Policy

Highlights The 2018 outlook for both economic growth and corporate profits remains constructive for risk assets, although evidence is gathering that global growth is peaking. Some measures of global activity related to capital spending have softened in recent months. Nonetheless, the G3 aggregate for capital goods orders remains in an uptrend, suggesting that it is too soon to call an end in the mini capital spending boom. Our global leading indicators are not heralding any major economic slowdown. The dip in early 2018 in the Global ZEW index likely reflected uncertainty over protectionist trade action. Economic growth in the major countries outside of the U.S. may have peaked, but will remain robust at least through this year. The potential for a trade war is a key risk facing investors. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy. That said, there are hopeful signs that the latest trade skirmish will not degenerate into a full-blown trade war and thereby cause lasting damage to risk assets. Stay overweight equities and corporate bonds. President Trump will announce on May 19 whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Stay long oil and related investments. The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated. EPS growth is peaking in Europe and Japan, but has a bit more upside in the U.S. later this year. Cross-country equity allocation is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. Rising U.S. corporate leverage is not an issue now, but could intensify the next downturn as ratings are slashed, defaults rise and banks tighten lending standards. The bond bear market remains intact, although the consolidation phase has further to run. By Q1 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below NAIRU. Policymakers will then try to nudge up the unemployment rate, but the odds of avoiding a recession are very low. Feature Investors are right to be concerned following the March 23 U.S. announcement of tariffs on about $50 billion of Chinese imports. The President is low in the polls and needs a victory of some sort heading into midterm elections. Getting tough on trade plays well with voters, and the President faces few constraints from Congress on this issue. Trump wants a raft of items from China, including opening up to foreign investment and a crackdown on intellectual theft. Sino-American tensions are likely to intensify over the long term as the two nations spar over geopolitical and military supremacy.1 That said, we do not expect the latest trade skirmish to degenerate into a full-blown trade war. First, China has already signaled it wants to avoid significant escalation. Beijing has offered several concessions, and its threat of retaliatory trade action has been measured so far. On the U.S. side, the fact that the Administration has decided to bring its case against China to the World Trade Organization (WTO) shows that the Americans are willing to proceed through the normal trade-dispute channels. The bottom line is that, while we cannot rule out escalating trade action that causes meaningful damage to the equity market, it is more likely that the current round of tensions will be limited to brief flare-ups. Investors should monitor the extent of European involvement. If Europe joins the U.S. effort to force China to change its trade practices via the WTO, then China will have little choice but to give in without a major fight. In terms of other geopolitical risks, North Korea should move to the back burner for a while now that the regime has agreed to negotiations. Of greater near-term significance is May 19, when Trump will announce whether he will terminate the nuclear agreement with Iran. Cancelation could be a game-changer for Iranian internal politics, and the return of hardliners would signal greater instability in the region. Oil prices would benefit if the May deadline for issuing waivers on Iran sanctions passes. Trade penalties against Iran would reduce its oil production and exports. The U.S. is also considering sanctions on Venezuela's oil industry. Moreover, Russia and Saudi Arabia are reportedly considering a deal to greatly extend their alliance to curb oil supply. While there are downside risks as well, our base case outlook sees the price of Brent reaching US$74 before year end. Global Growth: Some Mixed Signs Also facing investors this year is the risk that the recent softening in the economic data morphs into a serious growth scare. The 2018 outlook for both the economy and corporate profits remains constructive in our view, but evidence is gathering that global growth is peaking. Investors may begin to question recent upward revisions to the growth outlook for this year and next. Industrial production has softened and the manufacturing PMI has shifted lower in most of the advanced economies (Chart I-1). Bad weather in North America and Europe in early 2018 may be partly to blame, but Korean exports, a leading indicator for the global business cycle, have also softened. The Chinese economy is decelerating and we believe the growth risks are underappreciated. President Xi has cemented his power base and there has been a shift toward accelerated reform. Chinese leaders recognize that leverage in the system is a problem, and the regime is tightening policy on a multi-pronged basis. Structural reforms are positive for long-term growth, but are negative in the short term. The tightening in financial conditions is already evident in the Chinese PMI and the sharp deceleration in the Li Keqiang index (although the latest reading shows an uptick; not shown). A hard landing is not our base case, but the risks are to the downside because the authorities will err on the side of tight policy and low growth. It is also disconcerting that some of our measures of global activity related to capital spending have softened in recent months, including capital goods imports and industrial production of capital goods (Chart I-2). Nonetheless, the fact that the G3 aggregate for capital goods orders remains in an uptrend suggests that it is too soon to call an end in the mini capital spending boom. Consumer and business confidence continues to firm in the major economies. Chart I-1Some Signs Of A Peak In Global Growth Chart I-2A Soft Spot For Capital Spending Our global leading indicators are not heralding any major economic slowdown (Chart I-3). BCA's Global LEI remains in an uptrend and its diffusion index is above the 50 line. In contrast, the global measure of the ZEW investor sentiment index plunged in March. We attribute the decline to the announcement of steel and aluminum tariffs and the subsequent market swoon, suggesting that the ZEW pullback will prove to be temporary. Turning to the U.S., retail sales disappointed in January and February, especially considering that taxpayers just received a sizable tax cut. Nonetheless, this probably reflects lagged effects and weather distortions. Our U.S. consumer spending indicator continues to strengthen as all of the components remain constructive outside of auto sales. Household balance sheets are the best that they have been since 2007; net worth is soaring and the aggregate debt-to-income ratio is close to the lowest level since the turn of the century (Chart I-4). Given robust employment growth and the tightest labor market in decades, there is little to hold U.S. consumer spending back. We expect that the tax cut effect on retail sales will be revealed in the coming months, helping to sustain the healthy backdrop for corporate profits. Chart I-3Global Leading Indicators Mostly Positive Chart I-4U.S. Consumers In Good Shape Global Margins Still Rising The profit picture remains bright as global margins continue to make new cyclical highs and earnings revisions are elevated (Chart I-5). Earnings-per-share surged in the early months of the year in both the U.S. and Japan, although they languished in the Eurozone according to IBES data (local currencies; not shown). Relative equity returns in local currency tend to follow relative shifts in 12-month forward EPS expectations over long periods, and bottom-up analysts have lifted their U.S. earnings figures in light of the fiscal stimulus (Chart I-6). Chart I-5Global Margins Still Rising Chart I-6EPS And Relative Equity Returns The key question is: can the U.S. market outperform again in 2018 now that the tax cuts have largely been priced in? One can make a compelling case either way. Growth: Global growth will remain robust for at least the next year, and the Eurozone and Japanese markets are more geared to global growth than is the U.S. However, the impressive fiscal stimulus in the pipeline means that economic growth momentum is likely to swing back toward the U.S. this year. GDP growth in Europe and Japan will remain above-trend, but it has probably peaked for the cycle in both economies. Valuation: Our composite measure of valuation suggests that Europe and Japan are on the cheap side relative to the U.S. based on our aggregate valuation indicator, which takes into consideration a wide variety of yardsticks (Chart I-7). That said, one of the reasons why European stocks are on the cheap side at the moment is that export-oriented German exporters are quite exposed to rising international tariffs. Earnings: Previous currency shifts will add to EPS growth in the U.S. in the first half of the year, but will be a drag in Europe and Japan (Chart I-8). However, these effects will wane through the year unless the dollar keeps falling. Indeed, we expect the dollar to firm modestly over the next year, favoring the European equity market at the margin. In contrast, we expect the yen to strengthen in the near term, which will trim Japanese EPS growth. Chart I-7Valuation Ranking Of Nonfinancial ##br##Equity Markets Relative To The U.S. Chart I-8Impact Of Currency Shifts On EPS Growth Chart I-9 updates the forecast from our top-down earnings models. The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up. Narrowing margins are less of a risk in Europe. U.S. EPS growth should be above that of Europe in 2018, but will then fall to about the same pace in 2019. We expect Japanese profit growth to remain very strong this year and next, given Japan's highly pro-cyclical earnings sensitivity. However, this does not incorporate the risk of further yen strength. Earnings expectations will also matter. Twelve-month bottom-up expectations are higher than our U.S. forecast ('x' in Chart I-9 denotes 12-month forward EPS expectations). In contrast, expectations are roughly in line with our forecast for the European market. It will therefore be more difficult at the margin for U.S. earnings to surprise to the upside. Monetary Policy: The relative shift in monetary policies should favor the European and Japanese markets to the U.S. The FOMC will continue tightening, with risks still to the upside on rates in absolute terms and relative to the other two economies. Sector Performance: Sector skews should work in Europe's favor. Financials are the largest overweight in Euro area bourses, while technology is the largest overweight in the U.S. We are constructive on the financial sector in both markets, but out-performance of the sector will favor the Eurozone broad market. Meanwhile, tech companies are particularly sensitive to changes in discount rates, since they often trade on the assumption that most of their earnings will be realized far into the future. As such, higher long-term real bond yields will adversely affect U.S. tech names, especially in an environment where the dollar is strengthening. The Japanese market has a relatively high weighting in industrials and consumer discretionary. The market will benefit if the global mini capex boom continues, but this could be counteracted by softness in global auto sales and further yen strength. It is a tough call, but relative monetary policy, our positive view for the dollar, the potential for earnings surprises and better value bias us toward European stocks relative to the U.S. in local currency terms. We continue to avoid the Japanese market for the near term because of the potential for additional yen gains. As for the equity sector call, investors should remain oriented toward cyclicals versus defensives. Our key themes of a synchronized global capex mini boom, rising bond yields and firm oil prices favor the industrials, energy and financial sectors. Chart I-10 highlights four indicators that support the cyclicals over defensives theme, the dollar and the business sales-to-inventories ratio. Telecom, consumer discretionary and homebuilders are underweight. Chart I-9Profit Forecast Chart I-10These Indicators Favor Cyclical Stocks We will be watching the indicators in Chart I-10 to time the shift to a more defensive equity sector allocation. Leverage And The Next Recession As the economic expansion enters the late stages, investors are focused on where leverage pressure points may lurk. Last month's Special Report on U.S. corporate vulnerability to higher interest rates and a recession raised some eyebrows. For our sample of 770 companies, we estimated how much interest coverage for the average company would decline under two scenarios: (1) interest rates rise by 100 basis points across the curve; and (2) interest rates rise by 100 basis points and there is a recession in which corporate profits fall by 25% peak to trough. Given all the client inquiries, we decided to delve deeper into the results. We were concerned that our sample of high-yield companies distorted the overall results because it includes many small firms and outliers. We are more comfortable with the results using only the investment-grade firms, shown in Chart I-11. The 'x' marks the interest rate shock and the 'o' marks the combined shock. Nonetheless, the main qualitative message is unchanged. The starting point for interest coverage is low, considering that interest rates are near the lowest levels on record and profits are extremely high relative to GDP. This is the result of an extended period of corporate releveraging on the back of low borrowing rates. Chart I-12 shows that the interest coverage ratio has declined even as profit margins have remained elevated. Normally the two move together through the cycle. Chart I-11Corporate Leverage Will Take A Toll Chart I-12The Consequences Of Rising Leverage The implication is that the next recession will see interest coverage fare worse than in previous recessions. Of course, there are many other financial ratios and statistics that the rating agencies employ, but our results suggest that downgrades will proliferate when the agencies realize that the economy is turning south. Moreover, banks may tighten C&I lending standards earlier and more aggressively because they will also be finely attuned to the first hint of economic trouble given the leverage of the companies in their portfolio. Recovery rates may be particularly low in the next recession because the equity cushion has been squeezed via buybacks, which will intensify widening pressure in corporate spreads. Tighter lending standards would generate more corporate defaults, even wider spreads and a greater overall tightening in financial conditions. Corporate leverage could therefore intensify the pullback in business spending in the next recession. The good news is that we do not see any other major macro-economic imbalances, such as areas of overspending, that could turn a mild recession into a nasty one. As long as growth remains solid, the market and rating agencies will ignore the leverage issue. Indeed, ratings migration has improved markedly following the energy related downgrades in 2014 and 2015. An improving rating migration ratio is usually associated with corporate bond outperformance relative to Treasurys (Chart I-13). We remain overweight U.S. investment-grade and high-yield bonds within fixed-income portfolios for now. The European corporate sector is further behind in the leverage cycle (Chart I-14). Europe does not appear to be nearly as vulnerable to rising interest rates. Nonetheless, our European Corporate Health Monitor (CHM) has deteriorated over the past couple of years due to some erosion in profit margins, debt coverage and the return on capital. Meanwhile, the U.S. CHM has improved in recent quarters because the favorable earnings backdrop has temporarily overwhelmed rising leverage (top panel of Chart I-14). For the short-term, at least, corporate health is moving in favor of the U.S. at the margin. Chart I-13Ratings Migration Is Constructive For Now Chart I-14Corporate Health Trend Favors U.S. The implication is that, while we see trouble ahead for the U.S. corporate sector in the next economic downturn, in the short term we now favor the U.S. over Europe in the credit space. We are watching our Equity Scorecard, bank lending standards, the yield curve and our profit margin proxy in order to time our exit from both corporate bonds and equities (see last month's Overview section). We are also watching for a rise in the 10-year TIPS breakeven rate above 2.3% as a signal that the FOMC will get more aggressive in leaning against above-trend growth and a falling unemployment rate. Powell Doesn't Rock The Boat The Fed took a measured approach when reacting to the fiscal stimulus that is in the pipeline. The FOMC lifted rates in March and marginally raised the 'dot plot' for 2019 and 2020. Policymakers shaved the projection for unemployment to 3.6% by the end of 2019. This still appears too pessimistic, unless one assumes that the labor force participation rate will rise sharply. Table I-1 provides estimates for when the unemployment rate will reach 3½% based on different average monthly payrolls and participation rates. Our base case scenario, with 200k payrolls per month and a flat participation rate, sees the unemployment rate reaching 3½% by March 2019. Table I-1Dates When 3.5% Unemployment Rate Threshold Is Reached The soft-ish February reports for consumer prices and average hourly earnings took some of the heat off the FOMC. Core CPI, for example, rose 'only' 0.2% from the month before. Still, when viewed on a 3-month rate-of-change basis, underlying inflation remains perky; the core CPI inflation rate increased from 2.8% in January to 3% in February (Chart I-15). Inflation in core services excluding medical care and shelter, as well as in core goods, have also surged on a 3-month basis. We expect the latter to continue to pressure overall inflation higher, following the upward trend in import prices. The recent downtrend in shelter inflation should also stabilize due to the falling rental vacancy rate. Chart I-15U.S. Inflation Is Perky Moreover, the NFIB survey of U.S. small businesses shows that the gap between the difficulties of finding qualified labor versus demand problems is close to record highs. The ISM manufacturing survey shows that companies are paying more for their inputs and experiencing delays with suppliers. This describes a late-cycle environment marked with rising inflationary pressures. We expect that core inflation will grind up to the 2% target by early next year. By the first quarter of 2019, the Fed could find itself with inflation close to target, above-trend growth driven by a strong fiscal tailwind, and an unemployment rate that is a full percentage point below its estimate of the non-inflationary limit. Policymakers will then attempt a 'soft landing' in which they tighten policy enough to nudge up the unemployment rate. Unfortunately, the Fed has never been able to generate a soft landing. Once unemployment starts to rise, the next recession soon follows. Our base case is that the next recession begins in 2020. Bond Bear In Hibernation For Now The bond market showed that it can still intimidate in February, but things have since calmed down as the U.S. mini inflation scare ebbed, some economic data disappointed and trade friction created additional macro uncertainty. Bearish sentiment and oversold technical conditions suggest that the consolidation period has longer to run. Nonetheless, unless inflation begins to trend lower, the fact that even the doves on the FOMC believe that the headwinds to growth have moderated places a floor under bond yields. Fair value for the 10-year Treasury is 2.90% based on our short-term model, but we expect it to reach the 3.3-3.5% range before the cycle is over. Both real yields and long-term inflation expectations have room to move higher. Private investors will also have to absorb US$680 billion worth of bonds this year from governments in the U.S., Eurozone, Japan and U.K., the first positive net flow since 2014 (see last month's Overview). Yields may have to fatten a little in order for the private sector to make room in their portfolios for that extra government supply. In the Eurozone, the net supply of government bonds available to the private sector will still be negative this year, even if the ECB tapers to zero in September as we expect. Some investors are concerned about a replay in the European bond markets of the Fed's 'taper tantrum' of 2013, when then-Chair Bernanke surprised markets with a tapering announcement. The ECB has learned from that mistake and has given several speeches recently highlighting that policymakers will be making full use of forward guidance to avoid "...premature expectations of a first rate rise."2 We think they will be successful in avoiding a similar tantrum, but the flow effect of waning bond purchases will still place some upward pressure on the term premium in Eurozone bonds (Chart I-16).3 Chart I-16ECB: End Of QE Will Pressure Term Premium The bottom line is that monetary policy will undermine global bond prices in both the U.S. and Eurozone, but we expect U.S. yields to lead the way higher this year. Japanese bond prices will be constrained by the 10-year yield target. Investors with a horizon of 6-12 months should remain overweight JGBs, at benchmark in Eurozone government bonds and underweight Treasurys within hedged global bond portfolios. We recommend hedging the currency risk because we continue to expect the dollar to rebound this year. This month's Special Report, beginning on page 18, discusses the cyclical factors that will support the dollar: interest rate differentials, a rebound in U.S. productivity growth and a shift in international growth momentum back in favor of the U.S. In terms of the longer-term view, the Special Report makes the case that the U.S. dollar's multi-decade downtrend will persist. This does not mean, however, that long-term investors will make any money by underweighting the greenback. The 30-year U.S./bund yield spread of 190 basis points means that the €/USD would have to rise to more than 2.2 to offset the yield disadvantage of being overweight the euro versus the dollar over the next 30-years. Indeed, once it appears that the U.S. yield curve has discounted the full extent of the Fed tightening cycle (perhaps 12 months from now), it will make sense for long-term investors to go long U.S. Treasurys versus bunds on an unhedged basis. Conclusion Recent data releases suggest that global growth is peaking, especially in the manufacturing sector. Nonetheless, we do not believe that this heralds a slowdown in growth meaningful enough to negatively impact the profit outlook in the major countries. Indeed, the major fiscal tailwind in the U.S. will lift growth and extend the runway for earnings to expand at least through 2019. That said, fiscal stimulus at this stage of the U.S. business cycle will serve to accentuate a boom/bust cycle, where stronger growth in 2018/19 gives way to higher inflation a hard landing in 2020. The Fed is willing to sit back and watch the impact of fiscal stimulus unfold in the near term. But by early 2019, the Fed will find itself behind the curve with rising inflation and an overheating economy. The monetary policy risk for financial markets will then surge, setting up for a classic end to this expansion. The consequences of years of corporate releveraging will come home to roost. This year, trade skirmishes will be a headwind for risk assets and will no doubt generate further bouts of volatility. Nonetheless, recent signals from both the U.S. and China suggest that the situation will not degenerate into a trade war. The bottom line is that, while the economic expansion and equity bull market are both in late innings, investors should stay overweight risk assets and short duration for now. Stay overweight cyclical stocks versus defensives, overweight corporate bonds versus governments, overweight oil-related plays, and modestly long the U.S. dollar against most currencies except the yen. Our checklist of items to time the exit from risk is not yet flashing red. We would change our mind if our checklist goes south, our forward-looking indicators turn sharply lower or U.S. inflation suddenly picks up. We are also watching closely the situation in Iran, the U.S./China trade spat and NAFTA negotiations. Mark McClellan Senior Vice President The Bank Credit Analyst March 29, 2018 Next Report: April 26, 2018 1 For more information on why we believe that Sino-American conflict will be a defining feature of the 21st century, please see BCA Geopolitical Strategy Weekly Report "We Are All Geopolitical Strategists Now," dated March 28, 2018, available at gps.bcaresearch.com 2 ECB President Mario Draghi. Speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html 3 For more information, please see BCA's Global Fixed Income Strategy Weekly Report "Bond Markets Are Suffering Withdrawal Symptoms," dated March 20, 2018, available at gfis.bcaresearch.com II. U.S. Twin Deficits: Is The Dollar Doomed? In this Special Report, we review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar. The long-term structural downtrend in the dollar is intact. This trend reflects both a slower underlying pace of U.S. productivity growth relative to the rest of the world and a persistent external deficit. The U.S. shortfall on its net international investment position, now at about 40% of GDP, is likely to continue growing in the coming decades. Fiscal stimulus means that the U.S. twin deficits are set to worsen, but the situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns regarding sustainability. The U.S. is not close to the point where investors will begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see little reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are some parallels today with the Nixon era, but we do not expect the same outcome for the dollar. The Fed is unlikely to make the same mistake as it made in the late 1960s/early 1970s. There are risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. While the underlying trend in the dollar is down, cyclical factors are likely to see it appreciate on a 6-12 month investment horizon. Growth momentum, which moved in favor of the major non-U.S. currencies in 2017, should shift in the greenback's favor this year. U.S. fiscal stimulus is bullish the dollar, despite the fact that this will worsen the current account balance. Additional protectionist measures should also support the dollar as long as retaliation is muted. The U.S. dollar just can't seem to get any respect even in the face of a major fiscal expansion that is sure to support U.S. growth. Nonetheless, there are a lot of moving parts to consider besides fiscal stimulus: a tightening Fed, accumulating government debt, geopolitical tension and growing trade protectionism among others. The interplay of all these various forces can easily create confusion about the currency outlook. Textbook economic models show that the currency should appreciate in the face of stimulative fiscal policy and rising tariffs, at least in the short term, not least because U.S. interest rates should rise relative to other countries. However, one could also equate protectionism and a larger fiscally-driven external deficit with a weaker dollar. Which forces will dominate? In this Special Report, we sort out the moving parts. We review the theory behind exchange rate determination and examine the cyclical and structural forces that will drive the dollar in the short- and long-term. Tariffs And The Dollar Let's start with import tariffs. In theory, higher tariffs should be positive for the currency as long as there is no retaliation. The amount spent on imports will fall as consumer spending is re-directed toward domestically-produced goods and services. A lower import bill means the country does not need to export as much to finance its imports, leading to dollar appreciation (partially offsetting the competitive advantage that the tariff provides). Tariffs also boost inflation temporarily, which means that higher U.S. real interest rates should also lift the dollar to the extent that the Fed responds with tighter policy. That said, the tariffs recently announced by the Trump Administration are small potatoes in the grand scheme. The U.S. imported $39 billion of iron and steel in 2017, and $18 billion of aluminum. That's only 2% of total imports and less than 0.3% of GDP. If import prices went up by the full amount of the tariff, this would add less than five basis points to inflation. The positive impact on U.S. growth is also modest as the tariffs benefit only two industries, and higher domestic prices for steel and aluminum undermine U.S. consumers of these two metals. A unilateral tariff increase could be mildly growth-positive if there is no retaliation by trading partners. This was the result of a Bank of Canada study, which found that much of the growth benefits from a higher import tariff are offset by an appreciation of the currency.1 Even a short-term growth boost is not guaranteed. A detailed analysis of the 2002 Bush steel tariff increase found that the import tax killed many more jobs than it created.2 Shortages forced some U.S. steel-consuming firms to source the metal offshore, while others made their steel suppliers absorb the higher costs, leading to job losses. A recent IMF3 study employed a large macro-economic model to simulate the impact of a 10% across-the-board U.S. import tariff without any retaliation. It found that tariffs place upward pressure on domestic interest rates, especially if the economy is already at full employment (Chart II-1). This is because the central bank endeavors to counter the inflationary impact with higher interest rates. However, a stronger currency and higher interest rates eventually cool the economy and the Fed is later forced to ease policy. This puts the whole process into reverse as interest rate differentials fall and the dollar weakens. Chart II-1At Full Employment, Import Tariffs Raise Rates The economic outcome would be much worse if U.S. trading partners were to retaliate and the situation degenerates into a full-fledged trade war involving a growing number of industries. In theory, the dollar would not rise as much if there is retaliation because foreign tariffs on U.S. exports are offsetting in terms of relative prices. But all countries lose in this scenario. China is considering only a small retaliation for the steel and aluminum tariffs as we go to press, but the trade dispute has the potential to really heat up, as we discuss in the Overview section. The bottom line is that the Trump tariffs are more likely to lead to a stronger dollar than a weaker one, although far more would have to be done to see any meaningful impact. Fiscal Stimulus And The Dollar Traditional economic theory suggests that fiscal stimulus is also positive for the currency in the short term. The boost in aggregate demand worsens the current account balance, since some of the extra government spending is satisfied by foreign producers. The U.S. dollar appreciates as interest rates increase relative to the other major countries, attracting capital inflows. The currency appreciation thus facilitates the necessary adjustment (deterioration) in the current account balance. The impact on interest rates is similar to the tariff shock shown in Chart II-1. All of the above market and economic adjustments should be accentuated when the economy is already at full employment. Since the domestic economy is short of spare capacity, a vast majority of the extra spending related to fiscal stimulus must be imported. Moreover, the Fed would have to respond even more aggressively to the extent that inflationary pressures are greater when the economy is running hot. The result would be even more upward pressure on the U.S. dollar. Reality has not supported the theory so far. The U.S. dollar weakened after the tax cuts were passed, and it did not even get a lift following the Senate spending plan that was released in February. The broad trade-weighted dollar has traded roughly sideways since mid-2017. Judging by the market reaction to the fiscal news, it appears that investors are worried about a potential replay of the so-called Nixon shock, when fiscal stimulus exacerbated the 'twin deficits' problem, investors lost confidence in policymakers and the dollar fell. Twin deficits refers to a period when the federal budget deficit and the current account deficit are deteriorating at the same time. Chart II-2 highlights that the late 1960s/early 1970s was the last time that the federal government stimulated the economy at a time when the economy was already at full employment. Seeing the parallels today, some investors are concerned the dollar will decline as it did in the early 1970s. Chart II-2A Replay Of The Nixon Years? Current Account And Budget Balances Often Diverge... The two deficits don't always shift in the same direction. In fact, Chart II-3 highlights that they usually move in opposite directions through the business cycle. This is not surprising because the current account usually improves in a recession as imports contract more than exports, but the budget deficit rises as tax revenues wither. The process reverses when the economy recovers. Chart II-3Twin Deficits And The Dollar The current account balance equals the government financial balance (i.e. budget deficit) plus the private sector financial balance (savings less investment spending). Thus, swings in the latter mean that the current account can move independently of the budget deficit. Even when the two deficits move in the same direction, there has been no clear historical relationship between the sum of the fiscal and current account balances and the value of the trade-weighted dollar (shaded periods in Chart II-3). In the early 1980s, the twin deficits exploded on the back of the Reagan tax cuts and the military buildup, but the dollar strengthened. In contrast, the dollar weakened in the early 2000s, a period when the twin deficits rose in response to the Bush tax cuts, the Iraq War, and a booming housing market. ...But Generally Fiscal Expansion Undermines The Current Account Over long periods, a sustained rise in the fiscal deficit is generally associated with a sustained deterioration in the external balance. Numerous academic studies have found that every 1 percentage-point rise in the budget deficit worsens the current account balance by an average of 0.2-0.3 percentage points over the medium term. One study found that the current account deteriorates by an extra 0.2 percentage points if the fiscal stimulus arrives at a time when the economy is at full employment (i.e. an additional 0.2 percentage points over-and-above the 0.2-0.3 average response, for a total of 0.4 to 0.5).4 Given that the U.S. economy is at full employment today, these estimates imply that the expected two percentage point rise in the budget deficit relative to the baseline over 2018 and 2019 could add almost a full percentage point to the U.S. current account deficit (from around 3% of GDP currently to 4%). It could be even worse over the next couple of years because the private sector is likely to augment the government sector's drain on national savings. The mini capital spending boom currently underway will lift imports and thereby contribute to a further widening in the U.S. external deficit position. Nonetheless, theory supports the view that the dollar will rise in the face of fiscal stimulus, at least in the near term, even if this is accompanied by a rising external deficit. Theory gets fuzzier in terms of the long-term outlook for the currency. However, the traditional approach to the balance of payments suggests that the equilibrium value of the dollar will eventually fall. An ongoing current account deficit will accumulate into a rising stock of foreign-owned debt that must be serviced. The Net International Investment Position (NIIP) is the difference between the stock of foreign assets held by U.S. residents and the stock of U.S. assets held by foreign investors. The NIIP has fallen increasingly into the red over the past few decades, reaching 40% of GDP today (Chart II-4). The dollar will eventually have to depreciate in order to generate a trade surplus large enough to allow the U.S. to cover the extra interest payments on its growing stock of foreign debt. Chart II-4Structural Drivers Of the U.S. Dollar The structural depreciation of the U.S. dollar observed since the early 1980s supports the theory, because it has trended lower along with the NIIP/GDP ratio. However, the downtrend probably also reflects other structural factors. For example, U.S. output-per-employee has persistently fallen relative to its major trading partners for decades (Chart II-4, third panel). The bottom line is that, while the dollar is likely to remain in a structural downtrend, it should receive at least a short-term boost from the combination of fiscal stimulus and higher tariffs. What could cause the dollar to buck the theory and depreciate even in the near term? We see three main scenarios in which the dollar could fall on a 12-month investment horizon. (1) Strong Growth Outside The U.S. First, growth momentum favored Europe, Japan and some of the other major countries relative to the U.S. in 2017. This helps to explain dollar weakness last year because the currency tends to underperform when growth surprises favor other countries in relative terms. It is possible that momentum will remain a headwind for the dollar this year. Nonetheless, this is not our base case. European and Japanese growth appears to be peaking, while fiscal stimulus should give the U.S. economy a strong boost this year and next (see the Overview section). (2) A Lagging Fed The Fed will play a major role in the dollar's near-term trend. The Fed could fail to tighten in the face of accelerating growth and falling unemployment, allowing inflation and inflation expectations to ratchet higher. If investors come to believe that the Fed will remain behind-the-curve, rising long-term inflation expectations would depress real interest rates and thereby knock the dollar down. This was part of the story in the Nixon years. Under pressure from the Administration, then-Fed Chair Arthur Burns failed to respond to rising inflation, contributing to a major dollar depreciation from 1968 to 1974. We see this risk as a very low-probability event. Today's Fed acts much more independently of Congress beyond its dual commitment on inflation and unemployment. And, given that the economy is at full employment, there is nothing stopping the FOMC from acting to preserve its 2% inflation target if it appears threatened. Chair Powell is new and untested, but we doubt he and the rest of the Committee will be influenced by any political pressure to keep rates unduly low as inflation rises. Even Governor Brainard, a well-known dove, has shifted in a hawkish direction recently. President Trump would have to replace the entire FOMC in order to keep interest rates from rising. We doubt he will try. (3) Long-Run Sustainability Concerns It might be the case that the deteriorating outlook for the NIIP undermines the perceived long-run equilibrium value of the currency so much that it overwhelms the impact of rising U.S. interest rates and causes the dollar to weaken even in the near term. This scenario would likely require a complete breakdown in confidence in current and future Administrations to avoid a runaway government debt situation. Historically, countries with large and growing NIIP shortfalls tend to have weakening currencies. The sustainability of the U.S. twin deficits has been an area of intense debate among academics and market practitioners for many years. One could argue that the external deficit represents the U.S. "living beyond its means," because it consumes more than it produces. Another school of thought is that global savings are plentiful, and investors seek markets that are deep, liquid and offer a high expected rate of return. Indeed, China has willingly plowed a large chunk of its excess savings into U.S. assets since 2000. If the U.S. is an attractive place to invest, then we should not be surprised that the country runs a persistent trade deficit and capital account surplus. But even taking the more positive side of this debate, there are limits to how long the current situation can persist. The large stock of financial obligations implies flows of income payments and receipts - interest, dividends and the like - that must be paid out of the economy's current production. This might grow to be large enough to significantly curtail U.S. consumption and investment. At some point, foreign investors may begin to question the desirability of an oversized exposure to U.S. assets within their global portfolios. We are not suggesting that foreign investors will suddenly dump their U.S. stocks and bonds. Rather, they may demand a higher expected rate of return in order to accept a rising allocation to U.S. assets. This would imply that the dollar will fall sharply so that it has room to appreciate and thereby lift the expected rate of return for foreign investors from that point forward. Chart II-5 shows that a 2% current account deficit would be roughly consistent with stabilization in the NIIP/GDP ratio. Any deficit above this level would imply a rapidly deteriorating situation. A 4% deficit would cause the NIIP to deteriorate to almost 80% of GDP by 2040. The fact that the current account averaged 4.6% in the 2000s and 2½% since 2010 confirms that the NIIP is unlikely to stabilize unless major macroeconomic adjustments are made (see below). Chart II-5Scenarios For The U.S. Net International Investment Position Academic research is inconclusive on how large the U.S. NIIP could become before there are serious economic consequences and/or foreign investors begin to revolt. Exorbitant Privilege The U.S. has been able to get away with the twin deficits for so long in part because of the dollar's status as the world's premier reserve currency. The critical role of the dollar in international transactions underpins global demand for the currency. This has allowed the U.S. to issue most of its debt obligations in U.S. dollars, forcing the currency risk onto foreign investors. The U.S. is also able to get away with offering foreign investors a lower return on their investment in the U.S. than U.S. investors receive on their foreign investment. Chart II-6 provides a proxy for these two returns. Relatively safe, but low yielding, fixed-income investments are a large component of foreign investments in the U.S., while U.S. investors favor equities and other assets that have a higher expected rate of return when investing abroad (Chart II-7). This gap increased after the Great Recession as U.S. interest rates fell by more than the return U.S. investors received on their foreign assets. Today's gap, at almost 1½ percentage points, is well above the 1 percentage point average for the two decades leading up to the Great Recession. Chart II-6U.S. Investors Harvest Higher Returns Chart II-7Composition Of Net International ##br##Investment Position A yield gap of 1.5 percentage points may not sound like much, but it has been enough that the U.S. enjoys a positive net inflow of private investment income of about 1.2% of GDP, despite the fact that foreign investors hold far more U.S. assets than the reverse (Chart II-6, top panel). In Chart II-8 we simulate the primary investment balance based on a persistent 3% of GDP current account deficit and under several scenarios for the investment yield gap. Perhaps counterintuitively, the primary investment surplus that the U.S. currently enjoys will actually rise slightly as a percent of GDP if the yield gap remains near 1½ percentage points. This is because, although the NIIP balance becomes more negative over time, U.S. liabilities are not growing fast enough relative to its assets to offset the yield differential. Chart II-8Primary Investment Balance Simulations However, some narrowing in the yield gap is likely as the Fed raises interest rates. Historically, the gap does not narrow one-for-one with Fed rate hikes because the yield on U.S. investments abroad also rises. Assuming that the yield gap returns to the pre-Lehman average of 1 percentage point over the next three years, the primary investment balance would decline, but would remain positive. Only under the assumption that the yield gap falls to 50 basis points or lower would the primary balance turn negative (Chart II-8, bottom panel). Crossing the line from positive to negative territory on investment income is not necessarily a huge red flag for the dollar, but it would signal that foreign debt will begin to impinge on the U.S. standard of living. That said, the yield gap will have to deteriorate significantly for this to happen anytime soon. What Drives The Major Swings In The Dollar? While the dollar has been in a structural bear market for many decades, there have been major fluctuations around the downtrend. Since 1980, there have been three major bull phases and two bear markets (bull phases are shaded in Chart II-9). These major swings can largely be explained by shifts in U.S./foreign differentials for short-term interest rates, real GDP growth and productivity growth. A model using these three variables explains most of the cyclical swings in the dollar, as the dotted line in the top panel of Chart II-9 reveals. Chart II-9U.S. Dollar Cyclical Swings Driven By Three Main Factors The peaks and troughs do not line up perfectly, but periods of dollar appreciation were associated with rising U.S. interest rates relative to other countries, faster relative U.S. real GDP growth, and improving U.S. relative productivity growth. Since the Great Recession, rate differentials have moved significantly in favor of the dollar, although U.S. relative growth improved a little as well. Productivity trends have not been a factor in recent years. Note that the current account has been less useful in identifying the cyclical swings in the dollar. Looking ahead, we expect short-term interest rate differentials to shift further in favor of the U.S. dollar. We assume that the Fed will hike rates three additional times in 2018 and another three next year. The Bank of Japan will stick with its current rate and 10-year target for the foreseeable future. The ECB may begin the next rate hike campaign by mid-2019, but will proceed slowly thereafter. We expect rate differentials to widen by more than is discounted in the market. As discussed above, we also expect growth momentum to swing back in favor of the U.S. economy in 2018. U.S. productivity growth will continue to underperform the rest-of-world average over the medium and long term. Nonetheless, we expect a cyclical upturn in relative productivity performance that should also support the greenback for the next year or two. Conclusion Reducing the U.S. structural external deficit to a sustainable level would require significant macro-economic adjustments that seem unlikely for the foreseeable future. We would need to see some combination of a higher level of the U.S. household saving rate, a balanced Federal budget balance or better, and/or much stronger growth among U.S. trading partners. In other words, the U.S. would have to become a net producer of goods and services, and either Europe or Asia would have to become a net consumer of goods and services. Current trends do not favor such a role reversal. Indeed, the U.S. twin deficits are sure to move in the wrong direction for at least the next two years. Longer-term, pressure on the federal budget deficit will only intensify with the aging of the population. The shortfall in terms of net foreign assets will continue to grow, which means that the long-term structural downtrend in the trade-weighted value of the dollar will persist. Other structural factors, such as international productivity trends, also point to a long-term dollar depreciation. It seems incongruous that the U.S. dollar is the largest reserve currency and that U.S. is the world's largest international debtor. The situation is perhaps perpetuated by the lack of an alternative, but this could change over time as concerns over the long-run viability of the Eurozone ebb and the Chinese renminbi gains in terms of international trade. The transition could take decades. The U.S. twin-deficits situation is not that dire that the U.S. dollar is about to fall off a cliff because of sudden concerns about the unsustainability of the current account deficit. Even though the NIIP/GDP ratio will continue to deteriorate in the coming years, it does not appear that the U.S. is anywhere close to the point where investors would begin to seriously question America's ability to service its debt. The U.S. will continue to enjoy a net surplus on its international investments except under a worst-case scenario for relative returns. From an economic perspective, we see no reason why the U.S. will not be able to easily continue financing its domestic saving shortfall in the coming years. There are other risks of course. Growing international political tensions and a trade war could threaten the U.S. dollar's status as the world's premier reserve currency. We will explore the geopolitical angle in next month's Special Report. In 2018, we expect the dollar to partially unwind last year's weakness on the back of positive cyclical forces. Additional protectionist measures should support the dollar as long as retaliation is muted. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy 1 A Wave of Protectionism? An Analysis of Economic and Political Considerations. Bank of Canada Working Paper 2008-2. Philipp Maier. 2 The Unintended Consequences of U.S. Steel Import Tariffs: A Quantification of the Impact During 2002. Trade Partnership Worldwide, LLC. Joseph Francois and Laura Baughman. February 4, 2003. 3 See footnote to Chart II-1. 4 Fiscal Policy and the Current Account. Center for Economic Policy Research, Discussion Paper No. 7859 September 16, 2010. III. Indicators And Reference Charts The earnings backdrop remains constructive for the equity market. In the U.S., bottom-up forward earnings estimates and the net earnings revisions ratio have spiked on the back of the tax cuts. Unfortunately, many of the other equity-related indicators in this section have moved in the wrong direction. The monetary indicator is shifting progressively into negative territory as the Fed gradually tightens the monetary screws. Valuation in the U.S. market improved a little over the past month, but our composite Valuation Indicator is still very close to one sigma overvalued. Technically, our Speculation Indicator is still in frothy territory, but our Composite Sentiment Indicator has pulled back significantly toward the neutral line. Our Technical Indicator broke below the 9-month moving average in March (i.e. a 'sell' signal). These are worrying signs. Nonetheless, at this point we believe they are a reflection of the more volatile late-cycle period that the market has entered. An equity correction could occur at any time, but a bear market would require a significant and sustained economic downturn that depresses earnings estimates. Our checklist does not warn of such a scenario over the next 12 months. It is also a good sign that our Willingness-to-Pay indicator is still rising, at least for the U.S. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. While this suggests that investor flows remain positive for the U.S. equity market, the WTP appears to have rolled over in both Europe and Japan. This goes against our overweight in European stocks versus the U.S. in currency hedged terms (see the Overview section). Our Revealed Preference Indicator (RPI) remained on its bullish equity signal in March. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. So far, the indicator has not flashed 'red'. Treasurys are hovering on the 'inexpensive' side of fair value, but are not cheap based on our model. Extended technicals suggest that the period of consolidation will persist for a while longer. Value is not a headwind to a continuation in the cyclical bear phase. Little has changed on the U.S. dollar front. It is expensive by some measures, but is on the oversold side technically. We still expect a final upleg this year, before the long-term downtrend resumes. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights The current U.S.-China trade skirmish is essentially the beginning of a new cold war. The U.S. and China are engaged in a struggle for supremacy, so trade conflicts will persist. The conflict could evolve into a "game of chicken" - the most dangerous type of game. The U.S. needs Europe's help against China - but an adventure in Iran could cost it that help. Geopolitical risks will cap the rise in bond yields over the next six months, push up oil, and give a tailwind to global defense stocks. Feature The opening salvo of the U.S.-China trade war has caught the investment community by surprise as the market is quickly repricing the odds of a global trade war.1 Nervousness over the breakdown of globalization comes at the same time as our key China view - that Beijing's structural reforms will constrain growth - are beginning to have an impact on global growth (Chart 1).2 Chart 1China Reforms Dragging On Global Growth Fortuitously, we found ourselves in Asia at the onset of "hostilities" and were thus able to see regional investors' reactions in real time. Our clients focused their questions on the economic impact of the announced tariffs (yet to be determined, in our view), constraints facing President Trump (minimal as well), and potential Chinese retaliation (understated). The focus, however, should be on the big picture. The March 23 U.S. announcement of tariffs on around $50 billion worth of Chinese imports is not just the opening salvo of a trade war. Rather the emerging trade war is the opening salvo of a new cold war, a global superpower competition between the U.S. and China that will define the twenty-first century. Put simply, the U.S. and China are now enemies. Not rivals, competitors, or sparing partners. Enemies. It will take the market some time for investors to internalize this idea and price it properly. Meanwhile, in the short term, fears of a full-born global trade war are overblown. The trade tensions are really only about two countries, with uncertain global implications. Investors are right to be cautious, but risks to global earnings are overstated at this time. How Did We Get Here? The ongoing trade tensions are not merely a product of a nationalist Trump administration that decided to call out China for decades of unfair trade practices. They are also the product of the geopolitical context, which we have defined through three "big picture" themes. These three themes allowed us to correctly forecast that the defining feature of the twenty-first century would be a Sino-American conflict. We would be thrilled to see this culminate merely in a trade war. The themes are: Multipolarity (Chart 2)3 Apex of globalization (Chart 3)4 The breakdown of laissez-faire economics (Chart 4)5 Chart 2Multipolarity Is Messy And Volatile Chart 3When Hegemony Declines, Globalization Declines Chart 2 elucidates a key lesson of history: the collapse of British hegemony at the end of the nineteenth century ushered in two world wars. Political science, game theory, and history teach us that periods of multipolarity are rarely peaceful.6 Today's world is not exactly multipolar, as the U.S. remains the preeminent global power. However, regional powers - such as China, the EU, Russia, India, Japan, Iran, and perhaps Turkey and Brazil - have a lot more room to maneuver within their spheres of influence. This means that global rules written by the U.S. at the conclusion of the Second World War are being rewritten for regional contexts. Normatively there is nothing wrong with this process. But practically, multipolarity means that "challenger powers" - such as China today or the German empire in the late nineteenth century - seek to undermine rules and norms of behavior that they had little or no say in setting up. And such rules are necessary to underpin geopolitical stability and grease the wheels of globalization. As Chart 3 shows, trade globalization peaked in the past when the hegemon could no longer enforce global rules. We have therefore emphasized to clients since 2014 that, if we are right that the world is multipolar, then we are essentially at the apex of globalization. A parallel process has seen the breakdown of the laissez-faire consensus, which underpinned the expansion of trade in goods, labor, and capital across sovereign borders. Economic globalization has lifted many boats around the world, but outsourcing - combined with technological innovation - has seen the lower middle class in developed nations face diminishing returns (Chart 4). Chart 4Globalization: No Friend To Developed-Market Middle Class That said, a revolt against globalization and "globalists" is thus far mainly an Anglo-Saxon phenomenon, and particularly an American one. Why? Because the particularities of the U.S. laissez-faire economic model, with its scant social protections, laid its middle class bare to the vagaries of globalization and technological change (Chart 5). However, there is no guarantee that other DM countries will not succumb to the same pressures down the line. Chart 5The 'Great Gatsby' Curve: Or, How Anglo-Saxons Turned Against Laissez Faire This background is important for investors because merely blaming a nationalist Trump administration or a mercantilist Beijing for today's tensions ignores the underlying context. President Trump can change his mind on a dime, but the geopolitical context can only evolve slowly.7 Mercantilism is here to stay; it is a feature, not a bug, of a multipolar world. Contrast today's tensions with those of the 1970s and 1980s between the U.S. and its major trade partners. The 1971 Smithsonian Agreement and the 1985 Plaza Accord ended overt trade protectionism by the U.S. (in 1971), and threats thereof (in 1985), by securing the compliance of these trade partners with Washington's currency and trade demands. Japan further conceded to U.S. demands in 1989 after a two-year trade war. Today, the U.S. and China are not geopolitical allies huddled under the same nuclear umbrella for protection against an ideologically fueled rival. They are ideological rivals. The reason it took a decade for the conflict to erupt is two-fold. First, the U.S. became entangled in the global war on terror after 9/11, which took its focus off of its emerging competitor in Asia. Second, the consensus view - that China would asymptotically approach a Western democracy as it embraced capitalism - has proven to be folly.8 Bottom Line: The China-U.S. trade conflict is a product of today's particular geopolitical context. At heart, it is a conflict for geopolitical primacy in the twenty-first century and thus unlikely to end quickly. Sino-American Conflict Is Intractable The current U.S.-China trade tensions are more of a skirmish than a war. We think that there is considerable room for a step-down in tensions over the next 12 months. First, the Trump administration has not launched an economic war against China. Not only has the U.S. restricted its list of Chinese goods under tariff consideration to just $50 billion of imports - roughly 12% of total Chinese exports to the U.S. - but it has decided to bring a case against China to the World Trade Organization (WTO). The latter is hardly a move by a mercantilist administration dead-set on across-the-board economic nationalism. Second, China has responded almost immediately by offering several concessions, including renewing pledges to open its economy to inward investment and to protect intellectual property (IP) rights. While these may seem like boilerplate concessions that Beijing has floated before, the current context of trade tensions and domestic structural reforms makes it more likely that Chinese policymakers will follow through on their promises. As such, we can see the current round of tensions tapering off, especially after the U.S. midterm elections. However, we doubt that the structural trajectory of Sino-American relations will be significantly altered even if current tensions subside. First, from China's perspective, its extraordinary economic ascent (Chart 6) is merely the return of the millennium's status quo (Chart 7). The last 180 years - roughly from the beginning of the First Opium War in 1839 to today - were the aberration. During this short period of Chinese weakness, the West - with Britain and then the U.S. at the helm - conspired to restructure global rules and norms of geopolitical and economic behavior without input from the Middle Kingdom. Chart 6China's Economic Rise Has Been Extraordinarily Fast... Chart 7China Sees Its Success As A Return To The Status Quo As such, China's influence in key post-WWII economic institutions like the WTO and the IMF is limited while its military has second-class status even in its own "Caribbean Sea," the South China and East China Seas. From the U.S. perspective, China's growth over the past two decades was made possible by U.S. hegemony. The U.S. secured the global rules and norms that enabled China to integrate seamlessly into the global marketplace and then compete its way to the top. Not only did the U.S. allow China to access its credit-fueled markets, but the U.S. Navy protected China's maritime trade, including vital energy supplies transiting from the Middle East. As a thank you for these efforts, China reneged on its WTO commitments, periodically suppressed its currency, stole American intellectual property, and withheld market access from U.S. corporations via tariff and non-tariff barriers to trade. Washington policymakers, and not only Trump's hawkish advisors, are turning against China. There is an emerging consensus among the U.S. foreign policy, defense, intelligence, and economic policy elites that: Sino-American economic symbiosis is over (Chart 8); Chart 8U.S.-China ##br##Symbiosis Is Dead Chart 9The U.S. Is Least##br## Exposed To Trade Chart 10China's Share Of Global##br## Exports Has Skyrocketed The U.S. can afford to confront China over trade because it is the least exposed major economy to global trade (Chart 9); The Chinese have acquired a massive share of global exports without a commensurate opening of their domestic market (Chart 10); Arresting Chinese technology transfer and intellectual property theft is a national security issue (Chart 11); The U.S. can confront China because it has emerged victorious from every global conflagration in the past (Chart 12). Chart 11China Imports Conspicuously Little U.S. IP Chart 12America Is Chaos-Proof Fundamentally, American policymakers want to see China's rapid economic growth slow, they want to see China's capital markets and companies constrained by openness to global competition, and they want to put a leash on China's catch-up in the technological and manufacturing value chain (Chart 13). This is not their stated objective as it would imply that the U.S. wants to see China weakened, and the Chinese leadership miss its decade and century economic development goals. But this is precisely what the U.S. establishment wants. As such, the political and economic visions of American and Chinese policymakers are directly at odds with one another. What does this mean for investors? Over the past several years we have developed a reputation of being sanguine about geopolitics. While many of our peers in the political analysis industry overstate the probability of geopolitical risk, we have (successfully) bet against the worst-case scenario in several prominent crises.9 We like to think that this is because we combine game theory with an understanding of the underlying power dynamics. By emphasizing constraints, we have successfully identified how power dynamics constrain the worst-case outcome.10 When it comes to Sino-American tensions, however, we have always been alarmists. This is because we believe the constraints to conflict are overstated, not understated. Furthermore, the potential market impact of a new cold war is unclear and potentially very large. Both the U.S. and China fundamentally think they can win a trade war. This means that they are engaged in a "regular game of chicken," named after the 1950s practice of racing hot rods head-on in order to prove one's manhood.11 Game theory teaches us that a game of chicken is the most unpredictable game because it can create an equilibrium in which all rational actors have an incentive to keep driving head on - to stick to their guns - despite the risks. In Diagram 1, we can see that continuing to drive carries the greatest risk, but also the greatest reward, provided that your opponent swerves. Chart 13China's Steady Climb Up##br## The Value Ladder Continues Diagram 1A Regular ##br##Game Of Chicken Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. In the current context, this means that the U.S. assumes that China is driven by economic rationality and will not dare face off against the U.S., which has far less to lose given its modest exposure to global trade. Chinese policymakers, however, also think they can win. They look over the Pacific and see a country riven by political polarization (Chart 14) where half of the country thinks the other is "a threat to the nation's well-being" (Chart 15).12 China, meanwhile, has just consolidated its political leadership and feels confident enough in its domestic stability to dabble with growth-constraining economic reforms. Beijing can use any trade tensions with the U.S. to further justify painful reforms. Chart 14Inequality Fuels Political Polarization Chart 15Live And Let Die Who is right? We do not know. And that scares us as it means that the most sub-optimal equilibrium - the bottom-right quadrant of Diagram 1 - is more probable than people think. An important difference maker, one that would alter Beijing's risk calculus considerably, is Europe. Despite being highly leveraged to China's growth, the EU still exports nearly double the value of goods to the U.S. than China (Chart 16). In addition, Europe's trade surplus with the U.S. mostly pays for its deficit with China (Chart 17). Chart 16The EU Exports More To U.S. Than China Chart 17EU Surplus With U.S. Pays For Deficit With China Over the next several months, investors will be able to gauge whether the Trump administration is filled with ideological nationalists who believe in Fortress America or wily realists who know how to get things done. The key question is whether Trump will embrace America's traditional transatlantic alliance with Europe and harness it for the trade war with China. If he embraces it, we will predict that the combined forces of U.S. and Europe will successfully force China to concede to the pressure. If Trump fails, however, we could have a prolonged U.S.-China trade war. Early indications are optimistic. The U.S. gave the EU an exemption from tariffs on steel and aluminum imports on March 22, a delay that will end on May 1. This followed a March 21 meeting between EU Commissioner for Trade Cecilia Malmström and U.S. Secretary of Commerce Wilbur Ross. We suspect, but have no evidence, that the U.S. asked the EU to join in its effort to force China to change its trade practices at the WTO. As an exporting bloc, the EU has a lot more to lose from attacking China than the U.S. But it also has much to lose from unabated Chinese mercantilism and technological theft, and much to gain if China opens its doors wider. As such, we posit that Europe will, in the end, join the U.S. and Japan in a concerted effort to pressure China. This will increase the probability that Beijing ultimately gives in to trade pressure. In the long term, it will also ensure that President Trump does not break the critical transatlantic alliance with Europe, which would be paradigm shifting. But, on the other hand, it will set China and the West on a collision course. China's and the West's suspicions of each other will ossify. Bottom Line: In the short term, trade tensions are likely overstated as U.S. actions against China are largely muted and restrained. In the long term, the U.S.-China trade war could potentially devolve into a "game of chicken," the most dangerous type of conflict. The key variable will be whether the U.S. administration is savvy enough to arrange European collaboration against China. If the U.S. treats the EU harshly and ignores its transatlantic ally on other issues - such as conflict with Iran, discussed below - we could be in for a wild ride in the coming months and years. Either way, Europe stands to gain from a conflict between China and the U.S. Both sides are likely going to try to enlist the EU on their side. As such, we are opening a long Europe industrials / short U.S. industrials trade. Meanwhile, growing trade tensions, policy-induced slowdown in China, and repricing of geopolitical risks in East Asia and the Middle East should cap global bond yields over the next six months. We take 50.4bps and 54.4bps profits on our short U.S. 10-year government bond vs. German bund and short Fed Funds December 2018 futures trades. Iran: The Next Target Of Trump's "Maximum Pressure" Policy President Trump's North Korea policy worked brilliantly in 2017. The policy of "maximum pressure" combined military maneuvers, economic sanctions, and extremely bellicose rhetoric to convince Pyongyang and regional powers that the U.S. has lowered its threshold for full-scale war on the Korean peninsula. China reacted swiftly, starving North Korea of hard currency through economic sanctions (Chart 18). The result was a declaration by Pyongyang in late November that it had finally completed its quest to obtain a nuclear deterrent (an exaggeration at best), an olive branch for the Olympics, and an offer by Supreme Leader Kim Jong Un to meet with President Trump. Chart 18China Gives Kim To Trump The policy of "maximum pressure" yielded such extraordinary results with North Korea that President Trump is now eager to trademark the process and apply it to Iran and potentially other global issues. Ahead of the all-important May 12 deadline - when the White House will decide whether to end the current waiver of economic sanctions against Iran - President Trump has replaced two establishment advisors with hawks. Secretary of State Rex Tillerson has been replaced with CIA Director and noted Iran-hawk Mike Pompeo. Meanwhile, National Security Advisor H.R. McMaster has been replaced by conservative pundit (and former U.S. Ambassador to the UN) John Bolton. Bolton is on record arguing that the U.S. should bomb Iran. The role of the national security advisor varies with the president. Some presidents rely on the position more than others. However, given this administration's inexperience with foreign policy, the role is critical in shaping the White House worldview. The national security advisor manages the staff of the National Security Council (NSC), whose role is to coordinate with the vast network of U.S. intelligence agencies and filter information to the president. Given how large America's foreign, defense, and intelligence establishment is, and given the nature of human and signals intelligence, U.S. presidents often have to act upon diametrically opposing pieces of intelligence. As such, the national security advisor and the NSC can play a critical role in deciding what intelligence makes it to the president's desk and in what context. Staffers in the National Security Council (NSC) are often apolitical. We have been told that several current experts are leftovers from the Obama administration. It is likely that an ideological pundit like John Bolton, who served briefly in the George W. Bush administration, will set out to quickly eliminate non-partisan staffers on the NSC and tilt the information flow away from the empirical to the conspiratorial. With Bolton and Pompeo effectively in charge of U.S. foreign policy it is possible that the U.S. will misapply "maximum pressure" policy to Iran and bungle the complicated coordination with geopolitical allies on China. In particular, the U.S. has to endear itself to the EU if it wants a global economic alliance against China. But the EU also does not want to renegotiate Iran sanctions. Abrogating the 2015 nuclear deal - the Joint Comprehensive Plan of Action (JCPA) - would throw the tentative Middle East equilibrium into chaos. While Iran has played a role in preserving the regime of Bashar al-Assad in Syria, it has largely kept its vast network of Shia militias and allies in check, particularly in Lebanon and Iraq. Ironically, it was the Obama administration's "flawed" JCPA that has allowed Trump to focus on China in the first place. As we argued when the deal was signed, the conservative critics of the deal itself were correct. The JCPA did not degrade Iran's nuclear capability but merely arrested it.13 The point of the deal was implicitly to give Iran a sphere of influence in the Middle East so that the U.S. could extricate itself and focus on China. The Obama administration assessed, in our view non-ideologically, that the U.S. cannot fight two wars at the same time. If the Trump administration decides not to waive sanctions on May 12, it will be in abrogation of the deal. Unlike North Korea, however, Iran has multiple levers it can deploy against the U.S. and its allies' interests in the region. As such, the policy of "maximum pressure" will create much greater risks when applied to Iran. At the very end, it could be as successful as when applied to North Korea, but our conviction view is much lower (and to remind clients, we were optimists about the strategy when applied to North Korea!).14 Furthermore, and again unlike North Korea, Iran is beset with domestic risks. This actually makes it less likely that Tehran will cooperate with the U.S. North Korea is a simple domestic political system where Kim Jong Un can alter policy on a whim without much domestic pushback. In Iran, the dovish and moderate President Hassan Rouhani has to contend for power with hawks who have been critical of the JCPA. Meanwhile, the restive youth population could rise up at the first sign of elite division or weakness. This complicated domestic dynamic is why we cautioned clients back in January that Iran would likely add geopolitical risk premium to the oil markets.15 Bottom Line: It appears that President Trump, motivated by the success of his "maximum pressure" strategy against North Korea, now thinks he can apply it as successfully to Iran. This raises the prospect that Trump will discontinue the waiver of economic sanctions on May 12, effectively re-imposing a slew of economic sanctions against Iran and foreign companies looking to conduct business with it. Geopolitical risks are likely to rise in the Middle East as a result of U.S.-Iran tensions. As we go to publication, Saudi authorities have intercepted another Houthi missile heading towards Riyadh just days after Saudi Crown Prince Mohammad Bin Salman visited Washington, D.C. The White House appears to relish the opportunity to fight a war on two fronts, a trade war with China and a geopolitical war with Iran. Expect volatility and an elevated geopolitical risk premium in oil markets. Stay overweight global defense companies across markets. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Market Reprices Odds Of A Global Trade War," dated March 6, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 6 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: Norton, 2001). 7 Would President Hillary Clinton have avoided a trade war with China? We do not think so. Secretary Clinton was considered a "China Hawk" while at the State Department and pushed for the "Pivot to Asia." Jennifer Harris, the lead architect of Clinton's economic statecraft agenda in the U.S. State Department, recently penned a book that called for greater use of economic tools for geopolitical ends. The book, War By Other Means, introduces the term geoeconomics and calls for the U.S. to use economic instruments to promote and defend national interests. Please see BCA Geopolitical Strategy Blog, "We Read (And Liked)... War By Other Means," dated July 13, 2016, available at gps.bcaresearch.com. 8 In 2000, while campaigning on behalf of China's WTO entry, President Bill Clinton remarked, "economically, this agreement (China's WTO entry) is the equivalent of a one-way street. It requires China to open its markets ... to both our products and services in unprecedented new ways. All we do is to agree to maintain the present access which China enjoys ..." Please see "Full Text of Clinton's Speech On China Trade Bill," dated March 9, 2009, available at nytimes.com. 9 To name just a few: the risk of an Israeli attack against Iran, the risk of a full-scale Russian invasion of Ukraine, the risk of Euro Area collapse, the risk of Saudi-Iranian war, the risk of Russian-Turkish war, etc. 10 For the best example of how game theory is combined with our constraint-based paradigm, please see BCA Geopolitical Strategy Special Report, "After Greece," dated July 8, 2015, available at gps.bcaresearch.com. 11 See James Dean in Rebel Without A Cause. 12 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Client Note, "Trump Re-Establishes America's 'Credible Threat,'" dated April 7, 2017, "North Korea: Beyond Satire," dated April 19, 2017, "Can Pyongyang Derail The Bull Market?" dated August 16, 2017, and "Insights From The Road - The Rest Of The World," dated September 6, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Weekly Report, "Watching Five Risks," dated January 24, 2018, available at gps.bcaresearch.com.

Highlights The China-specific tariffs proposed by the Trump administration last week represent a great escalation in U.S. protectionism, but the actual measures may be smaller than what was initially announced. The proposed tariffs, if applied as stated, would likely shave 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the highly leveraged Hong Kong economy that needs to be monitored. Feature The Trump administration doubled down on its protectionist agenda last week, by announcing its intention to levy US$50 billion in tariffs against a variety of imports from China. This follows the administration's decision earlier in the month to impose a tariff on all steel and aluminum imports, which we discussed at length in our March 7 Weekly Report.1 While the China-specific tariffs represent a great escalation in protectionism relative to those on steel and aluminum imports, there are several important factors for investors to take into consideration: Chart 1President Trump Can Ill-Afford ##br##Any Major Economic Turmoil The decision on Chinese import tariffs is not yet final, as the White House will propose a list of Chinese goods potentially subject to tariffs for public comment and consultations. This opens the door for an enormous lobbying effort from U.S. retailers and negotiations with Chinese officials, signaling that the end result is not set in stone. China's very muted retaliation (so far) increases the odds of a benign, negotiated outcome. Following the initial announcement of the steel and aluminum tariffs, the Trump administration significantly watered down the measures by granting Canada and Mexico an exemption and allowing exemption applications from other countries. This could suggest that the final tariffs to be applied against Chinese imports will be considerably smaller than what the administration signaled last week. Finally, given that the U.S. midterm election will be occurring later this year and that the administration can ill-afford to lose control of the legislative process, President Trump's actions on trade may be designed to maximize the perception of serious trade reform without threatening to substantially impact U.S. or global ex-U.S. economic momentum (Chart 1). This perspective would further support the notion that the bark of China-specific tariffs will be worse than the ultimate bite. The Impact Of Proposed Tariffs On Growth Still, investors cannot assume that the tariffs will be significantly watered down, meaning that it is important to have a forecast for the impact of the proposed tariffs on Chinese growth. We take a simple approach to judging the economic impact on nominal export growth, by calculating an aggregate tariff rate as if the amount of proposed tariffs applied equally across all Chinese exports to the U.S. We then multiply that rate by an estimate of U.S. import price elasticity, and again by the weight of U.S. exports as a share of total Chinese exports. Table 1 presents a list of import elasticity estimates for the G7 countries, both over the short- and long-term. Given that the short-run is our primary concern when modeling the likely cyclical impact on Chinese exports, we use the 0.6 elasticity estimate for the U.S. as a starting point for our analysis. We shock this estimate upwards to 0.8, for two reasons: To generate a relatively conservative estimate of the impact on Chinese export growth It is not clear whether the demand for goods from China is more or less price elastic than goods from other countries. However, given that the majority of Chinese exports to the U.S. are consumer-oriented (and thus less differentiated than highly specialized industrial goods), it is plausible that the price elasticity of Chinese imports is higher than it is on average. Table 1U.S. Short-Run Import Price Elasticity Is Not Trivial Given that US$50 billion is roughly 10% of annual U.S. imports from China, our simple approach suggests that the proposed tariffs would cause China's total export growth to decelerate about 1.6% (10% effective tariff rate times -0.8 import price elasticity times 20% export weight). Including the effect of Chinese re-exports to the U.S. via other major trading partners would slightly increase this estimate, meaning that 1.5 - 2.0% is a conservative range of estimates for the tariff impact. When applied to the current growth rate of Chinese exports, the impact of this estimate would be minimal. Chart 2 shows that Chinese nominal export growth recently accelerated to 22% even when shown as a 3-month moving average, suggesting that a U.S. import tariff would be coming at a time of considerably strong export momentum. In fact, China's February export data was so positive that it raised the Citigroup economic surprise index for China to a 9-year high (Chart 3). Chart 2At First Blush, Chinese Export Growth ##br##Has Accelerated Significantly Chart 3The Pop In Export Growth Has##br## Turbocharged The Surprise Index However, our view is that the growth rates of China's nominal imports and exports do not currently reflect the underlying pace of trade, with both series likely overstating the recent pace of growth. On the import side, we have highlighted in previous reports that import demand has recently outpaced what the Li Keqiang index would suggest. On the export side, a model of global US$ imports from China regressed against extrapolated global industrial production growth has an extremely strong fit over the past several years, and implies that the underlying pace of Chinese export growth is closer to 10%. Chart 4 illustrates this estimate of underlying export growth (based on global imports from China) along with the impact of the proposed tariffs, and highlights that a 2% export growth shock would simply prevent the 2% acceleration in underlying growth that we would normally expect over the coming months given the recent pickup in our global LEI. Chart 4If Enacted, The Proposed Tariffs Will ##br##Prevent An Acceleration In Export Growth Bottom Line: The import tariffs proposed by the Trump administration, if applied as stated, would likely shave about 2% off of China's export growth over the coming 6-12 months. This would prevent an acceleration that we would have otherwise expected given the strength of the global economy. The Implications For Chinese Stock Prices A 2% deceleration in export growth is not a significantly negative event for China's economy, especially if underlying export growth was set to trend higher due to strong global activity. But it does have the strong potential to mute a source of positive economic momentum, at a time when the industrial sector is clearly slowing. We presented our decision tree for Chinese stocks (Chart 5) in our first report of the year,2 and referenced it again in our March 7th report. The decision tree lays out four key questions for investors to answer over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio: Is The Global Economy Slowing Significantly? Is Significant Further Monetary Policy Tightening Likely? Is The Pace Of Renewed Structural Reforms Likely To Be Too Aggressive? Is The Existing Slowdown In China's Growth Momentum Metastasizing? Chart 5The Chinese Equity 'Decision Tree' While the answer to questions 2 and 3 remains "no", Trump's shift towards protectionism certainly raises the risk of an eventual "yes" to the first question, especially given that our analysis has assumed no retaliation or counter-retaliation. Regarding the issue of China's industrial sector slowdown, the Li Keqiang index is not falling sharply, but it remains in a downtrend and is set to decline further according to our BCA Li Keqiang Leading Indicator (Chart 6). At best, the answer to question 4 is a lukewarm "no". We have previously noted that the uptrend in Chinese ex-tech stock prices vs their global peers over the past two years suggests that investors should have a high threshold for reducing exposure to China. We continue to agree with that assessment, but we must also acknowledge that the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We are not yet changing our investment recommendations, but we are putting Chinese ex-tech stocks on downgrade watch for Q2. An outright recommendation to cut exposure to neutral will likely occur in response to a technical breakdown which, for now, does not appear to be imminent (Chart 7). Chart 6China's Industrial Sector Is Set To Slow Further Chart 7Still In An Uptrend, For Now Bottom Line: A 2% deceleration in export growth is not in and of itself a significantly negative event for China's economy, but the shift in U.S. protectionism from rhetoric to action and the continued decline in our leading indicators makes a tenuous case for a continued overweight stance towards Chinese stocks. We recommend that investors put Chinese ex-tech stocks on downgrade watch over the course of Q2. An Update On The Hong Kong Dollar The Hong Kong dollar (HKD) has been weakening for the better part of a year, but recently it has fallen quite sharply relative to its history and now trades very close to the weak side of the peg (7.85 Hong Kong dollars to 1 U.S. dollar). The pace of recent weakness has caught the attention of investors and market participants, in part because it would be the first time in 12 years since the HKD threatened to decline below the lower end of the peg. In our view, both the HKD's weakness over the past year and the recent slide have been caused largely by technical factors, and are not in and of themselves signs of any major economic weakness or financial market instability that should concern investors. As highlighted in Chart 8, the significant rise in USD/HKD (a depreciation in the Hong Kong dollar) can be explained by a sizeable rise in the 3-month U.S. LIBOR / Hong Kong HIBOR spread. Panel 2 shows that the first portion of the rise in LIBOR vs HIBOR can be explained on the Hong Kong side. 3-month HIBOR itself has fallen quite substantially relative to the base rate, which has risen in lockstep with the Fed funds rate. This decline in 3-month HIBOR suggests that there is a supply-demand imbalance in the Hong Kong interbank market (in favor of excess supply), and that the Hong Kong Monetary Authority (HKMA) is likely to reduce the aggregate balance maintained by commercial banks in the days and weeks ahead (after having reduced it by HKD 80 billion in the second half of 2017; Chart 9) in order to defend the peg. Chart 8HKD Weakness Caused By Factors##br## On Both Sides Of The Pacific Chart 9To Raise 3-Month HIBOR, ##br##The HKMA Has To Tighten Interbank Liquidity Panel 3 of Chart 8 highlights that the second portion of the LIBOR/HIBOR spike is due to events completely unconnected with Hong Kong's monetary policy or its banking system. As discussed in detail in last week's U.S. Bond Strategy,3 the sharp rise in 3-month LIBOR relative to the Fed funds rate (the opposite of what is occurring in Hong Kong) appears to be driven by the U.S. Treasury rebuilding its cash balance following the recent extension of the debt ceiling, the money market effect of U.S. corporations repatriating U.S. dollars, and the Fed's ongoing balance sheet contraction. The combination of these two factors has created incentives for investors to sell the Hong Kong dollar and buy the U.S. dollar, which explains the weakness of the former. While these factors are technical in nature and are likely to dissipate over time, they are both significantly rooted in the fact that the U.S. is tightening its monetary policy. This will be discussed in more depth in next week's report, as the combination of tighter monetary conditions, the ongoing slowdown in China's industrial sector, and the extremely high levels of leverage in Hong Kong's private sector legitimately raises the odds of a smashup over the coming 1-2 years. We will gauge how bearish investors should be on Hong Kong and will present a new indicator that investors can use to monitor whether tighter monetary policy is likely to tip the economy into a debt-driven downturn. Stay tuned. Bottom Line: The recent weakness in the Hong Kong dollar is not a sign of any major economic weakness or financial market instability that should concern investors. However, the prospect of tighter monetary policy is a potential threat to the Hong Kong economy that needs to be monitored. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China And The Risk Of Escalation," dated March 7, 2018, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "The "Decision Tree" For Chinese Stocks," dated January 4, 2018, available at cis.bcaresearch.com. 3 Please see U.S. Bond Strategy Weekly Report, "Profiting From A Higher LIBOR," dated March 20, 2018, available at usbs.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Fixed Income Asset Allocation: Global growth indicators remain solid, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Gilts: Bank of England hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr in a 2yr/5yr/10yr butterfly trade. Feature Chart of the WeekStill A Bond-Bearish Backdrop Higher financial market volatility remains the most important investment theme for 2018, as investors continue to be fed a steady diet of worrisome headlines. Threats of a U.S. - China trade war, widening LIBOR-OIS spreads in the U.S., the ascent of trade and foreign policy hawks in the White House, troubles at Facebook hitting the market-leading technology stocks - all are just the latest reasons for investors to become more cautious on taking risk. Yet the ability of markets to shrug off, or succumb to, growing uncertainty will be related to two things - the momentum of global economic growth and the future direction of global monetary policy. On the former, the latest data releases have shown some moderation in the strong coordinated global growth upturn witnessed over the past year. Our aggregate measures such as the global PMI and global ZEW indices have dipped lower in the first few months of 2018. These indicators remain at levels suggesting growth is still in decent shape, even with some worsening in expectations (Chart of the Week). On the latter, the BCA Central Bank Monitors are still showing a growing need to tighten monetary policy further in the major developed economies. This continues to put upward pressure on government bond yields through rising inflation expectations and a higher expected path of short-term interest rates. Until there is evidence of a more meaningful downturn in global growth, bond yields will keep on drifting higher. We continue to recommend a below-benchmark overall portfolio duration stance for fixed income investors, favoring spread product over government bonds, while running below-average portfolio risk (i.e. tracking error) given more elevated levels of market volatility. The "TINA Trade" Is Now The "TISNA Trade" - There Is STILL No Alternative Central bankers remain on a path to normalize the extraordinary monetary accommodation of the past several years, led by their steadfast belief in the Phillips Curve at a time of low unemployment in most countries. Against this backdrop, government bond yields cannot fall enough to limit the damage from rapid equity market selloffs without much softer growth or inflation data that would alter the expected trajectory of policy rates. This implies a higher structural level of market volatility now relative to previous years, as we discussed in a recent Global Fixed Income Strategy Weekly Report.1 Yet despite the signs of greater nervousness among investors, there is still a strong level of positive sentiment towards equities and bearish sentiment towards bonds according to the Market Vane indices (Chart 2). The latest edition of the widely-followed Bank of America Merrill Lynch Investor Survey also revealed a disconnect between the opinions of investors (worries over protectionism, trade wars, higher inflation and softer global growth) and actual positions (large equity overweight's favoring cyclical growth stocks).2 Investors seem to be "nervously complacent", staying long risk assets (equities, credit) and underweight safe havens (government bonds) but with a growing list of concerns. For now, this appears to be the most appropriate allocation, for the following reasons: Global growth is still generally strong. Our global manufacturing PMI remains close to the cyclical highs, although there was some pullback seen in the "flash estimates" for March in the euro area, Japan and the U.K. (Chart 3). The breadth of the current cyclical global upturn remains strong, with all eighteen countries in the composite index having a PMI in the "growth zone" above 50 (top panel). Chart 2Pro-Risk Sentiment,##BR##Despite More Volatile Markets Chart 3Global Growth##BR##Still Looks Good The OECD global leading economic indicator continues to accelerate, while the Citigroup global inflation surprise index is also picking up (Chart 4). These are pointing to continued upward pressure on global bond yields through higher real yields and faster inflation expectations, respectively. The global cyclical backdrop is boosting inflation. 75% of OECD countries are operating beyond full employment while capacity utilization rates in the developed economies are approaching 80% - the highest level since mid-2008 (Chart 5, top panel). Global oil prices should continue to grind higher, with BCA's commodity strategists now expecting the benchmark Brent oil price hitting $80/bbl in one year's time (middle panel). Also, global export price inflation is showing no signs of slowing, suggesting that global headline inflation should continue moving higher (bottom panel). Chart 4Upward Pressure On##BR##Real Yields AND Inflation Chart 5A More Inflationary##BR##Global Backdrop Central bankers are still biased towards becoming less accommodative. This was seen last week with the U.S. Federal Reserve hiking the fed funds rate and raising its growth and interest rate projections (Chart 6), while the Bank of England (BoE) gave a strong indication that an interest rate increase was coming in May. This comes as the European Central Bank continues to signal a tapering of its asset purchase program later this year. The latter point is critical for markets, as tighter global monetary policy has diminished the ability for investors to ignore sources of potential uncertainty. Take the current concern over trade tensions between the U.S. and China, for example. A Google Trends search of the phrase "China Trade War" shows, unsurprisingly, a huge recent spike in interest in that topic (Chart 7, top panel). There was also a big increase in such online searches around the time of Donald Trump's election victory in November 2016 and his inauguration in January 2017. At that time, however, global monetary policy was still accommodative, with the real fed funds rate well below the neutral "r-star" estimate (middle panel) and central bank balance sheets in the major developed economies expanding at a 20% annual rate (bottom panel). Chart 6The Fed Will Keep On Hiking Chart 7Expect More Vol Spikes While CBs Tighten The easy monetary settings helped keep market volatility low despite the shock of Trump's election win and what it meant for the implementation of his more aggressive campaign promises, like raising tariffs on U.S. imports from China. Fast forward to today and the real fed funds rate is now at neutral and central banks are buying bonds at a much slower pace. This means that markets will have a tougher time ignoring greater uncertainty, as was witnessed in last week's equity market selloff following President Trump's announcement of $60 billion in Chinese import tariffs. Going forward, without the soothing balm of very low interest rates and plentiful central bank liquidity expansion, volatility spikes like the ones seen in early February and last week will become more frequent. The implication is that volatility-adjusted returns on risk assets will be lower, even if the global growth backdrop remains reasonably supportive. A pro-risk investment bias, but playing with fewer chips on the table, is still appropriate over at least the next six months. Bottom Line: Global growth indicators remain at elevated levels, while inflation pressures continue to build. Central banks will remain focused on those factors, and not news-driven market volatility spikes, until the trends change. The cyclical environment still favors a below-benchmark duration stance for bond investors, favoring credit over government debt, but with lower risk-adjusted return expectations. U.K. Update: Sticking With Our Overweight Call On Gilts Chart 8Mixed Messages On U.K. Growth The BoE kept interest rates unchanged at last week's policy meeting, but sent clear signals that a rate hike would be very likely in May. Two members of the Monetary Policy Committee (MPC), Michael Saunders and Ian McCafferty, actually voted a rate hike last week, which was a surprise. The BoE's increasing hawkishness continues a process that began in autumn of 2017, when policymakers began shifting their language in advance of a November rate hike - the first BoE rate increase since May 2007. The central bank had been worried more about the risks to the U.K. growth outlook since the July 2016 Brexit vote, while ignoring the currency-driven overshoot of its inflation target. Now, the BoE seems a bit more comfortable with the U.K. growth outlook, even amid the ongoing Brexit uncertainty, as was noted in the official policy statement from last week's MPC meeting: Developments regarding the United Kingdom's withdrawal from the European Union - and in particular the reaction of households, businesses and asset prices to them - remain the most significant influence on, and source of uncertainty about, the economic outlook. In such exceptional circumstances, the MPC's remit specifies that the Committee must balance any significant trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity. The steady absorption of slack has reduced the degree to which it is appropriate for the MPC to accommodate an extended period of inflation above the target. We find it a bit of a surprise that the BoE would seek to switch to inflation-fighting mode now, for two reasons: U.K. growth momentum may be slowing. The flash estimate for the March manufacturing PMI fell to an 8-month low, while the leading economic indicators (LEIs) from both the OECD and Conference Board have clearly rolled over (Chart 8). The BoE did highlight the recent pickup in wage inflation, with year-over-year growth in average weekly earnings now up to 2.8% in nominal terms. This has pushed real wage growth back into positive territory (3rd panel), which appears to be feeding through into a slight pickup in consumer confidence (bottom panel). Although the modest increase in February retail sales suggests that a consumer spending revival may be slower to arrive than the BoE is hoping for. U.K. inflation momentum is slowing. The surge in U.K. inflation following the decline in the British Pound after the 2016 Brexit vote is in the process of unwinding. The trade-weighted currency is up 9% from the 2016 low, which has sliced imported goods price inflation from 10% to 2% over the same period (Chart 9). Headline CPI inflation, which rose from near 0% to 3.1% in November 2017, now sits at 2.7%. The upturn in core CPI inflation has also stabilized. While both CPI inflation measures remain above the 2% BoE target, the momentum has clearly peaked and pipeline price pressures continue to decelerate. Investors have listened to the signals sent by the BoE, pricing in 45bps of hikes over the next year and pushing the 2-year Gilt yield to 0.9% - the highest level since May 2011 (Chart 10). At the same time, market-based inflation expectations have dipped a bit and the U.K. data surprise index has fallen back to the zero line (bottom panel). Chart 9U.K. Inflation Has Peaked Chart 10A Rapid BoE Repricing At The Wrong Time? Conflicting signals can also be seen in the slope of the Gilt curve. The nominal 2-year/10-year Gilt curve now sits at 55bps, just above the 2016 post-Brexit lows. The real Gilt curve (the nominal curve minus the 2-year/10-year U.K. CPI swap curve) is sitting at the flattest levels last seen since 2015/16 (Chart 11, top panel) when the BoE base rate was above zero in real terms (2nd and 3rd panels). Now, the real base is deeply negative around -2%, suggesting that the Gilt curve may already be discounting higher real BoE policy rates. At the same time, the U.K. inflation expectations curve is steepening, with 2-year CPI swaps falling faster than 10-year CPI swaps, as was the case during that 2015/16 episode (bottom panel). U.K. money markets are now pricing in an increase in the base rate to 1% over the next year. Given the slowing trends in the U.K. LEIs, the manufacturing PMI and realized inflation rates, we remain doubtful that the BoE will be able to deliver more hikes than are currently discounted. We continue to view U.K. Gilts as a "defensive" overweight within dedicated global government bond portfolios, especially given our recommendation to also stay defensive on overall duration exposure. The primary trend in the performance of U.K. Gilts relative to the Barclays Global Treasury Index, on a currency-hedged basis, is broadly correlated (inversely) to the ratio of the U.K. OECD LEI to the overall OECD LEI (Chart 12, top panel). Thus, we feel comfortable sticking with our call to expect U.K. Gilt outperformance in the next 6-12 months as long as the U.K. LEI continues to underperform - especially with the yield betas of Gilts to U.S. Treasuries and euro area government bonds now well below 1 (middle panel). Chart 11The Gilt Curve##BR##Looks Too Flat Chart 12Stay O/W Gilts & Add Go Long##BR##The Belly On A 2/5/10 Butterfly Given the recent flattening of the Gilt curve, which appears a bit extreme, we are adding a new trade to our Tactical Overlay this week: going long the belly (5-year) of a 2-year/5-year/10-year (2/5/10) Gilt butterfly. The current level of that 2/5/10 butterfly is 9bps, and we are targeting a move down to the -10bp to -15bp range. This trade is mildly negative carry, with -0.75bps of flattening per month already discounted in the forwards over the next year (bottom panel), but we anticipate the 2/5/10 butterfly to compress at a faster rate than the forwards in the coming months. Bottom Line: BoE hawkishness is increasing, but policymakers will be hard pressed to tighten more than is currently priced. Stay overweight Gilts in hedged global government bond portfolios. Position for a steeper Gilt curve by going long the 5yr point in a 2yr/5yr/10yr butterfly trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6th 2018, available at gfis.bcaresearch.com. 2 https://www.bloomberg.com/news/articles/2018-03-20/cracks-in-bull-case-emerge-yet-stubborn-investors-not-moving Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Economy: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Fed: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loans: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Feature Yet another down week for risk assets, and all of a sudden 2018 is shaping up to be a pretty miserable year for spread product (Chart 1). High-Yield corporate bonds have underperformed duration-equivalent Treasuries by 29 basis points year-to-date, and investment grade corporates have underperformed by 90 bps. Meanwhile, the sell-off in Treasuries has also paused and the 10-year yield is now 12 bps below its 2018 peak. Chart 1Annual Excess Returns To Credit What exactly is going on? We identify two catalysts for the recent market moves and consider each in turn. Questioning The Synchronized Global Recovery Market moves during the past few weeks have, to some extent, been driven by investors starting to question the sustainability of the so-called "synchronized global recovery". The strong pace of global growth has been a key driver of higher bond yields and risk asset outperformance, and most indicators suggest this trend remains intact. The Global Manufacturing PMI is high compared to recent years, and our PMI diffusion index shows that only 1 out of 36 countries has a PMI below the 50 boom/bust line (Chart 2). Our Global Leading Economic Indicator is similarly elevated, and has a diffusion index that has mostly been in positive territory since mid-2016 (Chart 2, panel 2). But last week we received some evidence that this rapid pace of growth may not persist. Flash PMIs predict that the Eurozone Manufacturing PMI will fall to 56.6 in March, down from a recent peak of 60.6 (Chart 2, panel 3). Similarly, the Japanese PMI is predicted to fall to 53.2 in March, down from a recent peak of 54.8 (Chart 2, bottom panel). There is no Flash PMI data for China, the country with the largest weighting in the Global PMI index, but leading indicators suggest that Chinese PMI will also moderate in the months ahead. This is a risk we have flagged in several recent reports.1 Granted, these are all strong PMI readings that are still well above the 50 boom/bust line, but the pace of improvement has clearly moderated and this sort of marginal change often causes investors to extrapolate weaker growth into the future. This appears to be exactly what is happening. The Global ZEW index, a survey of investors' economic sentiment, fell in March (Chart 3). The BCA Carry Canary Indicator, a composite measure of emerging market currency trades geared to global growth, has also weakened (Chart 3, panel 2). Meanwhile, cyclical equity sectors (excluding technology) have not managed to outperform defensives even as Treasury yields have risen, a break from the prior correlation (Chart 3, panel 3). Of the four market-based indicators that most closely track the 10-year Treasury yield, only our Boom/Bust Indicator is not currently pointing to lower yields in the near-term (Chart 3, bottom panel). As usual, we turn to our 2-Factor Treasury Model to assess the impact of moderating global growth on the 10-year Treasury yield. At present, the model - which is based on the Global Manufacturing PMI and bullish sentiment toward the U.S. dollar - pegs fair value for the 10-year Treasury yield at 2.96% (Chart 4). However, if we assume that Flash PMI readings for the U.S., Eurozone and Japan are accurate, and also that PMIs in the rest of the world and dollar sentiment stay flat at current levels, then the fair value reading from our model will drop to 2.85% when the final March PMI data are released next week. This is not far from the current yield level, and could even be an optimistic forecast if the Chinese PMI starts to roll over, as we expect. Chart 2Global Recovery Still Intact Chart 3Global Growth Warning Signs Chart 42-Factor Treasury Model Of course the global economy also has to contend with the possibility of an escalating trade war between the U.S. and China. Markets reacted last week as the U.S. government ramped up the pressure by announcing a 25% tariff on $50-$60 billion worth of trade with China. While the immediate economic impact of these measures is highly uncertain, our Geopolitical strategists view an escalating trade war as a real possibility during the next 1-2 years.2 Bottom Line: There is no imminent danger of a significant deterioration in global growth, but the rate of improvement is peaking. The result of the more moderate pace of economic growth and the mounting threat of protectionism is that there is more two way risk in both bond yields and spreads than there has been for some time. Stay tuned. A Less Supportive Fed Chart 5Fed Versus Market The second catalyst driving bond markets at the current juncture is that the Fed is providing markets with a less accommodative monetary back-drop. Faced with a firmer outlook for U.S. growth and inflation, the Fed is now somewhat less responsive to tighter financial conditions than it has been during the past few years. This hawkishness will put a floor under Treasury yields going forward, and is also the most immediate risk to credit spreads, as we have explained in several recent reports.3 Chart 6The Fed's Phillips Curve Model Case in point, the Fed went ahead with a rate hike at last week's FOMC meeting despite the recent turbulence in financial markets. Not only that, but FOMC participants generally revised up their projections for both economic growth and the fed funds rate. The same number of participants (6) now expect four rate hikes this year as expect three. Last December only four participants expected four or more rate hikes in 2018. Further, the committee's median projection for the fed funds rate at the end of 2019 rose from 2.7% to 2.9%, the median for the end of 2020 rose from 3.1% to 3.4%, and even the median federal funds rate expected to prevail in the longer run rose from 2.8% to 2.9%. The market has moved a long way towards the Fed's dots in recent months, but is still somewhat more pessimistic. The overnight index swap curve is priced for slightly more than three rate hikes in 2018 (including last week's), but is below the Fed's median projection for 2019, 2020 and the longer run (Chart 5). As mentioned above, the Fed also revised up its projections for economic growth and the pace of labor market tightening. The Fed is now looking for an unemployment rate of 3.6% by the end of next year, well below its estimated 4.5% natural rate. At the same time, however, the Fed left its projections for core inflation largely unchanged leaving some to question whether the Fed is re-assessing its commitment to the Phillips curve. In fact, the following question was asked to Chairman Powell at last week's post-meeting press conference:4 Question: Interesting changes in the forecast. A higher growth forecast [...]. Lower unemployment, [...]. And yet, very little change in inflation. What does that say about what you and the Committee believe about the inflation dynamic? Answer: [...] that suggests that the relationship between changes in slack and inflation is not so tight. [...] It has diminished, but it's still there. In other words, the Chairman refused to dismiss the Phillips curve framework altogether but acknowledged that the slope is very flat. The implication is that the labor market will have to run hot for the next couple of years for the Fed to achieve its inflation target. By our assessment, the Fed's projections for the unemployment rate and inflation seem fairly reasonable. Chart 6 shows an expectations-augmented Phillips curve model of core inflation that we re-created from a 2015 Janet Yellen speech.5 Using the Fed's median projections for the unemployment rate, and also holding relative import prices and inflation expectations flat, the model projects that core inflation will rise during the next two years, but will remain slightly below the Fed's target. In other words, the Fed's inflation forecasts seem to agree with the empirical data. In Search Of A More Robust Phillips Curve One of the reasons that the Phillips curve is so flat is that while core PCE inflation includes some prices that respond briskly to labor market slack, it also includes many prices that are less driven by labor slack and more by idiosyncratic factors. The price of imported goods being a prime example. Recent research from the San Francisco Fed splits out those prices that are more sensitive to labor slack - procyclical inflation - from those that are less sensitive to labor slack - acyclical inflation.6 Interestingly, it is the acyclical components that have caused core inflation to run below the Fed's target in recent years, while procyclical inflation has been well above 2% (Chart 7). This framework is helpful because it allows us to estimate a more robust Phillips curve on just the components of inflation that are most sensitive to tightness in the labor market. For example, when we estimate a Phillips curve relationship on just procyclical inflation (excluding housing), the model shows that this component of inflation will rise by 0.18% for every percentage point decline in the unemployment rate. When we estimate the Phillips curve model on overall core PCE we find that a 1 percentage point decline in the unemployment rate only raises core PCE inflation by 0.09%. The top panel of Chart 8 shows that if the unemployment rate follows the path predicted by the Fed, then procyclical inflation (ex. housing) will rise during the next two years, and should stay above the Fed's 2% target. Our own model of housing inflation also shows that its deceleration should reverse in the coming months (Chart 8, panel 2). Chart 7Acyclical Components A Drag On Inflation Chart 8TCore Inflation Will Move Higher As for the acyclical components of inflation, in a prior report we discussed why health care inflation should rise during the next two years, and this has so far been confirmed by strong producer price data (Chart 8, panel 3).7 For the remaining acyclical components, of which 41% are goods and 59% are services, we would expect that at least the goods component will rise in response to the recent acceleration in non-oil import prices (Chart 8, bottom panel). In conclusion, there is reason to expect some upside in each component of core inflation. We anticipate that core inflation will move higher in the coming months and that the Fed will respond with continued gradual rate hikes. Bottom Line: The message from last week's Fed meeting is that the committee recognizes that the outlook for U.S. growth and inflation has improved. Going forward, we anticipate a more hawkish Fed that is somewhat less responsive to tightening financial conditions. This will keep a floor under Treasury yields and impart volatility to credit spreads. Leveraged Loan Update Chart 9Loan Coupons Will Rise We continue to recommend that investors favor floating rate leveraged loans over fixed rate high-yield bonds in their credit portfolios. The two main reasons for this recommendation are that (i) loans will benefit from higher coupons as the Fed lifts rates and LIBOR resets higher and (ii) loans will benefit from higher recoveries than bonds when the next default cycle occurs. However, somewhat puzzlingly, as 3-month LIBOR has increased during the past few years the coupon return on the S&P Leveraged Loan index has not kept pace. In fact, leveraged loans only started to outperform fixed rate junk a couple of months ago (Chart 9). There are two reasons for this. First, many leveraged loans have LIBOR floors at around 1%, so initial increases in LIBOR in 2016 had no impact on leveraged loan coupons. But 3-month LIBOR is now well above 1%, and yet leveraged loan coupons are still not rising. This is because issuers have been aggressively refinancing loans at lower spreads as LIBOR has increased. This spread compression has kept coupon payments low, but history tells us that this dynamic cannot persist. Eventually, as credit spreads stop tightening near the end of the credit cycle, issuers will not be able to reduce their interest costs through refinancing and will be forced to accept higher coupon payments as interest rates rise. Notice that even though the average price on the S&P Leveraged Loan index was higher between 2004 and 2006 than it is today, that did not prevent loan coupons from rising alongside LIBOR, after some initial lag (Chart 9, bottom panel). Bottom Line: Leveraged loans have not yet started to outperform fixed rate junk bonds, but this will change as we approach the end of the credit cycle and loan coupons follow interest rates higher. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 https://gps.bcaresearch.com/blog/view_blog/460 3 Please see U.S. Bond Strategy Weekly Report, "Brainard Gives The Green Light", dated March 13, 2018, available at usbs.bcaresearch.com 4 A full transcript of the post-meeting press conference: https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20180321.pdf 5 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 6 https://www.frbsf.org/economic-research/files/el2017-35.pdf 7 Please see U.S. Bond Strategy Weekly Report, "Monetary Restraints", dated February 27, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights After the March FOMC Meeting, market pricing for short-term rates is largely consistent with the Fed's forecasts. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. However, the U.S. / China trade disputes will now take center stage. How can investors prepare for the trough in Citigroup Economic Surprise Index? Investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. Feature The S&P 500 fell more than 2% last Thursday after President Trump announced a new round of tariffs aimed at China. Treasury yields drifted modestly lower, and the trade weighted dollar fell 1%. Credit spreads widened. The trade tensions and the softer dollar drove gold up by nearly 3%. Meanwhile, another drawdown in oil inventories drove WTI oil nearly 5% higher. The VIX climbed last week, and has more than doubled since the start of the year. The market largely ignored last week's FOMC meeting. Fed Chair Powell stuck to the script at his first post-meeting press conference, but noted that trade was a topic of discussion. The "...For Inflation" section of this week's report provides more detail on Fed's view of the economy and rates. U.S. risk assets also sold off last week as market participants reacted negatively to Trump's political woes and trade policies. BCA's view is that investors should fade the former and focus on the later. We discuss Trump's political situation, as well as the trade tensions in the second section of this week's report ("...For the Next Tweet"). Nearly all the data in last week's sparse economic calendar exceeded expectations. At 1.8%, the Atlanta Fed GDPNow estimate for Q1 finished the week where it started. An unusual run of harsh winter weather in the Northeastern U.S. in March will keep downward pressure on the Citigroup Economic Surprise Index for the next month or so. We provide more detail on the Citigroup Economic Surprise Index and the performance of risk assets as the index rises and falls in the "...For The Washout" section of this week's report. Moreover, in the final section of the report ("...For The Labor Market"), we discuss how the unemployment rate can get to BCA's target of 3.5% in the next 12 months. ... For Inflation As widely expected, the FOMC last week delivered its sixth rate hike of the cycle and Fed members were more optimistic on the economic outlook. However, U.S. trade policy is a cloud over the outlook. The Fed downgraded its assessment of current economic conditions, but upgraded the outlook. The current pace of economic activity was described as "moderate" and opposed to "solid" in the previous FOMC statement. This reflects some disappointing data releases, which is also apparent in the Atlanta Fed's GDPNow model forecasting just 1.8% growth in Q1. But the Fed does not expect the softness to persist and noted that "the economic outlook has strengthened" (details below in "...For the Washout"). This was reflected in the updated economic projections. GDP growth forecasts were revised to 2.7% and 2.4% for 2018 and 2019, respectively (Chart 1). That's up from 2.5% and 2.1%, and comfortably above the Fed's 1.8% estimate for potential growth. As a consequence, the Fed expects the unemployment rate to drop to 3.6% in 2019, which would be well below the Fed's revised 4.5% estimate of full employment (details below in "...For the Labor Market"). Despite growth being above-trend and the jobless rate falling far below NAIRU, FOMC participants are not forecasting a major acceleration in inflation. From 1.9% in 2018, core PCE inflation is seen fairly steady at 2.1% in 2019 and 2020. To some degree, the upward pressure on inflation will be mitigated by a higher path for the Fed funds rate. Although the median projection remains for three rate hikes this year, the Fed expects slightly faster rate hikes in 2019 and 2020 (Chart 2). The Fed funds rate is now expected to end 2020 at 3.375%, up from 3.125% expected in December. This will put monetary policy on the tighter side of the Fed's 2.875% estimate of the neutral rate. Chart 1The FOMC'S Latest Forecasts Chart 2Market And The Fed In Agreement On Rates Of course, the path of the Fed funds rate will depend on the degree of slack in the economy and the resulting inflationary pressures. The Fed could be underestimating the inflationary pressures associated with a jobless rate that will be nearly 1% below NAIRU. Alternatively, a rising participation rate could slow the decline in the unemployment rate, or the Fed's estimate of NAIRU could get revised much lower. Finally, while the fiscal stimulus is behind the Fed's more optimistic outlook, U.S. trade policy is a growing downside risk (details below in "...For the Next Tweet"). During his press conference, Fed Chair Powell said that FOMC members were aware of the risk, but it was not incorporated into their forecasts. President Trump announced tariffs on China last week. China may then retaliate with its own tariffs. As we've said before, nobody wins from trade wars. Economic activity will be weaker and prices will be higher. A full blown trade war could jeopardize the Fed's rosy forecasts. Bottom Line: Market pricing for short-term rates is largely consistent with the Fed's forecasts. Therefore, the outcome of last week's FOMC meeting is not very market relevant. Investors are more focused on trade policy for now. ... For The Next Tweet BCA is looking beyond any market volatility induced by President Trump's political scandals.1 The decision to impeach President Trump is a purely political decision that rests with the House of Representatives. Under GOP control, Trump will not likely be impeached if he continues to fire his White House aides or members of his cabinet. That is his purview as President. However, relieving Special Counsel Mueller of his duties would probably be a red line for House Republicans and lead to impeachment. That said, it is very difficult to see the impeachment in the House lead to Trump's removal by the Senate, given his elevated approval ratings among GOP voters (Chart 3). Trump's support with GOP voters, our Geopolitical Strategy service's critical measure of whether Trump can stay in power, is back at 2016 election levels with GOP voters (Chart 3). Furthermore, conviction in the Senate (and removal from office), requires 67 votes. If the Democrats take the House, they are likely to impeach Trump in 2019. But even if the Democrats retake the Senate this fall, they would fall far short of that 67-vote threshold for conviction. For investors and the Fed, the health of the economy and earnings matter more than Trump's political woes. Equity markets performed well when the economy and earnings backdrop was favorable during presidential scandals in the 1920s and the 1990s. In the early 1970s, amid soaring inflation and the worst recession since the Great Depression, there was a bear market in equities (Chart 4A). Likewise, surges in equity market volatility amid political scandals were related more to economic and financial events than politics (Chart 4B). Chart 4AFor Markets,##BR##Economy Matters More Than Politics Chart 4BMarket Volatility During##BR##U.S. Political Scandals Today's environment - while not as robust as in the 1920s or late 1990s - provides support for higher stock prices, above-trend economic growth, escalating inflation, three more Fed rate hikes this year, and higher Treasury bond yields. Moreover, none of the issues that investors care about (tax cuts, deregulation, lifting of the spending caps, etc.) can be reversed by Trump's impeachment. Even a Democratic wave in this fall's mid-term Congressional elections will not deliver the opposition party a veto-proof majority (Chart 5). Thus, in the current economic cycle, we expect pro-market forces at the legislative and executive branches of government to persist. Chart 5Democrats's Lead in Generic Congressional##BR##Ballot Has Moved Lower This Year However, Trump's political scandals may cost the GOP the House in this fall's mid-term elections. Table 1 and Chart 6 show that political gridlock is not positive for stock prices after controlling for important macro factors.2 The average monthly return on the S&P 500 is considerably higher when the executive and legislative branches are unified. The worst outcome for equity markets, by far, is when the President faces a split legislature. BCA's Geopolitical Strategy service noted that while the market has cheered the limited scope of tariffs imposed earlier this month, investors may be underestimating the political shifts that underpinned Trump's move. There is little reason to think that protectionism will fade when Trump leaves office. The Administration's decision late last week to introduce sanctions aimed at China represents another escalation of the trade spat initiated in early March. Increased trade tensions with China represent a near-term risk to the markets.3 However, BCA's Geopolitical Strategy team notes that the latest round of tariffs suggests that Trump has made a bid to increase negotiation leverage with China rather than launch a protectionist broadside. This is good news in the short term, relative to the worst fears given Trump's lack of legal/constitutional constraints. But in the long term, Trump's latest move on trade policy support's our view that geopolitical risk is moving to East Asia and the U.S. / China conflict is a high-risk scenario that markets are now going to have to start pricing in.4 Table 1Divided Government Is, In Fact, Bad For Stocks Chart 6A Unified Congress Is A Boon For Stocks Bottom Line: Investors should dismiss the risk of domestic political scandals interrupting the market-friendly policy back drop. However, U.S. / China trade disputes will take center stage. China is motivated to prevent a trade war through significant compromises that Trump can advertise as wins to his audience this November. If Trump accepts these concessions, then the risk of a trade war with China will likely be removed until the next race for President in 2020. ... For The Washout The U.S. economic data have disappointed so far this year, as illustrated by Citigroup Economic Surprise Index (Chart 7). The Index peaked at 84.5 in December 2017 and subsequently has moved lower for 64 days. Since early 2011, there were six other episodes when the Surprise Index behaved similarly. These phases lasted an average of 86 days; the median number of days from peak to trough was 66 days. The implication is that the trough in the Citigroup Economic Surprise reading may be a month or two away. However, the relatively low economic expectations at end-2017 suggest that the disappointment may be truncated. On the other hand, the Tax Cut and Jobs Act of 2017, along with the lifting of budgetary spending caps in early 2018, have likely raised economists' near-term projections. Chart 7U.S. Financial Markets As Economic Surprise Index Declines The performance of key financial markets and commodities since the Economic Surprise Index crested in December 2017 matches the historical record, with a few notable exceptions (Table 2 and Charts 7 and 8). As the Index rolled over in late 2017, stocks beat bonds, credit outperformed Treasuries and the dollar fell, matching previous episodes. However, counter to the historical trend, gold and oil prices have increased and small caps have underperformed in the past three months. Table 2Financial Market Performance As The Economic Surprise Index Falls Chart 8Economic Surprise Approaching A Turning Point Based on BCA's research,5 tactical investors should add to their risk positions as the Citigroup Economic Surprise Index bottoms and begins to climb. As the Economic Surprise Index rises, stocks beat bonds by an average of 8700 bps and in six of the seven episodes since 2011 (Table 3). Furthermore, the performance of stock-to-bond ratio is better when the Economic Surprise Index is accelerating. Table 3 again shows that all asset classes also perform better when the Index climbs. After briefly moving above zero in early 2017 - indicating that inflation data was stronger than analysts projected - the Citigroup Inflation Surprise index rolled over again (Chart 9, top panel) through year end 2017. Reports on the CPI, PPI and average hourly earnings continued to fall short of consensus forecasts despite tightening of the labor and product markets. The disappointment on price data relative to consensus forecasts is not new. Although there were brief periods when prices exceeded forecasts in 2010 and 2011, the last time that inflation exceeded market consensus in this business cycle was in late 2009 and early 2010. In the last few years of the 2001-2007 economic expansion through early 2009, the price data eclipsed forecasts more than half of the time. During this interval, economists underestimated the impact of surging energy prices on inflation readings. Table 3Financial Market Performance As The Economic Surprise Index Rises Chart 9The Fed Cycle And Inflation Surprise Moreover, the Citigroup Inflation Surprise index escalated during previous tightening regimes when the economy was at full employment and the Fed funds rate was in accommodative territory (Chart 9). The last time those conditions were in place, which was in 2005, the Fed was wrapping up a rate increase campaign that began in mid-2004. An increase in the Citigroup Inflation Surprise Index also accompanied most of the Fed's rate hikes from mid-1999 through mid-2000. In late 2015, as the current set of rate hikes commenced, the inflation surprise index was on the upswing, the economy was close to full employment and the Fed funds rate was accommodative. Bottom Line: The disappointing run of economic data will not end for another few months. The unusually harsh winter weather in March in the Northeastern exacerbates the situation. However, the weakness in the economic data is not a sign that a recession is at hand. We expect that the inflation surprise index will continue to grind higher, as unemployment dips further into 'excess demand' territory (details below in "...For The Labor Market"). After the Citigroup Economic Surprise Index forms a bottom and starts to rise, history suggests that stocks will beat bonds, investment-grade and high-yield corporate bonds will outpace Treasuries, and gold and oil will climb. Stay overweight stocks versus bonds, long credit and underweight duration. ... For The Labor Market BCA expects the unemployment rate to hit 3.5% by late 2018 or early next year, the first time since December 1969. Our base case assumes that the economy will generate 200,000 nonfarm payroll jobs per month and that the labor force participation rate will remain at 63%. The unemployment rate was 4.1% in February 2018 and bottomed at 4.4% in 2006 and 2007; the rate reached a 30-year low at 3.8% in 2000. As noted in the first section of this week's report, at the conclusion of last week's meeting, the FOMC nudged down its view of this year's unemployment rate to 3.8%. The FOMC also slightly adjusted its long-term forecast of the unemployment rate to 4.5%. The implication is that BCA and the FOMC expect the U.S. economy to continue to run below full employment this year. Nonetheless, investors remain skeptical that the unemployment rate can fall to 3.5% and wonder what pace of monthly payroll growth would be required to get it there. In Table 4 we look at various scenarios (monthly increases in payrolls, annual percentage change in participation rate) to show when the unemployment rate will dip below 3.5%. In the past three months, total nonfarm payroll employment increased by 242,000 per month, and in the past year, the average monthly increase was 190,000. The participation rate was 63% in February, little changed from a year ago as an improved labor market offset demographic factors that continue to drive down this rate. Our calculations assume that the labor force will expand by 0.9% per year, matching the growth rate in the past 12 months. Chart 10 shows the history of the unemployment rate and several scenarios in the next two years that assume the participation rate stays at 63%. Table 4Dates When 3.5% Unemployment Rate Threshold Is Reached Chart 10The Unemployment Rate Under Various Monthly Job Count Scenarios Bottom Line: BCA's view is that the FOMC's forecast for the unemployment rate at the end of 2018 (3.8%) is too high and only marginally lower than the current 4.1% rate. This is inconsistent with real GDP growth well in excess of its supply-side potential. The macro backdrop will likely justify the FOMC hiking more quickly than the March 2018 dots forecast. The risks are skewed to the upside. BCA expects the 2/10 Treasury yield curve to steepen through mid-year and then flatten by year-end, spending most of 2018 between 0 and 50 bps. Stay underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Policies Are Stimulative Everywhere But China," dated February 28, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report "The South China Sea: Smooth Sailing?," dated March 28, 2017, available at gps.bcaresearch.com. 5 Please see BCA U.S. Investment Strategy Weekly Reports, "Solid Start," dated January 8, 2018 and "The Revenge Of Animal Spirits," dated October 30, 2017. Both available at usis.bcaresearch.com.

Special Report

Dear Client, I am visiting clients in Asia this week and working on our Quarterly Strategy Outlook, which we will be publishing next week. As such, instead of our Weekly Report, we are sending you this Special Report written by my colleague Mathieu Savary, BCA's Chief Foreign Exchange Strategist. Mathieu discusses the current economic situation in Switzerland. While the Swiss economy has healed, the Swiss franc continues to exert structural deflationary pressures on the country. The SNB will do its utmost to engineer further depreciation in the franc versus the euro, but will lag behind the ECB when it comes time to increase interest rates. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Global Strategist Feature Switzerland is experiencing a meaningful economic rebound. The Swiss economy is enjoying real and nominal growth of 1% and 1.4%, respectively, and PMIs are hovering near eight-year highs. As a result, after hitting nadirs of -1.4% and -0.95%, headline and core inflation have both recovered and are clocking in at 0.6% and 0.5%, respectively. Moreover, thanks to economic and political improvements in the euro area, capital has begun to make its way back into the euro. As a result, EUR/CHF has rallied, creating a weaker trade-weighted Swiss franc. This means that while global monetary conditions are beginning to tighten, Swiss monetary conditions have eased in 2017 and 2018. As the Swiss economy improves, will the Swiss National Bank follow in the footsteps of many other major central banks and dial down its accommodative monetary policy? Is it time to sell EUR/CHF? In our view, Swiss domestic economic dynamics remain too fragile to let the Swiss franc appreciate meaningfully. Hence, the SNB will not be able to tighten policy much so long as the European Central Bank keeps rates at current levels. Thus, we would continue to bet on an appreciation of EUR/CHF, punctuated with periodic rallies in the Swiss franc when global volatility occasionally spikes. The Domestic Situation Switzerland's current domestic situation can be traced back to the botched abandonment of the currency peg in 2015. On January 15th, 2015, markets were caught off guard by the sudden removal of the 1.20 floor underpinning EUR/CHF. The SNB provided no forward guidance nor any explanation, and the franc surged 20% against the euro in just one day, tightening monetary conditions severely. Fearing a massive deflationary shock to the Swiss economy, the SNB responded with a large-scale injection of liquidity, expanding its assets from 80% of GDP to more than 120% today, the highest ratio in the G10. To enforce an unofficial floor placed under EUR/CHF of 1.08, Swiss foreign exchange reserves grew rapidly. This expansion in liquidity along with negative policy rates caused 10-year yields to decline to -0.6%. A weak franc and falling yields greatly eased monetary conditions (Chart 1). The current strength in the Swiss economy is a direct response to this extraordinarily accommodative policy setting: In response to loose monetary policy, the velocity of money has accelerated over the past three years, supporting nominal growth (Chart 2); Stronger global growth and a healing banking sector have lifted economic activity in the Eurozone. As a large exporter to both Europe and emerging Asia, Switzerland was a prime beneficiary of this development, providing a tailwind to the SNB's reflationary efforts; Swiss real GDP growth has stabilized and is forecast to accelerate further this year, as highlighted by the vigor of the KOF Composite Leading Indicator (Chart 3); Nominal GDP growth has also picked up due to positive developments in inflation and the reflationary boom of 2017; Improving economic activity has caused the Swiss unemployment rate to decline to 2.9%. Chart 1The SNB Eased Monetary##br## Conditions After January 2015 Chart 2The Velocity Of ##br##Money Has Risen Chart 3Swiss Growth Will ##br##Continue To Recover Based on these improvements, it is natural for investors to question whether the SNB needs to remain an aggressive agent of reflation going forward. However, we do still believe that the Swiss franc will continue to hamper the SNB's ability to tighten policy. Bottom Line: When the SNB scrapped its currency cap against the euro in 2015, the action yielded a near-disastrous outcome for the Swiss economy. However, the Swiss central bank soon eased policy massively in response to this self-inflicted shock, limiting its adverse impact on the Swiss economy and ultimately helping growth recover once global growth rebounded. Now that inflation is also perking back up, the SNB could have to tighten policy. However, the Swiss franc will remain the crucial impediment to doing so. The Swiss Franc Is Still Overvalued Chart 4Basic Balance: Providing Long-Term ##br##Support For The Franc Since Switzerland is a small, open economy - total trade amounts to 118.8% of GDP - the Swiss franc is a powerful determinant of domestic monetary conditions. Last year's 9.7% depreciation of the CHF against the euro and 5.3% decline against its major trading partners allowed the economy to climb out of its deflationary funk. However, the Swiss currency has a secular tendency to appreciate, creating a major problem for the SNB. This currency strength puts downward pressure on inflation and impedes the achievement of inflation targets. Officials are therefore forced to fight off any appreciation in order to stave off disinflationary pressures. While its role as a global safe haven contributes to the natural strength of the franc, several important factors supercharge it: First, the country's consistently low rate of inflation puts upward pressure on the CHF's Purchasing Power Parity fair value. This exacerbates demand for the Swiss franc as a global store of value. This creates a virtuous feedback loop of inflows, a stronger currency, lower inflation, and further inflows. Second, Switzerland sports a large positive net international investment position of 125% of GDP, which generates a net positive international income for Switzerland: 5.3% of GDP annually. Not only does this net positive income generate demand for the franc, but countries with much more international assets than liabilities historically experience appreciating real exchange rates. Third, at 8.5% of GDP, Switzerland has the largest basic balance-of-payments surplus in the G10. It has sported a favorable basic balance vis-à-vis the euro area over the past nine years, generating significant upward pressure on the currency (Chart 4). This basic balance-of-payments advantage is set to remain in place as Switzerland runs a current account surplus, and long-term capital continues to be attracted by Switzerland's low tax rates and investor-friendly climate. Brexit jitters are an additional factor favoring FDI inflows into Switzerland. Fourth, the euro area crisis, its associated double-dip recession and long periods of political risk generated a perception that the euro would break up. This stimulated large capital outflows out of the euro area into stable Switzerland. This created a cyclical boost to the Swiss franc beyond the normal structural positives. The strong upward bias to the CHF is not leaving the SNB unmoved. The Swiss central bank has been vocal in expressing its discontent, arguing that the franc is expensive. However this expensiveness does not seem evident when one looks at EUR/CHF against its Purchasing Power Parity equilibrium (Chart 5). EUR/CHF is only trading at marginal discount to its fair value, implying a small premium for the CHF. The reality is that PPP models do not tell the full story for the franc. When looking at Swiss labor costs, the expensiveness of the Swiss franc becomes obvious (Chart 6). By 2015, Swiss unit labor costs converted into euros had risen by 80% compared to 2000 levels. Even after the recent rally in EUR/CHF, Swiss ULCs are still 60% above their 2000 levels, implying a great loss of competitiveness than that experienced by Italy or France over the same timeframe. The Swiss franc may be attractive as a store of value, but this is now hurting the Swiss economy. Chart 5Modest Apparent Overvaluation##br##On A PPP Basis... Chart 6...But An Evident Overvaluation ##br##On A Labor Costs Basis Bottom Line: Thanks to Switzerland's low inflation, large positive net international investment position and basic balance-of-payments surplus, and its safe-haven status, the Swiss franc has been on an appreciating secular trend. Moreover, this long-term strength has been supercharged by the euro area crisis. The CHF has now made Switzerland uncompetitive. Avoiding The Specter Of Irving Fisher If the CHF is expensive, making the Swiss economy uncompetitive, why does Switzerland still have a trade surplus of 11% of GDP, and why is the Swiss unemployment rate not greater than 2.9%? One side of the answer relates to the behavior of Swiss export prices. When the franc is strong, Swiss exporters cut down the price of their products in order to remain competitive abroad (Chart 7). However, the story does not end there. The flexible nature of the Swiss labor market provides an offset to buffer corporate profitability. According to the World Economic Forum, Switzerland has the most efficient labor market in the world, well ahead of other major continental European economies (Chart 8). Swiss employers therefore hold the upper hand in labor negotiations. Chart 7A Strong Swiss Franc Hurts Selling Prices Chart 8The Swiss Labor Market Is Very Flexible In order to contain labor costs, companies have shifted the composition of the labor force. Full-time employment has been contracting since 2016 while all the jobs created have been part-time positions (Chart 9), resulting in elevated labor underutilization. Additionally, employers have been able to exact important concessions from workers, further depressing wage growth, which has averaged 0.5% per annum over the past three years (Chart 9, bottom panel). Low wage growth and labor underemployment have weighed on inflation through two channels: First, the Phillips curve is alive and well in Switzerland, and the current level of unemployment is consistent with low inflationary pressures (Chart 10). Chart 9The Swiss Job Market Is Weaker Than It Looks Chart 10The Swiss Phillips Curve Is Alive Second, low wage growth has translated into subdued household income gains. But at 216% of disposable income, Swiss households have one of the highest debt levels in the OECD. Without income growth, consumption growth has been limited. Swiss real retail sales have been falling more or less in a straight line since 2014 (Chart 11). In essence, the Swiss economy is experiencing a deflationary adjustment similar to the one undergone by Germany in the wake of the Hartz IV reforms implemented in 2005. These reforms put downward pressure on German wages and domestic demand, and fomented deflationary forces. However, 2005 was another era. The negative impact on German demand was buffeted by the extraordinary strength of the global economy, which boosted German exports. Switzerland does not enjoy this luxury: Since the Great Financial Crisis, global growth has been more muted, and global trade is not expanding anymore (Chart 12). Chart 11Regaining Competitiveness ##br##Is Hurting Domestic Demand Chart 12Germany Had ##br##It Easy Because of this lack of a foreign relief valve, weakness in the domestic economy has had another pernicious impact: Switzerland has not experienced any productivity growth since the Great Financial Crisis (Chart 13). As a consequence, the Swiss output gap remains in negative territory, further exacerbating the deflationary pressures created by the expensive Swiss franc (Chart 14). It is unsurprising that despite a massive surge in the central bank's balance sheet, generating inflation remains difficult in Switzerland. Chart 13No Productivity Growth Since 2008 Chart 14Swiss Output Gap Is Negative Finally, even the Swiss price measures theoretically unaffected by the output gap are declining. Owner-occupied home prices are contracting at a pace of 1% per annum (Chart 15). Since 2013, net migration in Switzerland has been declining, weighing on demand for housing. The 2014 referendum to curb immigration, put forward by the right-wing Swiss People's Party, has only added further downward impetus to immigration. Chart 15Real Estate Is Deflationary When deflationary forces are as strong and well-entrenched as they are in Switzerland, and when the economy is burdened by a large debt load - Swiss nonfinancial debt stands at 248% of GDP, the highest in the G10 - a nation runs the risk of entering into the debt-deflation spiral described by Irving Fisher in 1933.1 Falling prices can force a liquidation of debt, which forces further contraction in nominal output, forcing more debt liquidation, and so on. Calling a great depression in Switzerland is too radical, but the country could experience a Japanese scenario of many lost decades if inflation does not return. Therefore, it is no wonder that the SNB is obsessed with keeping monetary conditions as accommodative as possible. Since the exchange rate has a disproportionate impact on monetary conditions for economies as open as Switzerland, this means the SNB is likely to continue to target a weaker Swiss franc for longer. Bottom Line: An expensive Swiss franc has not caused the Swiss economy to experience a trade deficit because the Swiss labor market is so flexible. Instead, an expensive CHF has generated acute downward pressures on wages, domestic demand, and prices. This deflationary environment is especially dangerous for Switzerland as its private sector is massively over-indebted, raising the specter of the debt-deflation spiral described by Irving Fisher. The SNB will keep fighting these dynamics. What's In Store For The SNB? Chart 16Bern Is Tight-Fisted If Swiss fiscal policy was very easy, monetary policy would not have to be as accommodative. After all, Switzerland has fiscal legroom. Government net debt stands at 23% of GDP, the overall fiscal balance is at zero, and Bern enjoys a small cyclically-adjusted primary surplus of 0.3% of GDP. Moreover, after having purchased massive amounts of euros, the SNB is expecting to generate a profit of CHF54 billion in 2017 in the wake of the rally in EUR/CHF. Each canton is set to receive an additional windfall of CHF1 billion in addition to the normal CHF1 billion dividend they normally receive. The country's conservative fiscal management, however, means that the fiscal spigot will not be opened. The so-called "debt brake" rule introduced in 2003 requires a balanced cyclically-adjusted federal budget on an ex ante basis, and in cases of ex post over- and under-spending, offsetting surpluses and deficits in subsequent years as required. As a result, the IMF forecasts that the fiscal thrust will remain near zero for the coming years (Chart 16). Fiscal policy will therefore not come to the rescue. This means the SNB will want to ease monetary conditions further to push demand and inflation back up. Therefore, the SNB will continue to target a weaker CHF in the coming years. Chart 17The SNB Will Keep Rates Below The ECB... Despite this outcome, life for the SNB is getting easier, and its balance sheet will not expand much further. Euro area growth has been recovering, and European political instability has declined. As a result, the probability of a euro breakup has dropped, and rate of returns in the Eurozone have increased. Consequently, hot money flows into Switzerland have abated and the SNB has not had to increase its sight deposits - a key measure of its involvement in the FX market - to push the Swiss franc down. However, to ensure the CHF enjoys a structural downtrend, the SNB will have to keep interest rates across the yield curve below euro area levels, especially as the Swiss leading economic indicator is currently outpacing that of the Eurozone's, which normally coincides with a weaker EUR/CHF (Chart 17). This does not mean that the SNB will cut rates further. European bond yields are moving up and the ECB is slated to increase rates in the summer of 2019. This means that the SNB will not adjust policy until after the ECB does. Doing otherwise would put upward pressure on the Swiss franc - exactly what the SNB wants to avoid at all costs. The SNB is likely to keep this policy in place until the Swiss franc trades at a significant discount to the euro. In our assessment, this means a EUR/CHF exchange rate of around 1.30. Bottom Line: The various levels of the Swiss government have no inclination to ease fiscal policy. The burden of stimulating growth and inflation will continue to rest squarely on the SNB's shoulders, which means it will keep targeting a lower CHF. Thanks to economic and political improvements in the euro area, the SNB can curtail its direct involvement in the FX market. However, creating a negative carry against the CHF will remain the main tool in the SNB's arsenal, so Swiss policy rates will lag the euro area. This policy will remain in place until EUR/CHF trades closer to 1.30. Investment Implications At this juncture, the primary trend in EUR/CHF continues to point upward. The ECB is giving firmer signals that its asset purchasing program will end this September. The implementation of this program was associated with massive outflows of long-term capital out of the euro area (Chart 18). Its end is likely to limit outflows to Switzerland. Additionally, lower Swiss interest rates will continue to hurt the trade-weighted Swiss franc. While the primary trend for EUR/CHF points north, we worry that it will not be a one-way street as it was in 2017. As we have highlighted, Switzerland enjoys a large net international investment position, and its incredibly low interest rates have made the Swissie a funding currency. These attributes also make the CHF a safe-haven currency. Therefore, the franc is likely to rally each time global volatility picks up.2 While BCA expects risk assets to continue to appreciate through most of 2018, prices are likely to become more volatile: China is tightening policy and global central banks are progressively removing monetary accommodation in response to a slow return of inflation.3 These bouts of volatility will cause the occasional selloff in EUR/CHF along the way. The surge in the VIX on February 5th of this year provided a good template for the kind of gyrations that EUR/CHF will likely experience. Nonetheless, despite these occasional surges in volatility, we do expect EUR/CHF to end the year closer to 1.30. In fact, the return of volatility will further ensure that the SNB will lag the ECB in tightening policy. Finally, investors looking to buy EUR/CHF but who worry about these occasional bouts of volatility may hedge this trade by buying put options on AUD/CHF. This cross tends to experience more violent selloffs than EUR/CHF when global volatility rises, and it is furiously expensive on a long-term basis (Chart 19). Moreover, the balance-of-payments picture is very attractive for shorting this pair, as Australia runs a current account deficit of 2.3% of GDP, while Switzerland runs a surplus of 10%. Chart 18...But It Will Be Less Active In The FX Market Chart 19Short AUD/CHF As A Hedge Bottom Line: EUR/CHF is likely to appreciate to 1.30 this year as the SNB will lag the ECB when it comes to removing monetary accommodation. This trend is likely to be punctuated by violent selloffs associated with the return of volatility in global financial markets. Buying puts on AUD/CHF is an attractive way to hedge this risk. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Irving Fisher (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, No. 4 (Oct., 1933), pp. 337 - 357. 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More Than Pennies And Steamrollers," dated May 6, 2016, available at fes.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com; and Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility," dated March 16, 2018, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature Switzerland is experiencing a meaningful economic rebound. The Swiss economy is enjoying real and nominal growth of 1% and 1.4%, respectively, and PMIs are hovering near eight-year highs. As a result, after hitting nadirs of -1.4% and -0.95%, headline and core inflation have both recovered and are clocking in at 0.6% and 0.5%, respectively. Moreover, thanks to economic and political improvements in the euro area, capital has begun to make its way back into the euro. As a result, EUR/CHF has rallied, creating a weaker trade-weighted Swiss franc. This means that while global monetary conditions are beginning to tighten, Swiss monetary conditions have eased in 2017 and 2018. As the Swiss economy improves, will the Swiss National Bank follow in the footsteps of many other major central banks and dial down its accommodative monetary policy? Is it time to sell EUR/CHF? In our view, Swiss domestic economic dynamics remain too fragile to let the Swiss franc appreciate meaningfully. Hence, the SNB will not be able to tighten policy much so long as the European Central Bank keeps rates at current levels. Thus, we would continue to bet on an appreciation of EUR/CHF, punctuated with periodic rallies in the Swiss franc when global volatility occasionally spikes. The Domestic Situation Switzerland's current domestic situation can be traced back to the botched abandonment of the currency peg in 2015. On January 15th, 2015, markets were caught off guard by the sudden removal of the 1.20 floor underpinning EUR/CHF. The SNB provided no forward guidance nor any explanation, and the franc surged 20% against the euro in just one day, tightening monetary conditions severely. Fearing a massive deflationary shock to the Swiss economy, the SNB responded with a large-scale injection of liquidity, expanding its assets from 80% of GDP to more than 120% today, the highest ratio in the G10. To enforce an unofficial floor placed under EUR/CHF of 1.08, Swiss foreign exchange reserves grew rapidly. This expansion in liquidity along with negative policy rates caused 10-year yields to decline to -0.6%. A weak franc and falling yields greatly eased monetary conditions (Chart 1). The current strength in the Swiss economy is a direct response to this extraordinarily accommodative policy setting: In response to loose monetary policy, the velocity of money has accelerated over the past three years, supporting nominal growth (Chart 2); Stronger global growth and a healing banking sector have lifted economic activity in the Eurozone. As a large exporter to both Europe and emerging Asia, Switzerland was a prime beneficiary of this development, providing a tailwind to the SNB's reflationary efforts; Swiss real GDP growth has stabilized and is forecast to accelerate further this year, as highlighted by the vigor of the KOF Composite Leading Indicator (Chart 3); Nominal GDP growth has also picked up due to positive developments in inflation and the reflationary boom of 2017; Improving economic activity has caused the Swiss unemployment rate to decline to 2.9%. Chart 1The SNB Eased Monetary##br## Conditions After January 2015 Chart 2The Velocity Of ##br##Money Has Risen Chart 3Swiss Growth Will ##br##Continue To Recover Based on these improvements, it is natural for investors to question whether the SNB needs to remain an aggressive agent of reflation going forward. However, we do still believe that the Swiss franc will continue to hamper the SNB's ability to tighten policy. Bottom Line: When the SNB scrapped its currency cap against the euro in 2015, the action yielded a near-disastrous outcome for the Swiss economy. However, the Swiss central bank soon eased policy massively in response to this self-inflicted shock, limiting its adverse impact on the Swiss economy and ultimately helping growth recover once global growth rebounded. Now that inflation is also perking back up, the SNB could have to tighten policy. However, the Swiss franc will remain the crucial impediment to doing so. The Swiss Franc Is Still Overvalued Chart 4Basic Balance: Providing Long-Term ##br##Support For The Franc Since Switzerland is a small, open economy - total trade amounts to 118.8% of GDP - the Swiss franc is a powerful determinant of domestic monetary conditions. Last year's 9.7% depreciation of the CHF against the euro and 5.3% decline against its major trading partners allowed the economy to climb out of its deflationary funk. However, the Swiss currency has a secular tendency to appreciate, creating a major problem for the SNB. This currency strength puts downward pressure on inflation and impedes the achievement of inflation targets. Officials are therefore forced to fight off any appreciation in order to stave off disinflationary pressures. While its role as a global safe haven contributes to the natural strength of the franc, several important factors supercharge it: First, the country's consistently low rate of inflation puts upward pressure on the CHF's Purchasing Power Parity fair value. This exacerbates demand for the Swiss franc as a global store of value. This creates a virtuous feedback loop of inflows, a stronger currency, lower inflation, and further inflows. Second, Switzerland sports a large positive net international investment position of 125% of GDP, which generates a net positive international income for Switzerland: 5.3% of GDP annually. Not only does this net positive income generate demand for the franc, but countries with much more international assets than liabilities historically experience appreciating real exchange rates. Third, at 8.5% of GDP, Switzerland has the largest basic balance-of-payments surplus in the G10. It has sported a favorable basic balance vis-à-vis the euro area over the past nine years, generating significant upward pressure on the currency (Chart 4). This basic balance-of-payments advantage is set to remain in place as Switzerland runs a current account surplus, and long-term capital continues to be attracted by Switzerland's low tax rates and investor-friendly climate. Brexit jitters are an additional factor favoring FDI inflows into Switzerland. Fourth, the euro area crisis, its associated double-dip recession and long periods of political risk generated a perception that the euro would break up. This stimulated large capital outflows out of the euro area into stable Switzerland. This created a cyclical boost to the Swiss franc beyond the normal structural positives. The strong upward bias to the CHF is not leaving the SNB unmoved. The Swiss central bank has been vocal in expressing its discontent, arguing that the franc is expensive. However this expensiveness does not seem evident when one looks at EUR/CHF against its Purchasing Power Parity equilibrium (Chart 5). EUR/CHF is only trading at marginal discount to its fair value, implying a small premium for the CHF. The reality is that PPP models do not tell the full story for the franc. When looking at Swiss labor costs, the expensiveness of the Swiss franc becomes obvious (Chart 6). By 2015, Swiss unit labor costs converted into euros had risen by 80% compared to 2000 levels. Even after the recent rally in EUR/CHF, Swiss ULCs are still 60% above their 2000 levels, implying a great loss of competitiveness than that experienced by Italy or France over the same timeframe. The Swiss franc may be attractive as a store of value, but this is now hurting the Swiss economy. Chart 5Modest Apparent Overvaluation##br##On A PPP Basis... Chart 6...But An Evident Overvaluation ##br##On A Labor Costs Basis Bottom Line: Thanks to Switzerland's low inflation, large positive net international investment position and basic balance-of-payments surplus, and its safe-haven status, the Swiss franc has been on an appreciating secular trend. Moreover, this long-term strength has been supercharged by the euro area crisis. The CHF has now made Switzerland uncompetitive. Avoiding The Specter Of Irving Fisher If the CHF is expensive, making the Swiss economy uncompetitive, why does Switzerland still have a trade surplus of 11% of GDP, and why is the Swiss unemployment rate not greater than 2.9%? One side of the answer relates to the behavior of Swiss export prices. When the franc is strong, Swiss exporters cut down the price of their products in order to remain competitive abroad (Chart 7). However, the story does not end there. The flexible nature of the Swiss labor market provides an offset to buffer corporate profitability. According to the World Economic Forum, Switzerland has the most efficient labor market in the world, well ahead of other major continental European economies (Chart 8). Swiss employers therefore hold the upper hand in labor negotiations. Chart 7A Strong Swiss Franc Hurts Selling Prices Chart 8The Swiss Labor Market Is Very Flexible In order to contain labor costs, companies have shifted the composition of the labor force. Full-time employment has been contracting since 2016 while all the jobs created have been part-time positions (Chart 9), resulting in elevated labor underutilization. Additionally, employers have been able to exact important concessions from workers, further depressing wage growth, which has averaged 0.5% per annum over the past three years (Chart 9, bottom panel). Low wage growth and labor underemployment have weighed on inflation through two channels: First, the Phillips curve is alive and well in Switzerland, and the current level of unemployment is consistent with low inflationary pressures (Chart 10). Chart 9The Swiss Job Market Is Weaker Than It Looks Chart 10The Swiss Phillips Curve Is Alive Second, low wage growth has translated into subdued household income gains. But at 216% of disposable income, Swiss households have one of the highest debt levels in the OECD. Without income growth, consumption growth has been limited. Swiss real retail sales have been falling more or less in a straight line since 2014 (Chart 11). In essence, the Swiss economy is experiencing a deflationary adjustment similar to the one undergone by Germany in the wake of the Hartz IV reforms implemented in 2005. These reforms put downward pressure on German wages and domestic demand, and fomented deflationary forces. However, 2005 was another era. The negative impact on German demand was buffeted by the extraordinary strength of the global economy, which boosted German exports. Switzerland does not enjoy this luxury: Since the Great Financial Crisis, global growth has been more muted, and global trade is not expanding anymore (Chart 12). Chart 11Regaining Competitiveness ##br##Is Hurting Domestic Demand Chart 12Germany Had ##br##It Easy Because of this lack of a foreign relief valve, weakness in the domestic economy has had another pernicious impact: Switzerland has not experienced any productivity growth since the Great Financial Crisis (Chart 13). As a consequence, the Swiss output gap remains in negative territory, further exacerbating the deflationary pressures created by the expensive Swiss franc (Chart 14). It is unsurprising that despite a massive surge in the central bank's balance sheet, generating inflation remains difficult in Switzerland. Chart 13No Productivity Growth Since 2008 Chart 14Swiss Output Gap Is Negative Finally, even the Swiss price measures theoretically unaffected by the output gap are declining. Owner-occupied home prices are contracting at a pace of 1% per annum (Chart 15). Since 2013, net migration in Switzerland has been declining, weighing on demand for housing. The 2014 referendum to curb immigration, put forward by the right-wing Swiss People's Party, has only added further downward impetus to immigration. Chart 15Real Estate Is Deflationary When deflationary forces are as strong and well-entrenched as they are in Switzerland, and when the economy is burdened by a large debt load - Swiss nonfinancial debt stands at 248% of GDP, the highest in the G10 - a nation runs the risk of entering into the debt-deflation spiral described by Irving Fisher in 1933.1 Falling prices can force a liquidation of debt, which forces further contraction in nominal output, forcing more debt liquidation, and so on. Calling a great depression in Switzerland is too radical, but the country could experience a Japanese scenario of many lost decades if inflation does not return. Therefore, it is no wonder that the SNB is obsessed with keeping monetary conditions as accommodative as possible. Since the exchange rate has a disproportionate impact on monetary conditions for economies as open as Switzerland, this means the SNB is likely to continue to target a weaker Swiss franc for longer. Bottom Line: An expensive Swiss franc has not caused the Swiss economy to experience a trade deficit because the Swiss labor market is so flexible. Instead, an expensive CHF has generated acute downward pressures on wages, domestic demand, and prices. This deflationary environment is especially dangerous for Switzerland as its private sector is massively over-indebted, raising the specter of the debt-deflation spiral described by Irving Fisher. The SNB will keep fighting these dynamics. What's In Store For The SNB? Chart 16Bern Is Tight-Fisted If Swiss fiscal policy was very easy, monetary policy would not have to be as accommodative. After all, Switzerland has fiscal legroom. Government net debt stands at 23% of GDP, the overall fiscal balance is at zero, and Bern enjoys a small cyclically-adjusted primary surplus of 0.3% of GDP. Moreover, after having purchased massive amounts of euros, the SNB is expecting to generate a profit of CHF54 billion in 2017 in the wake of the rally in EUR/CHF. Each canton is set to receive an additional windfall of CHF1 billion in addition to the normal CHF1 billion dividend they normally receive. The country's conservative fiscal management, however, means that the fiscal spigot will not be opened. The so-called "debt brake" rule introduced in 2003 requires a balanced cyclically-adjusted federal budget on an ex ante basis, and in cases of ex post over- and under-spending, offsetting surpluses and deficits in subsequent years as required. As a result, the IMF forecasts that the fiscal thrust will remain near zero for the coming years (Chart 16). Fiscal policy will therefore not come to the rescue. This means the SNB will want to ease monetary conditions further to push demand and inflation back up. Therefore, the SNB will continue to target a weaker CHF in the coming years. Chart 17The SNB Will Keep Rates Below The ECB... Despite this outcome, life for the SNB is getting easier, and its balance sheet will not expand much further. Euro area growth has been recovering, and European political instability has declined. As a result, the probability of a euro breakup has dropped, and rate of returns in the Eurozone have increased. Consequently, hot money flows into Switzerland have abated and the SNB has not had to increase its sight deposits - a key measure of its involvement in the FX market - to push the Swiss franc down. However, to ensure the CHF enjoys a structural downtrend, the SNB will have to keep interest rates across the yield curve below euro area levels, especially as the Swiss leading economic indicator is currently outpacing that of the Eurozone's, which normally coincides with a weaker EUR/CHF (Chart 17). This does not mean that the SNB will cut rates further. European bond yields are moving up and the ECB is slated to increase rates in the summer of 2019. This means that the SNB will not adjust policy until after the ECB does. Doing otherwise would put upward pressure on the Swiss franc - exactly what the SNB wants to avoid at all costs. The SNB is likely to keep this policy in place until the Swiss franc trades at a significant discount to the euro. In our assessment, this means a EUR/CHF exchange rate of around 1.30. Bottom Line: The various levels of the Swiss government have no inclination to ease fiscal policy. The burden of stimulating growth and inflation will continue to rest squarely on the SNB's shoulders, which means it will keep targeting a lower CHF. Thanks to economic and political improvements in the euro area, the SNB can curtail its direct involvement in the FX market. However, creating a negative carry against the CHF will remain the main tool in the SNB's arsenal, so Swiss policy rates will lag the euro area. This policy will remain in place until EUR/CHF trades closer to 1.30. Investment Implications At this juncture, the primary trend in EUR/CHF continues to point upward. The ECB is giving firmer signals that its asset purchasing program will end this September. The implementation of this program was associated with massive outflows of long-term capital out of the euro area (Chart 18). Its end is likely to limit outflows to Switzerland. Additionally, lower Swiss interest rates will continue to hurt the trade-weighted Swiss franc. While the primary trend for EUR/CHF points north, we worry that it will not be a one-way street as it was in 2017. As we have highlighted, Switzerland enjoys a large net international investment position, and its incredibly low interest rates have made the Swissie a funding currency. These attributes also make the CHF a safe-haven currency. Therefore, the franc is likely to rally each time global volatility picks up.2 While BCA expects risk assets to continue to appreciate through most of 2018, prices are likely to become more volatile: China is tightening policy and global central banks are progressively removing monetary accommodation in response to a slow return of inflation.3 These bouts of volatility will cause the occasional selloff in EUR/CHF along the way. The surge in the VIX on February 5th of this year provided a good template for the kind of gyrations that EUR/CHF will likely experience. Nonetheless, despite these occasional surges in volatility, we do expect EUR/CHF to end the year closer to 1.30. In fact, the return of volatility will further ensure that the SNB will lag the ECB in tightening policy. Finally, investors looking to buy EUR/CHF but who worry about these occasional bouts of volatility may hedge this trade by buying put options on AUD/CHF. This cross tends to experience more violent selloffs than EUR/CHF when global volatility rises, and it is furiously expensive on a long-term basis (Chart 19). Moreover, the balance-of-payments picture is very attractive for shorting this pair, as Australia runs a current account deficit of 2.3% of GDP, while Switzerland runs a surplus of 10%. Chart 18...But It Will Be Less Active In The FX Market Chart 19Short AUD/CHF As A Hedge Bottom Line: EUR/CHF is likely to appreciate to 1.30 this year as the SNB will lag the ECB when it comes to removing monetary accommodation. This trend is likely to be punctuated by violent selloffs associated with the return of volatility in global financial markets. Buying puts on AUD/CHF is an attractive way to hedge this risk. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com 1 Irving Fisher (1933), “The Debt-Deflation Theory of Great Depressions,” Econometrica, Vol. 1, No. 4 (Oct., 1933), pp. 337 - 357. 2 Please see Foreign Exchange Strategy Special Report, "Carry Trades: More Than Pennies And Steamrollers," dated May 6, 2016, available at fes.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "Take Out Some Insurance," dated February 2, 2018, available at gis.bcaresearch.com; and Foreign Exchange Strategy Weekly Report, "The Return Of Macro Volatility," dated March 16, 2018, available at fes.bcaresearch.com. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Fed preview: The Fed will hike rates again this week, and may signal a faster pace of future hikes given signs that U.S. inflation is starting to accelerate. Maintain a below-benchmark duration stance and stay underweight U.S. Treasuries in global hedged bond portfolios. Oversold U.S. Treasuries: While most indicators of positioning and momentum for U.S. Treasuries show a deeply oversold market, an analysis of past such episodes shows that it can take 4-6 months before bond yields correct an oversold condition in the absence of slowing growth or inflation - with yields potentially hitting new highs in the interim. ECB Tapering: The ECB strongly believes that the "stock effect" of its asset purchases matters more for European bond yields than the "flow effect". This suggests that the odds of a European "Taper Tantrum" later this year are low, although bond yields there are still headed higher. Feature Chart of the WeekThis Time Is Different? Global bond markets have calmed down after the big surge that started the year. The 10-year U.S. Treasury yield has traded in a relatively narrow 2.80-2.95% range since the VIX spike in early February, despite a string of weaker-than-expected U.S. economic data prints that has triggered sharp downgrades to Q1/2018 U.S. GDP growth forecasts. At the same time, 10-year benchmark yields for other major government bond markets (Germany, France, U.K., Canada) have been drifting lower, but remain above levels that began the year. In the case of U.S. Treasuries, the overall level of yields is being held up by the steady climb at the short-end of the yield curve. Recent hawkish comments from new Fed Chairman Jay Powell and long-time Fed dove Lael Brainard have raised expectations for a rate hike at this week's FOMC meeting, which is now priced as a certainty. The 2-year Treasury yield has climbed to a 10-year high of 2.3%, which is helping keep a floor underneath longer-term Treasury yields despite positioning indicators showing that traders and bond managers already have significantly reduced duration exposure (Chart of the Week). The other factor that is likely holding up global bond yields is the incremental move by the European Central Bank (ECB) towards a tapering of its asset purchases. The market has already repriced both future interest rate expectations and the term premia embedded in European government bond yields, although recent comments from ECB officials suggest that they believe that there will not be a "Taper Tantrum 2.0" in Europe similar to the Treasury market sell-off in 2013. This week, we tackle those two critical issues for bond markets head-on: the implications of large short positions in the U.S. Treasury market versus the ECB taper impact on global bond yields. Our conclusion is that the impact of both is likely overestimated by investors. How To Think About A Technically Oversold Treasury Market The Fed will deliver another rate hike this week. That outcome has already been fully discounted by the market, which should not be considered surprising given the current U.S. economic backdrop: Inflation: Underlying inflation has clearly bottomed out and has begun to accelerate, with the 3-month annualized growth rate of core CPI inflation now up over 3% (Chart 2). That trend should continue in the next several months: our model for CPI Shelter inflation is calling for a pickup (2nd panel), core goods inflation is showing signs of responding to the weakening U.S. dollar (3rd panel), and the big plunge in U.S. wireless phone prices that severely dampened inflation in 2017 is about to wash out of the year-over-year CPI data and boost core services inflation (bottom panel). Growth: Despite some recent signs of softening momentum in the Q1 data, the underlying trend in U.S. growth remains upbeat. Labor demand is accelerating and our payrolls growth model suggests further gains are coming (Chart 3). Corporate profit growth remains solid and the impact of the Trump tax cuts will only boost earnings momentum and business confidence. Leading economic indicators are also accelerating and suggest that any loss of growth momentum in Q1 - which seems to be an annual occurrence despite the seasonal adjustment of data - will be short-lived (bottom panel). Chart 2U.S. Inflation Is Starting To Perk Up Chart 3No Reason For Any Dovish Fed Surprises Financial Conditions: U.S. equity prices have recovered much of the losses suffered during the February VIX-driven correction, while corporate credit spreads remain narrow from a historical perspective (Chart 4). Add in the weaker U.S. dollar - the impact of which is already boosting import prices and potentially following through into the shorter-term inflation expectations of households (bottom panel) - and overall financial conditions remain highly accommodative. Against this positive backdrop, the Fed can feel confident that its growth and inflation forecasts for 2018 will be achieved, and that inflation expectations can continue to climb back to levels consistent with the Fed's inflation target. There is even a chance that the Fed could accelerate its planned pace of rate hikes (Chart 5), particularly if there is an upgrade to the FOMC growth and inflation projections, which will be updated for this week's meeting. Chart 4U.S. Financial Conditions##BR##Remain Accommodative Chart 5All Eyes On##BR##The Dots This Week Yet for all the positive economic, bond-bearish news, one fact stands out - the U.S. Treasury market is deeply oversold from a technical perspective. This should, in theory, limit the ability for bond yields to continue rising and could set up a short-covering bond rally if there is a more meaningful and prolonged slowing of economic growth or inflation. The technical indicators that we regularly monitor for the U.S. Treasury market are all at or near the extremes of the ranges observed since 2000 (Chart 6). Chart 6U.S. Treasuries Are Very Oversold The 10-year Treasury yield is 43bps above its 200-day moving average The 26-week total return of the Bloomberg Barclays U.S. Treasury index is -4.3% The J.P. Morgan client survey of bond managers and traders showed the largest underweight duration positioning since the mid-2000s, although there has been some recent reduction of those positions The Market Vane index of sentiment for Treasuries is now at 49, near the bottom of the range since 2000 The CFTC data on positioning in 10-year Treasury futures shows a large net short of -8%, scaled by open interest Given this degree of investor negativity toward U.S. Treasuries, some pullback in yields seems inevitable. However, a look back at past episodes where Treasuries were this oversold shows that the timing of such a pullback is highly variable - anywhere from one month to seven months. The determining factor is the growth and inflation backdrop in the U.S. To show this, we did a simple study using two series from our list of Treasury technical indicators. Specifically, we looked at "oversold episodes" since 2000 where the Market Vane Treasury sentiment index dipped below 50 and where the 10-year Treasury yield was trading at least 30bps above its 200-day moving average. We then defined the end of the oversold episode as simply the point when the 10-year Treasury yield fell back below its 200-day moving average. We then looked at the duration (in days), and change in bond yields, for each oversold episode. There were eleven such episodes since the year 2000, not counting the current one which has not yet ended. In Table 1, we list them ranked by the number of days it took to complete each episode as we defined it. The longest correction of an oversold Treasury market since 2000 took place between July 2003 and February 2004, where 203 days passed before the 10-year yield dipped back below its 200-day moving average. The shortest correction was in May 2000, where only 28 days were needed. Table 1A Look At Prior Episodes Of An Oversold U.S. Treasury Market To determine what the U.S. economic backdrop was during each episode, we then simply asked if economic growth was rising or falling, or if inflation was stable/rising or falling, using the ISM Manufacturing index and core PCE inflation as the relevant data series. The answers to those questions are found in the final two columns of Table 1. All the positioning and economic indicators used in our historical study, shaded for the oversold episodes, are shown in Charts 7, 8 and 9. Chart 7U.S. Treasury Market##BR##Oversold Episodes 2000-2005 Chart 8U.S. Treasury Market##BR##Oversold Episodes 2006-2011 Chart 9U.S. Treasury Market##BR##Oversold Episodes 2011 To Today The simplest conclusion that we reached from our study is that the shortest corrections of an oversold Treasury market occurred, unsurprisingly, during the two episodes where both growth and inflation were slowing, with an average length of each episode of 42 days. The four episodes where growth and inflation were both rising had a more variable performance, lasting anywhere from 98 days to 203 days, averaging 156 days per episode. The five episodes where growth was slowing but inflation was stable or rising were also of varying length, averaging 140 days. In other words, it has taken around five months, on average, to correct an oversold Treasury market when inflation was stable or rising, and about 1.5 months when inflation was falling. In the current environment, where the ISM Manufacturing index is in an uptrend and core PCE inflation is rising, we should expect a longer period of time before the Treasury market corrects its oversold condition. If we mark the start of the current episode on February 20th of this year, using the definition described above, then the 10-year Treasury yield may return to its 200-day moving average of 2.4% by August (five months from now). A word of warning for traders and investors looking to play for that move by flipping to a long duration position now, though - the primary trend of the market, defined by that 200-day moving average, is currently rising. It was also rising during the two longest oversold correction episodes 2003-04 and 2013-14. The 10-year Treasury yield only declined -14bps and -17bps, respectively, over those entire episodes. During the 2013-14 episode, also a period similar to today when growth and inflation were both rising, yields actually climbed to new cyclical highs before finally peaking. In other words, betting on a reversal of an oversold bond market without any deterioration in growth and inflation dynamics may generate only modest returns over a lengthy period, and with substantial mark-to-market volatility in the meantime. In the current cycle, with leading indicators for U.S. growth and inflation accelerating and the Fed becoming more hawkish, we recommend maintaining below-benchmark duration positions in the U.S. rather than positioning now for a short-covering rally. Bottom Line: The Fed will hike rates again this week, and may signal a faster pace of future hikes given signs that U.S. inflation is starting to accelerate. While most indicators of positioning and momentum for U.S. Treasuries show a deeply oversold market, an analysis of past such episodes shows that it can take 4-6 months before bond yields correct an oversold condition in the absence of a slowing of economic growth or inflation - with yields potentially hitting new highs in the interim. Maintain a below-benchmark duration stance and stay underweight U.S. Treasuries in global hedged bond portfolios. The ECB Is Betting On A Tantrum-Free Taper Several key ECB officials have been giving speeches over the past week, spelling out a consistent message to the markets on the future of euro area monetary policy. Most notably, ECB President Mario Draghi and ECB Chief Economist Peter Praet gave speeches last week at a conference in Frankfurt. Both of them used nearly identical language to highlight how the ECB's main policy tool going forward will no longer be net asset purchases, but instead will be interest rates and forward guidance on changes to rates.1 This echoes the message sent after the ECB's policy meeting earlier this month, when the commitment to increase the pace of asset purchases was dropped from the ECB policy statement. Both Draghi and Praet repeated the ECB's official stance on the end of asset purchases, which requires a "sustained adjustment" in the path of inflation. This was described by Draghi as: Specifically, a sustained adjustment requires three conditions to be in place. [...] The first is convergence: headline inflation has to be on course to reach our aim over a meaningful definition of the medium term. The second is confidence: we need to be sure that this upward adjustment in inflation has a sufficiently high probability of being realized. The third condition is resilience: the adjustment in inflation has to be self-sustained even without additional net asset purchases. Draghi then went on to add these comments on the sequencing of rate hikes after the asset purchases are completed, with our emphasis added: [...] when progress towards a sustained adjustment in the path of inflation is judged to be sufficient, net purchases will come to an end. At that point, next to our forward guidance, appropriate financial conditions will be maintained by our reinvestment policy. [...] as regards the evolution of our policy rates beyond the end of our net purchases, we will maintain the sequencing that is currently set out in our forward guidance, namely our pledge to keep key interest rates at their current levels "well past" the end of net purchases. This time-based element of our guidance is already vital today, in particular to ensure that our policy stimulus is not weakened by premature expectations of a first rate rise, and so financial conditions remain consistent with inflation convergence. That last line can be roughly translated from policymaker-speak as "we want to avoid a Fed-style Taper Tantrum when we stop buying euro area government bonds." Chart 10An Orderly Repricing Of ECB Expectations Praet made similar comments in his speech, discussing how the first rate hike after the end of asset purchases must only take place once there is a "durable convergence" of euro area inflation with the ECB target of just below 2% on headline inflation. So far, the markets have been heeding the ECB's communication and policy guidance. The timing of the ECB's first full 25bp rate hike, taken from our "months-to-hike" indicator, shows that the market does not expect the ECB to adjust rates until November of 2019 (Chart 10). At the same time, the market is only slowly repricing the term premium on longer-dated euro area government bonds, which would be expected if the ECB were to take its time in fully tapering its asset purchases. With realized euro area inflation, and market-based inflation expectations, still well short of the ECB's target, the market appears to be "correctly" following the ECB's guidance on the timetable for future policy moves. This is keeping euro area bond yields at low levels and dampening interest rate volatility. There may be another factor at work holding down bond yields, however. In a speech given at the U.S. Monetary Policy Forum in New York last month - an event attended by numerous academic and Wall Street economists, as well as several current FOMC members - ECB Executive Board Member Benoit Coeure discussed the importance of the "stock" effect of central bank asset purchases compared to the "flow" effect.2 Or as Coeure described it: [...] the "stock effect" - that is, the persistence of the effects of the stock of bonds held by the central bank on its balance sheet under a commitment of reinvestment. If the effects of purchases dissipate quickly, a shorter purchase horizon could lead to term premia rising even as interest rate expectations remain well anchored by forward guidance. Financial conditions would then tighten. But if the effectiveness of asset purchases rises with the stock of assets already acquired - if there is some "crossover point" where the stock effect becomes more important than the continued flow of purchases - then a reduced pace of purchases would not unduly decompress the term premium. This brings up an interesting point about the ECB's policy strategy as it prepares to taper its asset purchase program. If the ECB can effectively communicate that it will continue to reinvest the maturing bonds on its balance sheet after the new asset purchases have stopped, then the market will not price in a bigger term premium on longer-dated bonds since the ECB will continue to own a huge share of the stock of euro area government debt. The stock effect will dominate the diminishing flow effect. Coeure noted in his speech that the experience of the U.S. in 2013, when Ben Bernanke surprised markets with talk that the Fed was planning on cutting back its asset purchases, is different than Europe today. The biggest reason is that the ECB owns a far bigger share of the European bond market than the Fed did at that time. That is because the ECB asset purchases since its bond buying program began in 2015 have dwarfed the net issuance of euro area government debt (Chart 11). At no point during the Fed's quantitative easing (QE) era did the central bank ever buy more U.S. Treasuries than the U.S. government was issuing. According to the logic of Benoit Coeure, the smaller Fed "footprint" in the Treasury market relative to the ECB's ownership share of euro area government bonds (Chart 12) should mean that the Treasury term premium will be more volatile than that for German bunds (and other euro area debt). That is because a greater share of Treasury issuance must be sold to private investors who are more price-sensitive than central banks. In other words, the flow effect dominates the stock effect. Chart 11ECB & BoJ Have Been Absorbing##BR##All Net Government Bond Issuance Chart 12The 'Stock Effect' Of QE##BR##Should Be Bigger In Europe & Japan In Chart 13, we try and visually prove Coeure's thesis. The chart plots the gap between central bank asset purchases and net government bond issuance (the blue solid line proxying the "flow effect", using IMF data) for the U.S., euro area and Japan versus our estimates of the term premium (the black dotted line). The correlation appears to be very strong for the euro area and Japan during the era of asset purchases for those central banks, perhaps due to the "stock effect" dominating the "flow effect". This differs from the experience seen in the U.S. during the Fed QE era, when there was no stable relationship between the term premium and the amount of Treasuries the Fed was purchasing relative to net issuance. Looking ahead, there are important implications of this "stock vs. flow" argument for the future direction of euro area (and Japanese) bond yields, both in absolute terms and relative to U.S. Treasuries. In Chart 13, we also added BCA's forecasts for net government bond issuance over the next two years relative to our projections for the pace of asset purchases from the ECB and BoJ (both new purchases and reinvestments), and the Fed's own projections for the runoff of Treasuries from its balance sheet. Our estimates show that there will still be no new government bond issuance for the private sector to absorb in the euro area and Japan in 2018 and 2019, even with the ECB expected to fully taper new buying to zero by the end of this year and the BoJ dramatically cutting back its pace of buying. This contrasts to the U.S., where the private sector will be forced to absorb an extra US$1 trillion (!) of Treasuries this year and next, thanks to the huge Trump fiscal stimulus and the diminished buying by the Fed. U.S. private investors may require a higher yield (i.e. term premium) to absorb that additional debt, especially if inflation expectations are rising and the Fed is hiking interest rates at the same time. The implication is that the spread between Treasuries and euro area debt (and Japanese bonds, for that matter) could stay stubbornly wide - at least until there is more decisive evidence that the U.S. economy is in a cyclical slowdown that would put the Fed rate hiking cycle on hold (Chart 14). Chart 13The 'Flow Effect' Of##BR##QE Does Still Matter Chart 14The 'Stock Effect' Could Keep The##BR##UST-Bund Spread Wider For Longer From the point of view of euro area debt, however, the existence of a "stock effect" means that those investors expecting a Taper Tantrum 2.0 will likely be disappointed in the size of any upward move in euro area bond yields this year. Bottom Line: The ECB strongly believes that the "stock effect" of its asset purchases (how much they already own) matters more for European bond yields than the "flow effect" (how much they are buying). This suggests that the odds of a European "Taper Tantrum" later this year are low, although bond yields there are still headed higher. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The Draghi speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_1.en.html, while the Praet speech can be found at http://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180314_2.en.html 2 Coeure's speech can be found at https://www.ecb.europa.eu/press/key/date/2018/html/ecb.sp180223.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Chart 7Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Chart 12Domestic... Chart 13...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform Chart 16Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).