Policy

Dear Client, I am travelling in Asia talking to investors and doing some field research. As such, there will be no CIS report next week. The next report will be sent to you on May 5th. Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature A special report I co-authored with my colleagues Arthur Budaghyan and Peter Berezin, and the webcast we all participated in with Caroline Miller late last month, focused on China's debt situation - a critical global macro issue that has been heatedly debated around the globe as well as within BCA.1 Economists rarely agree with one another, and financial markets are constant battles between buyers and sellers with diametrically opposed views. Similarly, it is not possible for senior research staff within BCA to always have uniform opinions. Our intention was to bring an internal debate on a critical global macro issue in front of clients in a straightforward and comprehensive way, which hopefully can enhance clients' own understanding of the topic. Our report and webcast received higher-than-normal questions and feedback. This week's report serves as a follow-up to clarify some of the more common questions we received. But It Is The Rapid Pace Of Increase In China's Debt-To-GDP Ratio That Is Alarming!! Even for clients that agree with Peter and myself and view Chinese debt from the savings investment identity perspective, a common pushback is that the pace of increase in China's debt-to-GDP ratio is alarmingly rapid, which is bound to create misallocations and financial risks (Chart 1). My arguments emphasizing the micro debt situation within the corporate sector and cross-country comparisons of efficiency ratios were reassuring, but not enough to alleviate all the concerns on the apparently rapid increase in debt relative to economic output in recent years. A few further points are in order: Chart 1The GDP Factor In China's Rising ##br##Debt-To-GDP Ratio First, the rapid increase in debt reflects the rapid increase in capital spending, which means the economy has become more capital intensive compared with before - i.e. it takes more capital to produce one unit of GDP. This could indicate declining efficiency in capital spending in terms of generating "growth." It could also mean the Chinese economy may have arrived at a much more capital intensive phase in its economic development curve. Dramatic improvement in the country's transportation infrastructure and urban development in recent years are tell-tale signs. Accumulating capital stock is the ultimate way for a developing country to improve productivity and lift living standards. China's growth path should be viewed as a norm rather than an anomaly. Second, the Chinese economy has directed massive financial resources toward infrastructure investment post the global financial crisis, largely undertaken by state-owned corporate entities such as state-owned enterprises and local government financing vehicles. These investments are not much different from the massive increase in fiscal deficits in other countries to finance social spending programs and welfare expenditures, as both were designed to support domestic demand during an economic downturn. The difference is that China's social welfare system is poorly developed and not large enough to make a meaningful contribution in supporting aggregate demand- and therefore the state sector must explicitly ramp up capex. Another important difference is that government expenditures on social benefit programs distributed to households in most other countries are ultimately consumed, whereas in China, state investment in infrastructure occurs on an accumulated physical asset. This is a key reason why I believe focusing only on the liabilities side of the balance sheet misses an important big-picture point. Finally, the apparently alarming increase in China's debt-to-GDP ratio is also partially attributable to how this ratio itself is calculated, in which the slowdown of China's nominal GDP growth rather than its increase in debt has played a much bigger role. Chinese nominal GDP growth dropped from almost 20% in 2010-'11 to close to 6% in 2015-early 2016. In a division calculation in mathematics, a falling denominator (nominal GDP) increases the result exponentially, while a rising numerator (debt) increases the result linearly. If nominal GDP growth had stayed stable, the pace would have been a lot less alarming. This also suggests that the best way to bring down the "debt-to-GDP" ratio is to increase the denominator - i.e. boosting growth either in real or nominal terms. In fact, Chinese nominal GDP expanded by 11.8% in the first quarter from a year ago, as reported early this week - the gap between credit growth and nominal GDP growth has already narrowed significantly. Has China Ever Delevered, And How To Delever Going Forward? In our joint report, Arthur cautioned that China in the past has had periods of deleveraging, and warned that a similar episode would be inevitable going forward, in which the Chinese authorities would have to rein in credit growth below nominal GDP growth, leading to a lower credit-to-GDP ratio (Chart 2). In my view, this diagnosis is misguided, and the policy prescription is dangerous. Chart 2Deleveraging Versus Inflation First, it is worth noting that China's credit-to-GDP ratio has been on an ever-rising trend ever since the data became available, which in my view reflects the accumulation of capital stock through savings and investments. There have indeed been a few short-lived periods when the ratio has declined, as Arthur pointed out, or the economy appeared to "delever," such as in the late 1980, early 1990s, early 2000s and prior to the global financial crisis. However, it is immediately clear that the periods of "deleveraging" in the 1980s and 1990s were both mainly due to massive increases in inflation, which artificially boosted nominal GDP growth. An inflation outbreak is hardly an ideal way to delever that policymakers should aim for. Inflation also picked up between 2003 and 2008, but not nearly as much as the previous two episodes, and the Chinese economy was characterized as experiencing "low inflation boom". However, it is important to note that the country's current account surplus jumped from 2% in 2003 to as high as 10% in 2007. This means Chinese savers collectively did not lend to domestic companies, and therefore debt was not accumulated within the country and shown in the debt-to-GDP ratio. Rather, they lent to foreign entities, such as the U.S. government, in the form of increased holdings of U.S. Treasurys. By the same token, after the global financial crisis, China's current account surplus tumbled back to 2% of GDP, which indicated a significant reduction in the pace of increase in foreign lending but simultaneously a sharp increase in domestic investment and credit. This is precisely what one would expect from the savings-investment identity in conceptualizing China's debt dynamics. In fact, the only period in which China's corporate sector indeed "delevered" in the "classic" textbook sense was the early 2000s, amid aggressive reforms of state-owned enterprises and the banking system. Mass bankruptcies of state-owned firms unleashed by the SOE reform efforts led to mounting losses in the banking sector. The government set up state-owned asset management companies as "bad banks" to take over the non-performing loans of commercial banks - financed by the issuance of special-purpose government bonds. Therefore, the government essentially engineered a "debt swap" in which corporate sector debt was exchanged for government debt - but the country's overall total outstanding debt hardly dropped. It is also noteworthy that the overall economy remained reasonably resilient throughout the "deleveraging" process, even though it was also hit by multiple severe external shocks such as the tech-bubble bust, terrorist attacks in New York City and the SARS crisis. In other words, the playbook of the early 2000s suggests that "deleveraging" will not necessarily hurt growth. In my view, "deleveraging" solely for the purpose of it is not only ineffective, but also counterproductive. Aggressive credit constraint intensifies deflationary pressures, creating a double-whammy on nominal GDP growth through both lower real growth and a falling GDP deflator - which makes it a lot harder to achieve a lower credit-to-GDP ratio. It goes without saying that irresponsible lending and investment behavior should be punished by market forces. However, as shown by "too big to fail" dilemma policymakers in the west had to deal with at the height of the global financial crisis, it is always a delicate balancing act, and it is overly dogmatic to suggest or expect Chinese policymakers to do otherwise. In fact, I have repeatedly argued that the much-touted "Likonomics"2 efforts named after the incumbent Chinese premier a few years ago that appeared to favor harsh "deleveraging" was one of the key reasons behind China's sharp growth slowdown in previous years. Chinese policymakers have since taken a more realistic approach in dealing with the corporate sector debt issue. The government embarked on a new debt-swap program in 2015 to deal with the existing debt load of local government financing vehicles.3 Some provincial "bad bank" asset management companies have been established to absorb regional banks' loan losses - both of which were taken from the early 2000s playbook. Furthermore, policy reflation has significantly eased deflationary pressures and lifted nominal GDP growth, which has narrowed the gap with the pace of credit expansion. In addition, the pace of IPOs in the domestic equity market has quickened notably - i.e. more domestic savings are being channeled into the economy via equity financing as opposed to bank loans. All of these measures in my view are the correct steps to lower the corporate debt-to-GDP ratio, rather than some "short term gain, long term pain" myopic fixes. China's Interbank Rate And The PBoC Liquidity Management Arthur argued in our report that the People's Bank of China (PBoC) in recent years has moved away from controlling money growth (the quantity of money) to targeting interest rates (the price of money), which effectively accommodates commercial banks' credit creation binge by injecting massive amounts of liquidity, as evidenced by the much-lowered volatility in China's interbank market since 2016 - with an explosion of PBoC direct lending to financial institutions (Chart 3). I doubt there is a connection between this point and China's loan growth. The PBoC's direct lending to commercial banks only began to increase in earnest starting in early 2016, while bank loan growth peaked six years before that. If anything, the recent change reflects the PBoC's more flexible and sophisticated management of the country's interbank liquidity compared with previously primitive and blunt measures. It is easy to spot the dramatic volatility in China's interbank rates before 2016 compared with other major economies. Chinese interbank rates routinely had sharp spikes, underscoring dramatic changes in interbank liquidity, which were both extremely rare and potentially damaging in other countries. Hong Kong's interbank rates showed similar spikes during the Asian Crisis in the late 1990s, when its currency peg was under furious speculative attack (Chart 4). U.S. interbank rates spiked amid the "Lehman shock" that marked a dramatic escalation of the global financial crisis. In "normal times" interbank rates closely track the policy interest rates of respective monetary authorities in major economies. Sharp spikes in interbank rates could easily tilt a country's financial institutions into a liquidity crisis, even without any solvency issues, and a central bank should seek all means to avoid such an event as the lender of last resort. Chart 3No Connection Between The PBoC Lending ##br##And Commercial Bank Loan Growth Chart 4Interbank Rates: Experiences In Other Countries In other words, the PBoC was effectively playing with fire in the past by allowing extreme swings in interbank liquidity. The impact on the country's banking system was not as dramatic as one would have expected, mainly because Chinese banks are heavily reliant on retail deposits for their loanable funds rather than on wholesale funding through the interbank market, as in other countries. Meanwhile, most Chinese banks are state-owned, which also reduces "perceived" counterparty risks. There were episodes in which some banks failed to honor their liquidity obligations during periods of extreme liquidity crunch, or technically defaulted, which in the west could well have triggered bankruptcies and a massive chain reaction. In China, these features, ironically, have made its banking sector more "resilient" to what effectively are central bank failures. Chart 5RRR Is Still Elevated The key reason was that the PBoC mainly relied on reserve requirement ratio (RRR) adjustments to manage interbank liquidity, which are by definition blunt and hard to adjust in a timely manner - the very reasons why other central banks have mostly abandoned it. More recently, the PBoC has been utilizing new liquidity tools, such as various lending facilities and open market operations. This is the sole reason behind the apparently steep increase in the PBoC's claims on commercial banks, shown in Chart 3. In fact, rather than providing massive liquidity relief, the PBoC still keeps the RRR at near historically high levels (Chart 5). Therefore, all the items on the PBoC's balance sheet should be cross-checked to assess its liquidity operations, rather than focusing on one item. In my view, what's happening is that PBoC has more recently been learning and experimenting with modern central banking, rather than accommodating/encouraging commercial banks' lending behavior. All in all, the debate on China's debt situation will likely stay, and its evolvement over time will be closely studied by policymakers and academia, which is probably irrelevant to most investors. From investors' point of view, the important point is that the market has been focusing on China's debt and leverage for many years, which means it is likely already priced in. Moreover, from a macro point of view, it is highly unlikely that such a well-known issue will cause a major risk event - black swans, by definition, are unheard of and unpredictable. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Special Report, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, ""Likonomics": Off To A Rocky Start," dated July 10, 2013, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Game Changer?" dated March 11, 2015, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

I am honored to join BCA Research as Senior Vice President of the U.S. Investment Strategy service. I have been researching and writing about the economy and financial markets for more than 30 years. I joined BCA Research from LPL Financial in Boston, MA where I served as the firm’s Chief Economic Strategist. At LPL I helped to manage more than $120 billion in client assets and provided more than 14,000 financial advisors and 700+ financial institutions with insights on asset allocation, global financial markets and economics. Prior to LPL, I served in similar functions at PNC Advisors, Stone & McCarthy Research, Prudential Securities, and the Congressional Budget Office in Washington, DC. I look forward to meeting you and providing quality research in the years to come. John Canally, Senior Vice President U.S. Investment Strategy Highlights We are not changing our view on Treasury markets or our stocks over bonds call despite the news that the Fed will begin shrinking its balance sheet later this year. The Fed's action is marginally dollar positive. For the major industrialized economies, the so-called "hard" data are moving in line with the "soft" survey data for the most part. Retail sales and industrial production have accelerated, although "hard" data on business capital spending remains weak. We introduce our Bond Duration checklist this week. These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. We continue to favor U.S. equites over bonds in 2017 and recommend keeping duration short of benchmark. Despite outsized performance from high-yield corporate bonds in 2016, investors should favor stocks over high-yield over the coming year. We introduce the BCA Beige Book Monitor this week. This metric provides a quantitative look at the qualitative, or "soft" data in the Fed's Beige Book. The Beige Book is due out Wednesday, April 19. Feature Chart 1Weak Data And More Weighed ##br##On Risk Assets U.S. stocks stumbled and Treasury yields slumped last week with the 10-year Treasury yield hitting a 2017 low. The drop in yields came despite news from the FOMC that the Fed is prepared to shrink its balance sheet later this year, a bit sooner than the market expected. Comments from Fed Chair Yellen - who expressed concern that the Fed's independence is "under threat"- should have jolted the bond market, but didn't. Not yet at least. Geopolitics played a role in the week's market action as well, the main culprits being upcoming French elections, the aftermath of President Trump's missile attack on Syria and ongoing tensions in North Korea. The looming Q1 earnings reporting season weighed on risk assets as well. The dollar ended lower last week. Trump told the Wall Street Journal he prefers a weak dollar. Those comments and the tepid data helped to offset the safe-haven bid generated by the geopolitical events of the week (Chart 1). The "hard" vs "soft" data debate will continue this week and likely for some time thereafter. "Hard" data on housing and manufacturing for March as well as the U.S. leading indicator are due out this week. Of course, the ultimate set of "hard" data is the corporate earnings data. Nearly 70 S&P 500 firms will report Q1 results and provide guidance for Q2 and beyond this week. "Soft" data on the PMI, Philly Fed and Empire State manufacturing sector for April will undoubtedly keep the debate going. Our view is that the hard data will catch up with the upbeat surveys in the U.S. This week we review the key economic indicators for the major advanced economies, which highlight that the global growth acceleration remains on track. We also introduce a Duration Checklist designed to help separate "signal from noise" in the bond market. Most of the items on the Checklist remain bond-bearish. Fed plans to shrink its balance sheet is not particularly negative for bond prices, but it certainly won't be supportive. The main risk to our bond-bearish view remains geopolitics, including the first round voting and results in the French election due on Sunday, April 23. Balance Sheet Bedlam? Maybe Not The release of Minutes from the FOMC's March meeting contained a robust discussion of the Fed's balance sheet. Until recently, most market participants had assumed that the Fed would maintain the size of its balance sheet via reinvesting through at least late 2017/early 2018. The latest FOMC minutes suggest that, assuming the economy continues to track the Fed's forecast, the FOMC will allow its balance sheet to shrink this year. The FOMC will achieve this by ceasing reinvestment of both its MBS and Treasury holdings at the same time. No decision has been made about whether the reinvestments will end all at once or will be phased out over time (tapered). Chart 2 shows that when QE1 ended in 2010 and QE2 ended in 2011, U.S. equities underperformed bonds. It's important to note, however, that underperformance didn't occur in a vacuum. The European debt crisis, the U.S. rating downgrade and debt ceiling debates all weighed on risk assets after QE1 and QE2 ended. Other factors played a role as well, such as weak economic growth and policy uncertainty. Amid QE3, U.S. equities surged in 2013, returning 32.4%, while bonds fell 8.5%. But in late 2013, the Fed announced that purchases would be tapered over the course of 2014. QE3 finally ended in late 2014. Stocks and bonds battled it out over 2014 and 2015, with stocks beating bonds by 3%. Chart 2Reminder What Happened When QE1, QE2 & QE3 Ended Bottom Line: Our view remains that Fed balance sheet run-off won't have a big impact on Treasury yields, although may lead to a widening of MBS spreads. What matters more for Treasury yields than the size of the balance sheet is the expected path of short rates. As for equities, while geopolitical risks are ever-present, the U.S. economy is in far better shape today than it was when QE1, QE2 and QE3 ended. U.S. corporate earnings are pointing higher as well. While we've clearly entered a new part in the Fed cycle, the news on the Fed's balance sheet does not change our view that U.S. stocks will outperform bonds this year. All else equal, the dollar should get a small boost from a shrinking Fed balance sheet, supporting our view that the dollar will rise 10% this year. Overplaying The Soft Data And Underplaying Geopolitics...In 2018 Chart 3Global Pick-Up On Track Traders and investors have been giving up on the global reflation story of late, sending the 10-year Treasury yield down to the bottom end of this year's trading range. Missile strikes, upcoming French elections and U.S. saber rattling regarding North Korea have lifted the allure of safe havens such as government bonds. At the same time, the Fed was unwilling to revise up the 'dot plot', doubts are growing over the ability of the Trump Administration to deliver any stimulus and a few recent U.S. data releases have disappointed. It is difficult to forecast the ebb and flow of safe-haven demand for bonds, especially related to North Korea and Syria. However, our geopolitical team holds a high-conviction view that angst over Eurozone elections this year are overblown. The Italian election in 2018 is more of a threat. While we cannot rule out an even stronger safe-haven bid from developing in the coming weeks, the global cyclical economic backdrop remains negative for government bond markets. For the major industrialized economies, 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 4.7% in February on a year-over-year basis (Chart 3). 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, which 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 4). 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 three months, rising 5.2% at annual rates (Chart 5). The weak spot has been in capital goods orders (Chart 3). We only have data for the big three economies - the U.S., Japan and the Eurozone - but growth is near to 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 3, third panel). Nonetheless, improving CEO sentiment, strengthening profit growth and activity surveys all suggest that capital goods orders will "catch up" in the coming months. Chart 4Manufacturing Rebound Is Not About Energy Chart 5U.S.: Non-Energy Production Surging That said, one risk to our positive capex outlook in the U.S. is that the Republicans could fail to deliver on their promises to cut taxes and boost infrastructure spending. 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 expenditures. Duration Checklist: What We're Watching BCA's Global Fixed Income Strategy service recently introduced a "Duration Checklist" designed to keep us focused on the most relevant factors while trying to sift out the signal from the noise (Table 1).1 These are the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio stance. Naturally, leading and coincident indicators for global growth feature prominently in the top section of the Checklist (Chart 6). All four of these indicators appear to have topped out except the Global Leading Economic Indicator (GLEI), suggesting that the period of maximum growth acceleration has past. Nonetheless, all four are still consistent with robust growth for at least the near term. Table 1Stay Bearish On Treasuries & Bunds Chart 6Some Warning From Leading Indicators The rapid decline in the diffusion index, based on the 22 countries that comprise our GLEI, is concerning. 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 remainder of the items on the checklist are related to growth, inflation pressure, central bank stance, investor risk-taking behavior and bond market technicals. We are focusing on the U.S. and Eurozone at the moment because we believe these two economies will be the main driver of global yields over the next 12 months. In the U.S., the Fed is tightening and market expectations are overly benign on the pace of rate hikes in the coming years. Upside pressure on global yields should intensify later this year, when the ECB announces the next "tapering" of its asset purchase program. All of the economic growth, inflation pressure and risk-seeking indicators on the Checklist warrant a check mark for the U.S., although this is not the case for the Eurozone inflation indicators. From a technical perspective, 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. This removes one of the largest impediments to a renewed decline in global bond prices. 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. Bottom Line: A number of political pressure points and some modest U.S. data disappointments have triggered an unwinding of short bond positions. Nonetheless, the global manufacturing revival and growth impulse remain in place, and the majority of items on our Checklist suggest that the recent bond rally represents a consolidation phase rather than a trend reversal. Keep duration short of benchmark within fixed-income portfolios. Favor Stocks Over Junk Bonds Table 2A New Trend In Junk Vs. Stocks? We continue to favor U.S. equities over bonds in 2017 and recommend keeping duration short of benchmark. But what about U.S. equities versus high-yield bonds? As a reminder, favoring corporate bonds over equities was a long-running BCA theme during the early stages of the economic recovery.We noted that corporate bonds were likely to outperform equities in a prescient Special Report published in late-2008,2 and we continued to favor corporate bonds until late-2012 when we shifted towards strong dividend-paying stocks. Table 2 highlights that our corporate bond vs equity recommendations have worked out well over the past several years. The table presents the annual total return for the S&P 500 and high-yield corporate bonds (as well as the difference between the two), and it shows that the former underperformed the latter from 2008 to 2011 (and again in 2012 in risk-adjusted terms). However, stocks materially outperformed high-yield bonds from 2013-2015, which followed our recommendation to favor the S&P Dividend Aristocrats index over corporate bonds in our November 2012 Special Report.3 But Table 2 also shows that the trend of stock outperformance reversed last year, with high-yield bonds having somewhat outpaced the S&P 500 in total return terms. Does this imply that investors are witnessing the beginning of a new uptrend in corporate bond outperformance versus equities? In our view, the answer is 'no'. Chart 7 presents our simple framework for the relative performance of stocks vs high-yield corporate bonds, which suggests that investors should favor the former over the latter. Panel 1 highlights that the trend in stocks vs high-yield is generally the same as that vs 10-year Treasuries, with a few notable exceptions of sustained difference. The first exception was from 2002 to 2004, when stocks significantly outperformed government bonds but were flat vs high-yield. The second exception occurred during the early part of this expansion, which again saw high-yield corporate bonds post equity-like returns. Chart 7Major Valuation Advantage Needed For High-Yield To Outperform Stocks Panel 2 suggests that both of these circumstances were fueled by a substantial high-yield valuation advantage over stocks. The panel illustrates the gap between the speculative-grade corporate bond yield-to-worst and the S&P 500 12-month forward earnings yield, which was elevated and fell materially in both of the cases of sustained divergence shown in panel 1. The key point for investors is that last year's outperformance of junk bonds is unlikely to continue. While the compression of the junk/stock yield gap did lead the former to outperform last year, the gap was not high to begin with and is currently not that far away from its historical lows. This suggests that there is no reason to expect the stock/junk relative performance trend to deviate from the overall stock/government bond trend, which we expect to rise further over the coming 6-12 months. Bottom Line: Despite outsized performance from high-yield corporate bonds in 2016, investors should continue to favor stocks over high-yield over the coming year (but favor both over Treasuries and cash). Introducing The BCA Beige Book Monitor Chart 8BCA Beige Book Monitor: ##br##A "Hard" Look At "Soft" Data The Fed's Beige Book is released eight times a year, two weeks ahead of each FOMC meeting. It was first released in 1983. The Beige Book's predecessor was the Red Book, first produced in 1970. The Beige Book itself got a makeover from the Fed in early 2017. The Fed changed the way the information was presented across the 12 Fed districts, but, according to the Fed, the Beige Book will continue to provide "an up-to-date depiction of regional economic conditions based on anecdotal information gathered from a diverse range of business and community contacts." In addition to the Beige Book, FOMC officials also review what is now known as the "Teal Book" at each meeting. The Teal Book combined the "Green Book" - a review of current economic and financial conditions - and the "Blue Book"- which provided context for FOMC members on monetary policy actions. As noted in the Fed's own description, the Beige Book is "soft data". In discussing the Beige Book, the financial press often notes the number of districts where growth is expanding and contracting or describes the pace of overall activity (modest, moderate etc). The BCA Beige Book Monitor takes a more quantitative approach to all the qualitative data in the Beige Book. We began by searching the document for all the words we could think of that signify strength: Strong, strength, rise, increase, accelerate, fast, expand, advance, positive, robust, optimistic, up, etc. We then counted up all the words that denote weakness: Weak, fell, slow, decelerate, decrease, decline, soft, negative, pessimistic, down, contract, etc. Next, we subtracted the number of weak words from the strong words to calculate the BCA Beige Book Monitor. The Monitor begins in 2005, so it covers the time period from the middle of the 2001-2007 expansion, through the Great Recession (2007-2009) and the recovery since 2009. A more streamlined approach, using the words "strong" and "strength" (and their derivatives like stronger, strengthened, etc) as proxy for all the strong words and the word "weak" as a proxy for all the weak words, showed the same results. We adopted this simpler approach. Chart 8, panels 1 and 2, shows the BCA Beige Book Monitor versus real GDP and CEO Confidence. The BCA Beige Book monitor does a good job explaining GDP, but it is more timely. The Monitor leads CEO confidence, especially around turning points. We intend to do more work with the Beige Book Monitor and present it to you in future editions of this publication. We also track mentions of other key words in the Beige Book. For example changes in mentions of "inflation" words in the Beige book track, and sometimes lead, core inflation (Panel 3). Mentions of the "strong dollar" track the dollar itself, although tends to be lagging (Panel 4). We'll be watching for those inflation words and mentions of the dollar in the Beige Book this week. The Beige Book will also help to shed some qualitative light on the recent weakness in capital spending and C&I loans. Has the uncertainty about the timing, scope and scale of Trump's legislative agenda (taxes, infrastructure and the repeal of Obamacare, etc) had an impact on corporate spending or borrowing? We'll find out this week. Bottom Line: Although technically it is "soft" data, the Beige Book is a major input on monetary policy decision making for the FOMC. As we showed last week, the rise in "inflation" words in the Beige Book has certainly captured the Fed's attention, and confirms the "hard" we've seen on inflation. The next FOMC meeting is on May 2-3, and neither we nor the consensus expects a hike at that meeting. Despite the apparent flare-up in geopolitics last week and the run of disappointing economic data, we continue to expect the Fed to raise rates 2 more times in 2017. 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 Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017, available at gfis.bcaresearch.com 2 Please see Global Investment Strategy Special Report, "Value And The Cycle Favor Corporate Debt Over Equities," dated November 14, 2008, available at gis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report, "The Search For Yield Continues: Aristocrats Or High Yield?" dated November 5, 2012, available at usis.bcaresearch.com

Highlights Despite President Trump's consternation, the dollar bull market will persist. The euro will reach parity against the greenback by the end of this year. The Fed will deliver more tightening over the next 12 months than the market is expecting, while the ECB will deliver less. The fact that U.S. Treasury-German bund spreads are near record-high levels will not prevent the euro from weakening further. About half of the Treasury-bund spread can be explained by two factors: 1) lower inflation expectations in the euro area; and 2) the hedge that bunds provide against redenomination risk in the event of a breakup of the common currency. The rest can be mostly explained by the fact that the euro area is still well behind the U.S. in its cyclical recovery. It is not the absolute level of interest rate spreads that matters for investors, but how spreads evolve relative to market expectations. The market is already pricing in a substantial amount of spread narrowing over the coming years. Investors expect real rates to be only 17 basis points higher in the U.S. than in the euro area in five years' time. This seems too low to us. Feature Can't Trump The Dollar After an impressive rally from its late-March lows, the dollar hit a roadblock on Wednesday following Trump's remarks on the currency. "I think our dollar is getting too strong," the President said, adding in typical Trumpian style, "and partially that's my fault because people have confidence in me." He went on to say that he prefers that the Fed keep interest rates low. We doubt that Trump will get his wish. If anything, with the Federal Reserve's independence under fire from Republicans in Congress, Fed officials could subconsciously react to Trump's rhetoric by accelerating the pace of rate hikes. Janet Yellen turned 70 last year and she would rather go out in style after serving one term as Fed chair than be perceived as doing Trump's bidding. Soft Versus Hard Data Chart 1U.S. Growth: Broader 'Nowcasts' ##br##Painting A More Flattering Picture Of course, the Fed's ability to keep hiking rates is contingent on growth holding up. As discussed in our Q2 Strategy Outlook, while we are worried that growth may disappoint towards the end of 2018, the next 12 months still look reasonably solid.1 Granted, the Atlanta Fed's widely-watched GDP model is pointing to growth of only 0.6% in Q1. However, we would discount this and other narrow tracking estimates, given that the so-called "nowcasts" - which use a broader array of data - paint a much more flattering picture (Chart 1). Some commentators have expressed concern that the nowcasts are being contaminated by "soft data" derived from surveys, which are sending much more bullish signals than the "hard data" published by government statistical agencies. We are less worried about this issue. For one thing, the soft data generally leads the hard data, so some divergence during periods of accelerating growth is not unusual. Second, survey data tends not to be revised, whereas the hard data often is. This is especially important at present because of question marks over seasonal adjustments to Q1 data, which by some calculations are biasing down growth by around one percentage point. Third, the soft data is more consistent with what we are seeing in the labor market. Despite a weak weather-distorted March payrolls report, the overall tone of the labor market data has been positive, as evidenced by near record-low levels of unemployment claims, a rising job openings rate, and ongoing improvement in the Conference Board's perception of job availability measure. Aggregate hours worked still managed to increase by 1.5% at an annualized rate in Q1. If GDP growth was barely above zero as the Atlanta Fed's model suggests, 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. ECB: Doves Are Still In Control There is no denying that economic data from the euro area has been strong this year (Chart 2). The composite PMI stood just shy of a 6-year high in March. Capital goods orders are in a clear uptrend, which bodes well for investment spending over the coming months. Private-sector credit growth reached 2.5% earlier this year, the fastest pace since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans (Chart 3). Chart 2The Euro Area Economy Will Continue To Recover Chart 3Euro Area: Credit Growth Should Accelerate Despite the bevy of good news, the ECB is in no rush to tighten monetary policy. Yes, the central bank did announce a one-off decrease in the size of its asset purchases in December, and will likely do so again in early 2018. However, Mario Draghi has made it clear that he will not raise rates until well after all asset purchases have been completed, which probably won't be until late 2019 at the earliest. The ECB's dovish bias is understandable. While the regionwide unemployment rate is falling, it is still 2% above pre-crisis lows (Chart 4). In Spain and Italy, the unemployment rate stands at 18% and 11.5%, respectively, up from 7.9% and 5.7%. Meanwhile, core inflation is still squarely below the ECB's 2% target and sluggish wage growth across most of the region suggests that this will remain the case for the foreseeable future (Chart 5). Chart 4The ECB's Dovishness Is Merited... Chart 5...Especially Given The Muted Inflation Backdrop Peering Through The Treasury-Bund Spread The usual rejoinder is that all this has been priced into the market. We disagree. The market is currently pricing in less than two Fed rate hikes over the next 12 months. In contrast, we expect the Fed to raise rates three or four times over this period. The FOMC is also likely to announce in December that it will allow the size of its balance sheet to shrink as maturing assets roll off. This could put some upward pressure on the term premium. On the flipside, the months-to-hike measure for the ECB has fallen from 60 last summer to only 30 today. We doubt it will go much lower. What about the fact that Treasury-bund spreads stand close to record-high levels? Doesn't that severely limit the downside for EUR/USD? The answer is no. First, one should ideally compare the U.S. Treasury yield with the composite euro area bond yield rather than the bund yield, since the former is what the ECB ultimately cares most about. Chart 6 shows that the GDP-weighted average of 5-year bond yields in Germany, France, the Netherlands, Belgium, Austria, Italy, and Spain currently stands 55 basis points above comparable bund yields. Second, it is not the absolute level of interest rate spreads that matters for investors, but how spreads evolve relative to market expectations. The euro area is still well behind the U.S. in its cyclical recovery. As such, the 5-year U.S.-euro area spread is currently 173 basis points. However, the 5-year, 5-year forward spread - the spread that investors expect to see in five years' time - is only 92 basis points (Chart 7). This means that investors expect the 5-year spread to fall by 81 basis points over the next half-decade as the business cycles in the two regions converge. Chart 6Bund Yields Remain Below Euro Area Peers Chart 7The Vanishing Transatlantic Bond Spread Third, both theory and evidence say that real interest rate differentials are what drive currencies. Investors have long believed that inflation is likely to be structurally lower in the euro area than the U.S. This is underscored by the fact that the CPI swaps market is signaling that inflation will be 0.8% points higher in the latter five years from now. If inflation evolves the way the market expects, U.S. real 5-year yields will be a mere 17 basis points higher than in the euro area in 2022 (Chart 8). This gap does not strike us as being particularly large. Chart 8AU.S. And Euro Area Bond Yields: A Nuanced Picture Chart 8BU.S. And Euro Area Bond Yields: A Nuanced Picture We can debate how low the neutral real rate is in the U.S., but whatever it is there, it is likely that it is even lower in the euro area, given the region's worse demographics and higher debt burdens. The anti-growth features of the common currency - namely, the inability to devalue one's currency in response to an adverse economic shock, as well as the austerity bias that comes from not having a central bank that can act as a lender of last resort to solvent but illiquid governments - also imply a lower neutral rate. This brings us back to Trump's rhetoric. If the neutral rate is lower in the euro area than it is in the U.S., any effort to weaken the dollar is bound to backfire. If the Fed raises rates too slowly, the economy could overheat, leading to higher inflation and the need for a sharp increase in rates later on. On the flipside, if the ECB raises rates too quickly, deflationary forces could set in, forcing it to reverse course. Central banks have firm control over many things, but the neutral rate of interest is not one of them.2 As such, we expect real U.S.-euro area spreads to widen over the coming months, which should help push EUR/USD to parity by the end of this year. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy, "Strategy Outlook: Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Plaza Accord 2.0: Unnecessary, Unfeasible, And Unlikely," dated February 10, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The Trump-Xi summit offers hopeful signs that the two sides are mending once-severely tested bilateral relations. The risk of escalation in trade tensions has declined. President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to show to his working-class electorates, while Xi's primary objective is to avoid the "Thucydides trap". This offers space for compromises. Unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Feature The summit between President Donald Trump and President Xi Jinping in Mar-a-Lago last week was hailed by both sides as an "ice breaking" success. Even though no substantive details have been offered, the two countries have formulated a new mechanism for senior-level dialogue, and established a 100-day process for addressing bilateral trade frictions. The risk still exists that Trump could unilaterally impose punitive measures against Chinese goods with his administrative powers, and it is overly simplistic to draw too much information from one particular event. However, the Trump-Xi summit confirms a developing trend: that some of President Trump's highly controversial remarks on his campaign trail are being quickly rolled back. The risk of escalating trade tensions between the world's two largest economies has on margin abated. Trump Goes Mainstream? America's China policy under recent administrations can best be described as "congagement" - an ambiguous mixture of containment and engagement by varying degrees. Trump's remarks on the campaign trail and in his early days in office suggested he was mainly interested in confrontation. But the Trump-Xi summit, along with some recent developments, implies that Trump's China policy is coming back to the middle ground, at least for now. After setting off a fierce firestorm on the Taiwan issue late last year, Trump reaffirmed the "One China" policy in a February phone call with President Xi, re-stating long-standing U.S. policy and easing a key source of diplomatic tensions. Taiwan is still re-emerging as a source of risk.1 But it is unquestionably positive in the short-term that Trump backed away from his initial, highly provocative approach. Treasury Secretary Steven Mnuchin stated in February that the Trump administration will stick to the existing statutory process in judging whether China manipulates its currency, a marked departure from Trump's repeated campaign pledges. It is almost certain that China will not be named a currency manipulator in the U.S. Treasury's upcoming semi-annual assessment due later this week.2 In his visit to Beijing last month, Secretary of State Rex Tillerson used Chinese verbiage to characterize the U.S.-China relationship. This verbiage was not repeated by other officials during Xi's visit to Florida, so it is unclear whether it signals the Trump administration's adoption of China's idea of a "new model of great power relations." Nonetheless, it is a drastic change from Tillerson's aggressive remarks at his congressional confirmation hearings, when he suggested blockading Chinese-built islands in the South China Sea. Separately, Secretary of Defense James Mattis, on his first trip abroad to Japan and South Korea, said he did not anticipate any "dramatic military moves" in the South China Sea. More recently, Steve Bannon, White House Chief Strategist, was removed from the National Security Council. It is futile to try to understand all the internal power struggles within the new administration. Nevertheless, Bannon's departure from the NSC is probably a positive development, viewed through the Chinese lens. Bannon not long ago openly identified China as a major threat to the U.S. and predicted a war in the South China Sea as inevitable. In short, President Trump's summit with President Xi marked continued "mainstreaming" of his China policy. Some strong anti-China rhetoric from him and his inner circle has apparently been sanded off, setting the stage for constructive negotiations with Beijing. Can China Accommodate? The restructuring of the Sino-U.S. comprehensive dialogue and the declaration of a 100-day process for addressing economic frictions are probably the most tangible outcomes from the discussions between the two leaders during the summit. Further detail deserve close attention in order to map out how relations between the world's two largest economies will evolve in the near future. In our view, China is likely to make concessions and avoid confrontations. First, trade appears to be front and center in President Trump's grand dealings with China, an important change compared with previous U.S. administrations that also focused heavily on values and ideological issues, such as democracy, freedom of speech and human rights. From China's perspective, the government has a lot more flexibility in making concessions on trade and economic fronts than in dealing with ideological differences. In the past, China has almost always yielded to U.S. pressure on trade-related issues. For instance, China depegged the RMB from the dollar in 2005 and allowed the RMB to continue to appreciate after the global economic recovery began, all under American political pressure. Chinese senior officials routinely led massive commercial delegations touring the U.S. with big procurement orders for everything from aircraft to agricultural goods in order to address American complaints. Both the U.S. and China understand that bilateral trade imbalances favor the U.S. in the event of an all-out trade war, which China will try its best to avoid. Strategically, President Trump and President Xi have different time horizons in setting policy priorities. Trump needs immediate success on trade and job creation to deliver on promises to his working-class electorate, while Xi is more interested in establishing a cooperative and productive strategic standing with the world's sole superpower. Xi's primary objective is to avoid the "Thucydides trap" - the likelihood of conflict between a rising power and a currently dominant one - by convincing the U.S. to grant China greater global sway. In this vein, Trump's withdrawal from the Trans Pacific Partnership (TPP) has been viewed as an important positive development from Xi's perspective, and it is likely that Beijing will offer incentives to further discourage President Trump to "pivot to Asia". It is already rumored that Beijing has drafted investment plans in the U.S. that could create 700,000 jobs, as well as further opening up agricultural goods imports and financial market access. We suspect these deals will be announced during the 100-day negotiation period, which should give Trump a much-needed boost in his approval ratings. Economically, Trump's resentment of China's trade practices is based on the old growth model that the country no longer adheres to. Trump's version of Chinese manufacturers - "sweat shops" operating in "pollution heaven" heavily dependent on state subsidies and a cheap currency - is increasingly out of touch with today's reality, as discussed in detail in a previous report.3 In a nutshell, Chinese manufacturers have quickly climbed up the value-add ladder due to rapidly rising labor costs, and pollution control has become an urgent social issue. Meanwhile, the RMB has been under constant downward pressure in recent years, and the Chinese authorities may welcome coordinated efforts to weaken the dollar and support the yuan. In short, China will not find it too painful to accept Trump's terms and conditions, as the "sick parts" of the Chinese economy will inevitably be cleansed regardless of pressure from the U.S. The risk to this view is that Trump finds China's progress too slow and grows impatient. Previous American presidents have come to accept China's gradualism and have demurred from punitive measures. Trump, with his populist base and promises, may at some point find it politically expedient to exact a price on China for failing to deliver the desired results on his electoral timeline. Across the board tariffs on Chinese imports are unlikely, but highly symbolic sanctions and anti-dumping measures remain distinct possibility. The End Game Of Sino-U.S. Trade Imbalances However, any immediate concessions from China on trade will do little to fundamentally change the U.S.'s external imbalances. It is well known that a country's current account balance is the residual of its national savings and domestic capital spending. Therefore, it is unrealistic to expect a meaningful reduction in the country's current account deficit without lifting America's domestic savings rate. Chart 1 shows the chronic nature of America's external deficit. It is worth noting that the "Nixon shock" in 1971 - the policy package of closing the gold window and imposing across-the-board tariffs on imports - was triggered when the U.S. was on track to have its first annual trade deficit since the 19th century. Fast forward 46 years later, various attempts by American administrations have failed to rescue the deteriorating trend. Many countries over the years such as Germany, Japan and newly-industrialized economies in Asia were all singled out as conducting unfair trade practices with the U.S., but none of the bilateral and multi-lateral efforts were effective with lasting impact. A fundamental change in global trade over the past four decades has been the rapid industrialization of China. In essence, China has become the final point of an increasingly integrated global assembly line, and therefore America's chronic deficit has been transferred from other countries to China. Chart 2 shows China's surplus with the U.S. has ballooned, while other countries' surpluses have dwindled. This has put China squarely under the spotlight, replacing previous scapegoats. Chart 1America's Secular Deficit... Chart 2... From Changing Sources From China's perspective, the country will continue to run a surplus with the U.S. so long as it remains in the most manufacturing-intensive phase of its development curve, though the product mix will continue to shift from lower-value-added goods to higher-value-added ones. Meanwhile, the Chinese corporate sector will shift production capacity to even lower cost countries, similar to what Japan, Hong Kong and Taiwan have done in relation to China since the early 1980s when China began to open up. Already, China's direct investment to Vietnam has surged in recent years, which partially explains the sharp increase in Vietnam's trade surpluses with the U.S. (Chart 3). In fact, Vietnamese trade surplus with the U.S. account for 15% of the country's GDP, even though its overall trade balance is barely positive. This means that America's demand for cheap consumer goods is the main driving forces for its deficit, rather than any particular country's unfair trade practices. The fact is that the U.S. has moved beyond industrialization and become a post-industrial society, where the service sector generates more wealth than the manufacturing sector. China's shrinking share of imports from the U.S. is the mirror image of America's shrinking share of the manufacturing sector in the overall economy (Chart 4). Furthermore, the self-imposed restrictions on some high-tech goods exports to China further limits American firms growth potential, as this is the most competitive segment of America's manufacturing sector in the global market. Without removing these restrictions, it is unrealistic to expect a material increase in sales to China. Chart 3The "China Factor" In Vietnam's##br## Growing Trade Surpluses Chart 4America's Deindustrialization And ##br##Shrinking Market Share In China For now, the Trump-Xi summit offers hopeful signs that the two sides are mending severely tested bilateral relations and that the risk of escalation in trade tensions has declined. Trump may adopt a "good cop / bad cop" strategy that creates greater volatility. Longer term, unless the Trump administration addresses America's "savings shortage," the country's external deficit will not change materially. Imposing tariffs on Chinese imports only pushes Chinese surpluses to other less-competitive countries; it does not bring jobs back to the U.S. Any serious negotiations on bilateral trade imbalances between China and the U.S. must deal with the root causes. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The RMB: Back In The Spotlight," dated March 16, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global political risks are understated in 2018; U.S. policy will favor the USD, as will global macro trends; Trump's trade protectionism will re-emerge; China will slow, and may intensify structural reforms; Italian elections will reignite Euro Area breakup risk. Feature In our last report, we detailed why political risks are overstated in 2017.1 First, markets are underestimating President Trump's political capital when it comes to passing his growth agenda. Second, risks of populist revolt remain overstated in Europe. Third, political risks associated with Brexit probably peaked earlier this year. Next year, however, the geopolitical calendar is beset with potential systemic risks. First, we fear that President Trump will elevate trade to the top of his list of priorities, putting fears of protectionism and trade wars back onto the front burner. In turn, this could precipitate a serious crisis in the U.S.-China relationship and potentially inspire Chinese policymakers to redouble their economic reforms - so as not to "let a good crisis go to waste." That, in turn, would create short-term deflationary effects. Meanwhile, we fear that investors will have been lulled to sleep by the pro-market outcomes in Europe this year. The series of elections that go against populists may number seven by January 2018 (two Spanish elections, the Austrian presidential election, the Dutch general election, the French presidential and legislative elections, and the German general election in September). However, the Italian election looms as a risk in early 2018 and investors should not ignore it. Investors should remain overweight risk assets for the next 12 months. Our conviction level, however, declines in 2018 due to mounting geopolitical risks. Mercantilism Makes A Comeback Fears of a trade war appear distant and alarmist following the conclusion of the Mar-a-Lago summit between U.S. President Donald Trump and his Chinese counterpart Xi Jinping. We do not expect the reset in relations to last beyond this year. Trump has issued a "shot across the bow" and now the two sides are settling down to business - but investors should avoid a false sense of complacency.2 Investors should remember that candidate Trump's rhetoric on China and globalization was why he stood out from the crowd of bland, establishment Republican candidates. Despite the establishment's tenacious support for globalization, Americans no longer believe in the benefits of free trade, at least not as defined by the neoliberal "Washington Consensus" of the past two decades (Chart 1). We take Trump's views on trade seriously. They certainly helped him outperform expectations in the manufacturing-heavy Midwest states of Michigan, Pennsylvania, and Wisconsin (Chart 2). And yet, Trump's combined margin of victory in the three states was just 77,744 votes -- less than 0.5% of the electorate of the three states! That should be enough to keep him focused on fulfilling his campaign promises to Midwest voters, at least if he wants to win in 2020.3 Chart 1America Belongs To The Anti-Globalization Bloc Chart 2Protectionism Boosted Trump In The Rust Belt In 2017, Trump's domestic agenda has taken precedent over international trade. The president is dealing with several key pieces of legislation, including the repeal and replacement of the Affordable Care Act, comprehensive tax reform, the repeal of Obama-era regulations, and infrastructure spending. However, there is considerable evidence that trade will eventually come back up: President Trump's appointments have favored proponents of protectionism (Table 1) whose statements have included some true mercantilist gems (Table 2). Table 1Government Appointments Certifying That Trump Is A Protectionist Table 2Protectionist Statements From The Trump Administration Secretary of Treasury Steven Mnuchin, who is not known as a vociferous proponent of protectionism, prevented the G20 communique from reaffirming a commitment to free trade at the March meeting of finance officials in Baden-Baden, Germany.4 Such statements were staples of the summits over the past decade. The Commerce Department - under notable trade hawk Wilbur Ross - looks to be playing a much more active role in setting the trade agenda under President Trump. Ross has already imposed a penalty on Chinese chemical companies in a toughly worded ruling that declares, "this is not the last that bad actors in global trade will hear from us - the games are over." He is overseeing a three-month review of the causes of U.S. deficits, planning to add "national security" considerations to trade and investment assessments, proposing a new means of collecting duties in disputes, and encouraging U.S. firms to bring cases against unfair competition. Ross is likely to be joined by a tougher U.S. Trade Representative (who has historically been the most important driver of trade policy in the executive branch). In addition, we believe that Trump's success on the domestic policy front, in combination with the global macro environment, will lead to higher risk of protectionism in 2018. There are three overarching reasons: Domestic Policy Is Bullish USD: We do not know what path the White House and Congress will take on tax reform. We think tax reform is on the way, but the path of least resistance may be to leave reform for later and focus entirely on tax cuts in 2017. Whatever the outcome, we are almost certain that it will involve greater budget deficits than the current budget law augurs (Chart 3). Even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows (Chart 4). This will perpetuate the dollar bull market. Chart 3Come What May, Trump Will Increase The Budget Deficit Chart 4A Fiscal Boost Will Accelerate Inflation Chinese Growth Scare Is Bullish USD: At some point later this year, Chinese data is likely to decelerate and induce a growth scare. Our colleague Yan Wang of BCA's China Investment Strategy believes that the Chinese economy is on much better footing than in early 2016, but that the year-on-year macro indicators will begin to moderate.5 This could rekindle investors' fears of another China-led global slowdown. Meanwhile, Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally on the interbank system. The seven-day repo rate, a key benchmark for Chinese lending terms, has surged to its highest level in two years, according to BCA's Foreign Exchange Strategy. It could surge again, dissuading small and medium-sized banks from bond issuance (Chart 5). Falling commodity demand and fear of another slowdown in China will weigh on EM assets and boost the USD. European Political Risks Are Bullish USD: Finally, any rerun of political risks in Europe in 2018 will force the ECB to be a lot more dovish than the market expects. With Italian elections to be held some time in Q1 or Q2 2018 - more on that risk below - we think the market is getting way ahead of itself with expectations of tighter monetary policy in Europe. The expected number of months till an ECB rate hike has collapsed from nearly 60 months in July 2016 to just 20 months in March, before recovering to 28 months as various ECB policymakers sought to dampen expectations of rate hikes (Chart 6).6 In addition, our colleague Mathieu Savary of BCA's Foreign Exchange Strategy has noted that a relationship exists between EM growth and European monetary policy (Chart 7), which suggests that any Chinese growth scares would similarly be euro-bearish and USD-bullish.7 Chart 5Interbank Volatility Will ##br##Dampen Chinese Credit Growth Chart 6Market Is Way Ahead Of ##br## Itself On ECB Hawkishness Chart 7EM Spreads, ECB Months-To-Hike: ##br##Same Battle The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. There are two parallels that investors should be aware of: 1971 Smithsonian Agreement - President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."8 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening a reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table.9 Economists in the cabinet opposed the surcharge, fearing retaliation from trade partners, but policymakers favored brinkmanship.10 The eventual surcharge was said to be "temporary," but there was no explicit end date. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination between allies. As such, the U.S. removed the surcharge by December without meeting most of its other objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the exchange-rate outcomes of the deal dissipated within two years. 1985 Plaza Accord - The U.S. reached for the mercantilist playbook again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 8). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that Americans were serious about tariffs. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 9). Chart 8Dollar Bull Market And ##br## Current Account Balance Chart 9The U.S. Got What It ##br##Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism as a negotiating tool in recent history. In fact, Trump's Trade Representative, the yet-to-be-confirmed Robert Lighthizer, is a veteran of the latter agreement, having negotiated it for President Ronald Reagan.11 Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. The problem is that 2018 is neither 1971 nor 1985. The Trump administration will face three constraints to using currency devaluation to reduce the U.S. trade imbalance: Chart 10Globalization Has Reached Its Apex Chart 11Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China can afford significant monetary policy tightening that engineers structural bull markets in the euro and RMB respectively. For Europe, the risk is that peripheral economies may not survive a back-up in yields. For China, monetary policy tightness would imperil the debt-servicing of its enormous corporate debt horde. Apex of Globalization: U.S. policymakers could negotiate the 1971 and 1985 currency agreements in part because the promise of increased trade remained intact. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 10), average tariffs appear to have bottomed (Chart 11), and the number of preferential trade agreements signed each year has collapsed (Chart 12). Temporary trade barriers have ticked up since 2008 (Chart 13). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Geopolitics: During the Cold War, the U.S. had far greater leverage over Europe and Japan than it does today over Europe and China. While the U.S. is still involved in European defense, its geopolitical relationship with China is hostile. What happens when the Smithsonian/Plaza playbook fails? We would expect the Trump administration to switch tactics. Two alternatives come to mind: Protectionism: As the Nixon surcharge demonstrates, the U.S. president has few legal, constitutional constraints to using tariffs against trade partners.12 As the Trump White House grows frustrated in 2018 with the widening trade imbalance, it may reach for the tariff playbook. The risk here is that retaliation from Europe and China would be swift, hurting U.S. exporters in the process. Dovishness: There is a much simpler alternative to a global trade war: inflation. Our theory that the USD will rally amidst domestic fiscal stimulus is predicated on the Fed hiking rates faster as inflation and growth pick up. But what if the Fed decides to respond to higher nominal GDP growth by hiking rates more slowly? This could be the strategy pursued by the next Fed chair, to be in place by February 3, 2018. We do not buy the conventional wisdom that "President Trump will pick hawks because his economic advisors are hawks" for two reasons. First, we do not know that Trump's economic advisors will carry the day. Second, we suspect that President Trump will be far more focused on winning the 2020 election than putting a hawk in charge of the Fed. Chart 12Low-Hanging Fruit Of Globalization Already Picked Chart 13Temporary Trade Barriers Ticking Up Bottom Line: Putting it all together, we expect that U.S. trade imbalances will come to the forefront of the political agenda in 2018. This will especially be the case if the USD continues to rally into next year, contributing to the widening of the trade deficit. We expect any attempt to reenact the Smithsonian/Plaza agreements to flame out quickly. America's trade partners are constrained and unable to appreciate their currencies against the USD. This could rattle the markets in 2018 as investors become aware that Trump's mercantilism is real and that chances of a trade war are high. On the other hand, Trump may take a different tack altogether and instead focus on talking down the USD. This will necessitate a compliant Fed, which will mean higher inflation and a weaker USD. Such a strategy could prolong the reflation trade through 2018 and into 2019, but only if the subsequent bloodbath in the bond market is contained. China Decides To Reform Presidents Trump and Xi launched a new negotiation framework on April 6 that they will personally oversee, as well as a "100 Day Plan" on trade that we expect will result in a flurry of activity over the next three months. One potential outcome of the meeting is a rumored plan for massive Chinese investment into the U.S. that could add a headline 700,000 jobs, complemented with further opening of China's agricultural, automotive, and financial sectors to U.S. investment and exports. Investors may be fêted with more good news, especially with President Trump slated to visit China before long. President Trump, a prominent China-basher, may decide that the deals he brings home from China will be enough to convince the Midwest electorate that he has gotten the U.S. a "better deal" as promised. This would enable him to stabilize China relations in order to focus on other issues, as all presidents since Reagan have done. However, we doubt that the Sino-American relationship can be resolved through short-term trade initiatives alone. There is too much distrust, as we have elucidated before.13 The 100-day plan is a good start but it carries an implicit threat of tariffs from the Trump administration if China fails to follow through; and China is not likely to give Trump everything he wants. Moreover, strategic and security issues are far from settled, despite some positive gestures. As such, we expect both economic and geopolitical tensions to resurface in 2018. Meanwhile Chinese policymakers may decide to use tensions with the U.S. as an opportunity to redouble efforts towards structural reforms at home. Since the Xi Jinping administration pledged sweeping pro-market reforms in 2013, the country has shied away from dealing with its massive corporate debt hoard (Chart 14) and has only trimmed the overcapacity in sectors like steel and coal (Chart 15). It fears incurring short-term pain, albeit for long-term gain. However, if Beijing can blame any reform-induced slowdown on the U.S. and its nationalist administration, it will make it easier to manage the political blowback at home, providing a means of rallying the public around the flag. Chart 14China's Corporate Debt Pile Still A Problem... Chart 15...And So Is Industrial Overcapacity China has, of course, undertaken significant domestic reforms under the current administration. It has re-centralized power in the hands of the Communist Party and made steps to improve quality of life by fighting pollution, expanding health-care access, and loosening the One Child policy. These measures have long-term significance for investors because they imply that the Chinese state is responsive to the secular rise in social unrest over the past decade. The political system is still vulnerable in the event of a major economic crisis, but the party's legitimacy has been reinforced. Nevertheless, what long-term investors fear is China’s simultaneous backsliding on key components of economic liberalization. Since the global financial crisis, the government has adopted a series of laws that impose burdens on firms, especially foreign and private firms, relating to security, intellectual property, technology, legal (and political) compliance, and market access. Moreover, since the market turmoil in 2015-16, the government has moved to micromanage the country’s stock market, capital account, banking and corporate sectors, and Internet and media. The general darkening of the business environment is a major reason why investors have not celebrated notable reform moves like liberalizing deposit interest rates or standardizing the business-service tax. These steps require further reforms to build on them (i.e. to remove lending preferences for SOEs, or to provide local governments with revenues to replace the business tax). But all reforms are now in limbo as the Communist Party approaches its “midterm” party congress this fall. Most importantly for investors, the government has still not shown it can "get off the train" of rapid credit growth that has underpinned China's transition away from foreign demand (Chart 16). The country's relatively robust consumer-oriented and service-sector growth remains to be tested by tighter financial conditions. And the property sector poses an additional, perpetual financial risk, which policymakers have avoided tackling with reforms like the proposed property tax (a key reform item to watch for next year).14 The PBoC's recent tightening efforts come after a period of dramatic liquidity assistance to the banks (Chart 17), and even though interbank rates remain well below their brief double-digit levels during the "Shibor Crisis" in 2013 (see Chart 5 above, page 6), any tightening serves to revive fears that financial instability could re-emerge and translate to the broader economy. Chart 16China's Savings Fueling Debt Buildup Chart 17PBoC Lends A Helping Hand What signposts should investors watch to see whether China re-initiates structural reforms? Already, personnel changes at the finance and commerce ministries, as well as the National Development and Reform Commission and China Banking Regulatory Commission, suggest that the Xi administration may be headed in this direction. Table 3 focuses on the steps that we think would be most important, beginning with the party congress this fall. Given current levels of overcapacity and corporate leverage, we suspect that genuine structural reform will begin with a move toward deleveraging, and involve a mix of bank recapitalization and capacity destruction, as it did in the 1990s and early 2000s. These reforms included the formation of new central financial authorities, like policy banks, regulatory bodies, and asset management companies, to oversee the cleaning up of bank balance sheets and the removal of numerous inefficient players from the financial sector.15 They eventually entailed transfers of funds from the PBoC, from foreign exchange reserves, and from public offerings as major banks were partially privatized. On the corporate side, the reforms witnessed the elimination of a range of SOEs and layoffs numbering around 40% of SOE employees, or 4% of the economically active workforce at the time. Table 3Will China Launch Painful Economic Restructuring Next Year? Chinese President Jiang Zemin launched these reforms after the party congress of 1997, just as his successor, Hu Jintao, attempted to launch similar reforms following the party congress of 2007. The latter got cut short by the Great Recession. The question now for Xi Jinping's administration is whether he will use his own midterm party congress to launch the reforms that he has emphasized: namely, deep overcapacity cuts and financial and property market stabilization through measures to mitigate systemic risks.16 Bottom Line: China may decide to use American antagonism as an "excuse" to launch a serious structural reform push following this fall's National Party Congress. Short-term pain, which is normal under a reform scenario in any country, could then be blamed on an antagonistic U.S. trade and geopolitical policy. While reforms in China are a positive in the long term, we fear that a slowdown in China would export deflation to still fragile EM economies. And given Europe's high-beta economy, it could also be negative for European assets and the euro. Europe's Divine Comedy Investors remain focused on European elections this year. The first round of the French election is just 11 days away and polls are tightening (Chart 18). Although Marine Le Pen is set to lose the second round in a dramatic fashion against the pro-market, centrist Emmanuel Macron (Chart 19), she could be a lot more competitive if either center-right François Fillon or left-wing Jean-Luc Mélenchon squeaks by Macron to get into the second round.17 Chart 18Melenchon's Rise: Comrades Unite! Chart 19Le Pen Cruisin' For A Bruisin' The risk of someone-other-than-Macron getting into the second round is indeed rising. However, Mélenchon's rise thus far appears to be the mirror image of Socialist Party candidate Benoît Hamon's demise. At some point, this move will reach its natural limits: not all Hamon voters are willing to switch to Mélenchon. At that point, the Communist Party-backed Mélenchon will have to start taking voters away from Le Pen. This is definitely possible, but would also create a scenario in which it is Mélenchon, not Le Pen, that faces off against a centrist candidate in the second round. As such, we see Mélenchon's rise primarily as a threat to Le Pen, not Macron.18 While we remain focused on the French election, we think that any market relief from that election - and the subsequent German one - will be temporary. By early next year, investors will have to deal with Italian elections. Unfortunately, there is absolutely no clarity in terms of who will win the Italian election. If elections were held today, the Euroskeptic Five Star Movement (M5S) would gain a narrow victory (Chart 20). However, it is not clear what electoral law will apply in the next election. The current law on the books, which the Democratic Party-led (PD) government is attempting to reform by next February, would give a party reaching 40% of the vote a majority-bonus. As Chart 20 illustrates, however, no party is near that threshold. As such, the next election may produce a hung parliament with no clarity, but with a Euroskeptic plurality. Meanwhile, the ruling center-left Democratic Party is crumbling. Primaries are set for April 30 and will pit former PM Matteo Renzi against left-wing factions that have coalesced into a single alliance called the Progressive and Democratic Movement (DP). For now, DP supports the government of caretaker PM Paolo Gentiloni, but its members have recently embarrassed the government by voting with the opposition in a key April 6 vote in the Senate. If Renzi wins the leadership of the Democratic Party again, DP members could formally split and contest the 2018 election as a separate party. The real problem for investors with Italy is not the next election, whose results are almost certain to be uncertain, but rather the Euroskeptic turn in Italian politics. First, aggregating all Euroskeptic and Europhile parties produces a worrying trend (Chart 21). And we are being generous to the pro-European camp by including the increasingly Euroskeptic Forza Italia of former PM Silvio Berlusconi in its camp. Chart 20Five Star Movement Set For Plurality Win Chart 21Euroskeptics Take The Lead Unlike its Mediterranean peers Spain and Portugal, Italian support for the euro is still plumbing decade lows -- no doubt a reflection of the country's non-existent economic recovery (Chart 22). It is difficult to see how Italians can regain confidence in European integration given that they are unwilling to pursue painful structural reforms. Chart 22Italian Economic Woes Hurt Euro Support The question is not whether Italy will face a Euroskeptic crisis, but rather when. It may avoid one in 2018 as the pro-euro centrists cobble together a weak government or somehow entice the center-right into forming a grand coalition. But even in that rosy scenario, such a government is not going to have a mandate for painful structural reforms that would be required to pull Italy out of its low-growth doldrums. As such, it is unlikely that the next Italian government will last its full five-year term. Bottom Line: Investors should prepare for a re-run of Europe's sovereign debt crisis, with Italy as the main event. We expect this risk to be delayed until after the Italian election in 2018, maybe later. However, it is likely to have global repercussions, given Italy's status as the third-largest sovereign debt market. Will Italy exit the euro? Our view is that Italy needs a crisis in order to stay in the Euro Area, as only the market can bring forward the costs of euro exit for Italian voters by punishing the economy through the bond market. The market, economy, and politics have a dynamic relationship and Italian voters will be able to assess the costs of an exit first hand, as yields approach their highs in 2011 and Italian banks face a potential liquidity crisis. Given that support for the euro remains above 50% today, we would expect that Italians would back off from the abyss after such a shock, but our conviction level is low.19 Housekeeping This week, we are taking profits on our long MXN/RMB trade. We initiated the trade on January 25, 2017 and it has returned 14.2% since then. The trade was a play on our view that Trump's protectionism would hit China harder than Mexico. Given the favorable conclusion to the Mar-a-Lago summit - and the likely easing of risks of a China-U.S. trade war in the near term - it is time to book profits on this trade. We still see short-term upside to MXN and investors may want to pair it by shorting the Turkish lira. We expect more downside to TRY given domestic political instability, which we expect to continue beyond the April 15 constitutional referendum. We see both the yes and no outcomes of the referendum as market negative. In addition, we are closing our short Chinese RMB (via 12-month non-deliverable forwards) trade for a profit of 5.89% and our long USD/SEK trade for a gain of 1.27%. Our short U.K. REITs trade has been stopped out for a loss of 5%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, available at gps.bcaresearch.com. 2 For this negotiating sequence, please see BCA Geopolitical Strategy and The Bank Credit Analyst Special Report, "A Q&A On Political Dynamics In Washington," dated November 24, 2016, available at bca.bcaresearch.com, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 3 Trump loves to win. 4 Please see Federal Ministry of Finance, Germany, "Communique - G20 Finance Ministers and Central Bank Governors Meeting," dated March 18, 2017, available at www.bundesfinanzministerium.de. 5 Please see BCA China Investment Strategy Weekly Report, "Chinese Growth: Testing Time Ahead," dated April 6, 2017, available at cis.bcaresearch.com. 6 The head of the Lithuanian central bank, Vitas Vasiliauskas, was quoted by the Wall Street Journal in early April stating that "it is too early to discuss an exit because still we have a lot of significant uncertainties." This was followed by the executive board member Peter Praet dampening expectations of even a reduction in the bank's bond-buying program and President Mario Draghi stating that the current monetary policy stance remained appropriate. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "ECB: All About China?" dated April 7, 2017, available at fes.bcaresearch.com. 8 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org, and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936 and 1971," Behl Working Paper Series 11 (2015). 9 Treasury Secretary John Connally was particularly protectionist, with two infamous mercantilist quips to his name: "foreigners are out to screw us, our job is to screw them first," and "the dollar may be our currency, but it is your problem." 10 Paul Volcker, then Undersecretary of the Treasury, provided some color on this divide: "As I remember it, the discussion largely was a matter of the economists against the politicians, and the outcome wasn't really close." 11 We highly recommend that our clients peruse Lighthizer's testimony to the U.S.-China Economic and Security Review Commission. Beginning at p. 29, he recommends three key measures: using the 1971 surcharge as a model (p. 31); going beyond "WTO-consistent" policies (p. 33); and imposing tariffs against China explicitly (p. 35). Please see Robert E. Lighthizer, "Testimony Before the U.S.-China Economic and Security Review Commission: Evaluating China's Role in the World Trade Organization Over the Past Decade," dated June 9, 2010, available at www.uscc.gov. 12 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Reports, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. See also the recent Geopolitical Strategy and Emerging Market Equity Sector Strategy Special Report, "The South China Sea: Smooth Sailing?" dated March 28, 2017, available at gps.bcaresearch.com. 14 Please see BCA's Commodity & Energy Strategy Special Report, "Chinese Property Market: A Structural Downtrend Just Started," dated June 4, 2015, available at ces.bcaresearch.com. 15 Please see BCA Geopolitical Strategy, "China: Is Beijing About To Blink?" in Monthly Report, "What Geopolitical Risks Keep Our Clients Awake?" dated March 9, 2016, available at gps.bcaresearch.com. 16 At a meeting of the Central Leading Group on Financial and Economic Affairs, which Xi chairs, the decision was made to make some progress on these structural issues this year, but only within the overriding framework of ensuring "stability." The question is whether Xi will grow bolder in 2018. Please see "Xi stresses stability, progress in China's economic work," Xinhua, February 28, 2017, available at news.xinhuanet.com. 17 That said, the most recent poll - conducted between April 9-10 - shows that Mélenchon may be even more likely to defeat Le Pen than Macron. He had a 61% to 39% lead in the second round versus Le Pen. 18 In the second round, Macron is expected to defeat Mélenchon by 55% to 45%, according to the latest poll, conducted April 9-10. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com.

Highlights High Conviction Views: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Medium Conviction Views: Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. Euro Area Bond Distortions: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Feature Chart of the WeekWhy Are Yields Falling? After publishing two Special Reports in the past two weeks, this Weekly Report is our first opportunity to comment on the markets in April. We find it somewhat surprising that government bonds in the developed world have rallied as much as they have since the most recent peak last month, with the benchmark 10-year U.S. Treasury and German Bund seeing yield declines of -29bps and -22bps, respectively. Most of the move in Treasuries has been in the real yield component, while Bunds have seen a more even split between declines in real yields and inflation expectations. This has occurred despite minimal changes in actual growth or inflation pressures in either the U.S. or Europe (Chart of the Week). The price action in the Treasury market after last week's U.S. Payrolls report is a sign that the bond backdrop remains bearish. Yields initially fell all the way to 2.26% after the March increase in jobs fell short of expectations, before subsequently rebounding sharply to end the day at 2.38%. While intraday yield reversals on Payrolls Fridays are as typical as the sun setting in the west, a 12bp swing is one of the larger ones in recent memory (perhaps because investors eventually noticed the weather-related distortions in the data or, more importantly, that the U.S. unemployment rate had fallen to 4.5%). We continue to favor a pro-growth bias for bond investors, staying below-benchmark on overall duration and selectively overweight on corporate credit (favoring the U.S.). Ranking Our Current Market Views, By Conviction We have seen little in the economic data over the past few weeks to change our main strategic market views and portfolio recommendations. We summarize our main opinions below, ranked in order of our conviction level: Highest conviction views: Below-benchmark on overall portfolio duration exposure (for dedicated bond investors). Global bond yields have more room to rise alongside solid economic growth, tightening labor markets, inflation expectations drifting higher and central banks moving to slightly less accommodative monetary policies, on the margin. While the sharp upward momentum in coincident bond indicators like the global ZEW sentiment index has cooled of late, the solid upturn in the BCA Global Leading Economic Indicator continues to point to future upward pressure on real yields (Chart 2). The recent pullback in yields also appears to have run too far versus the trend in global data surprises, which remain elevated (bottom panel). One factor that we see having a potentially huge negative impact on global bond markets is the European Central Bank (ECB) announcing a move to a less accommodative policy stance later this year. A taper of asset purchases starting in 2018 is the more likely outcome than any hike in policy interest rates, which we see as more of a story for 2019. This should help push longer-dated bond yields higher within the Euro Area, and drag up global bond yields more generally. Underweight U.S. Treasuries. We still expect the Fed to deliver at least two more hikes this year, and there is still room for U.S. inflation expectations to rise further and put bear-steepening pressure on the Treasury curve. Our two-factor model for the benchmark 10-year Treasury yield, which uses the global purchasing managers index (PMI) and investor sentiment towards the U.S. dollar as the explanatory variables, indicates that yields are now about 18bps below fair value. From a technical perspective, the Treasury market no longer appears as oversold as it did after the rapid run-up in yields following last November's U.S. elections. The large short positions indicated by the J.P. Morgan duration survey and the Commitment of Traders report for Treasury futures have largely been unwound, while price momentum has flipped into positive territory (Chart 3). This removes one of the largest impediments to a renewed decline in Treasury prices, and we expect that the 10-year yield to rise to the upper end of the recent 2.30%-2.60% trading range in the next couple of months, before eventually breaking out on the way to the 2.80%-3% area by year-end. Chart 2Maintain A Defensive Duration Posture Chart 3Stay Underweight U.S. Treasuries Underweight Italian government bonds, versus both Germany and Spain. Italian government debt continues to suffer from the toxic combination of sluggish growth and weak domestic banks. The OECD leading economic indicator for Italy is declining, in contrast to the stable-to-rising trends in Germany and Spain (Chart 4). Meanwhile, the 5-year credit default swaps (CDS) for the major banks in Italy remain elevated around 400bps, in sharp contrast to the declining CDS in Germany and Spain which are now at 100bps. It is no coincidence that the widening trend in Italy-Germany and Italy-Spain spreads began around the same time last year that Italian bank CDS started to disengage from the rest of Europe (bottom panel). Markets understand that the undercapitalized Italian banking system will need government assistance at some point, which will add to the Italian government's already huge debt/GDP ratio of 133%. Political uncertainty in Italy, with parliamentary elections due by the spring of 2018 and populist parties like the anti-euro Five-Star Alliance holding up well in the polls, will also ensure that the risk premium on Italian bonds stays wide both in absolute terms and relative to other Peripheral European markets. Overweight U.S. corporate bonds, versus both U.S. Treasuries and Euro Area equivalents. The positive case for U.S. corporate debt is built upon two factors - the cyclical decline in default risk and the marginal improvement in balance sheet metrics. The latest estimates from Moody's are calling for a decline in the U.S. speculative grade corporate default rate to 3.1% this year. This leaves our measure of default-adjusted spreads in U.S. high-yield at levels that our colleagues at our sister publication, U.S. Bond Strategy, have shown to have a high probability of delivering positive excess returns over Treasuries in the next 12 months.1 Add to that the recent change in trend of our U.S. Corporate Health Monitor (CHM), which appears largely driven by some more positive numbers coming from lower-rated issuers in the Energy space given the recovery in oil prices, and the optimistic case for U.S. corporate debt is compelling. This is in contrast to our Euro Area CHM, which shows that the improving trend in balance sheet metrics has stalled of late (Chart 5, top panel). Chart 4Stay Underweight Italy Chart 5Stay Overweight U.S. Corporates vs Europe The difference between the U.S. and European CHMs has proven to be a good directional indicator for the relative return performance between the two markets, and is currently pointing to continued outperformance of both U.S. investment grade and high-yield debt versus European equivalents (bottom two panels). The threat of an ECB taper also hangs over the Euro Area investment grade corporate bond market, given the large buying of that debt by the central bank over the past year that has helped dampen both yields and spreads. Chart 6Stay Overweight Inflation Protection Medium-conviction views: Overweight inflation protection (both inflation-linked bonds and CPI swaps) in the U.S., Euro Area and Japan. In the U.S., the breakeven inflation rate on 10-year TIPS looks a bit too wide relative to our shorter-term model based on financial variables. However, underlying U.S. inflation pressures remain strong (Chart 6, top panel), particularly given the evidence that conditions in the labor market are getting progressively tighter. We expect inflation expectations to eventually rise back to levels consistent with the Fed's 2% inflation target on headline PCE inflation (which is around 2.5% on 10-year TIPS breakevens that are priced off the CPI index). The reflation story is somewhat less compelling in Europe and Japan, although CPI swaps are now at levels consistent with the underlying trends in realized inflation in both regions (bottom two panels). We continue to view long positions in CPI swaps in Europe and Japan as having a positive risk/reward skew given the tightening labor market in the former and the yen-negative monetary policies in the latter. Long France government bonds (10yr OATs) versus Germany (10yr Bunds). This is purely a call on the upcoming French election, which our political strategists believe will not end in a victory for the populist Marine Le Pen. While Le Pen has seen a recent bump in support heading into the first round of voting on April 23rd, her strong anti-euro position will eventually prove to be her undoing in the run-off election on May 7th (Chart 7). We first made this recommendation back in early February, and even though France-Germany spreads have been volatile since then as both Le Pen and the far-left candidate Jean-Luc Melenchon have seen a pickup in their poll numbers, the yield differentials are essentially at the same levels.2 We take this as a sign that the market believes current spreads are enough to compensate for the likely probability that either candidate could win the French presidency. Overweight JGBs Vs. the Global Treasury index. The argument here is a simple one - in an environment where there is cyclical upward pressure on global bond yields, favor the lowest-beta bond market (Chart 8). Persistently low inflation will prevent the Bank of Japan (BoJ) from making any changes to its current hyper-accommodative policies this year, especially the 0% cap on the benchmark 10-year JGB yield.3 The lack of yield limits the prospects for JGBs on a total return basis, but relative to other government bond markets, JGBs should outperform over the next 6-12 months as non-Japanese yields rise further. Chart 7Stay Overweight France Vs Germany Chart 8Stay Overweight Low-Beta JGBs Underweight U.S. Agency Mortgage-Backed Securities (MBS). Investors should remain underweight U.S. MBS, as spreads remain tight by historical standards. Our colleagues at U.S. Bond Strategy note that nominal MBS spreads have been flat in recent weeks as the option cost, which is the compensation for expected prepayments, has tightened to offset a widening in the option-adjusted spread (OAS).4 Chart 9Stay Underweight U.S. MBS We tend to think of the OAS as being influenced by trends in net issuance while the option cost is linked to mortgage prepayments (Chart 9). Looking ahead, the supply of MBS should increase further when the Fed starts to shrink its balance sheet later this year (as was mentioned in the minutes of the March FOMC meeting that were released last week), leading to a wider OAS. At the same time, refinancing applications should stay low as Treasury yields and mortgage rates rise. This will keep downward pressure on the option cost component of spreads. But with the option cost already near its historical lows, it is unlikely to completely offset the widening in OAS going forward. We see little value in U.S. MBS at current spread levels. Bottom Line: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. How Much Has The ECB Distorted The European Bond Market? Last week, Benoit Coeure of the ECB Executive Board gave a speech entitled "Bond Scarcity and the ECB Asset Purchase Program."5 That title piqued our interest, as that exact topic has come up in several of our conversations with clients this year. In his speech, Coeure discussed how the huge rally at the short-end of the German government bond curve over the past year has been at odds with what has occurred in the Euro swap curve, where interest rates are much higher for shorter-maturity swaps. Typically, German yields and Euro swap rates move in tandem, with the only differences being a function of technical factors like fixed-rate corporate debt issuance or government bond repo rates - and, on occasion, shifts in the perceived health of Euro Area banks that are the counterparties to any interest rate swap. The latter has become much less of an issue in recent years given the regulatory changes to the swap market, where trading has moved to centralized exchanges to reduce counterparty risks. In this environment, the difference between German bond yields and Euro swap rates, a.k.a the swap spread, should be relatively modest. Yet as can be seen in Chart 10, there has been a notable divergence at the shorter-maturity portions of the respective yield curves, where swap rates are rising but bond yields remain subdued. We can also see the divergences in the slopes of the relative yield curves, with the Euro Area swap curve much flatter than the German bond curve, particularly at longer maturities (Chart 11). Chart 10Large Distortions At The Front End Of The German Curve Chart 11Euro Area Swap Curves Are Generally Flatter Coeure argued that part of this distortion can be attributed to ECB asset purchases, especially after the decision taken last December to allow bond buying at yields below the -0.4% ECB deposit rate. This created a more favorable demand/supply balance for German debt, especially given the dearth of short-dated issuance. In addition, Coeure noted that there have been substantial safe-haven flows into shorter-dated German bonds (including treasury bills) by non-Euro Area entities. Some of this demand comes from large institutional investors like sovereign wealth funds and currency reserve managers, who are worried about political risks in France and Italy, and about the general rising trend in global bond yields, and are thus seeking the safety of low duration German debt. But some of the demand for short-dated German paper also comes from non-Euro Area banks, who have excess liquidity that needs to be parked in Euros but do not have access to the ECB deposit facility for the excess reserves of Euro Area banks. We can see this in Chart 12, which shows ECB data for the relative government bond ownership trends for Germany, France and Italy. The data is broken into holdings for bonds with maturities of one year or less (short-term) and bonds with maturities greater than one year (long-term). It is clear that the non-Euro area buyers own a much larger share of short-term German paper, around 90%, than in France and Italy, while Euro Area entities own nearly 80% of long-term bonds in all three countries. Coeure is correct in pointing out that there is an excess demand condition for short-dated core European debt, exacerbated by foreigners who need Euro-denominated safe assets - particularly GERMAN safe assets, if those investors are at all worried about redenomination risks given the rise of anti-euro populist parties in Europe.6 It is clear that the economic messages sent by looking at the German bond and Euro swap curves are very different. The flatter swap curve is more consistent with a steadily growing Euro Area economy where economic slack is being steadily absorbed and inflation pressures are building (albeit slowly). Also, the sovereign spread differentials within Europe do not look as problematic using swaps as the reference rate rather than German bonds. That is the case in France, where spreads versus swaps look in line with the averages of the past few years (Chart 13). This contrasts with the yield differentials versus Germany, which have reportedly gone up as investors have priced in a higher sovereign risk premium before the French presidential election. Chart 12French Bond Valuations Look More Subdued vs Swaps Chart 13French Bond Valuations Look More Subdued vs Swaps The story is a little different for Italy, where bond spreads versus both German bonds and Euro Area swaps have risen for all but the shortest maturities (Chart 14). This could be consistent with an interpretation that Italy's banking sector woes will add to the nation's longer-term fiscal stresses (as discussed earlier in this report), but not in a way that raises immediate default risks (which is why the 2-year Italy vs swap spread is well-behaved). Regardless of the "bias of interpretation", one thing that is clear is that the ECB's extraordinary monetary policies have created distortions in Euro Area bond markets. These may start to unwind, though, if the ECB begins to signal a shift towards a tapering of asset purchases next year, as we expect. The distortions in Euro area government bond yields (and, by association, swap spreads) have occurred alongside both the cuts in ECB policy rates into negative territory and the expansion of its balance sheet to purchase government bonds (Chart 15). As the ECB moves incrementally towards less accommodative monetary policy, we would expect to see front-end Euro swap spreads narrow in absolute terms and relative to longer-tenor spreads, and the German bond curve to flatten toward levels seen in the swap curve. Chart 14Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Chart 15ECB Policies Have Caused The Distortions In Euro Swap Spreads Bottom Line: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 4 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 http://www.ecb.europa.eu/press/key/date/2017/html/sp170403_1.en.html 6 Coeure noted that, at the time that the ECB began its asset purchase program in March 2015, the share of German bonds of less than TWO years maturity held by foreigners was 70%, but that rose to 90% by the 3rd quarter of 2016. 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 Duration: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. Fed's Balance Sheet: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Credit Cycle: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Feature The bond bear market has been on pause for the past few months, with Treasury yields confined to a trading range since last November's post-election sell off. While yields have not moved meaningfully higher during this time, firm floors have also formed beneath both the 5-year and 10-year yields (Chart 1). Even after last Friday's disappointing payrolls number, the 10-year did not move below 2.3% and the 5-year did not move below 1.8%. Trading Range About To Break? Our sense is that the current consolidation phase in Treasuries is approaching its end and yields will soon head higher. Global growth indicators have continued to improve during the past few months, and as we noted in last week's report,1 our 2-factor Treasury model, based on Global PMI and U.S. dollar sentiment, pegs fair value for the 10-year yield at 2.54%. We attribute the recent leveling-off in yields to technical shifts in bond positioning and sentiment. Earlier this year, net positions in Treasury futures and asset manager duration allocations were deep in "net short" territory (Chart 2). Extreme short positioning usually leads to a period of bond market strength until short positions are washed out. Now that bond market positioning is closer to neutral, a key impediment to further yield increases has been removed. Chart 1Poised For A Breakout? Chart 2Positioning Has Normalized The elevated level of economic surprises has also been flagged as a potential roadblock to the bond bear market. Extended readings from the economic surprise index tend to mean revert as investor expectations are revised higher in the face of improving data. However, our research suggests that the change in Treasury yields tends to lead the economic surprise index by 1-2 months (Chart 2, bottom panel). Given this relationship, we suspect that the bond market has already discounted a lot of mean reversion in the economic surprise index. Chart 3Approaching Full Employment Finally, last week's employment report should not be taken as a signal that U.S. economic growth is weakening. Bad weather in the northeast played a key role in the low March payrolls number - only 98k jobs added. But more importantly, at this stage of the cycle we should expect payroll growth to slow and wage pressures to increase as we approach full employment. As can be seen in Chart 3, the late cycle trends of slowing payroll growth and rising wages are very much in place. Further, even broad measures of labor market tightness, such as the U6 unemployment rate,2 are quickly approaching levels that suggest the economy is operating at full employment. Increasingly it is measures of labor market utilization, wage growth and inflation that will guide the Fed's decision making, and these measures continue to improve. It was even noted in the minutes from the March FOMC meeting that "tight labor markets [are] increasingly a factor in businesses' planning". The minutes also reported that: Business contacts in many Districts reported difficulty recruiting workers and indicated that they had to either offer higher wages or hire workers with lower qualifications than desired Accordingly, surveys show that households are increasingly describing jobs as "plentiful" (Chart 3, panel 3) and small businesses are indeed ramping up their compensation plans (Chart 3, bottom panel). At this stage of the cycle, continued progress on measures of labor market utilization, wage growth and inflation will be sufficient for the Fed to continue lifting rates, pushing Treasury yields higher. Bottom Line: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. The Fed Will Shrink Its Balance Sheet This Year Last week's release of the minutes from the March FOMC meeting also contained some new information about how the Fed plans to deal with its large balance sheet. To summarize, we learned that: The Fed intends to start shrinking its balance sheet later this year (assuming growth maintains its current pace). The Fed will shrink its balance sheet by ceasing the reinvestment of both its MBS and Treasury holdings at the same time. Still no decision has been made about whether reinvestments will stop entirely or whether they will be phased out over time ("tapered"). On February 28, we published a detailed report about the Fed's balance sheet policy.3 In that report we explained why the winding down of the balance sheet will not have much of an impact on Treasury yields, but could lead to a material widening in MBS spreads. The new information received last week does not change either of these conclusions. The minutes did make clear that the Fed favors what Governor Lael Brainard recently called a "subordination strategy" for dealing with its balance sheet.4 [A subordination strategy] would prioritize the federal funds rate as the sole active tool away from the effective lower bound, effectively subordinating the balance sheet. Once federal funds normalization meets the test of being well under way, triggering an end to the current reinvestment policy, the balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a "new normal" has been reached, and then increasing in line with trend increases in the demand for currency thereafter. Under this strategy, the balance sheet might be used as an active tool only if adverse shocks push the economy back to the effective lower bound. Essentially, the Fed is 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. For our part, we think it would be unwise to "fight the Fed" on this issue. For Treasury yields, we observe that the real 10-year Treasury yield closely tracks changes in the expected number of rate hikes during the next 12 months, while the inflation component of the 10-year yield tracks changes in realized inflation (Chart 4). These two relationships will continue to determine trends in bond yields going forward, and Fed balance sheet shrinkage is only important if it impacts the expected pace of rate hikes or inflation. The Fed's "subordination strategy" should ensure that the act of winding down the balance sheet does not have much of an impact on the expected pace of rate hikes. Ironically, if Treasury yields were to rise sharply following the announcement of balance sheet runoff, then the ensuing tightening of financial conditions would probably lower the expected pace of rate hikes and bring Treasury yields back down again. The story for MBS is somewhat different. Nominal MBS spreads remain tight by historical standards and closely track implied interest rate volatility (Chart 5). But we can also think of nominal MBS spreads as being split between the option cost, which is the compensation for expected prepayments, and the option-adjusted spread (OAS), which tends to correlate with net supply (Chart 5, panel 2). Chart 4Focus On Rate Expectations Chart 5Stay Underweight MBS In recent weeks, the OAS has widened alongside rising net issuance, but this has been offset by a sharp decline in the option cost. This is generally the pattern we would expect to play out as the Fed lifts rates and removes itself from the MBS market. The increased supply of MBS should lead to wider OAS, but refinancing applications should also stay low as Treasury yields and mortgage rates rise (Chart 5, bottom panel). However, netting it all out, the option cost component of MBS spreads is already near its historical lows and the OAS could move materially wider just to catch up to net issuance. In prior reports,5 we have also made the case that rate volatility should rise as the fed funds rate moves further away from the zero-lower-bound. Investors should stay underweight MBS. Bottom Line: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Checking In On The Credit Cycle We continue to recommend overweight allocations to both investment grade and high-yield corporate bonds. This optimistic outlook is predicated on low inflation and a Fed that will support risk assets by remaining sufficiently accommodative until inflationary pressures are more pronounced. We think this "reflationary window" will stay open at least until core PCE inflation is firmly anchored around 2% and long-maturity TIPS breakevens reach the 2.4% to 2.5% range.6 Behind the scenes, however, leverage is building in the nonfinancial corporate sector. In this week's report we take a look at several different indicators of corporate credit quality and conclude that once the support from low inflation and accommodative monetary policy vanishes, it is very likely that corporate defaults will start to increase and corporate spreads will widen. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018. Corporate Health Vs. The Yield Curve Our Corporate Health Monitor (CHM, see Appendix for further details) has been signaling deteriorating nonfinancial corporate health since late 2013 (Chart 6), and moved even deeper into 'deteriorating health' territory in Q4 of last year. Chart 6Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Periods when the CHM is in 'deteriorating health' territory are marked by shaded regions in Chart 6. We see that these regions usually correspond with periods when corporate spreads are widening. Even in the current episode, corporate spreads have yet to regain their mid-2014 tights. However, the bottom panel of Chart 6 shows that periods of deteriorating corporate health and wider corporate spreads are typically preceded by a very flat (often inverted) yield curve. This makes sense because a flat yield curve usually signals that interest rates are high and monetary policy is tight. Tight policy and elevated rates lead to more stringent bank lending standards and increase firms' interest burdens. With the curve still quite steep, we think the risk of sustained spread widening is minimal. However, if the CHM is still above zero when the yield curve is flatter, no support will remain for excess corporate bond returns. Net Leverage & The Payback Period We would further argue that the CHM will almost certainly be in 'deteriorating health' territory once the yield curve is close to flat. In Chart 7 we see that net leverage (defined as: total debt minus cash, as a percent of EBITD) is not only positively correlated with spreads, but also has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. Chart 7The Uptrend In Leverage Will Only Be Broken By Recession Closer inspection of Chart 7 reveals that the period between 1986 and 1989 is the only period when corporate spreads tightened even though leverage remained in an uptrend. In the late 1980s, leverage and corporate spreads both shot higher as a collapse in the energy sector caused overall corporate earnings to contract (Chart 7, bottom panel). But then the energy sector recovered just as quickly, and earnings growth bounced back. This caused spreads to tighten for a couple of years, even though the trend in net leverage only ever managed to flatten-off. Debt growth stayed robust during this time, despite the wild fluctuations in earnings. If any of this sounds familiar, it should. The energy sector collapse of 2014 caused net leverage and spreads to shoot higher, and now spreads have started to tighten again as earnings have rebounded. Notice that just like in the late-1980s, net leverage has not reversed its uptrend. We believe that corporate spreads have entered a "payback period" very similar to the late 1980s. Spreads can tighten as earnings rebound, but because the economy is not in recession, debt growth will remain solid and leverage will continue to trend higher. Once inflationary pressures start to bite and Fed policy becomes less accommodative, the payback period will end and spreads will head wider. Debt Growth Chart 8Bond Issuance Is Back Although we have made the case that the corporate sector does not delever unless prompted by a recession, it is notable that net corporate bond issuance was negative in Q4 of last year and the growth rate in bank lending to the corporate sector has slowed sharply. We do not think this cycle is different, and expect corporate debt growth (both bonds and loans) to rebound in the coming months. We chalk up weak corporate bond issuance in 2016Q4 to uncertainty surrounding the U.S. election. In fact, we see that gross corporate bond issuance has already rebounded strongly in January and February of this year (Chart 8). Turning to bank loans, we observe that the outright level of outstanding bank loans only contracts following a recession, and that the rate of increase follows bank lending standards with a lag (Chart 9). In other words, Commercial & Industrial (C&I) loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that defaults have waned, this process will soon be thrown into reverse. In fact, our model of the 6-month rate of change in C&I lending - based on private non-residential fixed investment, small business optimism and corporate defaults - points to an imminent bottoming in C&I loan growth (Chart 10). Chart 9Loan Growth Follows Lending Standards Chart 10BCA C&I Loan Growth Model Bottom Line: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Ratings Trends & Shareholder Friendly Activities Chart 11Shareholder Friendly Activity Has Ebbed Our assessment of the cyclical back-drop for corporate spreads is primarily based on the combination of balance sheet quality - as determined by our Corporate Health Monitor and its underlying components - and the stance of monetary policy - as determined by the slope of the yield curve and C&I lending standards (among other factors). However, ratings migration and "shareholder friendly" activities have also historically provided advance notice of turns in the credit cycle. Net transfers to shareholders, i.e. payments to shareholders in the form of dividends and buybacks, are a direct transfer of capital from bondholders to equityholders. These transfers tend to rise late in the cycle, just before defaults start to increase and spreads start to widen (Chart 11). Net transfers to shareholders had been moving higher, but have recently rolled over. Similarly, ratings downgrades related to shareholder transfers have also moderated (Chart 11, panel 2). Historically, ratings migration related to "shareholder friendly" activities has been a more reliable indicator of the credit cycle than overall ratings migration. It has tended to move into "net downgrade" territory later in the cycle, closer to the onset of recession (Chart 11, panel 3). Ratings trends and transfers to shareholders are not flagging any imminent risk of spread widening. However, there is the additional risk that downgrades have simply not kept pace with the actual deterioration in credit quality of the nonfinancial corporate sector. Using firm-level data, we calculated the percent of high-yield rated companies with net debt-to-EBITDA ratios above 5. We see that actual ratings migration is too low relative to the number of highly-levered firms (Chart 11, bottom panel). It is possible that ratings agencies have already incorporated the rebound in energy prices and profit growth into their assessments while the actual debt-to-EBITDA data are lagging, but this is still a risk that bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 2 The U6 unemployment rate is a broader measure than the headline (U3) unemployment rate. It also includes those "marginally attached" to the labor force and those working part-time for economic reasons. 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/newsevents/speech/brainard20170301a.htm 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com Appendix Chart 12Corporate Health Monitor Components Box 1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole (Chart 12). These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The earnings rebound underway in Corporate America is being driven by more than just higher oil prices. S&P 500 profit margins have stabilized recently, but remain in secular decline. We remain bullish on the dollar and the other "Trump Trades" have legs as well. Uncertainty around tax policy may be restraining business capital spending and C&I loan growth. Feature Chart 1Excluding Energy Earnings Rebounding The so-called "Trump trades" have either stalled or partially reversed. The failure to reform Obamacare has dented hopes that the Administration and GOP will get a tax reform package done this year. The S&P 500 is not far off its all time high, but Treasury yields have returned to the bottom of the trading range and the dollar has weakened (although it has risen over the past 3 weeks). We still believe that the Republicans will at least push through tax cuts and some infrastructure spending this year, which will be stimulative for the economy. However, the 12-month outlook for the stock-to-bond ratio does not hinge solely on U.S. fiscal policy. As we have highlighted in the past, the underlying fundamentals for equities are positive, despite the fact that we see more dollar upside (see below). First quarter earnings season is about to kick off, and it should be another good one. Before we discuss the outlook for profits, let's review the fourth quarter of 2016. S&P 500 firms posted profit growth of 6% on a 4-quarter moving total year-over-year basis. The Q4 reading beat consensus bottom-up expectations at the start of earning season but were roughly in line with expectations at the start of Q4 2016 itself. The fourth quarter increase was the best year-over-year EPS gain since Q3 2014 - just after the oil price peak- and the first year-over-year increase in the 4-quarter sum since Q3 2015. Energy sector earnings posted a 6% advance in Q4, as oil prices averaged close to $49 per barrel in Q4 2016, up 17% from Q4 2015. It was the first time that oil prices posted a year-over-year increase in a quarter since Q2 2014. Part of the acceleration in earnings reflects the rise in oil prices from the Q1 2016 bottom, but higher energy prices are not the only factor driving the turnaround (Chart 1). Overall, 9 of the 11 S&P 500 sectors saw positive year-over-year profit gains in Q4 2016, led by technology (13%), financials (12%) and utilities (10%). In addition, Consumer Discretionary, Financials and Health Care all posted solid earnings figures in the last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is also benefiting from favorable comparisons. Eighty-eight percent of technology firms posted Q4 results that beat expectations, as did 80% of health care companies and 75% of financials, so the market was caught somewhat off guard by the pace of the upturn in earnings outside of energy. While earnings grew at 6% year-over-year in Q4 2016, revenues grew just 4% due to low nominal GDP growth last year (although the latter rebounded late in the year). Ten of 11 sectors posted year-over-year revenue increases in Q4, but the revenue gain just matched consensus estimates with only half of firms posting revenues that exceeded already low expectations. In short, the market didn't expect much and didn't get much from revenues in Q4. The Marginal Way: A Top Down View Looking ahead, a secular downtrend in margins will be a headwind for earnings growth in the coming years, as we highlighted in the February 27, 2017 Weekly Report. A "mean reversion" process for margins is underway, as a tight labor market pushes up wages but firms have difficulty passing along the cost pressure in a poor environment for pricing power. For large cap U.S. companies, global GDP is a better proxy for revenue than U.S. GDP. Nominal global GDP growth fell 6% year-over-year in 2015, but rebounded to a 2%+ increase in 2016 and the World Bank expects global GDP to accelerate rapidly to a 6% increase here in 2017. Thus, there is scope for U.S. corporate revenue growth to pick up after a long period of deceleration. Indeed, the risks for global growth are to the upside of consensus estimates in our view (Chart 2). For those industries and sectors with mainly domestic sales (utilities, telecom), U.S. GDP is a better proxy for top line sales. At just 3.0%, U.S. nominal GDP growth was disappointing in 2016, running 340 basis points below its long-term average (6.4%) and nearly a full percentage point shy of the 2010-2014 (post Great Recession but pre-oil price decline) average of 3.8%. We expect nominal GDP growth to accelerate this year, even absent potentially growth-enhancing legislation from Congress on tax cuts, tax reform and infrastructure. Compensation costs represent two thirds of business costs, and various measures of wage gains are slowly climbing as the U.S. economy approaches full employment. Average hourly earnings rose 2.7% in March 2017 versus a year ago, up from a low of 1.5% hit in 2012. The Employment Cost Index is accelerating as well. The Atlanta Fed's Wage tracker has been trending higher for 7 years, not coincidentally, along with service sector inflation. The Atlanta Fed wage tracker shows the same pattern for both job stayers and job seekers (Chart 3). Chart 2Global Growth Accelerating Chart 3Wage Pressures Building The quit rate from the BLS's JOLTs data has hit a new cycle high and is within striking distance of an all-time high. This is significant because a high quit rate means that job prospects are favorable and that employees are jumping to new jobs in search of higher wages. In addition, mentions of wages, skilled labor, and shortages in the Fed's Beige Book have been on the upswing for four years (Chart 4). Labor costs are rising faster than selling prices in the non-financial corporate sector, as highlighted by the downtrend in BCA's Profit Margin Proxy (Chart 5, Panel 1). The mean reversion process will continue, but that does not preclude periods of margin expansion. Indeed, margins rose in the third and fourth quarters on a four quarter moving total basis according to S&P data and we would not be surprised to see this continue early in 2017 as nominal GDP growth recovers from last year's depressed pace (Chart 5, Panel 2). Chart 4"Inflation Words" On The Rise Chart 5Bullish Profit Model What about the dollar? As we discuss below, BCA believes that the dollar bull market still has legs. A stronger dollar is both a blessing and a curse for margins. All else equal, a stronger dollar lowers the cost of imported goods and thereby boosts margins for import-intensive firms. On the other hand, a strong dollar undermines profits earned overseas. The net impact of dollar strength is negative for overall corporate profits. However, our quantitative work highlights that it does not take much in the way of stronger growth to offset the negative impact on profits from a rise in the dollar. Investors are also concerned about the impact of higher interest rates on corporate income statements, especially given all the corporate debt that has been accumulated. While we agree with the conventional wisdom that interest costs as a percent of sales have likely bottomed for the cycle, and will undermine margins if yields rise, research by the monthly Bank Credit Analyst revealed that it will require a large increase in interest rates to 'move the dial' on interest payments.1 This is because of a long maturity distribution and the fact that the average yield-to-maturity is still so far below the average coupon in the corporate debt indices that average coupons will continue to erode as debt rolls over in the coming years. Chart 6 shows that interest payments as a fraction of GDP will be roughly flat even if the yield curve shifts up by another 100 basis points in the near term. It would require a 200-300 basis point rise in yields to see a meaningful impact on interest payments over the next 1-2 years. The implication is that rising interest costs won't be a key driver of profit margins in our investment horizon. Chart 6U.S. Corporate Sector Interest Payment Projection Despite our secular view on profit margins, we remain upbeat for EPS growth this year. Our profit model remains constructive. Indeed, EPS growth for the year may not trail (perennially overly optimistic) bottom-up estimates for the year, currently at 10%. In short, we see a potential for upside surprise on earnings this year, although growth will not be as high as our short-term profit model suggests (Chart 5, Panel 3). Bottom Line: We certainly would not rule out a pullback in the S&P 500 on disappointment surrounding a lack of follow-through by Congress and the Trump Administration on a tax cut, tax reform and an infrastructure package. However, fears around margin contraction, the sustainability of the earnings rebound and valuations are overdone. Earnings estimates almost always come down over the course of the year. Moreover, while above-average valuations suggest below average-returns over the next decade, valuation tells us little about returns over the next 12 months. We continue to favor stocks over bonds in 2017. Is The Dollar Bull Over? The dollar has firmed over the past couple of weeks but it remains below the December high in trade-weighted terms. Is this just a consolidation phase? Or has the dollar peaked for this cycle because the maximum policy divergence between the Fed and the other major central banks is now in the price? Indeed, the global growth outlook outside of the U.S. has brightened at a time when some of the so-called "hard" U.S. economic data have disappointed and the promised Trump fiscal stimulus appears to be on the ropes. The European Central Bank (ECB) has already tapered its asset purchase program once and is expected to do so again early in 2018. Some are even speculating that the ECB will lift rates in the not-to-distant future. This raises the possibility that the bund yield curve begins to converge with the Treasury curve, placing upward pressure on the euro versus the dollar. The Eurozone economic data have certainly been stellar so far this year. The PMIs for manufacturing and services both pulled back a bit in March, but remain at levels consistent with continued above-trend growth. The uptrend in capital goods orders bodes well for investment spending over the coming months (Chart 7). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. The Eurozone unemployment rate is falling fast and there is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases in 2013 (Chart 8). Chart 7Solid Eurozone##br## Economic Data Chart 8Less Spare Capacity In Europe Now ##br##Vs. Pre-Taper Tantrum U.S. Nonetheless, the calm readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Our diffusion index for the components of the CPI points to some upside for core inflation in the coming months, but it fell back to 0.7% in March according to the flash estimate. The ECB will probably not feel comfortable announcing the next tapering until September of this year. But even then, policymakers will apply a heavy dose of "forward guidance" on the outlook for short-term rates in order to avoid an outsized impact on Eurozone bond yields. Some tapering is presumably already discounted in rates and the euro. Chart 9Market Is Reassessing The FOMC It will be much longer before the Bank of Japan is in any position to begin removing monetary accommodation. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year, and probably much longer. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well. This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese nominal interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. On the U.S. side, we believe that the market has over-reacted when the FOMC signaled last month that it was not yet prepared to adjust the 'dot plot.' The market is discounting only two rate hikes over the next 12 months, down by about 10 basis points since the FOMC meeting (Chart 9). The market view is too complacent for three reasons. First, we expect the U.S. "hard" to catch up with the more robust "soft" data readings in the coming months. Second, the FOMC did not signal a more dovish mindset last month. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. The poor (weather-related) March payroll report does not change the Fed outlook. The important point is that the market appears to be at full employment based on FOMC committee projections. In fact at 4.5% in March (the lowest since May 2007) the rate is below the median and midpoint of the FOMC's long-run forecast, of respectively 4.7% and 4.85%. Finally, the market is underestimating the prospects for stimulative tax cuts and infrastructure spending. The Republican's desire to cut taxes will dominate fears of blowing out the budget deficit. The resulting stimulus will add pressure on the FOMC to tighten monetary conditions. Bottom Line: Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms as yield spreads move further in favor of the greenback, but a move of that magnitude wouldn't be a major headwind for U.S. corporate earnings growth and would pale in comparison to the hit earnings took from the 20-25% gain in the dollar in late 2014 through early 2016. Our view remains that the U.S. bond bear phase is not yet over. Revisiting "Weak" U.S. CAPEX The BCA Model for business investment tracks broad capex swings and has been trending down for several months now. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Comments from management during the recent Q4 2016 earnings reporting season were upbeat, but cautious, and there is some evidence (the recent rollover in C&I) loans that businesses may be delaying some portion of capital spending until after tax cuts and or tax reform is enacted by Congress. Part of the macroeconomic narrative for many investors over the past several years is that U.S. growth has been slow this cycle because private investment has been weak. The prolonged nature of "weak" U.S. investment during this economic recovery has been offered as evidence of deep-seated structural problems by many market participants, and arguably remains a factor driving the continued prevalence of the secular stagnation narrative. Two elements of the "weak investment" narrative are undeniably true. First, overall investment has indeed grown at a sluggish pace over the past eight years relative to previous economic expansions. Second, residential investment has certainly been weak by any measure, which is to be expected given that housing was at the epicenter of the subprime financial crisis. However, Chart 10 presents a different perspective about the "weakness" of investment by examining the trend in non-residential fixed asset investment (i.e., capex). The chart shows that, relative to GDP, capex has not been weak at all this cycle: it experienced a V-shaped recovery over the past several years, and has risen either back to its post-1980 average (in nominal terms) or to a new high (in real terms). This highlights that growth in investment, abstracting from the housing effect, has been weak in absolute terms because consumption has been weak, rather than because of some other unexplained structural force. Chart 10Investment Has Not Been Weak Relative To GDP More recently, Chart 10 shows that there has been a decline in the capex-to-GDP ratio, which has been a concerning sign for some investors that U.S. growth may be faltering. Until the beginning of last year, this deceleration could have been simply blamed on a collapse in resource investment following the sharp decline in the price of oil that began in mid-2014. But Chart 11 shows that this ceased to be the case through to the fourth quarter, as real capex excluding mining structures has also decelerated sharply. The slowdown in capex last year is echoed by a sharp recent slowdown in U.S. bank lending, and a detailed analysis suggests they may both be (at least somewhat) related to the same cause. Chart 12 presents the 3-month annualized rate of change in commercial & industrial (C&I) loans, along with the U.S. Economic Policy Uncertainty Index. The recent spikes in the latter correspond with the U.K.'s vote to leave the European Union as well as the U.S. election in November, and the chart clearly shows a close correlation between these spikes and the deceleration in C&I loan growth. Indeed, C&I lending had begun to pick up again following the Brexit vote, only to decelerate again after November. Chart 11Oil Accounts For Some, But Not All, ##br##Of Recently Weak CAPEX Chart 12Tax Rule Certainty May Spur Bank##br## Lending And Investment Uncertainty over Brexit represented legitimate CEO concern about a potential global macro shock, but our view is that the recent uncertainty following the U.S. election has not been driven by fear. This is a crucial distinction with implications for the economic outlook: if the recent uptick has been driven by a dearth of information about how business-friendly fiscal policy will become as a result of the election, then investors are more likely observing uncertainty over how much and when to invest rather than whether to invest. If true, this suggests that weak bank lending and growth in non-resource capex in Q4 has merely been deferred until rule clarity emerges and firms are confident that they will benefit from any investment-related changes to the tax code. In short, far from being a bearish signal about economic activity, recent trends in C&I lending and non-resource capex may actually indicate that firms plan on responding positively to corporate tax relief, suggesting that overall economic growth may improve once the details of the plan are known. Bottom Line: A detailed analysis of recent weakness in C&I lending and non-resource capex points to policy-related uncertainty as the culprit, rather than impending economic weakness or a broad-based contraction in activity. This argues that some capex spending is pent up, and that economic growth will improve following the establishment of tax rule certainty by the Trump administration and/or congressional leadership. 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 The Bank Credit Analyst Monthly Report "Global Debt Titanic Collides With Fed Iceberg?", dated February, 2017, available at bca.bcaresearch.com

Highlights The European economy has outperformed that of the U.S. recently, prompting investors to bring forward their estimates of the first ECB rate hike. To make this judgement, one really needs to be positive on EM economies in general, and China in particular. This sphere is the source of the growth delta between Europe and the U.S. The recent tightening in Chinese monetary conditions points to risks for European growth bulls. In fact, we would expect emerging markets growth to begin disappointing in the coming months, which will limit the capacity of the ECB to hike by 2019. Cyclically, stay short the euro and commodity currencies. While cyclical headwinds against the yen are plentiful, the tightening in Chinese monetary conditions could provide a further temporary fillip for the JPY. Feature Chart I-1The Reason Behind The Euro's Resilience 2016 witnessed an astounding phenomenon: Euro area growth outperformed that of the U.S. This performance is even more impressive as Europe's trend GDP growth is around one percentage point lower than that of the U.S. As investors internalized this development, their perception of the ECB changed: from the first hike being expected 59 months in the future in July 2016, the ECB is now expected to hike in 2019 (Chart I-1). Obviously, with this kind of a move, the euro was able to remain resilient, even as 2-year real rates differentials moved in favor of the USD. Are markets correct to extrapolate the recent European economic strength into the future, or is there more at play? We believe that in fact, Europe's growth outperformance has mostly reflected something else: EM and Chinese resilience. This means that if our Emerging Market Strategy team is correct and EM economic conditions begin to soften anew, the days of economic outperformance in Europe are marked. Other FX crosses will feel the blow. Betting On Faster European Rate Hikes = Betting On A Further EM Rally Core inflation in Europe remains muted and in fact, slowed substantially last month (Chart I-2). Meanwhile, U.S. core CPI and PCE inflation are still clocking in at 2.2% and 1.8%, respectively, and remain perky when compared to the euro area. Going forward, for the path of the ECB policy to be upgraded relative to the Fed, thus, prompting a durable rally in the euro, economic slack in Europe needs to continue to dissipate faster than in the U.S. The recent economic data still points toward future growth improvement in Europe and in the global manufacturing cycle. Not only have euro area PMIs been very strong, Sweden's have also shot to the moon (Chart I-3). The small, open nature of Sweden's economy suggests that some real improvement is brewing behind the scenes. Hence, it would suggest that this European inflation underperformance should soon pass. Chart I-2No Domestic Inflationary Pressures Chart I-3European Growth Indicators Are On Fire However, this misses one key point: the source of the economic outperformance of Europe. It is true that Europe continues to create a fair amount of jobs as the unemployment rate has fallen to 9.5%, but the U.S. too is generating healthy job gains, averaging 210,000 jobs over the past nine months. Labor market dynamics are unlikely to be the source of the European economic outperformance, especially as European wages continue to underperform U.S. ones (Chart I-4). Instead, it would seem that some of the positive growth delta that has lifted European economic activity above U.S. activity comes from outside Europe. Indeed, euro area PMIs and industrial production have outperformed that of the U.S. on the back of improving monetary conditions in China. As Chart I-5 illustrates, since 2008, easing Chinese MCI has led to stronger European PMI and IP. Even more interesting is the relationship exhibited in Chart I-6. The difference in economic activity between Europe and the U.S. is even more tightly correlated with the gap between Chinese M2 and Chinese M1. When M2 underperforms M1, the growth rate of time deposits slows. This is akin to saying that the marginal propensity to save in China is slowing. This boosts European economic activity. Meanwhile, when M2 outperforms M1, Chinese time deposits accelerate relative to checking deposits, Chinese savings intentions grow, and the European economy underperforms. Chart I-4U.S. Domestic Demand##br## Is Better Supported Chart I-5Euro/U.S. Growth Differentials ##br##And Chinese Liquidity (I) Chart I-6Euro/U.S. Growth Differentials ##br##And Chinese Liquidity (II) The dynamics between Europe's relative performance vis-à-vis the Chinese MCI and vis-à-vis time deposits are congruent. It highlights that China's economy does respond to tightening monetary conditions by raising its savings, which subtracts from domestic economic activity. These increased savings tend to be deflationary (as demand falls relative to supply), and also tend to limit the growth rate of imports. This is a shock for countries exporting to China. Here lies the key link explaining why Europe is more sensitive to Chinese dynamics: Europe trades more with China and EM than the U.S. does. The euro area's growth is therefore more sensitive to EM economic conditions than the U.S., a proposition supported by the IMF's work, which shows that a 1% growth shock in EM economies affect European growth by nearly 40 basis points, versus affecting U.S. growth by around 10 basis points (Chart I-7). So what does this mean going forward? We continue to be worried by dynamics in Chinese monetary conditions, even if the timing of their repercussion on economic activity is uncertain. Chinese monetary conditions have already begun to tighten, suggesting savings should rise and that growth in the industrial sector should deteriorate. Buttressing this tightening, nominal rates in China keep rising with the 7-day interbank repo rate in a clear uptrend (Chart I-8, top panel). Chart I-7Europe Is More Sensitive To EM Chart I-8Higher Chinese Rates Have Consequences This rise in interest rates could have a material impact on Chinese credit growth. As the bottom panel of Chart I-8 illustrates, bond issuance by small and medium banks has already fallen substantially. In this cycle, this variable has been a reliable leading indicator of the Chinese credit impulse. This makes sense: much of the recent Chinese credit growth has happened in the "shadow banking system", outside of the traditional channels. Research by the Kansas City Fed has shown that securitized credit tends to be very sensitive to short-term rates, thus, this slowing in bond issuance by small Chinese lenders is very likely to genuinely affect broader credit growth.1 Moreover, the risk of a vicious circle emerging is real. At the peak of the hard lending fears in China, real rates were at 10.5%, mostly reflecting deep producer prices deflation of 6%. This meant that for many highly indebted borrowers, debt servicing was a herculean effort that cut funding available for investments and economically accretive activities. As Chart I-9 shows, tightening Chinese monetary conditions have led to slowing PPI inflation. As the current tightening in China's MCI progresses, Chinese PPI inflation is likely to weaken, putting upward pressure on real rates and further hurting monetary conditions. These dynamics are dangerous, even if a repeat of the 2015 hecatomb is unlikely. Preventing as negative an outcome as occurred in 2015 are a few key factors: some of the excess capacity in the steel and material sector has been removed; the authorities have now better control of the capital account; and while PPI has downside, it is unlikely to plunge as deeply as it did in 2015 - oil prices are now better anchored, as consequential amounts of oil supply have been cut globally. This means that deep commodity deflation like in 2015 is unlikely to repeat itself and annihilate PPI inflation in China in the process (Chart I-10). Chart I-9Chinese PPI Will Roll Over Soon Chart I-10Commodity Prices: Friend And Foe Thus, as the Chinese monetary tightening progresses without spiraling out of control, it is likely that the window of opportunity for the ECB to increase interest rates will dissipate. When this reality dawns on the markets, we would expect the bear market in the euro to resume. Additionally, the global inflation surprise index has spiked massively. Historically, a surge in positive inflation surprises tends to prompt global tightening cycles (Chart I-11). In other words, because inflation surprises have been so strong, it is likely that global liquidity conditions tighten exactly as Chinese monetary and fiscal conditions do. In addition, the fiscal thrust in other EM economies deteriorate.2 This represents a potential headwind for growth in the EM space, which could temporarily limit the upswing in global inflation. These dynamics also reinforce the risks highlighted by Arthur Budaghyan, BCA's head of EM research, that EM spreads have little downside from here and may in fact be selling off in the coming quarters. As Chart I-12 shows, this would also imply that the ECB's perceived months-to-hike metric has more upside from here than potential downside. This is a cyclical handicap for the euro. Chart I-11Global Tightening On Its Way? Chart I-12EM Spreads, ECB Month-To-Hike: Same Battle These forces may also have implications for EUR/JPY. In the long-term, the yen is likely to be the main victim of the dollar strength as the Bank of Japan is currently the G7 central bank with the strongest dovish bias. But the short-term dynamics resulting from the tightening in Chinese monetary conditions could nonetheless prompt a fall in EUR/JPY over the next six months. To begin with, since 2014, the spread between German and Japanese inflation expectations has been linked to Chinese monetary conditions (Chart I-13). German 5-year / 5-year forward inflation expectations are already melting. An underperformance relative to Japan would suggest that the perception by investors of the increasing proximity of an ECB rate hike is likely to be disappointed. Chart I-13China Tightens, Germany Feels It More Moreover, the yen continues to display stronger "funding currency" attributes than the euro. Japan has a positive net international investment position of 170% of GDP versus -8% for the euro area. This suggests that the potential for repatriations when global market turbulence emerges is greater in Japan than in the euro area. Additionally, the market currently expects the ECB to begin hiking one year before the Bank of Japan. This would also mean that there is more room in the European fixed-income markets to further push away the first rate hike than there is in Japanese markets in the event of an EM deflationary shock. Does the reasoning described above have any implications for the dollar? On a 12-to-18-months basis, these dynamics support being more bullish the USD than the euro. The U.S. economy is less exposed to EM growth than that of Europe. This implies that on over such a horizon, the Fed will be less constrained than the ECB by EM economies, especially as the domestic side of the ledger is more promising in the U.S. Additionally, our Geopolitical Strategy team continues to argues that tax cuts are far from dead in the U.S., and that some significant fiscal stimulus will emerge over the course of the next 12 months in the U.S. In Europe, while no fiscal drag is tabulated, the potential for a similarly-sized fiscal boost is more limited. These same dynamics are also unambiguously bearish commodity and EM currencies versus the USD as commodity currencies are a direct play on EM activity (Chart I-14). The Australian dollar is the most poorly placed currency in the G10. It is 11% overvalued on our productivity-adjusted metrics and investors are now very long the AUD. Most crucially, Australian's terms of trade are especially vulnerable to a slowdown in the Chinese sectors most exposed to the tightening in Chinese monetary conditions (Chart I-15). These risks are further compounded by the fact that China has accumulated large inventories of some of the natural resources most important for the Australian terms of trade. Chart I-14Problems In EM Equals Problems ##br##For Commodity Currencies Chart I-15AUD Is Most Exposed To ##br##The Chinese Tightening Tactically, the picture is more nuanced. Since 2015, the euro has benefited from some risk-off attributes, managing to rise against the USD when market sell-offs are at their most acute point. Again, while EUR does not display these "funding currency" attributes as strongly as the yen, it nonetheless does more so than the USD. Also, April is traditionally a month of seasonal weakness for the greenback. A homegrown shock could also give the euro a further fillip: the French election. Le Pen's probability of winning is low but not 0%. In a report co-published nine weeks ago, we and our Geopolitical Strategy team argued that a Le Pen victory was very unlikely.3 Hence, we expect that her bookies' odds of winning, which stands between 20% and 30%, will dissipate to 0% after the second round of the election, supporting the euro independently of relative monetary dynamics. Practically, in the short run, the euro could remain well bid until this summer. We prefer to express our positive tactical stance on the euro against the AUD instead of the USD. We are also more tactically positive on the yen than any other currency and thus hold short USD/JPY and short NZD/JPY positions. Cyclically, we are looking for either a market correction to unfold or a clear upswing in U.S. wages before moving outright short EUR and JPY against the USD. Our tactical and cyclical views on commodity currencies are lined up: we are shorting them. Bottom Line: The source of the delta in European growth seems to be emanating out of EM and China in particular. This means that if one wants to bet on the ECB being able to increase rates sooner than what is currently priced in - a key precondition to bet on a cyclical rebound in the euro - one needs to remain bullish EM. Currently, our Emerging Markets Strategy sister publication remains negative on the medium-term outlook for EM, this represents a big problem for cyclical euro bulls. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Tobias Adrian and Hyun Shong Shin, "Financial Intermediaries, Financial Stability and Monetary Policy," Federal Reserve Bank of New York, Staff Report No. 346, September 2008. 2 Please see Foreign Exchange Strategy Weekly Report, "Et Tu, Janet?" dated March 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy and Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017, available at fes.bcaresearch.com and gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The March FOMC minutes reveal that members discussed the possibility of a normalization of the bank's balance sheet in the near future, through phasing out or ceasing reinvestments of both Treasuries and mortgage-backed securities. This is quite a hawkish comment, as the Fed acknowledges a strengthening economy: ADP employment change recorded a 263,000 new jobs, above the 187,000 consensus; Initial jobless claims decreased to 234,000; ISM Manufacturing PMI came in at 57.2; ISM Prices Paid was at 70.5. Despite this data, some members also stated that stock prices were "quite high", which prompted weakness in the S&P, Treasury yields, and the dollar, as markets revised their growth outlook. Although this is most likely a misinterpretation, as the data quite accurately depicts the economy's fundamentals, the dollar will likely display a neutral bias this month due to seasonality effects. Report Links: U.S. Households Remain In The Driver's Seat - March 31, 2017 Healthcare Or Not, Risks Remain - March 24, 2017 USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro is likely to see some temporary strength on the back of improving economic conditions: Producer prices picked up to 4.5%, beating the 4.4% consensus; Retail sales remain strong at 1.8%; German manufacturing PMI remained unchanged at 58.3, while composite increased to 57.1. Nevertheless, PMIs were weak for many of the smaller, peripheral economies, which will cause downside for the euro in the longer-term. Adding confirmation to Praet's comments last week, Vitas Vasiliauskas, governor of Bank of Lithuania, stated that "the recovery of inflation is still fragile" and that they will first "have to end purchases and only then we can discuss other actions", further corroborating a weaker euro in the longer-term. In other news, the CNB seems to be softening its peg with the EUR as the bank progressively reverts to conducting an independent monetary policy. EUR/CZK depreciated more than 1.5%. Report Links: Healthcare Or Not, Risks Remain - March 24, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been mixed: The unemployment rate outperformed expectations, falling down to 2.8%. However, household spending contracted further, falling by 3.8%, underperforming expectations. Furthermore, the Nikkei manufacturing PMI, also underperformed expectations, falling to 52.4 This deterioration in Japanese economic data is most likely a byproduct of the appreciation that the yen this year. Indeed, inflationary pressures and economic activity in Japan have been closely linked to the yen. This relationship will embolden the BoJ to keep its aggressive monetary stance in place, as the rate-setting committee understands that a weakening yen is a key lever to kick star Japan's tepid economy. Thus, while we are bullish on the yen on a 3-month horizon, we remain yen bears on a cyclical basis. 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 Data in the U.K. has been disappointing as of late: GDP grew at 1.9% in Q4, against expectations of 2% growth. Construction and manufacturing PMI also underperformed, coming in at 52.2 and 54.2 respectively. Both measures also decreased from the previous month. Amid disappointing data, one bright spot for the pound was the massive reduction in their current account deficit. At 12 Billion pounds, the British current account deficit now stands at the lowest level since 2013. This is positive for the U.K. economy, as it provides a buffer against any slowdown in financial inflows that could materialize from the separation with the European Union. Thus, we continue to be bullish on the pound, particularly against the euro, as we believe that Brexit-related fears are overstated. 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 latest dwelling figures indicate the fastest increase since May 2010, with Sydney and Melbourne witnessing 19% and 17% increases, respectively. They are up 8.3% nationally. What really highlights risks for Australia is that interest-only loans account for 40% of the country's housing finance, which prompted the APRA to put forward a limitation to interest-only lending to 30% of new mortgages, as a part of numerous other restrictive macro-prudential measures put in place to curb euphoria. Low rates, while sustaining robust housing activity in the past years, have been a primary factor in this exuberance. Worryingly, these low rates have not been enough to support wages, leading to increasing debt-to-income ratios. The RBA will find it hard to lift rates in the face of high household debt and the large share of interest-only loans, limiting the AUD's upside. 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 Although the NZD has been slightly weak this week against the U.S. dollar, it has appreciated against the Aussie. This might have something to do with the recent uptick in dairy prices, stopping a correction in prices that started in late 2016. Furthermore, the weakness in this cross seems to be sending an ominous signal, as AUD/NZD tends to lead relative activity dynamics between the manufacturing and non-manufacturing sectors in China. There is a reason behind this relationship, as the staple commodities of Australia and New Zealand (iron and dairy prices) cater to the industrial sector and the consumer sector, respectively. We believe that the outperformance by the Chinese industrial sector might be on its last legs, thus AUD/NZD is an attractive short. 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 As highlighted numerously, the Canadian economy is haunted by the same underlying risk as the Australian economy. With the average price for a detached home in Toronto now at CAD 1.2 million, risks are coming into sharper focus. News media now highlights that the housing market is in a shortage, with multiple buyers in competition to purchase a single home, with buyers even skipping home inspections. In better news, the RBC Manufacturing PMI read at 55.5 in March, more than a 3-year high, with its output, new orders and employment components also at multi-year highs. Furthermore, the Business Outlook Survey highlights business intentions to expand and hire continue to be buoyant, which should augur well for the economy in the near future. Report Links: AUD And CAD: Risky Business - March 10, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 EUR/CHF has rebounded after coming close to hitting the SNB implied floor of 1.065 on Tuesday. It seems that this strategy is paying off for the SNB, as recent data shows an improving Swiss economy: Real retail sales outperformed expectations, as they exited contractionary territory. They are now growing at 0.6%. SVME PMI also outperformed, coming in at 58.6. This measure now stands at its highest level since 2011. Moreover Swiss headline inflation month-on-month grow came in above expectations at 0.6%, while the annual inflation rate came in at 0.2%. This batch of strong data will certainly reassure the SNB that its intervention in the currency market is helping kick start the Swiss economy. However, for the time being the peg will remain as the economy is not yet strong enough to handle a change in this policy. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits -December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK appreciated by almost 1.5%, even on the face of a nearly 5% rally in oil. This is not an isolated case: since the beginning of the year USD/NOK has become much less sensitive to oil and more sensitive to the changes in the dollar. The poor state of the Norwegian economy explains this phenomenon as core and headline inflation continue to plummet and the credit impulse still stands in negative territory. One could point to unemployment as a bright spot, as it now stands at 2.9%. However this reduction in unemployment is accompanied by a contraction in employment, which suggests that people are just leaving the labor market. These factors will continue to solidify the Norges Bank's dovish bias, causing NOK to underperform terms-of-trade dynamics. 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 As momentum retreats from oversold levels, the krona is displaying some strength on the back of buoyant economic data: Manufacturing PMI hit 65.2 for March; Industrial production in February increased at a 4.1% annual pace; New orders were up 12% in February. This data augurs well for Sweden's export sector, the economy's most key area. The Riksbank's Business Survey highlights these developments, with their proprietary economic activity indicators pointing to good growth. An interesting development in pricing pressures is that negotiated prices are no longer being reduced as often as before, which is "regarded as an incipient sign of demand, which in turn creates expectations of future price rises". The effects of rising commodity prices and a weaker krona are also now kicking in. 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

Highlights The rally in risk assets appears to have stalled, raising fears that the misnamed "Trump Trade" has ended. Investors are attaching too much importance to the reality show in Washington and not enough to the fundamentals underpinning the acceleration in global growth and corporate earnings. For now, these fundamentals are strong, and should remain so for the next 12 months. Beyond then, the impulse from easier financial conditions will dissipate and policy will turn less friendly, setting the stage for a major slowdown - and possibly a recession - in 2019. Stay overweight global equities and high-yield credit, but be prepared to reduce exposure next spring. Feature Risk Assets Hit The Pause Button After rallying nearly non-stop following the U.S. presidential election, risk assets have stalled since early March (Chart 1). The S&P 500 has fallen by 1.8% after hitting a record high on March 1st. Treasury yields have also backed off their highs and credit spreads have widened modestly. Globally, the picture has been much the same (Chart 2). The yen - a traditionally "risk off" currency - has strengthened, while "risk on" currencies such as the AUD and NZD have faltered. EM currencies have dipped, as have most commodity prices. Only gold has found a bid. Chart 1A Pause In Risk Assets In The U.S.... Chart 2...And Globally The key question for investors is whether all this merely represents a correction in a cyclical bull market for global risk assets, or the start of a more sinister trend. We think it is the former. Global Growth Still Solid For one thing, it would be a mistake to attach too much significance to the unfolding reality show in Washington. As we discussed in last week's Q2 Strategy Outlook,1 the recovery in global growth and corporate earnings began a few months before last year's election and would have likely continued regardless of who won the White House (Chart 3). For now, the global growth picture still looks reasonably bright. Our global Leading Economic Indicator remains in a solid uptrend. Burgeoning animal spirits are powering a recovery in business spending, as evidenced by the jump in factory orders and capex intentions (Chart 4). Consumer confidence is also soaring. If history is any guide, this will translate into stronger consumption growth in the months ahead (Chart 5). Chart 3Recovery Predates President Trump Chart 4Global Growth Backdrop Remains Solid Chart 5Rising Consumer Confidence Will Provide A Boost To Consumption The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 6 shows that the 12-month change in our U.S. Financial Conditions Index leads the business cycle by 6-to-9 months. The current message from the index is that U.S. growth will stay sturdy for the remainder of 2017. Stronger global growth should continue to power an acceleration in corporate earnings over the remainder of the year. Global EPS is expected to expand by 12.5% over the next 12 months. Analysts are usually too bullish when it comes to making earnings forecasts. This time around they may be too bearish. Chart 7 shows that the global earnings revisions ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. Chart 6Easing Financial Conditions Will Support Activity In 2017 Chart 7Global Earnings Picture Looking Brighter Gridlock In Washington? As far as developments in Washington are concerned, it is certainly true that the failure to repeal and replace the Affordable Care Act has cast doubt on the ability of Congress to implement other parts of President Trump's agenda. Despite reassurances from Trump that a new health care bill will pass, we doubt that the GOP can cobble together any legislation that jointly satisfies the hardline views of the Freedom Caucus and the more moderate views of the Republicans in the Senate. Ironically, the failure to jettison Obamacare may turn out to be a blessing in disguise for Trump and the Republican Party. Opinion polls suggest that the GOP would have gone down in flames if the American Health Care Act had been signed into law (Table 1). According to the Congressional Budget Office, the proposed legislation would have caused 24 million fewer Americans to have health insurance in 2026 compared with the status quo. The bill would have also reduced federal government spending on health care by $1.2 trillion over ten years. Sixty-four year-olds with incomes of $26,500 would have seen their annual premiums soar from $1,700 to $14,600. Even if one includes the tax cuts in the proposed bill, the net effect would have been a major tightening in fiscal policy. Now, that would have warranted lower bond yields and a weaker dollar. Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly Granted, the political fireworks over the past month serve as a reminder that comprehensive tax reform will be more difficult to achieve than many had hoped. However, even if Republicans are unable to overhaul the tax code, this will not prevent them from simply cutting corporate and personal taxes. Worries that tax cuts will lead to larger budget deficits will be brushed aside on the grounds that they will "pay for themselves" through faster growth (dynamic scoring!). Throw some infrastructure spending into the mix, and it will not take much for the "Trump Trade" to return with a vengeance. Trump's Fiscal Fantasy This is not to say that the "Trump Trade" won't fizzle out. It will. But that will be a story for 2018 rather than this year. This is because the disappointment for investors will stem not from the failure to cut taxes, but from the underwhelming effect that tax cuts end up having on the economy. The highly profitable companies that will benefit the most from lower corporate taxes are the ones who least need them. In many cases, these companies have plenty of cash and easy access to external financing. As a consequence, much of the tax cuts will simply be hoarded or used to finance equity buybacks or dividend payments. A large share of personal tax cuts will also be saved, given that they will mostly accrue to higher income earners. Chart 8From Unrealistic To Even More Unrealistic The amount of infrastructure spending that actually takes place will likely be a tiny fraction of the headline amount. This is not just because of the dearth of "shovel ready" projects. It is also because the public-private partnership structure the GOP is touting will severely limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Indeed, the bill could turn out to be little more than a boondoggle for privatizing existing public infrastructure projects, rather than investing in new ones. Meanwhile, the Trump administration is proposing large cuts to nondefense discretionary expenditures that go above and beyond the draconian ones that are already enshrined into current law (Chart 8). In his Special Report on U.S. fiscal policy, my colleague Martin Barnes argues that "it is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control."2 As such, the risk to the economy beyond the next 12 months is that markets push up the dollar and long-term interest rates in anticipation of continued strong growth and major fiscal stimulus but end up getting neither. Investment Conclusions Risk assets have enjoyed a strong rally since late last year, and a modest correction is long overdue. Still, as long as the global economy continues to grow at a robust pace, the cyclical outlook for risk assets will remain bullish. As such, investors should stay overweight global equities and high-yield credit at the expense of government bonds and cash. We prefer European and Japanese equities over the U.S., currency-hedged (See Appendix). As we discussed in detail last week, global growth is likely to slow in the second half of 2018, with the deceleration intensifying into 2019, possibly culminating in a recession in a number of countries. To what extent markets "sniff out" an economic slowdown before it happens is a matter of debate. U.S. equities did not peak until October 2007, only slightly before the Great Recession began. Commodity prices did not top out until the summer of 2008. Thus, the market's track record for predicting recessions is far from an envious one. Nevertheless, investors should err on the side of safety and start scaling back risk exposure next spring. The 2019 recession will last 6-to-12 months. By historic standards, it will probably be a mild one. However, with memories of the Great Recession still fresh in most people's minds and President Trump up for re-election in 2020, the response could be dramatic. This will set the stage for a period of stagflation in the 2020s. Chart 9 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 9Market Outlook For Major Asset Classes Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com 2 Please see BCA Special Report, "U.S. Fiscal Policy: Facts, Fallacies And Fantasies," dated April 5, 2017, available at bca.bcaresearch.com. Appendix Tactical Global Asset Allocation Monthly Update We announced last week that we are making major upgrades to our Tactical Asset Allocation Model. In the meantime, we will send you a concise update of our recommendations every month based on a combination of BCA's proprietary indicators as well as our own seasoned judgement (Appendix Table 1). Appendix Table 2Global Asset Allocation Recommendations (Percent) In a Special Report published last year, we laid out the quantitative factors that have historically predicted stock market returns. Appendix Chart 1 updates the output of that model for the U.S. It currently shows a slightly above-average return profile for the S&P 500 over the next three months. Appendix Chart 1S&P 500: Above Average Returns Over The Next 3 Months Applying this model to the rest of the world yields a somewhat more positive picture for Europe and Japan, given more favorable valuations and easier monetary conditions in those regions. The technical picture has also improved in Europe and Japan. This is especially true with respect to price momentum: After a long period of underperformance, euro area equities have outpaced the U.S. by 11.5% in local-currency terms since last summer’s lows. Japanese stocks have suffered over the past few months, but are still up 12.5% against the U.S. over the same period (Appendix Chart 2). Turning to government bonds, the extreme bearish sentiment and positioning that prevailed in February and early March has been largely reversed, suggesting that the most recent rally in bonds could run out of steam (Appendix Chart 3). Looking ahead, yields are likely to rise anew on the back of strong economic growth and rising inflation. Thus, an underweight allocation to government bonds is warranted, particularly in the U.S. Appendix Chart 2Relative Performance Of Euro Area ##br##And Japanese Equities Troughed Last Summer Appendix Chart 3Rally In Bonds Could Soon Peter Out Clients should consult our Q2 Strategy Outlook for a more detailed discussion of the global investment outlook. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades