Policy

Highlights Growth figures coming out of China in the coming months may be viewed as less market friendly, which could be taken as an excuse for a much-anticipated correction in risk assets. Cyclically, the Chinese economy will remain buoyant, even if year-over-year growth numbers begin to moderate. All three main sectors of the economy will likely be on more solid footing. China's inflation and growth dynamics do not warrant significant policy tightening. Leading indicators point to an immediate top in Chinese PPI. The economy would need to run a lot hotter for a lot longer for genuine inflation pressures to build up. Feature Most of the latest macro figures from China released over the past several days confirm that the mini-cycle upswing remains firmly in place. It is almost a sure bet at this point that Chinese GDP likely continued to accelerate in the last quarter, with the positive momentum having become well recognized and accepted among global investors. We have been travelling as of late talking to clients and taking the pulse of the market - collectively investors' concerns on China have eased along with strengthening growth numbers, but worries on some key macro issues remain deeply rooted.1 Looking forward, investors' delicate complacency on China will be tested in the coming months on two possible scenarios: Macro indicators based on year-over-year comparisons begin to moderate, rekindling investors' fears of another China-led global slowdown. Building inflationary pressures and policy tightening by the Chinese authorities ignites another economic downturn. For now, it is impossible to foresee how risk assets will react to these possible scenarios, especially at the moment when some major equity indexes have already become richly valued and the market could take any excuse for a long overdue correction. However, we maintain the view that the level of China's economic activity will likely stay reasonably buoyant, even if year-over-year growth numbers begin to moderate, and that the inflation and growth dynamics do not warrant significant policy tightening. A major relapse in activity is not in the cards, unless the Chinese authorities commit a policy mistake by stepping on the brakes prematurely, or a major disruption in global trade due to protectionism occurs. Reasons To Stay Positive The annual growth rates of Chinese macro indicators will likely roll over, as by definition these ratios cannot always accelerate. Meanwhile, the economy had already begun to improve in the second quarter of last year, which means the positive "base effect" will likely begin to fade going forward. These tedious technical factors aside, we expect business activity to remain buoyant, as all three main sectors of the economy will likely be on more solid footing. Chart 1Improving Labor Market And Strengthening Confidence ##br##Will Boost Consumption On the consumer sector, the labor market has continued to improve, as indicated by the improving employment component of the purchasing managers' surveys (PMIs). An improving labor market helps boost job creation and income, both of which bode well for consumer confidence and household demand. Indeed, various measures of consumer confidence have improved sharply in recent months to multi-year highs (Chart 1). Moreover, it appears that side effects of China's harsh anti-corruption campaign on economic growth have abated. The sudden collapse of luxury goods sales since late 2013 has run its course. Jewelry sales growth has been strengthening; high-end liquor prices have been rising rapidly; Swiss watch exports to China and Hong Kong have turned positive after a prolonged slump. Even though the anti-corruption drive remains in high gear, the "froth" of luxury goods consumption associated with bribing has been squeezed out, and demand for high-end products has been pushed higher along with rising income levels. All of this should support retail sales going forward. On the corporate sector, the destocking cycle is well advanced and companies will likely beef up inventories going forward (Chart 2). Albeit rising slowly, the inventory component of PMI surveys remains below 50, underscoring limited buildup of final products. In addition, the new orders-to-inventory ratio remains elevated by historical standards, underscoring very lean stock, which also limits the downside in industrial production even if the improvement in new orders stalls. More importantly, we expect China's capital spending cycle has likely bottomed out. An important change in China's macro conditions since last year has been the sharp turnaround in the corporate profit cycle, which has historically led Chinese capital spending, especially among private enterprises in the manufacturing and mining sectors (Chart 3). The recovery in producer prices and corporate profitability underscore tightened capacity utilization, which has historically preluded investment. It is premature to expect a major boom, but the case for a modest upturn in private capital spending is strengthening. Chart 2Inventory Restocking ##br##Has Further To Go Chart 3Profit Recovery Should Boost Private Capital Spending ##br##Profit The export sector remains a wildcard for China's growth performance,2 and President Donald Trump and President Xi Jinping's summit later this week will be closely watched for clues of the bilateral relationship between the world's two largest economies under the new U.S. administration. President Trump's executive order last Friday to launch investigations into countries against whom the U.S. runs a bilateral trade deficit suggests he may still unilaterally impose punitive tariffs on Chinese imports, which risks a sudden escalation of protectionism pressures with unpredictable consequences on global trade and financial markets. Barring such a bleak outcome, strengthening growth in the U.S. should also boost Chinese exports (Chart 4). The PMI New Export Orders index has remained above the 50 expansion/contraction threshold for five consecutive months, and the latest reading reached its highest level since early 2012, pointing to further acceleration in overseas sales, at least in the near term. Chart 4Exports Will Likely Continue To Accelerate Chart 5Market Is Anticipating Pboc Rate Hike Bottom Line: Domestic demand, both consumption and capital spending, will likely strengthen, and external demand is also on the mend. The risk of a major slowdown in China is low. Will Inflation Induce Tightening? The People's Bank of China (PBoC) has continued to guide money market rates higher by adjusting open-market operation tools. We remain skeptical that the central bank will hike its policy rate, but Chinese financial markets have begun to price in such a move. The two-year swap rate, which can be roughly viewed as the market's expectations of the PBoC policy rate, has edged up by around 20 basis points since early this year (Chart 5). This also means that the market impact may be muted, even if the PBoC does raise its benchmark rate. In fact, the significant growth improvement in recent months, especially in nominal terms, justifies tighter policy. In other words, higher rates are largely reflective rather than restrictive. Chart 6PPI Has likely Peaked Inflation risk has once again become a focal point of discussion in our recent client meetings. Investors appear increasingly concerned that the sharp surge in Chinese producer prices could lead to broader inflationary pressures, which could in turn force the PBoC to take more draconian measures. Historically, Chinese PPI and CPI have largely moved in sync, even though PPI has been a lot more volatile than the headline CPI. In our view, odds of an inflation-induced policy tightening cycle are low. At the onset, it is overly simplistic to extrapolate the recent PPI trend infinitely. In fact, after a sharp recovery since early last year, the acceleration in PPI has likely already peaked (Chart 6). The depreciation of the trade-weighted RMB has stalled, and the annual rate of change in commodities prices has also rolled over, both of which point to an immediate top in Chinese PPI. Meanwhile, the pace of improvement in corporate sector pricing power is also moderating (Chart 6, bottom panel). Moreover, the recent sharp decline in headline CPI is entirely related to food prices, which could stay volatile going forward (Chart 7), but Chinese core inflation remains low and stable, ranging between 1.5-2.5%. Such an inflation rate is arguably too low for a rapidly growing economy. The important point is that the Chinese economy is highly productive, which leads to constant downward pressure on prices. Chart 8 shows U.S. import prices from China have remained essentially flat since 2004, while costs of manufactured goods from other countries have all gone up, a remarkable development given the dollar has dropped by almost 20% against the RMB over this period while strengthening against almost all other major currencies. This means Chinese producers' faster productivity growth has enabled them to undercut their competitors in other countries in pricing to gain global market share. In this environment, deflation tends to be a bigger threat than inflation. Indeed, with the accumulation of debt in the economy, debt deflation is a much more dreadful situation to deal with than an inflation outbreak. The economy would need to run a lot hotter for a lot longer for genuine inflation pressures to build up. It is overly alarmist to warn of inflation risks at the moment. Chart 7Food Prices Still Dominate Headline CPI Chart 8Strong Productivity Growth Means ##br##China Is Less Prone To Inflation All in all, we remain cyclically positive on Chinese equities, especially H shares. Growth figures coming out of China in the coming months may be viewed as less market friendly, which could be taken as an excuse for a much-anticipated selloff in risk assets. However, the broad trend of growth improvement in the Chinese economy remains intact, which in the absence of a sudden eruption of protectionist backlash will reinforce the upturn in the global business cycle. Therefore, we tend to view any China-induced selloff, if it happens, as transitory and corrective in nature, and to be used as an opportunity to add positions. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA 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, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Following the debacle of the failed attempt to repeal and replace Obamacare, the Trump Administration is focusing on another important part of its policy platform: reforming taxes and reshaping government spending. In theory, the legislative obstacles should be easier to overcome than with the controversial health care bill, but many challenges still lie ahead. Meanwhile, the assumptions underpinning many of the key measures are questionable. The Administration's fiscal proposals are based on the following assertions: The level of U.S. taxes puts the U.S. at a competitive disadvantage and is a hindrance to faster economic growth. Military and infrastructure spending needs to rise sharply after having been cut back too severely in recent years. The federal government, outside of defense, has become bloated and needs to be drastically pruned. Entitlement spending remains politically untouchable. Proposed tax changes will be broadly deficit neutral after allowing for the revenue boost from faster economic growth. The above assertions supporting the administration's policy platform are a mix of facts, fallacies and fantasies. A frustrating aspect of economic debates is that it often is relatively easy to cherry pick data to support any particular argument one wants to make. In other words, there are plenty of alternative facts to choose from. In this report, I will endeavor to illuminate the debate about fiscal policy with unvarnished official statistics, untainted by partisan biases. Are U.S. Taxes Too High? Taxes are a necessary evil if a country's residents want their government to provide some services such as defense, policing, schooling, and old-age benefits etc. In a democracy, the exact level of services provided by a government is a choice that can be voted on at election time. Sometimes, politicians campaign on a platform of increased government spending (and implicitly higher taxes) and at other times, the opposite is true. As a presidential candidate, Donald Trump campaigned on a promise to reduce the government's involvement in the economy and society in general, with a corresponding reduction in tax burdens. The government's revenue grab takes many forms beyond just taxing incomes and can occur at the federal, state or local level. There are taxes on spending, assets, imports and employment, and a multitude of fees ranging from park entrance charges to speeding tickets. Chart 1 shows total U.S. tax and fee revenues from all levels of government, expressed as a share of GDP since 1980.1 The most striking thing about the chart is how little the ratio has changed over the past quarter century. Government revenues have averaged around 27% of GDP over the period and the only years with a marked divergence from that level were the late 1990s when the tech-driven stock market boom triggered unusually strong capital gains tax receipts and in 2009/10 when the economic collapse and temporary tax cuts led to a plunge in revenues. The other interesting point to note is that, according to OECD data, the U.S. is the lowest taxed industrial country, except for Ireland. Taxes and social security contributions as a share of GDP are more than ten percentage points below the unweighted average of 21 other industrial countries. And this gap has been relatively constant over the years (Chart 2). The unweighted average for European countries is almost 39% of GDP. Chart 1U.S. Total Tax Burdens Chart 2U.S. Tax Burdens: An International Perspective As noted earlier, whether a country's overall tax burdens are high or low is largely a reflection of voter preference. In the majority of countries outside the U.S., the government is the main or even sole provider of health care and that often is used to explain the lower level of U.S. taxes. Yet, it is not widely realized that U.S. government spending on health care as a percent of GDP is higher than the industrial country average (Chart 3).2 The point is that the U.S.'s low ranking in terms of global tax burdens does not simply reflect the lack of a universal government-funded health care system. Low taxes are a very good thing if they are sufficient to finance the required level of government services and provide positive incentives for economic growth. However, there is a loose but positive correlation between the level of tax burdens and structural budget deficits. In other words, the countries with low tax burdens have tended to have higher average cyclically-adjusted budget deficits (Chart 4). Again, that is choice that voters can make: choosing lower taxes today at the expense of rising debt burdens that will have costs in the future. The U.S. has been at the extreme end of the spectrum so far this century with the combination of low taxes and large deficits. Chart 3Government Spending on Health Care Chart 4Lower Tax Burdens Generally Mean Larger Fiscal Deficits The data I have shown highlight that the U.S. is a low-tax country from an international perspective and that overall tax burdens have not changed dramatically over time. Nonetheless, there is plenty of scope for reforming taxes in order to improve economic incentives and efficiency. The Case For Tax Reform There is a disconnect between low overall U.S. tax burdens and the facts that the country has the highest marginal corporate tax rate in the industrial world and that so many people feel over-taxed. The principal explanation is the skewed nature of the U.S. tax system with its heavy dependence on taxes on income rather than consumption. The U.S. is the only industrial country in the world without a national value added tax (VAT), and state and local sales taxes are low by international standards. This means that taxes on goods and services account for less than 18% of general government tax revenues in the U.S. compared with an unweighted average of almost 33% for all OECD countries (Table 1). As a result, the U.S. is forced to rely more on taxes on income and profits. These account for almost 48% of tax revenues in the U.S., 14 percentage points higher than the OECD average. General perceptions about tax burdens probably are more affected by income tax rates than by taxes on goods and services, many of which are hidden from view. Table 1The Structure of Government Tax Receipts Problems are compounded by the skewed distribution of income tax payments. For example, although the marginal U.S. corporate tax rate is around 39%,3 many large companies with overseas subsidiaries pay a significantly lower rate. According to Internal Revenue Service (IRS) corporate tax return data, the largest businesses (annual receipts above $100 million) paid an average federal rate of 22.8% on their taxable income in 2013 (the latest year for which detailed corporate returns are available), compared with 32.2% for companies with sales between $10 million and $100 million and 27.5% for those with sales of less than $10 million. It is no wonder that many multinationals are keen to shelter income overseas. There is a case for reforming the corporate tax code to equalize the playing field between multinationals and those with domestic operations. When it comes to personal taxes, there also are distortions. As is well known, there are many hard-to-justify allowances including those on carried interest and on mortgages up to the value of $1 million. Even if the government wanted to use the tax system to subsidize home ownership (which many countries have stopped doing), it would make sense to cap the benefit at the mortgage required to finance a median-priced home. The national median price for a single-family home currently is $230,000. A key problem is the fact that many people do not earn enough to pay much income tax, so the burden falls heavily on a relatively narrow group. The average personal federal tax rate has not changed very much over the past 35 years (Chart 5), but Table 2 shows the remarkably skewed nature of personal tax payments by income level. In 2014 (the latest year for detailed IRS personal data), 148 million tax returns were filed, but more than one-third had no taxable income. Almost 45% of filers reported gross adjusted income of less than $30,000 and, overall, this group received net tax refunds. At the other end of the scale, those with incomes above $200,000 represented only 4.2% of filed returns yet accounted for almost 63% of total federal taxes paid. It is no surprise that many high-income earners feel over-taxed. It is harder to justify the fact that 55% of respondents to a recent Fox News poll said that taxes were too high. The message is that taxes can never be low enough! Chart 5The Average Federal Personal Tax Rate Table 2The Skewed Nature of Personal Income Taxes An obvious way to improve the tax structure would be to eliminate some deductions and use the savings to reduce marginal rates. An even more significant change would be to broaden the tax base by introducing a VAT, using the revenue to dramatically lower income tax rates. The regressive nature of a VAT can be countered by exempting certain items such as food, energy, and children's clothing. The main argument against a VAT is that, once introduced, it becomes an easy way to raise revenue and an initial rate of say 5% eventually could end up at European levels (20%). The proposal for a new Border Adjustment Tax would be a step toward rebalancing tax burdens toward consumption and away from incomes. However, there is considerable opposition to such a move and its future is in doubt. To conclude, the data do not support the notion that the U.S. is overly taxed - either compared to its own history or relative to other countries. But the system has many distortions and there is a strong case for increased taxes on consumption, using the revenues to reduce marginal income tax rates in both the corporate and personal sector. The Case For More Spending On Infrastructure And Defense Unlike tax reform, increased infrastructure spending is not a contentious issue. As Larry Summers likes to quip, anyone flying to New York and driving into Manhattan can see infrastructure spending needs all around, from dreary airports to dodgy bridges and pothole-filled roads. Real government spending on non-defense structures (a proxy for infrastructure) has risen by only 20% over the past 50 years, a drop of almost 30% in per capita terms (Chart 6). As a share of GDP, infrastructure spending has almost halved in the past half century. The administration has talked about boosting infrastructure spending by $1 trillion over the next ten years. If we assume a constant baseline of spending averaging 1.6% of GDP (the 2016 level), an additional $1 trillion would equate to an additional 30% rise in overall infrastructure expenditure over the decade. But even with this increase, spending would still only be 2% of GDP, a relatively modest level by historical standards. The administration's infrastructure proposal is quite reasonable in terms of its scale and desirability. Of course, there is no guarantee that it will materialize. The administration's plan to significantly increase defense spending is a more debatable issue. The number of military personnel has been in a sharp downtrend since the end of the Vietnam War. In the past 35 years or so, a key driver has been the impact of technology with machines replacing people, but defense spending as a share of GDP also has been in a structural downtrend (Chart 7). At the same time, real spending per military employee has been in a strong uptrend, reflecting the switch in strategy away from boots on the ground towards sophisticated equipment. From an international perspective, U.S. defense spending remains very high compared to other countries. According to the SIPRI Military Expenditure Database, in 2015, the U.S. spent as much as the next eight largest military spenders combined.4 Yet, the combined GDP of those eight countries was 55% above that of the U.S. Chart 6Government Infrastructure Spending Chart 7Trends In Defense Spending The Budget Control Act of 2011 put tough spending caps on discretionary spending and these have not been repealed. According to the Congressional Budget Office (CBO), under current law, defense outlays as a share of GDP would fall from 3.2% of GDP to 2.6% by fiscal 2027. The Trump Administration has proposed a $54 billion increase in defense spending authority for fiscal 2018, implying an increase of around 9% from the 2017 level. And while we do not have details, we can assume that the longer-term plan is to reverse the downtrend in spending as a share of GDP. What is the right level of defense spending? The world remains a dangerous place, but the U.S. already outspends other countries by a huge margin. At the end of the day, financial constraints mean it boils down to a choice between defense and other spending programs. Voters may state a preference for increased defense spending, but that likely would change if other programs were crowded out. Is The Federal Government Bloated? Chart 8Federal Non-Defense Discretionary Spending Spending on entitlements is widely regarded as untouchable from a political perspective and it is no surprise that Trump has promised to defend these programs. Given the administration's platform of tax cuts and increased military and infrastructure spending, containing budget deficits implies tough constraints on non-defense discretionary spending. This includes spending by the Departments of Agriculture, Education, Energy, Homeland Security, Health and Human Services, Justice, State and Veterans Affairs. Such spending has already declined sharply during the past several decades, both as a share of total government outlays and as a share of GDP (Chart 8). The administration seeks further drastic cuts in the years ahead. There is a general perception that much of government spending is wasteful, implying huge savings can be made. At the same time, surveys show that people do not want cuts in areas such as security, veterans affairs, education and health. The problem is that spending by the Departments of Education, Health and Human Services, Homeland Security, Justice and Veterans Affairs account for more than half of non-defense discretionary spending. Thus, pressures for spending cuts fall heavily on other areas. But this often is not practical given that many of these other programs are so small. For example, spending on foreign aid represents less than 0.2% of GDP and less than 5% of non-defense discretionary spending. As for federal employment being bloated, it should be noted that civilian federal employment has shown no net change over the past 50 years, despite the marked growth in the population and economy over the period. Federal employment currently accounts for less than 2% of total employment, down from 4% in 1970 (bottom panel of Chart 8). There inevitably are areas of wasteful government spending and it is appropriate to look for savings. However, it is not reasonable to believe that there can be tax cuts and increases in defense spending and domestic security, while protecting entitlements programs and preventing a massive rise in the budget deficit. And that is even without adding in the cost of the proposed border wall with Mexico. Entitlement Spending Is The Major Problem Social Security has been called the third rail of American politics - touch it and you are dead. No politician seeking election would dare campaign on a platform of major cuts to the program in the form of reduced benefits, higher contributions, means testing, or an increase in the age eligibility limit. And the same is broadly true for Medicare. Voter dislike of government involvement in the provision of health care does not seem to extend to those over the age of 65! The combination of rising life expectancy and a decline in the ratio of taxpayers to retirees will place growing financial strains on the Social Security and Medicare systems. In 1970, there were 5.4 people between the ages of 20 and 64 for every person 65 and older. That ratio has since dropped to 4 and will be down to 2.6 within the next 20 years (Chart 9). Spending on entitlements (Social Security, Medicare, Medicaid, income security, and government pensions) is on an unsustainable trajectory. In fiscal 2016, these programs equaled 74% of federal revenues and the CBO estimates that this will rise to 84% by 2027, absent any change to current law (Chart 10). If we also allow for net interest costs, total mandatory spending is projected to exceed revenues within the next 12 years or so, meaning that deficit financing will be required for all discretionary spending. Chart 9The Demographic Fiscal Headwind Chart 10The Entitlement Problem Politicians operating in a world of two-year election cycles have no incentive to support short-term pain for long-term gain. At some point, markets will force change, but it is hard to know exactly when that will happen. According to the CBO's latest estimates, current policies imply that the federal deficit will average 4% of GDP over the next decade, rising to 6.2% and 8.4% over the subsequent two 10-year periods. As a result, the debt-to-GDP ratio rises from 77% currently to 113% by 2037 and 150% by 2047.5 Of course, that is a long way in the future and much can happen to undermine these projections - for the better or for the worse. Long-run fiscal projections are subject to a wide margin of error because, in addition to legislative changes, they are very sensitive to assumptions about economic growth, inflation and interest rates. The CBO's baseline estimates published in mid-2009 had Medicare spending rising from 3.1% to 7.2% of GDP between 2010 and 2037. The latest CBO report has 2037 Medicare spending at a much lower 5.3% of GDP, representing massive savings from the 2009 estimate. Unfortunately, total federal revenues as a share of GDP were revised down by an even greater amount, with the result that expected deficits and debt levels have been revised up sharply since the 2009 report, despite the slower path of Medicare spending (Chart 11). Chart 11Long-Term Fiscal Projections: Prone to Revisions One can point to Japan as an example of how a high government debt-to-GDP ratio need not imply economic disaster. Japan's gross debt currently stands at 250% of GDP and there has not been any difficulty in financing its ongoing deficits. However, two qualifications are necessary. First, it is too soon for Japan to claim victory: its horrible demographic profile points to an ever-worsening fiscal position and there likely will be a crisis at some point. Secondly, Japan finances its deficits internally which protects it from the whims of foreign investors. Although the dollar's status as reserve currency also gives the U.S. protection, the country's ongoing large current account deficit creates vulnerability to financing problems if overseas investors lose confidence in the U.S. fiscal outlook. Concluding Thoughts Public discussions of fiscal policy invariably morph into partisan arguments about the appropriate size and role of the government in the economy. It quickly becomes frustrating when the warring factions then use misleading or outright wrong data to support their positions. In the spirit of the adage that "everyone is entitled to their own opinions, but there is only one set of facts," I have focused this paper on published and reputable data about government revenues and spending. Several points emerge: One may want taxes to come down, but it is a FACT that the U.S. is a low-tax country by international standards, and tax burdens have not noticeably risen over time. It is a FACT that the U.S. tax system has serious distortions and is crying out for some reform. But what these reforms should be is open to debate, and are a matter of opinion. There is a strong case for increased infrastructure because it is a FACT that spending has fallen sharply over the years. It is less obvious that a major rise in defense spending is warranted. It would be a matter of preference rather than incontrovertible need. It is a FALLACY to describe overall non-defense discretionary spending as massively bloated and out-of-control. Of course, there are many places where the government can make cuts and improve efficiency, but squeezing this category of spending will provide only limited savings. It is FANTASY to think that entitlement programs can be maintained over the long run in their current form. The longer that reforms are delayed, the bigger the cutbacks will have to be. Government deficits and debt do matter, but it is virtually impossible to predict when financing problems might occur. There is no particular level of the debt-to-GDP ratio that will trigger a crisis because much depends on the domestic and global economic and financial environment. But, to quote the late Herb Stein, "if something cannot go on forever, it will stop." The Trump administration's fiscal desires are a mix of sensible policies, wishful thinking and impracticalities. Hopefully, there will be progress with boosting infrastructure, and making some positive reforms to the tax code. However, there will be serious challenges to tax changes once special interests get involved. The end point may very well be outright tax cuts without reform, and that would be much less desirable. On the spending side, increased defense spending is a perfectly legitimate choice, but the planned severe cuts to non-defense discretionary spending are impractical. The good news is that the odds of such severe cuts being implemented are very low. It seems almost certain that federal deficits will head higher over the coming few years. Using dynamic scoring to suggest that the economy will improve by enough to make tax cuts and spending increases virtually self-financing will have little credibility outside of the administration and will be challenged by the calculations of the CBO and Joint Committee on Taxation. If the government is successful in implementing major fiscal stimulus then the biggest problem might be overheating the economy. As I discussed in a recent report, the U.S. economy already is operating close to full capacity and it will not take much to create a classic late-cycle build-up of inflationary pressures.6 That would set the scene for enough Fed tightening in 2018 to give high odds of a recession in 2019. Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com 1 The totals exclude government interest receipts and transfers from the Federal Reserve to the Treasury as those largely represent transactions related to intra-government holdings of Treasury securities. 2 Overall the U.S. devotes a much larger share of its GDP to health care than other countries. According to OECD data, total health care spending represented 16.9% of U.S. GDP in 2015, compared to an unweighted average of 10% for other industrial countries. Within these totals, the government share was 8.4% in the U.S and 7.6% elsewhere, with the private sector making up the difference. 3 This comprises a top federal rate of 35% and state and local taxes of 6%, fully deductible against federal taxes. 4 SIPRI stands for the Stockholm International Peace Research Institute. Details available at https://www.sipri.org/databases/milex 5 For more information, please see The 2017 Long-Term Budget Outlook, Congressional Budget Office, March 2017. Available at www.cbo.gov 6 Please see BCA Special Report, "Beware the 2019 Trump Recession," dated March 7, 2017 available at bcaresearch.com

Highlights Global political risks are overstated, at least in 2017; Global rally in risk assets hinges on hard data, not politics; But Trump and the GOP can still pass tax reforms or cuts this year; The EU's guidelines on Brexit are benign, risks have peaked; The French presidential election remains harmless to markets. Feature Investors have a love/hate relationship with populism. On one hand, we fear what anti-establishment movements will mean for the twentieth-century institutions that have underpinned post-Cold War stability.1 On the other, markets have cheered populism and its ability to jolt policymakers out of their torpor, particularly on fiscal policy.2 This dichotomy of outcomes informs our investment theme for 2017, which holds that markets are navigating a "Fat-Tails World."3 The failure to repeal and replace the Affordable Care Act (ACA, "Obamacare") - which took us by surprise - reminded investors that President Trump will not have smooth sailing through the murky waters of congressional politics. Opposition to him has put into doubt the consensus view that populism is a political defibrillator that will shock policymakers into action. Instead of right-tail outcomes, markets are again fretting about left-tail risks: namely gridlock and obstructionism, but also protectionism, trade war, and competing nationalisms. In the long term, we are pessimists. We do not see how China and the U.S. will escape the dreaded "Thucydides Trap." We remain concerned that President Trump will grow frustrated with America's trade imbalances and strike out at friends and foes alike. But these are concerns for 2018 and beyond. In 2017, we believe that political risks remain overstated. In this weekly, we explain why. It's The Economy, Stupid! The global macro backdrop remains positive for the time being. Despite a very high global policy uncertainty index print, the market is responding to strong economic data (Chart 1), with the sum of the Citibank global economic- and inflation-surprise indexes rising to the highest level in the 14-year history of the survey.4 Chart 1Is Political Risk Overstated? Chart 2The Apex Of Globalization... Delayed? The global economic improvements are real. Chart 2 shows that PMI indexes in the developed world have reached their highest level since 2011, with global export volumes recovering from their multi-year doldrums. The Baltic dry index has gone vertical. Several other positive developments have caught our eye: Global Earnings: The global growth story has started to funnel down to company earnings, with a recovery in the net earnings-revisions ratio (Chart 3), which had been negative since 2011. Chart 3Strong Global Earnings Chart 4Godot Is Here! Return Of Capex U.S. Capex: The long-awaited capex recovery may finally be coming to the U.S., with real non-residential investment bottoming in 2016 (Chart 4). Manufacturing Renaissance: Global industrial production should have a solid year, at least judging by the strong leading economic-indicator print (Chart 5). Chart 5Industrial Renaissance Chart 6Consumers Are Elated Consumer Confidence: U.S. consumer confidence is at its highest level in 16 years (Chart 6), and should firm up from here, according to the BCA disposable-income indicator (Chart 7), and our expectation that Trump and the Republicans pass tax cuts.5 Chart 7Income Growth To Follow Chart 8Euro Area Is Doing Great European Renaissance: Data from the Euro Area remains bullish, despite the focus on political risk (Chart 8). BCA's real GDP growth models, introduced by The Bank Credit Analyst in their March report, corroborate the bullish view (Chart 9).6 Chart 9BCA's GDP Models Are Bullish The broad-based recovery in the data strongly suggest that the market's performance since the U.S. election is based on more than just a bet on Trump and his policies. Markets are responding to genuine improvements in the global economic outlook. Certainly there is something of a bet on the populists "getting it right," but hard data should continue to back up the optimism. How long can the party last? Our colleagues Martin Barnes and Peter Berezin have both recently warned of heightened recession risks in 2019.7 We are perhaps even less sanguine, observing dark clouds gathering for 2018. However, we will save that story for next week's missive. This week, we will provide our reasons for optimism about the remainder of this year. U.S.: Fade The Trumpocalypse S&P 500 fell 1.2% on March 21, the day that apparently sealed the fate of the Republicans' seven-year pledge to repeal and replace Obamacare. In our view, investors are overstating the conditional relationship between "repeal and replace" and the GOP's forthcoming tax bill. The most important political question for investors this year is simple: will the GOP blow out the budget deficit or focus on austerity? Getting the answer to this question right will go a long way in determining whether the impact on nominal GDP growth, inflation expectations, and thus the Fed's reaction-function is bullish for the S&P 500 and the U.S. dollar. This is the Trump trade: the idea that overarching reflation policy is swinging from monetary to fiscal. We still believe in Trump! That said, we acknowledge that comprehensive tax reform is tough - otherwise it would have occurred more recently than 1986.8 It is also true that the failure to repeal Obamacare will leave a few hundred billion dollars in the federal deficit that would have otherwise been available for tax cuts. Table 1 shows that the average time it takes to pass tax reform - from introduction of the bill to its signing by the president - is around five months. It is therefore not impossible, though assuredly difficult, for Congress to return from August recess this year and squeeze through a bill by Christmas Eve. TableMajor Tax Legislation And The Congressional Balance Of Power Chart 10Intra-Party GOP Polarization Falls##br## In Line With Last 80 Years Plus, Trump could always pivot away from tax reform and go after tax cuts, which are what Presidents Reagan and Bush did in 1981 and 2001. Both of these efforts took only one month to pass.9 From an economic perspective, the less ambitious option of tax cuts would be more flammable than tax reform, as it would merely increase the deficit and thus act as a more significant short-term stimulus. We see five reasons why the GOP will pass some form of tax legislation this year that will (1) add to the budget deficit, (2) lower household and probably corporate tax rates, and (3) likely include some provisions for infrastructure spending: Polarization is overstated: Intraparty ideological polarization is rising within the Republican Party, whereas it appears to be significantly declining in the Democratic Party (Chart 10).10 However, the move is not as significant as the media suggests. The average level of polarization within the GOP is well within the range of the past century. In fact, the GOP remains considerably less polarized than the Democrats were for most of the post-Second World War era. The data therefore suggests that while the GOP is indeed becoming more conservative (Chart 11), it is doing so uniformly. The measurable differences between the "Tea Party," represented in the House of Representatives by the Freedom Caucus, and the rest of the party are overstated. Chart 11Polarization Increasing Between, Not Within, The Two Parties Trump still has political capital: Despite a slump in national opinion polls, the president retains support among Republican voters (Chart 12). This means that he can threaten to campaign against Freedom Caucus representatives in the 2018 mid-term elections, as he did recently in an ominous tweet.11 Data suggest that voters would indeed follow Trump and dump the Freedom Caucus. Trump is very popular among Tea Party voters, even in Texas when put up against the state's Tea Party champion Senator Ted Cruz (Chart 13). Given that voter turnout in primary races in a mid-term election is below 10% for Republicans, a series of Trump rallies in Freedom Caucus districts could be sufficient to change the course of the election. Chart 12Republican Voters Support Trump Chart 13Trump Is A Threat To The Tea Party Chart 14Budget Deficits: Not As Hot Of A Priority Budget deficits are less relevant: Given the first two points, why did the Freedom Caucus oppose President Trump on health care? Because Obamacare and its replacement were both "big government programs," whereas these are "small government" Republicans. It was not because Freedom Caucus constituencies are laser-focused on lowering budget deficits! In fact, 22% fewer Republicans see reducing the budget deficit as the top policy priority as did in 2012, when the Tea Party was in full stride (Chart 14). Tax cuts are popular among Republican voters. Expanded budget deficits can be sold to them as a way to "starve the beast" of government.12 Institutional constraints to reform are overstated: "God put the Republican Party on earth to cut taxes." The famous quip from Washington Post columnist Robert Novak is a good guide for investors on tax reform. Many of our colleagues and clients tend to over-complicate their political analysis. Opposing tax reform and/or cuts will be political suicide for Republican legislators. And if budget deficits grow too much, the GOP can rely on two time-tested strategies to find "offsets" for tax cuts: Revenue Offsets: Republicans still have a handful of possibilities to raise revenues to offset the loss from cuts in tax rates even if they abandon the border adjustment tax (which they have not yet done). First, they can require companies to repatriate their offshore earnings, whose taxes are deferred. Second, they could engage in limited reform by closing some loopholes in the tax code. Third, they could let certain "tax extenders" expire at the end of the year as they are technically scheduled to do. Fourth, they could reduce the size of the tax cuts from the very ambitious plans outlined in their now outdated 2016 proposals. These decisions would be politically difficult, but that does not mean that all of them will fail. Crucially, the leader of the Freedom Caucus, Representative Mark Meadows (R-N.C.), now claims he would support tax cuts that are not fully offset by revenues. The Freedom Caucus appears to have expended most of its political capital on opposing the Obamacare replacement and is now tucking its tail between its legs! Dynamic Scoring: Republicans have emphasized macroeconomic feedback, i.e. the fact that tax cuts generate growth, which in turn generates tax revenues, defraying the initial revenue losses of the cuts. The Republicans will argue that static accounting methods make tax cuts seem more costly than they will be in reality. For instance, while it is true that President Bush's White House vastly overestimated the U.S.'s long-term revenue when it oversaw major cuts in 2001-3, nevertheless revenues did ultimately go up over the ten-year period - contrary to the Congressional Budget Office's estimates at the time (Chart 15). Various studies suggest that Republicans could use a variety of growth models to write off about 10% of the cost of their tax cuts (Chart 16). Chart 15Bush Was Right, ##br##CBO Was Wrong! Chart 16Dynamic Scoring Will Offset About##br## 10% Of Revenues Lost To Tax Cuts Timing is flexible: The GOP have the option of making tax cuts retroactive and thus avoiding a huge market disappointment if tax cuts come later in the year. It is even legally possible for tax laws passed in 2018 to take effect on January 1, 2017 - though it is admittedly more of a stretch than doing it this year.13 Chart 17Republicans Are Not Deficit-Neutral Our high-conviction view remains that tax reform - or less ambitious tax cuts - is still coming this year. It is empirically false that Republicans care more about balancing the budget than about reducing the tax burden on individuals and corporates (Chart 17). Arguments to the contrary rely on the time-tested (and failed) analytical strategy of "this time is different." Of course, the timing and legislative process lack clarity (Diagram 1). Republicans still plan to use "budget reconciliation" to sneak through tax reform or cuts. This allows them to approve tax policy with a simple majority, i.e. to bypass any "points of order" or filibusters in the Senate that would raise the bar to a 60-vote supermajority. The rules of reconciliation require a bill to be deficit-neutral beyond the five- or ten-year window mapped out in Congress's preceding budget resolution (the latter, for FY2018, has not yet passed). But this means that a bill that blows out the budget deficit can still be passed as long as it has a "sunset clause" at the end of the 10-year period, as was the case with President Bush's tax cuts.14 We are also sanguine on the more immediate question of government funding. Congress has to agree to fund the government by April 28 - the expiration date of December's continuing resolution - in order to avoid a government shutdown. Democrats are threatening to sink the appropriations bills (or omnibus bill) if Republicans attach noxious "riders" to it, such as defunding Planned Parenthood or building Trump's border wall. We think the Democrats are bluffing. Furthermore, leading Republicans are already signaling that they will postpone their moves on the most toxic issues to avoid a shutdown that would make them look incompetent. Diagram 1U.S. Congressional Budget Timeline 2017 What about the upcoming vote to confirm President Trump's pick for the Supreme Court, Judge Neil M. Gorsuch? Is there any investment relevance of the pick? We do not think so. Judge Gorsuch will replace Judge Antonin Scalia and thereby protect the slightly conservative tilt of the court. Investors should watch to see if enough Democrats in fact filibuster the nomination and if Republicans change Senate rules to override filibusters for Supreme Court nominations (the so-called "nuclear option"). If Democrats insist on goading Republicans into this rule change, then the odds of bipartisan compromise on legislative initiatives (such as an infrastructure package) will fall, relative to a situation where some Democrats endorse Gorsuch and Republicans uphold Senate norms. Bottom Line: The market no longer believes that corporate tax reform will happen. High tax-rate companies have given back all of their post-election equity gains (Chart 18). We think this selloff is a mistake. As our report this week attests, we base our view on a study of political, legislative, and constitutional constraints to tax reforms and cuts. We are highly skeptical of "this time is different" narratives that overstate the power of the Freedom Caucus. As a direct bet on our high conviction view, we recommend that investors go long the high tax-rate basket relative to the S&P 500. Chart 18How To Profit From Tax Reform Chart 19Brexit Political Risk Bottomed In January Brexit: Much Ado About Nothing? The market has ignored both the invocation of Article 50 by London on March 29 and the publication of the EU's negotiation "guidelines" on March 31.15 As we discussed in January, political tensions between the EU and the U.K. likely peaked before January 16. This was the day when the market fully priced in the rumors that the U.K. would seek to withdraw from the EU Common Market. Prime Minister Theresa May confirmed the rumors on January 17 with a key speech. We have been long the GBP since.16 Investors continue to fret that there are more risks to come, but the market agrees with our assessment. The GBP bottomed against the EUR on October 11 (just after the Conservative Party conference where PM May affirmed the government's commitment to the referendum result) and bottomed against the USD on January 16. It has rallied against both currencies since the latter date (Chart 19). Why? First, the EU guidelines on the Brexit negotiations do not appear to be aggressive. The EU has offered the U.K. a "transition period," for an indefinite time between the U.K.'s technical withdrawal (March 29, 2019) and the new cross-channel status quo (for example, a free trade agreement, FTA). This is significant given that financial media doubted whether any transitional deal would be on offer as recently as a week ago. Second, the EU has implied that it will at least begin talks on an FTA with the U.K. while the negotiations on withdrawal are still ongoing. This is not exactly what London asked for but it is close.17 This means that the EU will hold the U.K.'s liabilities to the bloc for ransom before it begins negotiating a post-membership deal, but it also means that the EU does not want to threaten a "status cliff" where the U.K. and EU fail to forge any deal and hence revert back to basic WTO tariffs. Third, a leaked copy of an EU parliamentary resolution on Brexit also suggests that a "transition period," in this case limited to three years, is in the offing.18 It also hints at what we have long argued, that the EU would treat the U.K.'s notice of withdrawal (triggering Article 50) as revocable, i.e. reversible. That said, some negatives are obvious from both documents: The EU parliamentary resolution insists that the City of London does not get special access to the EU's common market; Spain will get a veto on whether the final agreement applies to the territory of Gibraltar; The U.K. will have to settle its financial commitments to the EU; No "cherry picking" of common-market benefits will be allowed. These points do not surprise us. We have been pessimists on London's ability to retain access to the EU common market well before Brexit. And May's own speech on January 17 cited that London would not seek to "cherry pick" benefits from the common market. Our assessment remains that the EU is not out for blood. Or, as we put it in our January 25 note: Now that the U.K. has chosen to depart from the common market, the EU no longer needs to take as hostile of a negotiating position as before. The EU member states were not going to let the U.K. dictate its own terms of membership. That would have set a precedent for future Euroskeptic governments looking for an alternative relationship with the bloc, i.e. the so-called "Europe à la carte" that European policymakers dread. But now that the U.K. is asking for a clean exit, with a free trade agreement to be negotiated in lieu of common market membership, the EU has less reason to punish London. May's January 17 speech was therefore a classic "sell the rumor, buy the news" moment. Of course, we expect further risks and crises, especially with the British press laser-focused on the issue. But much of the hysterics will be irrelevant. Take the issue of the dreaded "exit fee." The media has focused on the fee as if the EU is seeking to impose a blood tax on the U.K. Instead, the roughly €60 billion "fee" is merely the remaining portion of U.K.'s contribution to the 2014-2020 EU budget, plus other liabilities. The EU sets its budgets on a seven-year horizon and the U.K. is going to remain a member state until March 2019. Some British newspapers think that the U.K. can continue to live in an EU apartment for the remainder of its lease without paying rent! The fact of the matter is that the EU is a trading power focused on expanding its markets. It is not in the interest of core member states, especially the export-oriented powerhouses such as Germany, Sweden, and the Netherlands, to lose the U.K. as a trading partner. And it is certainly not in their interest to impose such painful retribution as to risk harming their own economies. What about the message that the EU would want to send to other member states? This is only important if the likelihood of exit by another EU member state is high. As we discussed immediately after the referendum, the risks of EU dissolution are grossly overstated.19 Recent elections in Austria and the Netherlands confirm our analysis, and we expect that French elections will as well. Yes, Italy is a risk to the EU, given that Euroskepticism is on the rise there. However, the EU has ample tools with which to dissuade the Italians from exiting - starting with a market riot that the ECB can induce at any time by reversing its offer to buy Italian debt. And it is doubtful that the EU can change Italian sentiment through punitive Brexit negotiations. What kind of a post-Brexit relationship should investors expect between the U.K. and the EU? There are three options: Customs union: The U.K. is not likely to accept a Turkish arrangement in which it belongs to the customs union but not the common market. That is because the customs union forces Turkey to apply the common EU tariff on all imports, while its exports do not benefit from other countries' trade deals with the EU. The U.K. wants more autonomy over trade, so this is unlikely to be the solution. The Turkish deal also excludes trade in services, which the U.K. will want to promote. Common market lite: The U.K. has a low-probability option of accepting the Norwegian or Swiss options of membership in the common market despite non-membership in the customs union. These options would allow only a few limits to the EU's demand of free movement of goods, services, people, and capital; they are currently non-starters because the U.K. is prioritizing curbs on immigration. It is possible that the U.K. could come around to something similar later, but it would require a shift in domestic politics, of which there is little evidence yet. Chart 20British Public Remains Divided On Brexit FTA: The U.K. is more likely to have an FTA arrangement, comparable to the just-signed EU deal with Canada. This would give the U.K. more autonomy on trade deals with third parties, while keeping tariffs to a minimum and incurring no obligation of free movement of people. It would also likely be more robust than the Canadian deal because of the much higher level of existing integration. Still, the U.K.'s prized service sector would suffer, as FTAs rarely cover services adequately. In fact, one of London's long-standing problems with the EU itself was lack of implementation of the 2006 EU Services Directive, which was supposed to harmonize trade in services and reduce non-tariff barriers to trade. We place the probability of the U.K. reverting back to WTO rules on trade with the EU - the most adverse scenario - to zero. Why such a high-conviction view? The EU has a customs agreement with Turkey, a country that threatens Europe with a Biblical exodus of refugees once every fortnight. In comparison, the U.K. and the EU are geopolitical allies that cooperate on national security, foreign policy, climate change, and other issues. There is no way that investors will wake up in 2019 and find that the U.K. has a worse trade agreement with the EU than Turkey.20 It is not all smooth sailing for the U.K., however. Brexit is not an optimal outcome for the U.K. economy.21 Leaving the EU means a deep cut in its labor-force growth rate, service exports, and inward FDI flows, reducing the U.K.'s growth potential. That said, given that the transitional deal will likely extend the horizon of "final Brexit" to around 2022 - or even beyond - and that there is still a small chance of a total reversal of Brexit, it is very difficult to predict the final impact on the U.K. economy now. There is another option that investors should consider. With Scottish independence gaining steam,22 and political risks rising in Northern Ireland, perhaps the EU is trying to kill Brexit with kindness. Polls on the Brexit referendum remain tight (Chart 20), which suggests that the "Remain" camp could eventually regain the upper hand - particularly if the shock to household income from inflation persists (Chart 21). With the U.K.'s own union at risk, perhaps the Tory leadership will alter its exit strategy over the course of negotiations. Meanwhile, investors should remember that: Chart 21Bremain May Regain Popularity ##br##When Brexit Bites Chart 22British Public Not Divided On ##br##Current Leadership Article 50 is almost certainly revocable. This is a political issue, not a legal one, as we have long stressed, and as the EU parliament leak suggests. Theresa May has promised that the final deal with the EU will be put to a vote in parliament. The bearish view has assumed that a failure of the vote would cast the U.K. into the abyss of no trade relationship other than the WTO's general agreement on tariffs. But failure could also follow from a shift in politics in the U.K. that seeks to act on the revocability of Article 50 and rejoin the EU. We see no sign of such a shift at the moment (Chart 22), but two to five years is time enough for one to develop. The next U.K. election will take place by May 2020, unless the government engineers a special early election. That is only a year after Article 50's two-year withdrawal period ends. If political winds are changing direction, the EU's allowance of a transition period could widen the window for a relatively smooth reverse-Brexit. In other words, "Brexit still means Brexit," but there are various escape hatches if the public demurs. The Scottish referendum has put a new constraint on the Tories and the EU may have figured out that the best way to encourage the Brits to change their mind is to smother them with kindness. What indications would suggest that the U.K. is changing strategies or the EU turning aggressive? In the U.K., a move to hold early elections could suggest that Prime Minister May wants a mandate of her own. This could enable her to pursue her current strategy more resolutely, but it could also give her the flexibility to reverse it. A sudden loss of support for the Tories, or a surge in the polling in favor of "Bremain," could also trigger a change in the government's approach. A significant public concession by the government in the negotiations could also mark a pivot point. In the EU, the following actions would suggest that the Brexit strategy will become less benign (and that our sanguine view is wrong): stonewalling in the exit negotiations, a reversal of the "Barroso doctrine" in order to encourage Scottish independence, a decision to shorten or deny the transition period, a lack of seriousness in trade negotiations, a downgrading of security and defense relations, or a move to pry away Gibraltar, among others. Bottom Line: We maintain our view that the pound bottomed along with the political risk on January 16. Yes, Brexit is not an optimal outcome, but the EU appears to be willing to push off the final date of the break with the U.K. into the future. At some point, we expect the U.K.'s inward FDI to suffer as companies - especially banks - grapple with the reality of Brexit. However, given the negotiations and potential transitional deal of up to three years, that date could be anywhere from two to five years into the future. Update On France: Can We Worry Now? We have spent much ink this year explaining why populist Marine Le Pen is not going to win the two-round French election on April 23 and May 7.23 Polls continue to support our view, with Le Pen trailing Emmanuel Macron by 26% with 33 days to go to their likely second-round matchup (Chart 23). At this point in the U.S. election, candidate Trump trailed Secretary Hillary Clinton by only 5%. Even Francois Fillon appears to be rallying against Le Pen. Despite ongoing corruption allegations against him, Fillon is leading Le Pen in a hypothetical second-round matchup by 16%. Chart 23Le Pen Lags Both Her Rivals##br## In Key Second Round Chart 24Is American Midwest A Path To##br## Le Pen Presidency? Chart 25No Comparison Between ##br##Le Pen And Trump A sophisticated New York client challenged our comparison of Trump's national polling against Clinton to that of Le Pen and her rivals. Instead, the client asked us to focus on the massive underperformance of the polls in the Midwest, where Trump surprised to the upside and beat long odds to win in Pennsylvania, Michigan, and Wisconsin (Chart 24). We agree that it is all about voter turnout, but again the numbers bear out Le Pen's weakness. She would have to perform six times better than Trump did in the Midwest to win the election (Chart 25). Chart 26Italy's Euroskeptics Much ##br##Stronger Than France's Chart 27The Market Is Missing ##br##The Italian Risks Chart 28Long French Bonds, Short Italian We are not dogmatic on the subject, we just refuse to agree with the lazy conventional wisdom that "polls are wrong." They are not. National polls got the U.S. election almost perfectly (the polls predicted a 3.2% Clinton victory and she won the popular vote by 2.1%). It is not our problem that pundits overestimated Clinton's strength, especially in the rustbelt states. Our own quantitative model gave Trump a 40% chance of winning the election on the night of the vote, roughly double the consensus view.24 We will therefore upgrade Le Pen's chances of winning when she starts making serious improvement in her second-round, head-to-head polling. Meanwhile, in Italy, the establishment continues to lose support to Euroskeptic parties (Chart 26). The media have not caught on to this risk, perhaps because they are feasting on negative news from France (Chart 27). The bond market has begun to price higher risks in Italy, with spreads between French and Italian bonds having risen 76 bps since January 2016 (Chart 28). However, they remain 296 bps away from their highs in 2012. We suspect that Italian bonds will see further underperformance relative to French bonds. Bottom Line: We continue to monitor risks in France due to the presidential elections. However, Le Pen remains behind both of her likely opponents by double digits in the second round. We remain long French industrial equities relative to their German counterparts as a play on expected structural reforms post-election. In addition, we are initiating a long French bonds / short Italian bonds recommendation due to our fear that Italy is the one and only risk to European integration in the short and medium term. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com Matt Gertken, Associate Editor Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 4 Please see BCA Global Investment Strategy Special Report, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 5 Please see BCA Foreign Exchange Strategy Weekly Report, "U.S. Households Remain In The Driver's Seat," dated March 31, 2017, available at fes.bcaresearch.com. 6 Please see The Bank Credit Analyst, "March 2017," dated February 23, 2017, available at bca.bcaresearch.com. 7 Please see BCA Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax," dated February 8, 2017, available at gps.bcaresearch.com. 10 Data for polarization analysis uses "nominate" (nominal three-step estimation), a multidimensional scaling method developed to analyze preference and choice. Researchers use the bulk of roll call voting in the U.S. Congress over its entire history. Our Chart 10 measures intra-party polarization along the "primary dimension," which is the liberal-conservative spectrum on the basic role of the government in the economy. 11 "The Freedom Caucus will hurt the entire Republican agenda if they don't get on the team, & fast. We must fight them, & Dems, in 2018!" @realDonaldTrump 12 The quote "starve the beast" is a proverbial phrase that has applied to taxes at least since the 1970s. Nowadays it refers to cutting taxes and revenue in an effort to force cuts in expenditures. While the quote is attributed to President Ronald Reagan, he never used it. Instead, he used the analogy of a child's allowance during his campaign in 1980: "If you've got a kid that's extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker." Subsequent Republican administrations have used similar rhetoric to justify tax cuts, including that of George W. Bush. 13 Congress, after the sweeping 1986 tax reforms, corrected certain oversights in that law by passing subsequent measures in 1987. These were made to be retroactive back to the previous calendar year, i.e. January 1, 1986, and courts upheld the legislation. Hence there is precedent for Republicans to pass tax reform in 2018 that takes effect January 1, 2017, though admittedly the circumstances would matter. Courts have even upheld retroactive tax legislation back to two calendar years. Please see Erika K. Lunder, Robert Meltz, and Kenneth R. Thomas, "Constitutionality of Retroactive Tax Legislation," Congressional Research Service, October 25, 2012, available at fas.org. 14 Please see Megan S. Lynch, "The Budget Reconciliation Process: Timing Of Legislative Action," Congressional Research Service, October 24, 2013, available at digital.library.unt.edu, and Tax Policy Center, "What Is Reconciliation," Briefing Book, available at www.taxpolicycenter.org. See also David Reich and Richard Kogan, "Introduction to Budget 'Reconciliation,'" Center on Budget and Policy Priorities, November 9, 2016, available at www.cbpp.org. 15 Please see Council of the European Union, "Draft guidelines following the United Kingdom's notification under Article 50 TEU," dated March 31, 2017, available at bbc.co.uk. 16 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 17 The exact wording from the EU guidelines: "While an agreement on a future relationship between the Union and the United Kingdom as such can only be concluded once the United Kingdom has become a third country, Article 50 TEU requires to take account of the framework for its future relationship with the Union in the arrangements for withdrawal. To this end, an overall understanding on the framework for the future relationship could be identified during a second phase of the negotiations under Article 50. The Union and its Member States stand ready to engage in preliminary and preparatory discussions to this end in the context of negotiations under Article 50 TEU, as soon as sufficient progress has been made in the first phase towards reaching a satisfactory agreement on the arrangements for an orderly withdrawal." 18 Please see Daniel Boffey, "First EU response to article 50 takes tough line on transitional deal," The Guardian, March 29, 2017, available at www.theguardian.com. 19 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 20 No way. 21 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, Special Report, "The French Revolution," dated February 3, 2017, Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com.

Highlights Dear Client, In light of the recent political crisis in South Africa, we are re-publishing the following brief from BCA’s Emerging Markets Strategy service. As we have argued since 2015, South African politics are devolving into populism. We believe that the market is finally catching up to that reality and we see little to cheer in the short term. For our clients who are interested in EM macro fundamentals, we suggest they give our Emerging Markets Strategy a try. Please contact your account manager for more details. Kindest Regards, Marko Papic, Senior Vice President Geopolitical Strategy Feature Political risks have not risen in South Africa with the dismissal of Finance Minister Pravin Gordhan. They had never declined in the first place. The markets have, however, ignored them in the past 12 months. Investors have failed to recognize the fundamental problem underpinning the disarray in the ruling African National Congress (ANC): growing public discontent with persistently high unemployment and income inequality. Despite a growing body of evidence that political stability has been declining for a decade, strong foreign portfolio flows have papered over the reality on the ground and allowed domestic markets to continue "whistling in the dark." Investors even cheered the poor performance of the ANC in municipal elections in August 2016, despite the fact that by far the biggest winners of the election were the left-wing Economic Freedom Fighters (EFF), not the centrist Democratic Alliance. This confirms BCA's Geopolitical Strategy's forecast that the main risk to President Jacob Zuma's rule is from his left flank, led by the upstart EFF of Julius Malema, and by the Youth and Women's Leagues of his own ANC.1 As such, it was absolutely nonsensical to expect Zuma to pivot towards pro-market reforms. Unsurprisingly, he has not. But could the Gordhan firing set the stage for an internal ANC dust-up that gives birth to a pro-reform, centrist party? This is the hopeful narrative in the press today. We doubt it. First, if the ANC splits along left-right lines, it is not clear that the reformers would end up in the majority. Therefore, the hope of the investment community that Deputy President Cyril Ramaphosa takes charge and enacts painful reforms is grossly misplaced. Second, Zuma may no longer be popular, but his populist policies are. While both the Communist Party (a partner of the Tripartite Alliance with the ANC) and the EFF now officially oppose his rule, they do not support pro-market reforms. Third, ethnic tensions are rising, particularly between the Zulu and other groups. These boiled over in social unrest last summer in Pretoria when the ruling ANC nominated a Zulu as the candidate for mayor of the Tshwane municipality (which includes the capital city). As such, we see the market's reaction as a belated acceptance of the reality in South Africa, which is that the country's consensus on market reforms is weakening, not strengthening. It is not clear to us that a change at the top of the ANC, or even a vote of non-confidence in Zuma, would significantly change the country's trajectory. In addition, the political tensions are growing at a time when budget revenue growth is dwindling and the fiscal deficit is widening (Chart 1). To placate investor anxiety over the long-term fiscal outlook, the government should ideally cut its spending. However, it is impossible to do so when there are escalating backlashes from populist parties and from within the ruling Tripartite Alliance. Odds are that the current and future governments will resort to more populist and unorthodox policies. That will jeopardize the public debt outlook and erode the currency's value. Needless to say, the nation's fundamentals are extremely poor - outright decline in productivity being one of the major causes (Chart 2). Chart 1South Africa: Fiscal Stress Is Building Up Chart 2Underlying Cause Of Economic Malaise We believe the rand has made a major top and local currency bond yields reached a major low (Chart 3). We continue to recommend shorting the ZAR versus both the U.S. dollar and Mexican peso. Traders, who are not short, should consider initiating these trades at current levels. Investors who hold local bonds should reduce their exposure. Dedicated EM equity investors should downgrade this bourse from neutral to underweight (Chart 4). Chart 3South Africa: ##br##Short The Rand And Sell Bonds Chart 4Downgrade South African##br## Equities To Underweight Finally, EM credit investors should continue underweighting the nation's sovereign credit within the EM universe and relative value trades should stay with buy South African CDS / sell Russian CDS protection. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, and Strategic Outlook, "Strategic Outlook 2016: Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com.

Highlights Recommended Allocation The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath Chart 2Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Chart 19Global Sector Performance First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Chart 25A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights With the labor market near full employment and the economy growing modestly, the U.S. economy is not in dire need of a "shot in the arm" from fiscal stimulus. Stocks may dip temporarily out of disappointment, but the economy will be fine even if Congress fails to boost infrastructure spending and/or cut taxes. Our view is that the market will adjust up expectations toward the Fed's view for 2018. The timing of this convergence will depend critically on the path of realized inflation and inflation expectations. If the 5-year, 5-year forward TIPS breakeven rate rises above a level that is consistent with the Fed's 2% inflation target. That would signal that investors fear the Fed is falling behind the inflation curve. Our view remains that U.S. equities will continue to outperform U.S. Treasury bond market in 2017, although that view is as much about the poor prospective returns in the bond market as it is about our bullish view on stocks. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. Feature With the labor market near full employment and the economy growing modestly, the U.S. economy is not in dire need of a "shot in the arm" from fiscal stimulus (Chart 1). The situation is very different from the early 1980s, early 2000s and during the aftermath of the collapse of Lehman Brothers in the fall of 2008. In early 2009, when the Congress and President Obama passed the $787 billion American Recovery and Reinvestment Act (ARRA), the economy was in the midst of the Great Recession and was still reeling from the collapse of Lehman Brothers and the freezing up of credit markets. Chart 1Trump Inheriting Best Economy For A New President In Decades Similarly, the economy was still struggling from the aftermath of the bursting of the technology, telecom and media bubble in 2000, when President Bush and an all-Republican Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001. When President Reagan and a split Congress passed the Economic Recovery Tax Act (ERTA) in August 1981, the economy had entered the second recession in as many years. While the economic expansion since the end of the Great Recession has been sluggish, and has not benefited all Americans the same way, the U.S. economy today is in much better shape than any of the three periods listed above. Monetary policy remains stimulative, financial conditions are easy and none of our forward-looking indicators warn of an economic downturn. Longer term, many of the policy proposals rattling around the Trump Administration may help to boost productivity and, ultimately, growth over the coming years. These include: simplifying the tax code; reducing regulation; and enacting legislation to enhance the nation's infrastructure. In the short term, however, some of those proposals may create uncertainty and thereby spark an economic soft patch (for example, the "border adjustment tax" or repealing Obama Care without immediately replacing it). Nonetheless, our main point is that the U.S. economy doesn't need a shot in the arm from fiscal policy to "rescue it" as was the case in decades past. The bottom line is that stocks may dip temporarily out of disappointment, but the economy will be fine even if Congress fails to boost infrastructure spending and/or cut taxes. Resetting The Stage The odds of a recession this year remain low, as there are few excesses in the system that typically lead to economic downturns. Just because the economic expansion that began in mid-2009 will turn eight years old later this quarter, that doesn't mean that a recession is imminent. We will continue to carefully monitor the economy for signs that excesses are building. But for now, our view remains that modest economic growth will continue, even without a boost from fiscal stimulus. The market has long questioned the pace of Fed rate hikes contained in the FOMC's 'dot plot'. Expectations for 2017 have converged on two more quarter-point hikes this year (Chart 2). It's a different story for 2018 and 2019, where the Fed sees 3 more hikes in 2018 and 4 more in 2019, but the market is pricing in just 2 and 1. Our view is that the market will adjust up expectations toward the Fed's view for 2018. The timing of this convergence will depend critically on the path of realized inflation and inflation expectations. A Tale Of Two Halves Headline inflation is likely to remain elevated and above the Fed's 2% target in 1H 2017, before fading modestly in the second half of the year as we pass the anniversary of the low in oil prices. That may cause markets to temporarily roll back the outlook for Fed tightening in 2018. Nonetheless, a continuing upward march in wage growth will keep pressure on core PCE inflation. The FOMC will likely 'look through' any softening in the headline rate that is simply due to oil prices. Notably, service sector inflation, which accounts for 2/3 of CPI, has been accelerating for 7 years and is above 3% (Chart 3). Chart 2Connected In 2017 And Disconnected After Chart 3Service Inflation Accelerating Rising short-term interest rates should not be a major headwind for the equity market to the extent that it is reflective of robust growth rather than surging inflation. Inflation expectations are only creeping higher at the moment according to market-based measures (Chart 4). Risk assets could run into trouble if the 5-year, 5-year forward TIPS breakeven rate rises above a level that is consistent with the Fed's 2% inflation target, at 2.4-2.5%. That would signal that investors fear the Fed is falling behind the inflation curve and will have to crank up the pace of tightening. The so-called 'Trump trades' are under pressure following the failure to reform Obamacare, at a time when U.S. equity valuations are stretched and some measures of equity sentiment are elevated. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. A lack of progress on a meaningful tax package and infrastructure plan may well end up being the catalyst for the first U.S. equity market correction of more than 5% in the Trump era. Nonetheless, the lack of excesses in the economy, general agreement between the Fed and the market on the path of rates for this year and rising, but still modest, inflation are likely to make any pullback in U.S. stocks a buying opportunity for investors. In fact, one could argue that fiscal stimulus at this point in the cycle would truncate the expansion because the Fed would have to respond more aggressively if the stimulus boosted inflation pressures. Fed Chair Yellen has made this point in recent public appearances. The failure to pass a tax reform package might undermine the long-term productivity story, but it could actually extend the length of this expansion and the equity bull market by delaying aggressive Fed rate hikes. Our view remains that U.S. equities will continue to outperform the U.S. Treasury bond market in 2017, although that view is as much about the poor prospective returns in the bond market as it is about our bullish view on stocks (Chart 5). Chart 4Inflation Expectations##br## Well Contained Chart 5Equities Continue To ##br##Outperform Bonds This Year The remainder of this week's publication focuses on the forces behind the continuing drop in risk asset correlations, and the implications for a mean-reversion in the equity risk premium. Correlation, ERP And Hurdle Rates Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification (Chart 6). Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart 7). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.1 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. Chart 6Market Correlations Are Shifting Chart 7Market Correlation And The ERP A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart 8). But why was the ERP so elevated after 2007? The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.2 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.3 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart 9). Chart 8Modeling The Stock Price ##br##Correlation Within The S&P 500 Chart 9Capex Hurdle Rates ##br##Never Came Down J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.4 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. Chart 10Forward Multiple Scenarios The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart 10). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 2 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 3 Are Firms Underinvesting - And If So Why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 4 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016.

Highlights Economic Outlook: The global economy is in a reflationary window that will stay open until mid-2018. Growth will then slow, culminating in a recession in 2019. While the recession is likely to be mild, the policy response will be dramatic. This will set the stage for a period of stagflation beginning in the early 2020s. Overall Strategy: Investors should overweight equities and high-yield credit during the next 12 months, while underweighting safe-haven government bonds and cash. However, be prepared to scale back risk next spring. Fixed Income: For now, stay underweight U.S. Treasurys within a global fixed-income portfolio; remain neutral on the euro area and the U.K.; and overweight Japan. Bonds will rally in the second half of 2018 as growth begins to slow, but then begin a protracted bear market. Equities: Favor higher-beta developed markets such as Europe and Japan relative to the U.S. in local-currency terms over the next 12 months. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate by 10% before peaking in mid-2018. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is close to a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks in the middle of next year. Feature Reflation, Recession, And Then Stagflation The investment outlook over the next five years can be best described as a three-act play: First Act: "Reflation" (The present until mid-2018) Second Act: "Recession" (2019) Third Act: "Stagflation" (2021 onwards) Investors who remain a few steps ahead of the herd will prosper. All others will struggle to stay afloat. Let us lift the curtain and begin the play. Act 1: Reflation Reflation Continues If there is one chart that best encapsulates the reflation theme, Chart 1 is it. It shows the sum of the Citibank global economic and inflation surprise indices. The combined series currently stands at the highest level in the 14-year history of the survey. Consistent with the surprise indices, Goldman's global Current Activity Indicator (CAI) has risen to the strongest level in three years. The 3-month average for developed markets stands at a 6-year high (Chart 2). Chart 1The Reflation Trade In One Chart Chart 2Current Activity Indicators Have Perked Up What accounts for the acceleration in economic growth that began in earnest in mid-2016? A number of factors stand out: The drag on global growth from the plunge in commodity sector investment finally ran its course. U.S. energy sector capex, for example, tumbled by 70% between Q2 of 2014 and Q3 of 2016, knocking 0.7% off the level of U.S. real GDP. The fallout for commodity-exporting EMs such as Brazil and Russia was considerably more severe. The global economy emerged from a protracted inventory destocking cycle (Chart 3). In the U.S., inventories made a negative contribution to growth for five straight quarters starting in Q2 of 2015, the longest streak since the 1950s. The U.K., Germany, and Japan also saw notable inventory corrections. Fears of a hard landing in China and a disorderly devaluation of the RMB subsided as the Chinese government ramped up fiscal stimulus. The era of fiscal austerity ended. Chart 4 shows that the fiscal thrust in developed economies turned positive in 2016 for the first time since 2010. Financial conditions eased in most economies, delivering an impulse to growth that is still being felt. In the U.S., for example, junk bond yields dropped from a peak of 10.2% in February 2016 to 6.3% at present (Chart 5). A surging stock market and rising home prices also helped buoy consumer and business sentiment. Chart 3Inventory Destocking Was A Drag On Growth Chart 4The End Of Fiscal Austerity? Chart 5Corporate Borrowing Costs Have Fallen Fine For Now... Looking out, global growth should stay reasonably firm over the next 12 months. 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 6). The lagged effects from the easing in financial conditions over the past 12 months should help support activity. Chart 7 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 remain sturdy for the remainder of 2017. Chart 6Global Growth Will Stay Strong In The Near Term Chart 7Easing Financial Conditions Will Support Activity ... But Storm Clouds Are Forming Home prices cannot rise faster than rents or incomes indefinitely; nor can equity prices rise faster than earnings. Corporate spreads also cannot keep falling. As the equity and housing markets cool, and borrowing costs start climbing on the back of higher government bond yields, the tailwind from easier financial conditions will dissipate. When that happens - most likely, sometime next year - GDP growth will slow. In and of itself, somewhat weaker growth would not be much of a problem. After all, the economy is currently expanding at an above-trend pace and the Fed wants to tighten financial conditions to some extent - it would not be raising rates if it didn't! The problem is that trend growth is much lower now than in the past - only 1.8% according to the Fed's Summary of Economic Projections. Living in a world of slow trend growth could prove to be challenging. The U.S. corporate sector has been feasting on credit for the past four years (Chart 8). Household balance sheets are still in reasonably good shape, but even here, there are areas of concern. Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 9). Together, these two categories account for over two-thirds of non-housing related consumer liabilities. Chart 8U.S. Corporate Sector Has Been Feasting On Credit Chart 9U.S. Household Balance Sheets Are In Good Shape, But Auto And Student Loans Are A Potential Problem The risk is that defaults will rise if GDP growth falls below 2%, a pace that has often been described as "stall speed." This could set in motion a vicious cycle where slower growth causes firms to pare back debt, leading to even slower growth and greater pressure on corporate balance sheets - in other words, a recipe for recession. Act 2: Recession Redefining "Tight Money" "Expansions do not die of old age," Rudi Dornbusch once remarked, "They are killed by the Fed." On the face of it, this may not seem like much of a concern. If the Fed raises rates in line with the median "dot" in the Summary of Economic Projections, the funds rate will only be about 2.5% by mid-2019 (Chart 10). That may not sound like much, but keep in mind that the so-called neutral rate - the rate consistent with full employment and stable inflation - may be a lot lower now than in the past. Also keep in mind that it can take up to 18 months before the impact of tighter financial conditions take their full effect on the economy. Thus, by the time the Fed has realized that it has tightened monetary policy by too much, it may be too late. As we have argued in the past, a variety of forces have pushed down the neutral rate over time.1 For example, the amount of investment that firms need to undertake in a slow-growing economy has fallen by nearly 2% of GDP since the late-1990s (Chart 11). And getting firms to take on even this meager amount of investment may require a lower interest rate since modern production techniques rely more on human capital than physical capital. Chart 10Will The Fed's 'Gradual' Rate Hikes End Up Being Too Much? Chart 11Less Investment Required Rising inequality has also reduced aggregate demand by shifting income towards households with high marginal propensities to save (Chart 12). This has forced central banks to lower interest rates in order to prop up spending. From this perspective, it is not too surprising that income inequality and debt levels have been positively correlated over time (Chart 13). Chart 12Savings Heavily Skewed Towards Top Earners Chart 13U.S.: Positive Correlation Between Income Inequality And Debt-To-GDP Then there is the issue of the dollar. The broad real trade-weighted dollar has appreciated by 19% since mid-2014 (Chart 14). According to the New York Fed's trade model, this has reduced the level of real GDP by nearly 2% relative to what it would have otherwise been. Standard "Taylor Rule" equations suggest that interest rates would need to fall by around 1%-to-2% in order to offset a loss of demand of this magnitude. This means that if the economy could withstand interest rates of 4% when the dollar was cheap, it can only withstand interest rates of 2%-to-3% today. And even that may be too high. Consider the message from Chart 15. It shows that real rates have been trending lower since 1980. The real funds rate averaged only 1% during the 2001-2007 business cycle, a period when demand was being buoyed by a massive, debt-fueled housing bubble; fiscal stimulus in the form of the two Bush tax cuts and the wars in Iraq and Afghanistan; a weakening dollar; and by a very benign global backdrop where emerging markets were recovering and Europe was doing well. Chart 14The Dollar Is In The Midst Of Its Third Great Bull Market Chart 15The Neutral Rate Has Fallen Today, the external backdrop is fragile, the dollar has been strengthening rather than weakening, and households have become more frugal (Chart 16). And while President Trump has promised plenty of fiscal largess, the reality may turn out to be a lot more sobering than the rhetoric. Chart 16Return To Thrift End Of The Trump Trade? Not Yet The failure to replace the Affordable Care Act has cast doubt in the eyes of many observers about the ability of Congress to pass other parts of Trump's agenda. As a consequence, the "Trump Trade" has gone into reverse over the past few weeks, pushing down the dollar and Treasury yields in the process. We agree that the "Trump Trade" will eventually fizzle out. However, this is likely to be more of a story for 2018 than this year. If anything, last week's fiasco may turn out to be a blessing in disguise for the Republicans. 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). Table 1Passing The American Health Care Act Could Have Cost The Republicans Dearly The GOP's proposed legislation would have 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. That would have warranted lower bond yields and a weaker dollar. The failure to pass an Obamacare replacement serves 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 Where the disappointment will appear is not during the legislative process, but afterwards. The highly profitable companies that will benefit the most from corporate tax cuts 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 corporate tax cuts may 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 17From 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. Chart 18Euro Area Credit Impulse Will Fade In The Second Half Of 2018 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 17). 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 lavish fiscal stimulus only to get neither. Euro Area: A 12-Month Window For Growth The outlook for the euro area over the next 12 months is reasonably bright, but just as in the U.S., the picture could darken later next year. Euro area private sector credit growth reached 2.5% earlier this year. This may not sound like a lot, but that is the fastest pace of growth since July 2009. A further acceleration is probable over the coming months, given rising business confidence, firm loan demand, and declining nonperforming loans. Conceptually, it is the change in credit growth that drives GDP growth. Thus, as credit growth levels off next year, the euro area's credit impulse will fall back towards zero, setting the stage for a period of slower GDP growth (Chart 18). In contrast to the U.S., the ECB is likely to resist the urge to raise the repo rate before growth slows. That's the good news. The bad news is that the market could price in some tightening in monetary policy anyway, leading to a "bund tantrum" later this year. As in the past, the ECB will be able to defuse the situation. Unfortunately, what Draghi cannot do much about is the low level of the neutral rate in the euro area. If the neutral rate is low in the U.S., it is probably even lower in the euro area, reflecting 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. Chart 19Anti-Euro Sentiment Is High In Italy Indeed, it is entirely possible that the neutral rate is negative in the euro area, even in nominal terms. If that's the case, the ECB will find it difficult to keep inflation from falling once the economy begins to slow late next year. The U.K.: And Now The Hard Part The U.K. fared better than most pundits expected in the aftermath of the Brexit vote. Nevertheless, it would be a mistake to assume that the Brexit vote has not cast a pall over the economy. The pound has depreciated by 11% against the euro and 16% against the dollar since that fateful day, while gilt yields have fallen across the board. Had it not been for this easing in financial conditions, the economic outcome would have been far worse. As the tailwind from the pound's devaluation begins to recede next year, the U.K. economy could suffer. Slower growth in continental Europe and the rest of the world could also exacerbate matters. The severity of the slowdown will hinge on the outcome of Brexit negotiations. On the one hand, the EU has an interest in taking a hardline stance to discourage separatist forces elsewhere, particularly in Italy where pro-euro sentiment is tumbling (Chart 19). On the other hand, the EU still needs the U.K. as both a trade partner and a geopolitical ally. Investors may therefore be surprised by the relatively muted negotiations that transpire over the coming months. In fact, news reports indicate that Brussels has already offered the U.K. a three year transitional deal that will give London plenty of time to conclude a free trade agreement with the EU. In addition, the EU has dangled the carrot of revocability, suggesting that the U.K. would be welcomed back with open arms if enough British voters were to change their minds. Whatever the path, our geopolitical service believes that political risk actually bottomed with the January 17 Theresa May speech.2 If that turns out to be the case, the pound is unlikely to weaken much from current levels. China And EM: The Calm Before The Storm? The Chinese economy should continue to perform well over the coming months. The Purchasing Manager Index for manufacturing remains in expansionary territory and BCA's China Leading Economic Indicator is in a clear uptrend (Charts 20 and 21). Chart 20Bright Spots In The Chinese Economy Chart 21Improving LEI Points To Further Growth Acceleration Moreover, there has been a dramatic increase in the sales of construction equipment such as heavy trucks and excavators, with growth rates matching levels last seen during the boom years before the global financial crisis. Historically, construction machinery sales have been tightly correlated with real estate development (Chart 22). Reflecting this reflationary trend, the producer price index rose by nearly 8% year-over-year in February, a 14-point swing from the decline of 6% experienced in late-2015. Historically, rising producer prices have resulted in higher corporate profits and increased capital expenditures, especially among private enterprises (Chart 23). Chart 22An Upturn In Housing Construction? Chart 23Higher Producer Prices Boosting Profits The key question is how long the good news will last. As in the rest of the world, our guess is that the Chinese economy will slow late next year, setting the stage for a major growth disappointment in 2019. Weaker growth abroad will be partly to blame, but domestic factors will also play a role. The Chinese housing market has been on a tear. The authorities are increasingly worried about a property bubble and have begun to tighten the screws on the sector. The full effect of these measures should become apparent sometime next year. Fiscal policy is also likely to be tightened at the margin. The IMF estimates that China benefited from a positive fiscal thrust of 2.2% of GDP between 2014 and 2016. The fiscal thrust is likely to be close to zero in 2017 and turn negative to the tune of nearly 1% of GDP in 2018 and 2019. The growth outlook for other emerging markets is likely to mirror China's. The IMF expects real GDP in emerging and developing economies to rise by 5.1% in Q4 of 2017 relative to the same quarter a year earlier, up from 4.2% in 2016 (Table 2). The biggest acceleration is expected to occur in Brazil, where the economy is projected to grow by 1.4% in 2017 after having contracted by 1.9% in 2016. Russia and India should also see better growth numbers. Table 2World Economic Outlook: Global Growth Projections We do not see any major reason to challenge these numbers for this year, but think the IMF's projections will turn out to be too rosy for 2018, and especially, 2019. As BCA's Emerging Market Strategy service has documented, the lack of structural reforms in EMs over the past few years has depressed productivity growth. High debt levels also cloud the picture. Chart 24 shows that debt levels have continued to grow as a share of GDP in most emerging markets. In EMs such as China, where banks benefit from a fiscal backstop, the likelihood of a financial crisis is low. In others such as Brazil, where government finances are in precarious shape, the chances of another major crisis remains uncomfortable high. Japan: The End Of Deflation? If there is one thing investors are certain about it is that deflationary forces in Japan are here to stay. Despite a modest increase in inflation expectations since July 2016, CPI swaps are still pricing in inflation of only 0.6% over the next two decades, nowhere close to the Bank of Japan's 2% target. But could the market be wrong? We think so. Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 25). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. Over the past quarter century, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at only 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 26). Chart 24What EM Deleveraging? Chart 25Japan: Easing Deflationary Forces Chart 26Japan: Low Household Saving Rate And A Tightening Labor Market Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seems to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous cycle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Unfortunately, external events could conspire to sabotage Japan's escape from deflation. If the global economy slows in late-2018 - leading to a recession in 2019 - Japan will be hard hit, given the highly cyclical nature of its economy. And this could cause Japanese policymakers to throw the proverbial kitchen sink at the problem, including doing something that they have so far resisted: introducing a "helicopter money" financed fiscal stimulus program. Against the backdrop of weak potential GDP growth and a shrinking reservoir of domestic savings, the government may get a lot more inflation than it bargained for. Act 3: Stagflation Who Remembers The 70s Anymore? By historical standards, the 2019 recession will be a mild one for most countries, especially in the developed world. This is simply because the excesses that preceded the subprime crisis in 2007 and, to a lesser extent the tech bust in 2000, are likely to be less severe going into the next global downturn than they were back then. The policy response may turn out to be anything but mild, however. Memories of the Great Recession are still very much vivid in most peoples' minds. No one wants to live through that again. In contrast, memories of the inflationary 1970s are fading. A recent NBER paper documented that age plays a big role in determining whether central bankers turn out to be dovish or hawkish.3 Those who experienced stagflation in the 1970s as adults are much more likely to express a hawkish bias than those who were still in their diapers back then. The implication is the future generation of central bankers is likely to see the world through more dovish eyes than their predecessors. Even if one takes the generational mix out of the equation, there are good reasons to aim for higher inflation in today's environment. For one thing, debt is high. The simplest way to reduce real debt burdens is by letting inflation accelerate. In addition, the zero bound is less likely to be a problem if inflation were higher. After all, if inflation were running at 1% going into a recession, real rates would not be able to fall much below -1%. But if inflation were running at 3%, real rates could fall to as low as -3%. The Politics Of Inflation Political developments will also facilitate the transition to higher inflation. In the U.S., the presidential election campaign will start coming into focus in 2019. If the economy enters a recession then, Donald Trump will go ballistic. The infrastructure program that Republicans in Congress are downplaying now will be greatly expanded. Gold-plated hotels and casinos will be built across the country. Of course, several years could pass between when an infrastructure bill is passed and when most new projects break ground. By that time, the economy will already be recovering. This will help fuel inflation. As the economy turns down in 2019, the Fed will also be forced to play ball. The market's current obsession over whether President Trump wants a "dove" or a "hawk" as Fed chair misses the point. He wants neither. He wants someone who will do what they are told. This means that the next Fed chair will likely be a "really smart" business executive with little-to-no-experience in central banking and even less interest in maintaining the Federal Reserve's institutional independence. The empirical evidence strongly suggests that inflation tends to be higher in countries that lack independent central banks (Chart 27). This may be the fate of the U.S. Chart 27Inflation Higher In Countries Lacking Independent Central Banks Europe's Populists: Down But Not Out Whether something similar happens in Europe will also depend on political developments. For the next 18 months at least, the populists will be held at bay (Chart 28). Le Pen currently trails Macron by 24 percentage points in a head-to-head contest. It is highly unlikely that she will be able to close this gap between now and May 7th, the date of the second round of the Presidential contest. In Germany, support for the europhile Social Democratic Party is soaring, as is support for the common currency itself. For the time being, euro area risk assets will be able to climb the proverbial political "wall of worry." However, if the European economy turns down in 2019, all this may change. Chart 29 shows the strong correlation between unemployment rates in various French départements and support for Marine Le Pen's National Front. Should French unemployment rise, her support will rise as well. The same goes for other European countries. Chart 28France And Germany: Populists Held At Bay For Now Chart 29Higher Unemployment Would Benefit Le Pen Meanwhile, there is a high probability that the migrant crisis will intensify at some point over the next few years. Several large states neighboring Europe are barely holding together - Egypt being a prime example - and could erupt at any time. Furthermore, demographic trends in Africa portend that the supply of migrants will only increase. In 2005, the United Nations estimated that sub-Saharan Africa's population will increase to 2 billion by the end of the century, up from one billion at present. In its 2015 revision, the UN doubled its estimate to 4 billion. And even that may be too conservative because it assumes that the average number of births per woman falls from 5.1 to 2.2 over this period (Chart 30). Chart 30Population Pressures In Africa The existing European political order is not well equipped to deal with large-scale migration, as the hapless reaction to the Syrian refugee crisis demonstrates. This implies that an increasing share of the public may seek out a "new order" that is more attuned to their preferences. European history is fraught with regime shifts, and we may see yet another one in the 2020s. The eventual success of anti-establishment politicians on both sides of the Atlantic suggests that open border immigration policies and free trade - the two central features of globalization - will come under attack. Consequently, an inherently deflationary force, globalization, will give way to an inherently inflationary one: populism. The Productivity Curse Just as the "flation" part of stagflation will become more noticeable as the global economy emerges from the 2019 recession, so will the "stag." Chart 31 shows that productivity growth has fallen across almost all countries and regions. There is little compelling evidence that measurement error explains the productivity slowdown.4 Cyclical factors have played some role. Weak investment spending has curtailed the growth in the capital stock. This means that today's workers have not benefited from the same improvement in the quality and quantity of capital as they did in previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. Most prominently, the gains from the IT revolution have leveled off. Recent innovations have focused more on consumers than on businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. Human capital accumulation has also decelerated, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 32). Educational achievement, as measured by standardized test scores in mathematics, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 33).5 Given that test scores are extremely low in most countries with rapidly growing populations, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 31Productivity Growth Has Slowed In Most Major Economies Chart 32The Contribution To Growth From Rising Human Capital Is Falling Chart 33Math Skills Around The World Productivity And Inflation The slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on (Chart 34). Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Chart 34A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation.6 One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a decade during which productivity growth slowed and inflation accelerated. Financial Markets Overall Strategy 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 with a 12-month horizon should stay overweight global equities and high-yield credit at the expense of government bonds and cash. 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, followed by a gradual recovery that sees the restoration of full employment in most countries by 2021. At that point, inflation will take off, rising to over 4% by the middle of the decade. The 2020s will be remembered as a decade of intense pain for bond investors. In relative terms, equities will fare better than bonds, but in absolute terms they will struggle to generate a positive real return. As in the 1970s, gold will be the standout winner. Chart 35 presents a visual representation of how the main asset markets are likely to evolve over the next seven years. Chart 35Market Outlook For Major Asset Classes Equities Cyclically Favor The Euro Area And Japan Over The U.S. Stronger global growth is powering an acceleration in corporate earnings. Global EPS is expected to expand by 12% 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 36 shows that the global earnings revision ratio has turned positive for the first time in six years, implying that analysts have been behind the curve in revising up profit projections. We prefer euro area and Japanese stocks relative to U.S. equities over a 12-month horizon. We would only buy Japanese stocks on a currency-hedged basis, as the prospect of a weaker yen is the main reason for being overweight Japan. In contrast, we would still buy euro area equities on a U.S. dollar basis, even though our central forecast is for the euro to weaken against the dollar over the next 12 months. Our cyclically bullish view on euro area equities reflects several considerations. For starters, they are cheap. Euro area stocks currently trade at a Shiller PE ratio of only 17, compared with 29 for the U.S. (Chart 37). Some of this valuation gap can be explained by different sector weights across the two regions. However, even if one controls for this factor, as well as the fact that euro area stocks have historically traded at a discount to the U.S., the euro area still comes out as being roughly one standard deviation cheap compared with the U.S. (Chart 38). Chart 36Global Earnings Picture Looking Brighter Chart 37Euro Area Stocks Are A Bargain... Chart 38...No Matter How You Look At It European Banks Are In A Cyclical Sweet Spot Of course, if euro area banks flounder over the next 12 months as they have for much of the past decade, none of this will matter. However, we think that the region's banks have finally turned the corner. The ECB is slowly unwinding its emergency measures and core European bond yields have risen since last summer. This has led to a steeper yield curve, helping to flatter net interest margins. Chart 39 shows that the relative performance of European banks is almost perfectly correlated with the level of German bund yields. Our European Corporate Health Monitor remains in improving territory, in contrast to the U.S., where it has been deteriorating since 2013 (Chart 40). Profit margins in Europe have room to expand, whereas in the U.S. they have already maxed out. The capital positions of European banks have also improved greatly since the euro crisis. Not all banks are out of the woods, but with nonperforming loans trending lower, the need for costly equity dilution has dissipated (Chart 41). Meanwhile, euro area credit growth is accelerating and loan demand continues to expand. Chart 39Performance Of European Banks And Bond Yields: A Good Fit Chart 40Corporations Healthier In The Euro Area Chart 41Cyclical Background Positive For Bank Stocks Beyond a 12-month horizon, the outlook for euro area banks and the broader stock market look less enticing. The region will suffer along with the rest of the world in 2019. The eventual triumph of populist governments could even lead to the dissolution of the common currency. This means that euro area stocks should be rented, not owned. The same goes for U.K. equities. EM: Uphill Climb Emerging market equities tend to perform well when global growth is strong. Thus, it would not be surprising if EM equities continue to march higher over the next 12 months. However, the structural problems plaguing emerging markets that we discussed earlier in this report will continue to cast a pall over the sector. Our EM strategists favor China, Taiwan, Korea, India, Thailand, Poland, Hungary, the Czech Republic, and Russia. They are neutral on Singapore, the Philippines, Hong Kong, Chile, Mexico, Colombia, and South Africa; and are underweight Indonesia, Malaysia, Brazil, Peru, and Turkey. Fixed Income Global Bond Yields To Rise Further We put out a note on July 5th entitled "The End Of The 35-Year Bond Bull Market" recommending that clients go structurally underweight safe-haven government bonds.7 As luck would have it, we penned this report on the very same day that the 10-year Treasury yield hit a record closing low of 1.37%. We continue to think that asset allocators should maintain an underweight position in global bonds over the next 12 months. In relative terms, we favor Japan over the U.S. and have a neutral recommendation on the euro area and the U.K. Chart 42The Market Expects 50 Basis Points Of Tightening Over The Next 12 Months Underweight The U.S. For Now We expect the U.S. 10-year Treasury yield to rise to around 3.2% over the next 12 months. The Fed is likely to raise rates by a further 100 basis points over this period, about 50 bps more than the 12-month discounter is currently pricing in (Chart 42). In addition, the Fed will announce later this year or in early 2018 that it will allow the assets on its balance sheet to run off as they mature. This could push up the term premium, giving long Treasury yields a further boost. Thus, for now, investors should underweight Treasurys on a currency-hedged basis within a fixed-income portfolio. The cyclical peak for both Treasury yields and the dollar should occur in mid-2018. Slowing growth in the second half of that year and a recession in 2019 will push the 10-year Treasury yield back towards 2%. After that, bond yields will grind higher again, with the pace accelerating in the early 2020s as the stagflationary forces described above gather steam. Neutral On Europe, Overweight Japan Yields in the euro area will follow the general contours of the U.S., but with several important qualifications. The ECB is likely to roll back some of its emergency measures over the next 12 months, including suspending the Targeted Longer-Term Refinancing Operations, or TLTROs. It could also raise the deposit rate slightly, which is currently stuck in negative territory. However, in contrast to the Fed, the ECB is unlikely to hike its key policy rate, the repo rate. And while the ECB will "taper" asset purchases, it will not take any steps to shrink the size of its balance sheet. As such, fixed-income investors should maintain a benchmark allocation to euro area bonds. Chart 43A Bit More Juice Left A benchmark weighting to gilts is also warranted. With the Brexit negotiations hanging in the air, it is doubtful that the Bank of England would want to hike rates anytime soon. On the flipside, rising inflation - though largely a function of a weak currency - will make it difficult for the BoE to increase asset purchases or take other steps to ease monetary policy. We would recommend a currency-hedged overweight position in JGBs. The Bank of Japan is committed to keeping the 10-year yield pinned to zero. Given that neither actual inflation nor inflation expectations are anywhere close to that level, it is highly unlikely that the BoJ will jettison its yield-targeting regime anytime soon. With government bond yields elsewhere likely to grind higher, this makes JGBs the winner by default. High-Yield Credit: Still A Bit Of Juice Left The fact that the world's most attractive government bond market by our rankings - Japan - is offering a yield of zero speaks volumes. As long as global growth stays strong and corporate default risk remains subdued, investors will maintain their love affair with high-yield credit. Thus, while credit spreads have fallen dramatically, they could still fall further (Chart 43). Only when corporate stress begins to boil over in late 2018 will things change. Nevertheless, investors will continue to face headwinds from rising risk-free yields in most economies even in the near term. This implies that the return from junk bonds in absolute terms will fall short of what is delivered by equities over the next 12 months. Currencies And Commodities Chart 44Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Will Support The Greenback We expect the real trade-weighted dollar to appreciate by about 10% over the next 12 months. Historically, changes in real interest rate differentials have been the dominant driver of currency movements in developed economies. The past few years have been no different. Chart 44 shows that the ascent of the trade-weighted dollar since mid-2014 has been almost perfectly matched by an increase in U.S. real rates relative to those abroad. Interest rate differentials between the U.S. and its trading partners are likely to widen further through to the middle of 2018 as the Fed raises rates more quickly than current market expectations imply, while other central banks continue to stand pat. Accordingly, we would fade the recent dollar weakness. As we discussed in "The Fed's Unhike," the March FOMC statement was not as dovish as it might have appeared at first glance.8 Given that monetary conditions eased in the aftermath of the Fed meeting - exactly the opposite of what the Fed was trying to achieve - it is likely that the FOMC's rhetoric will turn more hawkish in the coming weeks. The Yen Has The Most Downside, The Pound The Least Among the major dollar crosses, we see the most downside for the yen over the next 12 months. The Bank of Japan will continue to keep JGB yields anchored at zero. As yields elsewhere rise, investors will shift their money out of Japan, causing the yen to weaken. Only once the global economy begins to teeter into recession late next year will the yen - traditionally, a "risk off" currency - begin to rebound. The euro will also weaken against the dollar over the next 12 months, although not as much as the yen. The ECB's "months to hike" has plummeted from nearly 60 last summer to 26 today (Chart 45). That seems too extreme. Core inflation in the euro area is well below U.S. levels, even if one adjusts for measurement differences between the two regions (Chart 46). The neutral rate is also lower in the euro area, as discussed previously. This sharply limits the ability of the ECB to raise rates. Chart 45Market's Hawkish View Of The ECB Is Too Extreme Chart 46Core Inflation In The U.S. Is Still Higher, Even Excluding Housing Unlike most currencies, sterling should be able to hold its ground against the dollar over the next 12 months. The pound is very cheap by most metrics (Chart 47). The prospect of contentious negotiations over Brexit with the EU is already in the price. What may not be in the price is the possibility that the U.K. will move quickly to reach a deal with the EU. If such a deal fails to live up to the promises made by the Brexit campaign - a near certainty in our view - a new referendum may need to be scheduled. A new vote could yield a much different result than the first one. If the market begins to sniff out such an outcome, the pound could strengthen well before the dust settles. EM And Commodity Currencies The RMB will weaken modestly against the dollar over the coming year. As we have discussed in the past, China's high saving rate will keep the pressure on the government to try to export excess production abroad by running a large current account surplus. This requires a weak currency.9 Nevertheless, a major devaluation of the RMB is not in the cards. Much of the capital flight that China has experienced recently has been driven by an unwinding of the hot money flows that entered the country over the preceding years. Despite all the talk about a credit bubble, Chinese external debt has fallen by around $400 billion since its peak in mid-2014 - a decline of over 50% (Chart 48). At this point, most of the hot money has fled the country. This suggests that the pace of capital outflows will subside. Chart 47Pound: Cheap By All Accounts Chart 48Hot Money In, Hot Money Out A somewhat weaker RMB could dampen demand for base and bulk metals. A slowdown in Chinese construction activity next year could also put added pressure on metals prices. Our EM strategists are especially bearish on the South African rand, Brazilian real, Colombian peso, Turkish lira, Malaysian ringgit, and Indonesian rupiah. Crude should outperform metals over the next 12 months. This will benefit the Canadian dollar and other oil-sensitive currencies. However, Canada's housing bubble is getting out of hand and could boil over if domestic borrowing costs climb in line with rising long-term global bond yields. A sagging property sector will limit the ability of the Bank of Canada to raise short-term rates. On balance, we see modest downside for the CAD/USD over the coming year. The Aussie dollar will suffer even more, given the country's own housing excesses and its export sector's high sensitivity to metal prices. Finally, a few words on the most of ancient of all currencies: gold. We do not expect bullion to fare well over the next 12 months. A stronger dollar and rising bond yields are both bad news for the yellow metal. However, once central banks start slashing rates in 2019 and stagflationary forces begin to gather steam in the early 2020s, gold will finally have its day in the sun. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 2 Please see Geopolitical Strategy Weekly Report, "The "What Can You Do For Me" World?" dated January 25, 2017, and Special Report, "Will Scotland Scotch Brexit?" dated March 29, 2017, available at gps.bcaresearch.com. 3 Ulrike Malmendier, Stefan Nagel, and Zhen Yan, "The Making Of Hawks And Doves: Inflation Experiences On The FOMC," NBER Working Paper No. 23228 (March 2017). 4 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 5 Please see The Bank Credit Analyst Special Report, "Taking Off The Rose-Colored Glasses: Education And Growth In The 21st Century," dated February 24, 2011, available at bca.bcaresearch.com. 6 Note to economists: We can think of this relationship within the context of the Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. In the standard setup where the saving rate is fixed, slower population and productivity growth will always result in a lower equilibrium real interest rate. However, consider a more realistic setup where: 1) the saving rate rises initially as the population ages, but then begins to decline as a larger share of the workforce enters retirement; and 2) habit persistence affects consumer spending, so that households react to slower real wage growth by saving less rather than cutting back on consumption. In that sort of environment, the neutral rate could initially fall, but then begin to rise. If the central bank reacts slowly to changes in the neutral rate, or monetary policy is otherwise constrained by the zero bound on interest rates and/or political considerations, the initial effect of slower trend GDP growth will be deflationary while the longer-term outcome will be inflationary. 7 Please see Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "The Fed's Unhike," dated March 16, 2017, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "Does China Have A Debt Problem Or A Savings Problem?" dated February 24, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The financial market landscape has shifted over the past month with asset correlations changing and the so-called 'Trump trades' going into reverse. Equity valuation is stretched and plenty of risks remain. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. The economic data remain constructive for profits in the major countries. The risks posed by upcoming European elections have eased for 2017, now that the Italian election appears unlikely until 2018. The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. If a tax reform package proves too difficult to pass, then the GOP will settle for straight tax cuts and a modest amount of infrastructure spending. Market reaction to the FOMC's 'dovish hike' was overdone. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Not before September will the ECB be in a position to announce a further tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. In Japan, the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. Our views on U.S. fiscal policy and 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 and the global bond bear phase is not yet over. Another key market development has been the continuing drop in risk asset correlations. This reflects falling perceptions of downside "tail risk", which is reflected in a declining equity risk premium (ERP). Absent further negative shocks, perceptions of downside risk should continue to wane, allowing risk premia and asset correlations to ease further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can focus more on long-term revenue generation rather than on guaranteeing their existence. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. The only adjustment to asset allocation we are making this month is an upgrade for U.S. high-yield based on improved valuation. Feature The financial market landscape has shifted over the past month with asset correlations changing and a number of popular trades going into reverse. First, the failure to replace Obamacare triggered a pull-back of the so-called 'Trump trades.' Stock indexes are holding up well, but the U.S. dollar has given back most of the gains made in March and the 10-year Treasury yield has dropped back to the bottom of the post-U.S. election trading range. Moreover, the negative correlation between the U.S. dollar and risk assets has flipped (Chart I-1). Even oil prices have diverged from their usual negative trading relationship with the dollar. Second, investors are questioning the FOMC's appetite for rate hikes in the coming months. They are also wondering how much longer the European Central Bank (ECB) and the Bank of Japan (BoJ) can maintain current hyper-stimulative policy settings. The whole narrative regarding equity strength, a dollar overshoot and bond price weakness may be over if there is not going to be any fiscal stimulus in the U.S., the Fed is not going to hike more aggressively than the market currently expects, and monetary policy is near a turning point in Japan and the Eurozone. Is it time for investors to become defensive, scale back on risk assets, upgrade bonds and short the dollar? We believe the answer is 'not yet', although 2017 was always destined to be a rough ride given the ups-and-downs in the U.S. legislative process and the lineup of European elections. President Trump's first 100 days are turning out to be even more tumultuous than many expected. Allegations of wiretaps and the FBI investigation into the alleged interference of Russia in the U.S. election are costing the President political capital, as well as raising question marks over the Republican Party's wish list. Simply removing the possibility of corporate tax cuts would justify a healthy haircut on the S&P 500. The political situation has admittedly become more complicated, but our geopolitical team makes the following observations: The GOP base supports Trump: Until the mid-term elections, Trump's popularity with Republican voters remains strong, which means that the President still has political capital (Chart I-2). Chart I-1Changing Correlations Chart I-2Trump Not Dead To Republicans Yet Republicans want tax reform: Even if reform gets bogged down, there is broad support for cutting taxes at a minimum. Many deficit hawks appear willing to use the magic of "dynamic scoring" to justify tax cuts as revenue-neutral. Even the chairman of the Freedom Caucus has signaled that he is open to tax reform that is not revenue neutral. Tax reform not conditional on Obamacare: The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. The Republicans will need to show success on at least one of their signature platforms before heading into the mid-term elections. The prospective savings from Obamacare's repeal are not needed to "fund" tax cuts. Infrastructure: We still expect that President Trump will get his way on additional spending on defense, veterans, infrastructure and the wall. The tax reform process will undoubtedly be full of drama and may be stretched out, adding volatility to the equity market. Our base case is that some sort of tax reform and infrastructure package will be passed by year end. However, if a reform package proves too difficult to pass, then we believe that the GOP will settle for straight-forward tax cuts and a modest amount of infrastructure spending (please see Table I-1 in the March 2017 monthly Bank Credit Analyst for the probabilities we have attached to the various GOP proposals). Tax cuts and increased spending will be positive for risk assets. The caveat is that we see little change in Trump's commitment to mercantilism. This means he will lean toward backing the border tax or tariff increases, which will offset some of the benefits for risk assets from reduced tax rates. Excess Reaction To FOMC Chart I-3FOMC & Market Disagree Beyond This Year Given the uncertainty on the fiscal side, one can't blame the FOMC for taking a "wait and see" approach. The range for the funds rate was raised to 0.75-1.00% at the March meeting, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50 bps of tightening is expected by the Committee this year, with 75 bps expected in both 2018 and 2019 (Chart I-3). The FOMC signaled in March that it was not yet prepared to adjust the 'dot plot,' sparking a rally in bond prices and a pullback in the dollar. This market reaction seemed excessive in our view. 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. Is The Dollar Bull Over? Still, recent market action suggests that the dollar may not get a lift from future Fed rate hikes because the outlook for global growth outside of the U.S. is brightening. Moreover, it could be that monetary policy in the Eurozone and Japan is at a turning point. There is increasing speculation that the ECB will have to taper the quantitative easing program sooner than planned. Some are even speculating the ECB will lift rates this year. The recent economic data for the euro area have indeed been stellar. The composite PMI surged to 56.7 in March, with the forward-looking new orders components hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart I-4). 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. With unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to establish a consensus view on the ECB policy committee. The Bundesbank has been quite vocal on this issue, especially given that Eurozone headline HICP inflation reached 2% in February. The core rate of inflation remains close to 1%, but the rising diffusion index suggests that budding inflation pressure is becoming more broadly based (Chart I-5). Chart I-4Solid Eurozone Economic Data Chart I-5Eurozone Inflation Broadening Out BCA's Global Fixed Income Strategy service recently compared the current economic situation to that of the U.S. around the time of the Fed's 2013 "Taper Tantrum."1 In Chart I-6, we show "cycle-on-cycle" comparisons for the Euro Area and U.S. In the Euro Area, the number of months to the first rate hike discounted in money markets peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, this indicator has converged with the U.S. path. 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. Nonetheless, the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Not before September will the ECB be in a position to announce another tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. We do not believe that the ECB will raise short-term interest rates before it starts the tapering process. A rate hike would result in a stronger euro, downward pressure on inflation, and an unwanted tightening in financial conditions that would threaten the current economic impulse. This means that, between now and September, the window is still open for U.S./Eurozone interest rate spreads to move further in favor of the dollar. The European election calendar remains a risk to our view on currencies and risk assets. Widening OAT/Bund yield spreads highlight that investors remain concerned that the French election will follow last year's populist script in the U.K. and the U.S. However, our geopolitical team believes that Le Pen is unlikely to win since she trails in the polls by a 25-30% margin relative to Macron, her most likely opponent. Even if she were to pull off a win, she will not hold the balance of power in the National Assembly. Over in Germany, where the election is heating up, the fact that the Europhile SPD party is gaining in the polls means that the September vote is unlikely to be a speed bump for financial markets. The real political risk lies in Italy. While the election has been pushed off to February 2018, it appears that there will be genuine fireworks at that time because Euroskeptic parties have seized the lead in the polls (Chart I-7). In the meantime, European elections will be a source of volatility, but investors should ride it out until we get closer to the Italian election. Chart I-6Less Spare Capacity In Europe ##br##Now Vs. Pre-Taper Tantrum U.S. Chart I-7Italian Elections: The Big Risk Japanese Yield Cap To Hold Chart I-8Japanese Wages Still Disappointing Similar to our view on the ECB, we do not believe that the Bank of Japan (BoJ) will be in a position to begin removing monetary accommodation anytime soon. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. 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 (Chart I-8). 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 interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. 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 and the global bond bear phase is not yet over. Admittedly, however, the next major move in global yields may not occur until the autumn when the ECB takes a less dovish tone. In the meantime, our fixed-income strategists remain underweight Treasurys within global currency-hedged portfolios. The team recently upgraded (low beta) JGBs to overweight at the expense of core European government bonds, which move to benchmark. Correlation, ERP And Hurdle Rates Chart I-9Market Correlations Are Shifting Another key market development has been the continuing drop in risk asset correlations, a trend that began before the U.S. election (Chart I-9). Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification. Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart I-10). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.2 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart I-11). But why was the ERP so elevated after 2007? Chart I-10Market Correlation And The ERP Chart I-11Modeling The Stock ##br##Correlation Within The S&P 500 The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.3 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending Chart I-12Capex Hurdle Rates Never Came Down An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.4 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart I-12). J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.5 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list, as highlighted in this month's Special Report on Brexit's implication for Scotland independence, beginning on page 19. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart I-13). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. We continue to favor higher beta developed markets where value is less stretched, such as the euro area and Japan, over the U.S. on a currency-hedged basis. Europe is about one standard deviation cheap relative to the U.S. index, although the extra value in the Japanese market has dissipated recently (Chart I-14). Moreover, both Eurozone and Japanese stocks in local currency terms will benefit from weaker currencies in the coming months, as rising inflation expectations and stable nominal interest rates result in declining in real rates, at least relative to the U.S. Chart I-13Forward Multiple Scenarios Chart I-14Eurozone Stocks Are Cheap Conclusion We have reassessed our asset allocation given that several market calls have gone against us over the past month. However, three key views argue to stay the course for now: Recent economic data support our view that a synchronized global acceleration is underway. This is highlighted by an update of the real GDP growth models we introduced last month (Chart I-15). The implication is that earnings growth will be constructive for stocks; Tax reform is still likely to be passed this year in the U.S. Moreover, were a broad tax reform package to elude the Administration, the fallback position will involve (stimulative) tax cuts, some infrastructure spending and de-regulation; and The FOMC will shift to a more hawkish tone in the coming months, while the ECB, Bank of England and Bank of Japan will maintain extremely accommodative monetary policy at least into the fall. The result is that stocks will outperform cash and bonds, while the dollar still has another 10% upside potential. The only adjustment we are making this month is in the U.S. high-yield corporate bond allocation. According to our fixed-income strategists, value has improved enough that it is worth upgrading the sector to overweight at the expense of Treasurys. Some of the indicators that comprise our default rate model have become more constructive for credit risk, including lending standards, the PMIs and profits. The combination of wider junk spreads and an improving default rate outlook have resulted in a widening in our estimate of the default-adjusted high-yield spread to 219 basis points (Chart I-16). Historically, high-yield earns a positive 12-month excess return 81% of the time when the default-adjusted spread is between 200 and 250 basis points. Chart I-15GDP Models Are Bullish Chart I-16Upgrade U.S. High Yield Turning to oil markets, we expect recent price weakness to reverse despite dollar strength. Building inventories have weighed on crude, but this is a head fake according to our commodity experts. We expect to see a sustained draw in OECD storage volumes this year, now that the year-end surge on crude product from OPEC's Gulf producers has been fully absorbed. With global supply/demand fundamentals now dominating price movements, the recent breakdown in the inverse correlation between oil prices and the dollar should persist. Oil prices will rise back toward the US$55 range that we believe will be the central tendency over 2016 and 2017. Risks are to the upside. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Shift to benchmark in Eurozone government bonds and upgrade JGBs to overweight within currency-hedged portfolios. The U.S. remains at underweight. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks over bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues in the U.S.; upgrade U.S. high-yield to overweight, but downgrade European investment-grade to underweight due to fading support from the ECB. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. Favor oil to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst March 30, 2017 Next Report: April 27, 2017 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?" dated March 7, 2017, available at gfis.bcaresearch.com. 2 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 3 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 4 Are Firms Underinvesting - and if so why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 5 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016. II. Will Scotland Scotch Brexit? This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... Chart II-2...Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart II-5Three Cheers For Brexit And The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs ##br##Threaten Scots Growth Chart II-7Scottish Patriots ##br##Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Chart II-8No Golden Goose In The North Sea Chart II-9Limited Domestic Energy Supplies Chart II-10The U.K. Pays For Scotland's Allegiance Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-11Scotland's Deficits Getting Worse Chart II-12Scottish Financial Assets Need Currency Stability Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: ##br##Poverty Not An Obstacle Chart II-14Scotland: If The Irish ##br##Can Do It So Can We Chart II-15EU Market No ##br##Substitute For British Market Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit Chart II-17Old Folks Loyal To The Union Jack The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote Chart II-19The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. III. Indicators And Reference Charts The S&P 500 index has pulled back from its recent highs, but it has not corrected enough to 'move the dial' in terms of the valuation or technical indicators. Stocks remain expensive based on our valuation index made up of 11 different measures. The technical indicator is still bullish. Our equity monetary indicator has dropped back to the zero line, meaning that it is not particularly bullish or bearish at the moment. The speculation index is elevated, however, pointing to froth in the market. The high level of our composite sentiment index and the low level of the VIX speaks to the level of investor complacency. Net earnings revisions remain close to the zero mark, although it is somewhat worrying that the earnings surprises index is slowly deteriorating. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. However, the widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking ahead, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. The composite technical indicator for the 10-year Treasury shows that oversold conditions are unwinding, although the indicator is not yet back to zero. This suggests that the consolidation period for bonds is not yet complete. Oversold conditions are almost completely gone in terms of the U.S. dollar. The dollar is very expensive on a PPP basis, although it is less so by other measures. We believe the dollar has more upside. Technical conditions are also benign in the commodity complex. However, we are only bullish on oil at the moment. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning Chart III-27U.S. And Global Macro Backdrop ECONOMY: Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Highlights Spread Product: Any near-term correction in risk assets is likely to be fleeting. Investors should take the opportunity to increase credit exposure and maintain overweight spread product allocations on a 6-12 month horizon. Duration: Our 2-factor Global PMI model pegs fair value for the 10-year Treasury yield at 2.54%. Economy: U.S. economic growth will remain solidly above-trend this year, helped along by renewed strength in both residential and non-residential investment. Above-trend growth will ensure that inflation remains in its current gradual uptrend. Feature Chart 1Back Above 400 bps The reflation trade has come under question during the past couple of weeks. The S&P 500 is 1.7% off its recent high, the VIX has bounced and the average spread on the Bloomberg Barclays High-Yield index is back above 400 basis points (Chart 1). After such a move, it is reasonable to ask if the economic landscape has changed enough to warrant a reversal of our current overweight spread product allocation. We think not, and we advise investors to buy the dips, adding credit risk to their portfolios from more attractive levels. This week we examine why risk assets are vulnerable to a near-term correction, but also why these corrections are likely to be short lived. On a 6-12 month investment horizon we continue to recommend a pro-risk portfolio characterized by: below-benchmark duration, overweight spread product, curve steepeners and TIPS breakeven wideners. Three Catalysts For A Near-Term Sell Off... Three main factors suggest that risk assets might continue to correct in the near-term. The first is that Fed rate hike expectations might be increasing too quickly. Chart 2 shows the fed funds rate that is priced into the overnight index swap curve for the end of this year. The lower dashed horizontal line is the level consistent with one more rate hike between now and the end of the year. The higher dashed horizontal line is the level consistent with two more rate hikes between now and the end of the year. We see that risk assets were able to handle the shift in rate expectations up to the lower dashed line with no trouble. The yield curve steepened and the cost of inflation compensation rose (Chart 2, bottom panel). But now, as rate expectations approach the higher dashed line, the reflation trade is starting to fray. The yield curve has started to flatten and TIPS breakevens are rolling over. A second reason why risk assets might sell-off in the near-term is the still elevated level of economic policy uncertainty (Chart 3, top panel). Last Friday, markets hung on every word related to the likelihood of a new healthcare bill being passed. Now that the bill has failed, attention will turn quickly to tax reform. It is very likely that risk assets will suffer if it appears as though tax reform will be delayed or scrapped altogether. Importantly, it is the opinion of our Geopolitical Strategy service that tax reform will be passed before the end of the year.1 Chart 2How Much Hawkishness Can Markets Take? Chart 3Correction Catalysts? A third reason why risk assets are vulnerable to a near-term correction is that investors have bought into the reflation trade, and sentiment is extremely bullish (Chart 3, bottom panel). Surveys of investors conducted by Yale University show that 99% of investors expect the Dow to increase during the coming year, while simultaneously only 47% of investors characterize the stock market as "not too high" relative to its fundamental value. The divergence in itself suggests that the equity rally is built on a shaky foundation. It seems likely that either confidence needs to wane or valuations need to correct for the rally to be prolonged. ...But The Fed Cycle Trumps Them All In previous reports2 we outlined the four phases of the Fed Cycle (see Box), and observed that in all likelihood we are currently in Phase I. Box: The Four Phases Of The Fed Cycle Chart 4Stylized Fed Cycle The four phases of the Fed Cycle are illustrated in Chart 4 and defined as follows: Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium (or neutral) level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. In Phase I, the Fed has begun to remove monetary accommodation but still needs inflation to rise back to target. In other words, if risk assets sell off and financial conditions start to tighten the Fed will adopt a more dovish policy stance to ensure that the recovery persists and inflation continues to trend higher. We note that core PCE inflation is running at 1.74% year-over-year, still below the Fed's 2% target. Further, the St. Louis Fed Price Pressures Measure3 is signaling only a 19% chance that PCE inflation will exceed 2.5% during the next twelve months, and market-based measures of inflation compensation are well below levels that are consistent with the Fed's inflation target (Chart 5). Chart 5Fed Still Needs Higher Inflation In this environment, if risk assets sell off because of overly aggressive rate hike expectations, fiscal policy disappointments or over-extended sentiment, the Fed will quickly adopt a more dovish policy stance, lending support to the reflation trade. Of course, if any of the catalysts for the market correction also cause a severe contraction in economic growth, then the reflation trade would face a more lasting setback. However, none of the three reasons for a market correction listed above seem likely to have significant pass-through effects on the economy. Even if fiscal stimulus turns out to be much less than was previously anticipated, there appears to be sufficient momentum in economic growth to maintain inflation on its upward trajectory (see section titled "Above-Trend Growth: Aided By Housing & Capex" below). It follows from this analysis of the Fed Cycle that a strategy of "buying the dips" should work whenever we are in an environment where the Fed needs inflation to move higher. It is only when inflation is more firmly anchored around the Fed's target that the Fed will be less willing to support markets, making a "buy the dips" strategy less effective. To test this theory, we devised a trading rule for high-yield bonds where we buy the High-Yield index whenever spreads widen by 20 bps or more during a month. We then hold that position for a period ranging from 1 to 3 months and calculate excess returns relative to duration-matched Treasuries during that period. Our goal is to see if the effectiveness of this "buy the dips" strategy differs depending on the stage of the Fed Cycle. For this test we define the stages of the Fed Cycle using the aforementioned St. Louis Fed Price Pressures Measure, which we split into four ranges: 0% to 15%: An environment of very limited inflation pressure most consistent with Phase IV of the Fed Cycle. 15% to 30%: Still muted inflation pressures. Roughly consistent with Phase I of the Fed Cycle. 30% to 50%: Rising inflation pressures, but still less than a 50% chance that PCE will exceed 2.5% in the coming 12 months. This likely coincides with some Phase I periods and some Phase II periods of the Fed Cycle. 50% to 70%: Strong inflation pressures, and a good chance of inflation overshooting the Fed's target. Most likely coincides with Phase II or Phase III of the Fed Cycle. We indeed find that a "buy the dips" strategy is more effective when inflation pressures are lower (Table 1). A strategy of buying the junk index after spreads widen by at least 20 bps and holding it for three months produces positive excess returns 65% of the time when the St. Louis Fed Price Pressures Measure is between 0% and 15%. This same strategy works 59% of the time when the Price Pressures Measure is between 15% and 30%, 44% of the time when the Measure is between 30% and 50% and only 25% of the time when the Measure is between 50% and 70%. Table 1High-Yield Corporate Bond Returns* Achieved By Holding The Junk Index Following ##br##A 20 BPs Widening In High-Yield Corporate OAS** Under Different Ranges##br## Of The St. Louis Fed Price Pressure Measure*** (February 1994 To Present) With the Price Pressures Measure at only 19% currently, we advise investors to increase exposure to spread product on any near-term correction. Bottom Line: Any near-term correction in risk assets is likely to be fleeting. Investors should take the opportunity to increase credit exposure and maintain overweight spread product allocations on a 6-12 month horizon. Above-Trend Growth: Aided By Housing & Capex For the analysis of the Fed cycle performed above to be applicable, we must have confidence in the view that GDP will continue to grow at an above-trend pace. That is, growth must at least be strong enough to remove slack from the labor market and cause inflation to trend gradually higher. This has mostly been the case since measures of core inflation bottomed in early 2015 and we see no evidence at the moment to suggest it is about to change. In fact, measures of global growth most relevant for Treasury yields have hooked up strongly in recent months, and our model now suggests that fair value for the 10-year U.S. Treasury yield is 2.54% (Chart 6). At the time of publication the 10-year yield was 2.40%. The fair value reading from our model moved higher during the past month even though PMIs in both the U.S. and Japan ticked down. This negative move was offset by an acceleration in Eurozone PMI and a decline in bullish sentiment toward the dollar (Chart 6, bottom two panels). Less bullish dollar sentiment is a signal that the global recovery is becoming more synchronized which means that U.S. Treasury yields must rise more quickly for a given level of global growth.4 Returning to the U.S. growth outlook specifically, a recent BCA Special Report 5 showed that cyclical spending as a percent of overall GDP is an excellent leading indicator of economic downturns (Chart 7). Cyclical spending has been relatively firm as a percent of GDP during the past couple of years, and would have been stronger if not for stagnant residential investment (Chart 7, panel 3) and contracting non-residential investment in equipment & software (Chart 7, bottom panel). However, leading indicators suggest that both of these factors should shift from being sources of disappointment to sources of strength in the coming months. Chart 610-Year Treasury Fair Value Model Chart 7Cyclical Spending Is Firm... Chart 8 shows the year-over-year change in each of the three cyclical components of GDP as a percent of overall growth alongside a reliable leading indicator. Consumer confidence suggests that consumer spending on durables will remain firm (Chart 8, panel 1). Our composite indicator of New Orders surveys also points to a rebound in nonresidential investment on equipment & software (Chart 8, panel 2). In prior reports we observed that nonresidential investment was held back by the 2014 oil price shock and should recover now that oil prices have found a floor.6 Also, any potential benefit from a more favorable tax and regulatory environment under the new federal government would only increase the upside for capex. Residential investment as a percent of GDP also rolled over last year, but homebuilder confidence has been trending sharply higher during the past few months (Chart 8, bottom panel). Home construction will be strong this year, despite the recent increase in mortgage rates. As was recently observed by our U.S. Investment Strategy service,7 the constraint on housing demand since the financial crisis has not come from un-affordable monthly mortgage payments. In fact, we calculate that even if mortgage rates rise by another 200 bps from current levels, the mortgage payment as a percent of income for the median household would still be below its long-run average (Chart 9). Chart 8...And Likely To Increase Chart 9Higher Rates Won't Kill Housing Rather, the constraint on housing demand has come from insufficient savings on the part of potential first time homebuyers relative to required down payments. This constraint can only subside as household savings increase and mortgage lending standards ease, two trends that are ongoing. Finally, housing supply is approaching historically low levels relative to demand (Chart 9, bottom panel) even including the "shadow inventory" from foreclosed properties which has now mostly vanished in any case. With supply at such depressed levels and demand likely to remain firm, it is no wonder that homebuilders are feeling more confident. Bottom Line: U.S. economic growth will remain solidly above-trend this year, helped along by renewed strength in both residential and non-residential investment. Above-trend growth will ensure that inflation remains in its current gradual uptrend. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 3 A composite of 104 economic indicators designed to capture the probability of PCE inflation exceeding 2.5% during the subsequent 12 month period. https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure 4 A more detailed explanation of the inverse relationship between dollar sentiment and Treasury yields can be found in the U.S. Bond Strategy Weekly Report, "Dollar Watching: Another Update", dated January 31, 2017, available at usbs.bcaresearch.com 5 Please see BCA Special Report, "Beware The 2019 Trump Recession", dated March 7, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Investment Strategy Special Report, "U.S. Housing: What Comes Next?", dated March 27, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The years since the 2008 Global Financial Crisis have been dominated by the major central banks emptying their toolkits to fight off deflationary pressures and sustain even modest nominal growth rates. Extraordinary policy measues like quantitative easing, negative interest rates and "forward guidance" were all intended to be signals to expect nothing but stimulative monetary policy, even if there were brief pickups in growth or realized inflation rates. This helped suppress both bond yields and volatility, forcing investors to take on more risk to generate acceptable returns in fixed income markets. Now, however, there are signs that the world economy may finally be becoming a bit more "normal" after the years of malaise. While growth can hardly be described as booming, there are a growing number of countries that appear to have passed the worst phase of the excess capacity/deflation pressures that dominated the post-crisis era. This is creating more two-way risk with regards to central bank decisions than we have seen for some time. In this Special Report, we update one of our favorite tools to assess the potential for monetary policy changes, the BCA Central Bank Monitors. We present them in a chartbook format with a focus on the relationship to government bond yields. Feature An Overview Of The BCA Central Bank Monitors The BCA Central Bank Monitors are composite indicators that are designed to measure the cyclical growth and inflation pressures that can influence future central bank policy decisions. We created Monitors for the major developed economies: the U.S., Euro Area, Japan, the U.K., Australia, Canada and New Zealand. The list of data series used to construct the Monitors is not the same for each country, but the components generally measure the same things (i.e. manufacturing cycles, domestic demand pressures, commodity prices, labor market conditions, exchange rates, etc) Right now, the Monitors are rising in a coordinated fashion for the first time since 2011 (Chart 1 on Page 1). What is different in 2017 is that there is much less spare capacity in the developed economies than there was six years ago. For central bankers who still adhere to the Phillips curve tradeoff of unemployment versus inflation, tight labor markets alongside highly accommodative policy settings pose a problem. In the rest of this report, we show the individual Central Bank Monitors, along with measures of spare capacity and inflation for each country. We also show the correlations between the Monitors and changes in government bond yields, both before and after the 2008 Crisis. Correlations have shifted in the post-crisis era, but there are still some reliable relationships that can provide signals for bond investors. The broad conclusions: Japanese Government Bonds (JGBs) are the ideal country overweight in a world where all other developed economy central banks are witnessing rising cyclical pressures, while bonds in the U.K., Australia and New Zealand are likely to struggle as central banks in those regions become increasingly hawkish (Chart 2). Chart 1More Central Banks Are Under Pressure To Tighten Chart 2Tightening Pressures (Ex-Japan) ##br##Can Push Bond Yields Higher The Fed Monitor Is Pointing To Additional U.S. Rate Hikes Our Fed Monitor has just recently pushed above the zero line, indicating the need for the Fed to tighten policy (Chart 3A). The Fed already began raising the funds rate back in late 2015, but this was the beginning of normalizing the crisis-era policy settings rather than a move to offset improving U.S. cyclical conditions. The latter is now indeed happening, and it is perhaps no surprise that the Fed has just delivered 50bps of rate hikes in a span of three months. Chart 3AU.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. Chart 3CThe Fed Monitor Is Most Correlated To ##br##Shorter Maturity U.S. Treasuries We still see the Fed pursuing a relatively gradual process of raising rates further in 2017, but in line with the current FOMC projections of another 50bps of tightening before year-end. Measures like the output gap and the unemployment gap (unemployment relative to the level consistent with stable inflation) show no spare capacity in the U.S. economy (Chart 3B). At the same time, core inflation continues to only grind higher and inflation expectations are also drifting up towards the Fed's 2% target. This can hardly be qualified as an "overheating" economy that needs a sharp tightening of monetary conditions, particularly with the still-expensive U.S. dollar not providing any stimulus. The correlations between our Fed Monitor and the year-over-year changes in U.S. Treasury yields (Chart 3C) have been extremely low since the 2008 Crisis - unsurprising with the Fed keeping the funds rate near zero for most of that period while also buying large amounts of Treasuries. While the correlations appear to be shifting on the margin, we still see the Treasury curve steepening first (via rising inflation expectations), then flattening later (through tighter monetary conditions). BoE Monitor Calling For Tighter U.K. Policy Our Bank of England (BoE) Monitor is at very elevated levels (Chart 4A), driven by a combination of improving production data and high inflation. There is much more bubbling beneath the surface, however. The more domestically-focused components of the Monitor are losing some upward momentum, while the inflation elements are also starting to top out as the big post-Brexit depreciation of the Pound is losing momentum. Chart 4AU.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Chart 4CGilts Are At Risk From A More Hawkish Turn From The BoE This is creating a dilemma for the BoE - respond to high U.K. inflation with tighter monetary policy, or focus on the slowdown in domestic demand and do nothing? The BoE signaled in February that the biggest concern for policy was a slump in consumer spending led by lower real income growth on the back of rising inflation. Yet at the March policy meeting, one BoE member even voted to raise rates and others raised concerns about the elevated level of U.K inflation. With even policymakers unsure about their next move, the marginal swings in U.K. growth should have an even greater impact on Gilt yields. The U.K. economy is running around full capacity and both headline and core inflation are rising (Chart 4B). Somewhat surprisingly, the correlations between changes in Gilt yields and our BoE Monitor have actually increased since the 2008 Crisis (Chart 4C). This raises a potential risk for the Gilt market if the BoE decides that the U.K. economy is not slowing as much as it is expecting. For now, we continue to recommend a neutral stance on Gilts until there is greater clarity on the state of the economy. ECB Monitor Reflects A Less Deflationary Backdrop In Europe Our European Central Bank (ECB) Monitor has recently crept above the zero line for the first time in three years (Chart 5A). This is driven mostly by the current uptrend in headline inflation in the Euro Area, but also by the steady improvement in economic growth. Chart 5AEuro Area: ECB Monitor Chart 5BExcess Capacity in Europe Dwindling Fast Chart 5CStable Correlations Between The ECB Monitor & The Front End Of The Yield Curve The Euro Area is the one economy presented in this report where no indicator (either the output gap or unemployment gap) is pointing to a lack of spare capacity (Chart 5B). All of the rise in headline Euro Area inflation can be attributable to base effects related to last year's rise in oil prices and decline in the euro. The latest ECB projections call for core inflation to return to just under 2% in 2019, suggesting that there is no hurry to begin tightening monetary policy. Yet the ECB remains in an asset purchase program which is set to expire at the end of this year, so a policy decision must be made in the next 3-6 months. We expect the ECB to begin tapering its bond buying in the first quarter of 2018, with interest rate hikes to follow after the tapering has been completed. The ECB could raise rates before tapering to try and minimize the impact on Peripheral sovereign and corporate bond yields (it is buying both), although that would likely create a greater degree of tightening than the ECB would like before full employment is reached. Given the strong correlations between our ECB Monitor and much of the Euro Area yield curve (Chart 5C), however, we anticipate moving soon to an underweight stance on Euro Area bonds after our recent downgrade to neutral. BoJ Monitor: Nothing To See Here Our BoJ Monitor has been in the "easier policy required" zone for most of the past 25 years, barring a brief blip above the zero line that heralded the rate hikes in 2006/07 (Chart 6A). Inadequate growth and excess capacity remain the biggest problem with Japan's economy, preventing any meaningful upturn in inflation beyond that caused by higher commodity prices or a weaker yen. Chart 6AJapan: BoJ Monitor Chart 6BTight Labor Market, But Still No Inflation Chart 6CLonger-Maturity JGB Yields Have No Correlation To The BoJ Monitor Even with Japan operating at full employment, with an unemployment rate at 3%, there has barely been any acceleration in wages or core inflation (Chart 6B). The only way out of this for Japan is to keep monetary policy settings as easy as possible to ensure that there is enough growth to eat away at the remaining spare capacity in the Japanese economy. That means keeping both policy rates and the yen as low as possible, and hoping that this will cause enough of a rise in inflation expectations to lower real interest rates and boost domestic demand. As an added "kicker", the BoJ is even anchoring the long end of the Japan yield curve by targeting a 0% yield level on 10-year government debt - a policy that we do not expect to change anytime soon. We see Japan as a low-beta "safe haven" government bond market in an environment where other central banks are seeing some tightening pressures and Japanese bonds have virtually no correlation to the BoJ Monitor (Chart 6C). We continue to recommend an overweight stance on Japan within an overall defensively positioned government bond portfolio with below-benchmark duration exposure. BoC Monitor: No Big Need To Tighten In Canada Our Bank of Canada (BoC) Monitor has recently moved into positive territory (Chart 7A) , primarily due to some improvement in growth and higher commodity prices. Given the close linkages between the U.S. and Canadian economies, we include some U.S. growth variables in our BoC Monitor and these are also helping boost the indicator. However, there are no signs that the Canadian economy is overheating - unless you are trying to buy a home in Toronto - with both the output gap and unemployment gap not yet in positive territory (Chart 7B). Chart 7ACanada: BoC Monitor Chart 7BStill Not Much Inflation In Canada Chart 7CThe BoC Monitor Is Highly Correlated To Shorter-Maturity Canadian Bonds The BoC is maintaining a dovish bias at the moment. Some of that has to do with the uncertainty over the U.S. economic outlook, especially with regards to the fiscal and trade policies of the Trump administration. While a boost to U.S. growth via a fiscal easing could help support Canadian exports to the U.S., any move to renegotiate trade agreements involving the two countries could end up hurting the Canadian economy. Add to that the concerns over the bubbly valuations of Canadian real estate that could be pricked by even modest rate increases, and the BoC will likely not want to contemplate any early tightening of monetary policy. The higher correlations between our BoC Monitor and the front end of the Canadian yield curve (Chart 7C) suggest that a bear flattener would be the appropriate trade if and when the BoC does contemplate a rate hike. For now, however, we see that as a low-probability event and we are maintaining a neutral stance on Canadian bonds until there is greater clarity on U.S. growth and Trump's policy agenda. RBA Monitor: Higher Because Of Growth, Not Inflation Our Reserve Bank of Australia (RBA) Monitor has surged into the "tighter policy required" territory in recent months (Chart 8A), driven by higher commodity prices and stronger Asian export demand. Survey-based measures of inflation expectations are also part of the Monitor, and those have also been rising despite a lack of realized inflation in Australia (Chart 8B). The low inflation readings have been causing a bit of a problem for the RBA, given the tight labor market and that boost to Aussie demand from better Asian growth. This is especially true given the surprisingly soft readings on employment growth, consumer confidence and spending, all occurring against a persistent deceleration in core inflation. The RBA was focusing on the inflation story last year when it delivered some surprise rate cuts, and we still suspect that a lack of inflation pressure will keep the RBA on hold for at least the next few months. We are currently at a neutral stance on Australian government bonds, given these conflicting forces of better export growth but weakening domestic demand. The lack of an inflation threat could make Australia an outperformer in a world of rising bond yields. Given the surge in our RBA Monitor, however, we see some risk in looking at Aussie bonds as a potential safe haven market given upward pressures on yields in the U.S. and Europe. The correlations between Australian yields and the RBA Monitor are extremely high (Chart 8C), and have actually gone up in the post-crisis era. Chart 8AAustralia: RBA Monitor Chart 8BNo Inflation Pressures On The RBA Chart 8CAussie Bonds Across The Curve Are Highly Correlated To The RBA Monitor RBNZ Monitor: A Strong Case For A Rate Hike Our Reserve Bank of New Zealand (RBNZ) Monitor is strongly in positive territory (Chart 9A), led by the components focused on commodity prices and global growth. However, there is a fairly solid structural case for an RBNZ rate hike, given the lack of any spare capacity in New Zealand and inflation on the rise (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor Chart 9BFull Employment & Rising Inflation In NZ Chart 9ANZ Bonds Are Vulnerable To Current Cyclical Pressures The RBNZ has been maintaining a dovish bias of late, although it has chosen to sight more "international" risks related to geopolitics, rather than domestic economic conditions. Perhaps this is nothing more than a fear of a potential shock outcome in the upcoming French elections, although it could also be worries that tensions between the Trump White House and China (or, worse yet, North Korea) could trigger a hit to demand for New Zealand exports to Asia. In the end, we think the RBNZ will be forced to a hike off the current record low interest rates as the next policy move. While we do not include New Zealand government bonds as part of our model fixed income portfolio, we do currently have a bearish rates trade on in our list of Tactical Overlay Trades, choosing to pay 12-month NZD OIS rates. We will maintain that recommendation, but we may look to add some bearish New Zealand bond trades, as well, given the strong correlation between our RBNZ Monitor and bond yields (Chart 9C). Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com