for the first electoral round this weekend, ahead of Marine Le Pen. Yet the press continues to focus on Jean-Luc Mélanchon's surge in the polls, despite the fact that his popularity gains have stalled at 19%. This means that markets may get positively surprised Sunday night when French electoral results come in as the implied probability of a Le Pen / Mélanchon second round has risen. If as is more likely, Macron, not Mélanchon, makes it to the second round, it is important to remember that in head-to-head polls, he currently scores 64% vs 36% for Marine Le Pen (Chart I-6). Beyond these short-term dynamics, the outlook for the dollar continues to look brighter. To begin with, major leading indicators of the U.S. economy still point to a rebound later this year: The ISM manufacturing highlights that the decline in credit growth may be a temporary episode (Chart I-7). Chart I-6Positive Euro Stock This Weekend? Chart I-7U.S. Credit Growth Will Pick Up The U.S. CEO Confidence survey is at a 12 year high, and points toward both stronger capex and GDP growth (Chart I-8). The soft job number in March is likely to have been an aberration, as various indicators suggest that job growth will remain perky (Chart I-9). Moreover, this is happening in an environment where labor market slack is likely to prove limited. Not only is the headline U-3 unemployment rate now in line with NAIRU, but also hidden labor market slack - as approximated by discouraged workers and part-time workers for economic reasons - has greatly normalized (Chart I-10), suggesting that healthy job creation should result in accelerating wage growth this year. The elevated level of consumer confidence along with the healthy state of household finances - debt to disposable income still stands near 15-year lows and debt-service payments are at multi-generational lows - are together pointing toward stronger consumer spending. Chart I-8When CEOs Are Happy, ##br##So Is The Economy Chart I-9Soft March Payrolls: ##br##An Aberration Chart I-10U.S. Labor Market ##br##Slack Is Limited These developments are important as our Composite Capacity Utilization Gauge for the United States has now firmly moved into no-slack territory (Chart I-11). As such, improvements in the U.S. economy later this year will give the Fed plenty of ammunition to increase rates. Thus, we think that markets are ultimately underestimating the FOMC's capacity to lift rates by only anticipating marginally more than one rate hike over the next 12 months. Chart I-11U.S. Capacity Constraints Are Getting Hit As a result, buy any further dips in the dollar. We are already long the USD against commodity currencies, but will use any weakness to close our short USD/JPY trade and begin accumulating the dollar against the euro. In terms of level, we will close our short USD/JPY position at 107 and look to open a short EUR/USD bet at 1.10. Bottom Line: Markets are revising down their expected path for U.S. interest rates, causing a correction in the dollar in the process. After a period of robust and widespread growth improvement, expectations had become lofty and a period of indigestion was all but inevitable. However, forward looking indicators for U.S. growth are still healthy. With U.S. spare capacity becoming increasingly limited, investors are in the process of overdoing their downward adjustment in future U.S. rates. Use any further pull back in the U.S. dollar to buy the greenback. Currency Manipulators On Notice? Not Really This week, the U.S. Treasury published its annual report on Forex policies for the U.S.'s major trading partners, the so-called currency manipulator report. This time around, the report was especially interesting in light of the aggressive campaign rhetoric from President Trump. Chart I-12Conditions For Inflation Are ##br##Emerging In Japan Six countries were highlighted as hitting two of the three criteria necessary to be labeled currency manipulators. These were China, Germany, Japan, South Korea, Switzerland, and Taiwan. Most interesting was the tone of the discussion around China and Japan. Regarding China, the Treasury acknowledged that the PBoC is intervening in the currency market, however not to depress the value of the yuan, but to support it. The discussion was centered on the need for China to ease import restrictions and promote household consumption in order to narrow both the overall current account surplus and the bilateral trade surplus with the United States. These would be steps in the right direction to normalize the Sino-U.S. trade disequilibrium without entering in an all-out trade war. The discussion vis-à-vis Japan was also nuanced. Obviously, Japan's US$69 billion trade surplus with the U.S. was flagged, but the Treasury also acknowledged that the country's 3.7% current account surplus mostly reflected a very large positive income balance. Additionally, the Treasury also recognized that the large surplus was a reflection of Japan's poor domestic demand and that Japan needed to complement its very accommodative monetary policy with further fiscal boost and reforms. We interpreted this comment as a tacit acceptance that Abenomics and the BoJ's policy were squarely domestically focused and that the weak yen was a casualty, not the ultimate end-goal of these policies. With this recognition, it seems unlikely that the calls for a Plaza 2.0 accord would go anywhere. Instead, we expect similar demands to the one exerted on China to take precedence: more opening of the domestic market to imports and more Japanese FDI in the U.S. With this, the U.S. will live with a very dovish BoJ. In this optic, a key development emerged this week in Japan. Two BoJ governors have been replaced by two Abe philosophical allies, Mr. Hitoshi Suzuki and Mr. Goshi Kataoka. Therefore, Japan's monetary policy will remain very accommodative going forward as the near total control of the board by ultra-doves reinforces the institution's commitment to "irresponsible" monetary policy. Most importantly, our Composite Capacity Utilization Gauge for Japan is now in the zone where core inflation should accelerate (Chart I-12). This suggests that inflationary dynamics are likely to emerge after the current wave of global negative economic surprises abates. This should result in exactly what the BoJ wants: lower real rates and higher inflation expectations. This would be poisonous for the yen. Any further yen rally should be used to once again short the JPY. With regards to Germany, the Treasury acknowledged that ECB monetary policy is out of Berlin's control, but it would like to see more efforts to boost domestic demand, and a higher real exchange rate. In other words, at this point the Treasury seems to be hoping for higher German inflation more than for a higher euro. This too is re-assuring considering the initial aggressive stance of the Trump administration toward Germany. Switzerland, Korea, and Taiwan are in slightly more precarious conditions as all have been engaging in open market operations to depress the value of their currencies in recent years. However, with the softened tone exhibited toward China, Japan, and Germany, there is a high chance that the Treasury will find ways to turn a blind eye on these countries going forward. Bottom Line: The current U.S. administration is softening its tough rhetoric on trade and it is coming to grips with the reality that it may not be able to bully its trading partners into appreciating their currencies. Instead, Trump is likely to have to be content with fewer trade barriers to access these nations, and further efforts to stimulate domestic demand, which indirectly may help U.S. exports to these countries. We see these developments as steps in the right direction that should decrease the risks currently hanging over global trade. Politics Abound: What To Do With The Euro And The Pound? This week, Theresa May called for a snap election on June 8. The market perceived this announcement as very positive for the U.K.: it will decrease the risk of a very harsh form of Brexit. A larger Conservative victory, which seems highly likely based on current polls, implies that May will be less reliant on the most extremist Brexiters to govern. As such, the U.K. is perceived to be more likely to concede on some key EU demands such as Brussels's request that London pays the GBP 60 billion it owes to the EU's 2014-2020 budget. If these demands are met by the U.K., it is expected that the EU will be less intransigent when it comes to negotiating transitional agreements. On these dynamics, GBP/USD rallied 2.2% on Tuesday and now stands above its 200-day moving average for the first time since that fateful June 2016 night. EUR/GBP too was hurt by the pound rally, retesting its post referendum lows. What is the outlook for GBP/USD and EUR/GBP? The picture for EUR/GBP is the cleanest. A quick rally next week if Macron clenches a spot in the second round of the French election is very likely, especially as investors might have discounted the positive implications of the election on the pound too quickly. Any such rally should be used to begin building short EUR/GBP positions. EUR/GBP is currently trading 12% above its PPP fair value, but it is also trading at a large premium to real interest rate differentials (Chart I-13, top panel). Moreover, investors are starting to adjust upward the expected path of short rates in the U.K. relative to the euro area. This historically has been associated with a stronger pound (Chart I-13, bottom panel). Additionally, as we have argued, the negative factors affecting the U.K. economy are well known. Yet, the stability of long-term U.K. household inflation expectations suggests that the adjustment in consumption in response to high inflation caused by the lower pound could be limited as households may look through any temporary bump in inflation.1 Finally, positioning and sentiment on EUR/GBP are extremely stretched. Historically, such extended levels of bullishness toward the euro relative to the pound have been followed by sharp sell-offs in EUR/GBP (Chart I-14). Chart I-13Real Rates Points To ##br##EUR/GBP Downside Chart I-14Investors Are Positioned For##br## Further Euro Strength When it comes to the GBP/USD, the pound may continue to rebound in the short term toward 1.35. However, the upside in GBP/USD is likely to be capped if our bullish view on the dollar does pan out. This is why we prefer to express positive views on the pound via a short position in EUR/GBP. Bottom Line: The June 8 U.K. general election is important as it does increase the probability that Theresa May will be able to soften the U.K.'s negotiating stance on key budgetary points regarding Brexit. This means that longer and smoother transitional agreements between the U.K. and the EU are likely to emerge at the end of the Article 50 negotiations. Meanwhile, EUR/GBP is expensive relative to PPP metrics and rate differentials. The risk of a breakdown below 0.83 is growing, especially as investors are not positioned for a rally in the pound against the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the U.K. economy, please refer to the Foreign Exchange Strategy Special Report titled "GBP: Dismal Expectations", dated January 13, 2017 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The greenback's weakness has been a result of declining price and wage pressures this month. A weaker than expected jobless claims and Philadelphia Fed Manufacturing Survey are both indications of the current economic soft patch. However, this is a temporary setback that will do little to alter the Fed's intended hiking cycle. The DXY is currently at a crucial technical level and could face significant pressure from an appreciating euro in the run-up to the French elections. After the outcome of these elections is digested, a return to robust U.S. data will likely propel the greenback upwards as the Fed will keeping lifting rates relative to the rest of the G10. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro strengthens on the back of an optimistic interpretation of Praet's speech in New York. The central banker alluded to diminishing growth risks, but pointed out that short-term risks still remain. It seems that markets have priced in the end of the ECB's easing cycle. Further lifting the euro is expectations that Emmanuel Macron is on his way to the second round of the French election. However, it remains true that peripheral economies are stumbling along with high unemployment and little-to-no wage growth, which points toward widening U.S./European real rate differentials in the longer term. Inflation figures remained unchanged in March both in monthly and annual terms. An annual core inflation figure of 0.7% implies that inflationary pressures remain muted. A bearish outlook on the euro after the French elections is warranted. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 ECB: All About China? - April 7, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 On Tuesday the Japanese parliament nominated Hitoshi Suzuki and Goshi Kataoka to replace two members of the BoJ who had been serial dissenters of Governor Kuroda. This development is important as both of the nominees are known reflationists, which confirms our thesis that the Abe government is committed to support Kuroda's agenda. As the BoJ becomes increasingly dominated by doves, Kuroda will have more leeway in implementing radical reflationary measures, which is bearish for the yen on a cyclical basis. On a tactical basis, we believe the downtrend in USD/JPY might be approaching its last legs, given that we expect the dollar correction to end soon. On the other hand, a risk-off period in the markets seems probable, thus we will stay short NZD/JPY to capture investor's risk aversion. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Cable surged following Theresa May's call of a snap election as the market became less bearish on the U.K. economy given that the election provides an opportunity for the Prime Minister to assert her power over the more radical MPs, and thus set the stage for a softer Brexit. We continue to be relatively optimistic on the pound, particularly against the euro, as we believe that the market is too pessimistic on the U.K. economy. Furthermore, the BoE has shown much less dovish than the ECB as Governor Carney has stated that they will undergo "some modest withdrawal of stimulus" in the next few years, while many members seem to be leaning towards a rate hike. Taking these factors into account, as well as the overly bullish positioning on the euro relative to the pound, we are now confident in shorting EUR/GBP. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The antipodean currency experienced significant downside amidst dovish remarks by the RBA. Highlighted in the minutes were worries associated with the labor market, with members citing higher unemployment and underemployment as contributors to faltering wage growth. As a corollary, the rise in underlying inflation is expected to be "more gradual", with headline inflation expected to reach its 2% target sometime this year. However, members also stressed the role of energy prices, which could complicate the process. An important observation is the adverse impact of Hurricane Debbie on coal production, a major export for Australia. In merrier news, China's economy outperformed expectations, achieving a growth rate of 6.9% in Q1. However, this is a backward looking indicator and likely corroborates the AUD's strength in Q1, while the recent weakness in Chinese capital spending plans and residential property prices are more accurate indicators of future AUD development. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 This week, kiwi headline inflation came at 2.2%, not only surpassing expectations but also reaching the upper half of the 1%-3% target inflation range for the RBNZ. This confirms our suspicion that inflationary pressures in New Zealand are much stronger than what the RBNZ would lead you to believe, and opens the possibility that the RBNZ could abandon its neutral bias for a more hawkish one. This should help the NZD outperform the AUD on a cyclical basis, given that the Australia's domestic inflationary pressures are much weaker. On a tactical basis, we continue to be short the NZD relative to the JPY, given that a China induced risk-off episode will boost safe heavens and hurt carry currencies. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Within the commodity space, CAD should benefit against other commodity currencies. Oil is likely to face relatively consistent global demand vis-a-vis other commodities, such as industrial metals, as it is more insusceptible to the "unwinding of the Trump trade". Moreover, BCA foresees an extension of the OPEC production cuts for the remainder of the year, which will support oil-based currencies. Faltering capital expenditure in China will work against industrial metal demand, further accentuating this development. Limiting the CAD's upside, however, is a stronger USD this year, most probably after April is over. Real rate differentials will evolve in favor of the USD, limiting the upside to commodity prices in general. The result will be an outperformance of CAD relative to AUD and NZD. Finally, the recent non-resident tax implemented by Ontario my cause hick-ups in Canada's largest housing market. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Economic data in Switzerland continues to improve as various measures such as manufacturing PMI, employment PMI and purchase prices have reached 2011 highs. These developments along with rising inflation, will reassure the SNB that the unofficial floor under EUR/CHF has been effective. Nevertheless, we expect the SNB to keep this floor in place until the end of the year, as not only do French elections pose a short term risk, but core inflation and wage growth would have to stay high for a sustainable period of time for the SNB to consider removing accomodation. Moreover, the removal of the floor would likely be gradual, as the SNB has learned from 2015 that a sharp appreciation in the franc could quickly undo any economic progress. Report Links: The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Although USD/NOK has been quite uncorrelated with oil in recent months, EUR/NOK continues to be highly correlated with oil prices. Overall, we expect the NOK to exhibit weakness against the dollar on a cyclical basis given that dollar bull markets tend to weigh on this cross. Moreover, the Norges Bank will continue to have a dovish bias, given that inflation is falling sharply and economic conditions remain weak. However, on a tactical basis, it is possible that the NOK outperforms the AUD, given that base metals are more sensitive to weaknesses in the Chinese economy. Oil, on the other hand, should stay relatively resilient, given that an extension of the OPEC deal until the end of the year seems very likely. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has largely been trading on the news flow from the U.S. and the euro area following a quiet week in Sweden. Similar to the DXY, USD/SEK is at a crucial technical spot, and EUR/SEK is likely to continue its uptrend in the run-up to the French election. Next week's Riksbank meeting is the last meeting before asset purchases end in June. As inflationary pressures are unlikely to subside substantially, we firmly believe that asset purchases will not be extended further. Nevertheless, while not shifting the policy rate, the Riksbank is likely to reiterate that a future cut is more likely than a future hike, especially as recent inflation figures have disappointed. This is likely to help USD/SEK in the longer run. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades