Policy

Highlights High Conviction Views: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Medium Conviction Views: Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. Euro Area Bond Distortions: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Feature Chart of the WeekWhy Are Yields Falling? After publishing two Special Reports in the past two weeks, this Weekly Report is our first opportunity to comment on the markets in April. We find it somewhat surprising that government bonds in the developed world have rallied as much as they have since the most recent peak last month, with the benchmark 10-year U.S. Treasury and German Bund seeing yield declines of -29bps and -22bps, respectively. Most of the move in Treasuries has been in the real yield component, while Bunds have seen a more even split between declines in real yields and inflation expectations. This has occurred despite minimal changes in actual growth or inflation pressures in either the U.S. or Europe (Chart of the Week). The price action in the Treasury market after last week's U.S. Payrolls report is a sign that the bond backdrop remains bearish. Yields initially fell all the way to 2.26% after the March increase in jobs fell short of expectations, before subsequently rebounding sharply to end the day at 2.38%. While intraday yield reversals on Payrolls Fridays are as typical as the sun setting in the west, a 12bp swing is one of the larger ones in recent memory (perhaps because investors eventually noticed the weather-related distortions in the data or, more importantly, that the U.S. unemployment rate had fallen to 4.5%). We continue to favor a pro-growth bias for bond investors, staying below-benchmark on overall duration and selectively overweight on corporate credit (favoring the U.S.). Ranking Our Current Market Views, By Conviction We have seen little in the economic data over the past few weeks to change our main strategic market views and portfolio recommendations. We summarize our main opinions below, ranked in order of our conviction level: Highest conviction views: Below-benchmark on overall portfolio duration exposure (for dedicated bond investors). Global bond yields have more room to rise alongside solid economic growth, tightening labor markets, inflation expectations drifting higher and central banks moving to slightly less accommodative monetary policies, on the margin. While the sharp upward momentum in coincident bond indicators like the global ZEW sentiment index has cooled of late, the solid upturn in the BCA Global Leading Economic Indicator continues to point to future upward pressure on real yields (Chart 2). The recent pullback in yields also appears to have run too far versus the trend in global data surprises, which remain elevated (bottom panel). One factor that we see having a potentially huge negative impact on global bond markets is the European Central Bank (ECB) announcing a move to a less accommodative policy stance later this year. A taper of asset purchases starting in 2018 is the more likely outcome than any hike in policy interest rates, which we see as more of a story for 2019. This should help push longer-dated bond yields higher within the Euro Area, and drag up global bond yields more generally. Underweight U.S. Treasuries. We still expect the Fed to deliver at least two more hikes this year, and there is still room for U.S. inflation expectations to rise further and put bear-steepening pressure on the Treasury curve. Our two-factor model for the benchmark 10-year Treasury yield, which uses the global purchasing managers index (PMI) and investor sentiment towards the U.S. dollar as the explanatory variables, indicates that yields are now about 18bps below fair value. From a technical perspective, the Treasury market no longer appears as oversold as it did after the rapid run-up in yields following last November's U.S. elections. The large short positions indicated by the J.P. Morgan duration survey and the Commitment of Traders report for Treasury futures have largely been unwound, while price momentum has flipped into positive territory (Chart 3). This removes one of the largest impediments to a renewed decline in Treasury prices, and we expect that the 10-year yield to rise to the upper end of the recent 2.30%-2.60% trading range in the next couple of months, before eventually breaking out on the way to the 2.80%-3% area by year-end. Chart 2Maintain A Defensive Duration Posture Chart 3Stay Underweight U.S. Treasuries Underweight Italian government bonds, versus both Germany and Spain. Italian government debt continues to suffer from the toxic combination of sluggish growth and weak domestic banks. The OECD leading economic indicator for Italy is declining, in contrast to the stable-to-rising trends in Germany and Spain (Chart 4). Meanwhile, the 5-year credit default swaps (CDS) for the major banks in Italy remain elevated around 400bps, in sharp contrast to the declining CDS in Germany and Spain which are now at 100bps. It is no coincidence that the widening trend in Italy-Germany and Italy-Spain spreads began around the same time last year that Italian bank CDS started to disengage from the rest of Europe (bottom panel). Markets understand that the undercapitalized Italian banking system will need government assistance at some point, which will add to the Italian government's already huge debt/GDP ratio of 133%. Political uncertainty in Italy, with parliamentary elections due by the spring of 2018 and populist parties like the anti-euro Five-Star Alliance holding up well in the polls, will also ensure that the risk premium on Italian bonds stays wide both in absolute terms and relative to other Peripheral European markets. Overweight U.S. corporate bonds, versus both U.S. Treasuries and Euro Area equivalents. The positive case for U.S. corporate debt is built upon two factors - the cyclical decline in default risk and the marginal improvement in balance sheet metrics. The latest estimates from Moody's are calling for a decline in the U.S. speculative grade corporate default rate to 3.1% this year. This leaves our measure of default-adjusted spreads in U.S. high-yield at levels that our colleagues at our sister publication, U.S. Bond Strategy, have shown to have a high probability of delivering positive excess returns over Treasuries in the next 12 months.1 Add to that the recent change in trend of our U.S. Corporate Health Monitor (CHM), which appears largely driven by some more positive numbers coming from lower-rated issuers in the Energy space given the recovery in oil prices, and the optimistic case for U.S. corporate debt is compelling. This is in contrast to our Euro Area CHM, which shows that the improving trend in balance sheet metrics has stalled of late (Chart 5, top panel). Chart 4Stay Underweight Italy Chart 5Stay Overweight U.S. Corporates vs Europe The difference between the U.S. and European CHMs has proven to be a good directional indicator for the relative return performance between the two markets, and is currently pointing to continued outperformance of both U.S. investment grade and high-yield debt versus European equivalents (bottom two panels). The threat of an ECB taper also hangs over the Euro Area investment grade corporate bond market, given the large buying of that debt by the central bank over the past year that has helped dampen both yields and spreads. Chart 6Stay Overweight Inflation Protection Medium-conviction views: Overweight inflation protection (both inflation-linked bonds and CPI swaps) in the U.S., Euro Area and Japan. In the U.S., the breakeven inflation rate on 10-year TIPS looks a bit too wide relative to our shorter-term model based on financial variables. However, underlying U.S. inflation pressures remain strong (Chart 6, top panel), particularly given the evidence that conditions in the labor market are getting progressively tighter. We expect inflation expectations to eventually rise back to levels consistent with the Fed's 2% inflation target on headline PCE inflation (which is around 2.5% on 10-year TIPS breakevens that are priced off the CPI index). The reflation story is somewhat less compelling in Europe and Japan, although CPI swaps are now at levels consistent with the underlying trends in realized inflation in both regions (bottom two panels). We continue to view long positions in CPI swaps in Europe and Japan as having a positive risk/reward skew given the tightening labor market in the former and the yen-negative monetary policies in the latter. Long France government bonds (10yr OATs) versus Germany (10yr Bunds). This is purely a call on the upcoming French election, which our political strategists believe will not end in a victory for the populist Marine Le Pen. While Le Pen has seen a recent bump in support heading into the first round of voting on April 23rd, her strong anti-euro position will eventually prove to be her undoing in the run-off election on May 7th (Chart 7). We first made this recommendation back in early February, and even though France-Germany spreads have been volatile since then as both Le Pen and the far-left candidate Jean-Luc Melenchon have seen a pickup in their poll numbers, the yield differentials are essentially at the same levels.2 We take this as a sign that the market believes current spreads are enough to compensate for the likely probability that either candidate could win the French presidency. Overweight JGBs Vs. the Global Treasury index. The argument here is a simple one - in an environment where there is cyclical upward pressure on global bond yields, favor the lowest-beta bond market (Chart 8). Persistently low inflation will prevent the Bank of Japan (BoJ) from making any changes to its current hyper-accommodative policies this year, especially the 0% cap on the benchmark 10-year JGB yield.3 The lack of yield limits the prospects for JGBs on a total return basis, but relative to other government bond markets, JGBs should outperform over the next 6-12 months as non-Japanese yields rise further. Chart 7Stay Overweight France Vs Germany Chart 8Stay Overweight Low-Beta JGBs Underweight U.S. Agency Mortgage-Backed Securities (MBS). Investors should remain underweight U.S. MBS, as spreads remain tight by historical standards. Our colleagues at U.S. Bond Strategy note that nominal MBS spreads have been flat in recent weeks as the option cost, which is the compensation for expected prepayments, has tightened to offset a widening in the option-adjusted spread (OAS).4 Chart 9Stay Underweight U.S. MBS We tend to think of the OAS as being influenced by trends in net issuance while the option cost is linked to mortgage prepayments (Chart 9). Looking ahead, the supply of MBS should increase further when the Fed starts to shrink its balance sheet later this year (as was mentioned in the minutes of the March FOMC meeting that were released last week), leading to a wider OAS. At the same time, refinancing applications should stay low as Treasury yields and mortgage rates rise. This will keep downward pressure on the option cost component of spreads. But with the option cost already near its historical lows, it is unlikely to completely offset the widening in OAS going forward. We see little value in U.S. MBS at current spread levels. Bottom Line: The global cyclical backdrop remains negative for government bond markets, and the recent declines in yields will not be sustained. We continue to recommend a below-benchmark overall duration stance, favoring U.S. corporate debt with underweight exposures to U.S. Treasuries and Italian government debt, as our highest conviction views. Staying overweight global inflation protection, French government bonds versus Germany, and Japanese Government Bonds (JGBs) versus the rest of the developed bond markets, while remaining underweight U.S. Mortgage Backed Securities, are recommendations that we hold with a more moderate conviction level. How Much Has The ECB Distorted The European Bond Market? Last week, Benoit Coeure of the ECB Executive Board gave a speech entitled "Bond Scarcity and the ECB Asset Purchase Program."5 That title piqued our interest, as that exact topic has come up in several of our conversations with clients this year. In his speech, Coeure discussed how the huge rally at the short-end of the German government bond curve over the past year has been at odds with what has occurred in the Euro swap curve, where interest rates are much higher for shorter-maturity swaps. Typically, German yields and Euro swap rates move in tandem, with the only differences being a function of technical factors like fixed-rate corporate debt issuance or government bond repo rates - and, on occasion, shifts in the perceived health of Euro Area banks that are the counterparties to any interest rate swap. The latter has become much less of an issue in recent years given the regulatory changes to the swap market, where trading has moved to centralized exchanges to reduce counterparty risks. In this environment, the difference between German bond yields and Euro swap rates, a.k.a the swap spread, should be relatively modest. Yet as can be seen in Chart 10, there has been a notable divergence at the shorter-maturity portions of the respective yield curves, where swap rates are rising but bond yields remain subdued. We can also see the divergences in the slopes of the relative yield curves, with the Euro Area swap curve much flatter than the German bond curve, particularly at longer maturities (Chart 11). Chart 10Large Distortions At The Front End Of The German Curve Chart 11Euro Area Swap Curves Are Generally Flatter Coeure argued that part of this distortion can be attributed to ECB asset purchases, especially after the decision taken last December to allow bond buying at yields below the -0.4% ECB deposit rate. This created a more favorable demand/supply balance for German debt, especially given the dearth of short-dated issuance. In addition, Coeure noted that there have been substantial safe-haven flows into shorter-dated German bonds (including treasury bills) by non-Euro Area entities. Some of this demand comes from large institutional investors like sovereign wealth funds and currency reserve managers, who are worried about political risks in France and Italy, and about the general rising trend in global bond yields, and are thus seeking the safety of low duration German debt. But some of the demand for short-dated German paper also comes from non-Euro Area banks, who have excess liquidity that needs to be parked in Euros but do not have access to the ECB deposit facility for the excess reserves of Euro Area banks. We can see this in Chart 12, which shows ECB data for the relative government bond ownership trends for Germany, France and Italy. The data is broken into holdings for bonds with maturities of one year or less (short-term) and bonds with maturities greater than one year (long-term). It is clear that the non-Euro area buyers own a much larger share of short-term German paper, around 90%, than in France and Italy, while Euro Area entities own nearly 80% of long-term bonds in all three countries. Coeure is correct in pointing out that there is an excess demand condition for short-dated core European debt, exacerbated by foreigners who need Euro-denominated safe assets - particularly GERMAN safe assets, if those investors are at all worried about redenomination risks given the rise of anti-euro populist parties in Europe.6 It is clear that the economic messages sent by looking at the German bond and Euro swap curves are very different. The flatter swap curve is more consistent with a steadily growing Euro Area economy where economic slack is being steadily absorbed and inflation pressures are building (albeit slowly). Also, the sovereign spread differentials within Europe do not look as problematic using swaps as the reference rate rather than German bonds. That is the case in France, where spreads versus swaps look in line with the averages of the past few years (Chart 13). This contrasts with the yield differentials versus Germany, which have reportedly gone up as investors have priced in a higher sovereign risk premium before the French presidential election. Chart 12French Bond Valuations Look More Subdued vs Swaps Chart 13French Bond Valuations Look More Subdued vs Swaps The story is a little different for Italy, where bond spreads versus both German bonds and Euro Area swaps have risen for all but the shortest maturities (Chart 14). This could be consistent with an interpretation that Italy's banking sector woes will add to the nation's longer-term fiscal stresses (as discussed earlier in this report), but not in a way that raises immediate default risks (which is why the 2-year Italy vs swap spread is well-behaved). Regardless of the "bias of interpretation", one thing that is clear is that the ECB's extraordinary monetary policies have created distortions in Euro Area bond markets. These may start to unwind, though, if the ECB begins to signal a shift towards a tapering of asset purchases next year, as we expect. The distortions in Euro area government bond yields (and, by association, swap spreads) have occurred alongside both the cuts in ECB policy rates into negative territory and the expansion of its balance sheet to purchase government bonds (Chart 15). As the ECB moves incrementally towards less accommodative monetary policy, we would expect to see front-end Euro swap spreads narrow in absolute terms and relative to longer-tenor spreads, and the German bond curve to flatten toward levels seen in the swap curve. Chart 14Only Short-Dated Italian Bond Valuations Look More Subdued vs Swaps Chart 15ECB Policies Have Caused The Distortions In Euro Swap Spreads Bottom Line: The ECB's negative interest rate and asset purchase programs have created significant distortions in the German bond yield curve that are not as evident in the Euro Area swap rate curve, especially at shorter maturities. ECB tapering will be the trigger for a reversal of these trends. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy Weekly Report, "Buy The Back-Up In Junk Spreads", dated March 14, 2017, available at usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "Our Views On French Government Bonds", dated February 7, 2017, available at gfis.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Staying Behind The Curve, For Now", dated March 21, 2017, available at gfis.bcaresearch.com 4 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com 5 http://www.ecb.europa.eu/press/key/date/2017/html/sp170403_1.en.html 6 Coeure noted that, at the time that the ECB began its asset purchase program in March 2015, the share of German bonds of less than TWO years maturity held by foreigners was 70%, but that rose to 90% by the 3rd quarter of 2016. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. Fed's Balance Sheet: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Credit Cycle: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Feature The bond bear market has been on pause for the past few months, with Treasury yields confined to a trading range since last November's post-election sell off. While yields have not moved meaningfully higher during this time, firm floors have also formed beneath both the 5-year and 10-year yields (Chart 1). Even after last Friday's disappointing payrolls number, the 10-year did not move below 2.3% and the 5-year did not move below 1.8%. Trading Range About To Break? Our sense is that the current consolidation phase in Treasuries is approaching its end and yields will soon head higher. Global growth indicators have continued to improve during the past few months, and as we noted in last week's report,1 our 2-factor Treasury model, based on Global PMI and U.S. dollar sentiment, pegs fair value for the 10-year yield at 2.54%. We attribute the recent leveling-off in yields to technical shifts in bond positioning and sentiment. Earlier this year, net positions in Treasury futures and asset manager duration allocations were deep in "net short" territory (Chart 2). Extreme short positioning usually leads to a period of bond market strength until short positions are washed out. Now that bond market positioning is closer to neutral, a key impediment to further yield increases has been removed. Chart 1Poised For A Breakout? Chart 2Positioning Has Normalized The elevated level of economic surprises has also been flagged as a potential roadblock to the bond bear market. Extended readings from the economic surprise index tend to mean revert as investor expectations are revised higher in the face of improving data. However, our research suggests that the change in Treasury yields tends to lead the economic surprise index by 1-2 months (Chart 2, bottom panel). Given this relationship, we suspect that the bond market has already discounted a lot of mean reversion in the economic surprise index. Chart 3Approaching Full Employment Finally, last week's employment report should not be taken as a signal that U.S. economic growth is weakening. Bad weather in the northeast played a key role in the low March payrolls number - only 98k jobs added. But more importantly, at this stage of the cycle we should expect payroll growth to slow and wage pressures to increase as we approach full employment. As can be seen in Chart 3, the late cycle trends of slowing payroll growth and rising wages are very much in place. Further, even broad measures of labor market tightness, such as the U6 unemployment rate,2 are quickly approaching levels that suggest the economy is operating at full employment. Increasingly it is measures of labor market utilization, wage growth and inflation that will guide the Fed's decision making, and these measures continue to improve. It was even noted in the minutes from the March FOMC meeting that "tight labor markets [are] increasingly a factor in businesses' planning". The minutes also reported that: Business contacts in many Districts reported difficulty recruiting workers and indicated that they had to either offer higher wages or hire workers with lower qualifications than desired Accordingly, surveys show that households are increasingly describing jobs as "plentiful" (Chart 3, panel 3) and small businesses are indeed ramping up their compensation plans (Chart 3, bottom panel). At this stage of the cycle, continued progress on measures of labor market utilization, wage growth and inflation will be sufficient for the Fed to continue lifting rates, pushing Treasury yields higher. Bottom Line: Bond market positioning is no longer at a bearish extreme and the economy is quickly approaching full employment. We expect Treasury yields will soon break through the upside of their post-election trading range. Maintain below-benchmark duration. The Fed Will Shrink Its Balance Sheet This Year Last week's release of the minutes from the March FOMC meeting also contained some new information about how the Fed plans to deal with its large balance sheet. To summarize, we learned that: The Fed intends to start shrinking its balance sheet later this year (assuming growth maintains its current pace). The Fed will shrink its balance sheet by ceasing the reinvestment of both its MBS and Treasury holdings at the same time. Still no decision has been made about whether reinvestments will stop entirely or whether they will be phased out over time ("tapered"). On February 28, we published a detailed report about the Fed's balance sheet policy.3 In that report we explained why the winding down of the balance sheet will not have much of an impact on Treasury yields, but could lead to a material widening in MBS spreads. The new information received last week does not change either of these conclusions. The minutes did make clear that the Fed favors what Governor Lael Brainard recently called a "subordination strategy" for dealing with its balance sheet.4 [A subordination strategy] would prioritize the federal funds rate as the sole active tool away from the effective lower bound, effectively subordinating the balance sheet. Once federal funds normalization meets the test of being well under way, triggering an end to the current reinvestment policy, the balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a "new normal" has been reached, and then increasing in line with trend increases in the demand for currency thereafter. Under this strategy, the balance sheet might be used as an active tool only if adverse shocks push the economy back to the effective lower bound. Essentially, the Fed is trying to de-emphasize the size of the balance sheet and would rather investors focus on the fed funds rate to assess the stance of monetary policy. For our part, we think it would be unwise to "fight the Fed" on this issue. For Treasury yields, we observe that the real 10-year Treasury yield closely tracks changes in the expected number of rate hikes during the next 12 months, while the inflation component of the 10-year yield tracks changes in realized inflation (Chart 4). These two relationships will continue to determine trends in bond yields going forward, and Fed balance sheet shrinkage is only important if it impacts the expected pace of rate hikes or inflation. The Fed's "subordination strategy" should ensure that the act of winding down the balance sheet does not have much of an impact on the expected pace of rate hikes. Ironically, if Treasury yields were to rise sharply following the announcement of balance sheet runoff, then the ensuing tightening of financial conditions would probably lower the expected pace of rate hikes and bring Treasury yields back down again. The story for MBS is somewhat different. Nominal MBS spreads remain tight by historical standards and closely track implied interest rate volatility (Chart 5). But we can also think of nominal MBS spreads as being split between the option cost, which is the compensation for expected prepayments, and the option-adjusted spread (OAS), which tends to correlate with net supply (Chart 5, panel 2). Chart 4Focus On Rate Expectations Chart 5Stay Underweight MBS In recent weeks, the OAS has widened alongside rising net issuance, but this has been offset by a sharp decline in the option cost. This is generally the pattern we would expect to play out as the Fed lifts rates and removes itself from the MBS market. The increased supply of MBS should lead to wider OAS, but refinancing applications should also stay low as Treasury yields and mortgage rates rise (Chart 5, bottom panel). However, netting it all out, the option cost component of MBS spreads is already near its historical lows and the OAS could move materially wider just to catch up to net issuance. In prior reports,5 we have also made the case that rate volatility should rise as the fed funds rate moves further away from the zero-lower-bound. Investors should stay underweight MBS. Bottom Line: The unwinding of the Fed's balance sheet is only important for Treasury yields if it impacts the market's rate hike expectations. However, the extra supply of MBS should lead to wider MBS spreads. Checking In On The Credit Cycle We continue to recommend overweight allocations to both investment grade and high-yield corporate bonds. This optimistic outlook is predicated on low inflation and a Fed that will support risk assets by remaining sufficiently accommodative until inflationary pressures are more pronounced. We think this "reflationary window" will stay open at least until core PCE inflation is firmly anchored around 2% and long-maturity TIPS breakevens reach the 2.4% to 2.5% range.6 Behind the scenes, however, leverage is building in the nonfinancial corporate sector. In this week's report we take a look at several different indicators of corporate credit quality and conclude that once the support from low inflation and accommodative monetary policy vanishes, it is very likely that corporate defaults will start to increase and corporate spreads will widen. If our anticipated timeline plays out, we will be looking to scale back on credit risk in 2018. Corporate Health Vs. The Yield Curve Our Corporate Health Monitor (CHM, see Appendix for further details) has been signaling deteriorating nonfinancial corporate health since late 2013 (Chart 6), and moved even deeper into 'deteriorating health' territory in Q4 of last year. Chart 6Corporate Health Is Deteriorating, But Monetary Policy Remains Supportive Periods when the CHM is in 'deteriorating health' territory are marked by shaded regions in Chart 6. We see that these regions usually correspond with periods when corporate spreads are widening. Even in the current episode, corporate spreads have yet to regain their mid-2014 tights. However, the bottom panel of Chart 6 shows that periods of deteriorating corporate health and wider corporate spreads are typically preceded by a very flat (often inverted) yield curve. This makes sense because a flat yield curve usually signals that interest rates are high and monetary policy is tight. Tight policy and elevated rates lead to more stringent bank lending standards and increase firms' interest burdens. With the curve still quite steep, we think the risk of sustained spread widening is minimal. However, if the CHM is still above zero when the yield curve is flatter, no support will remain for excess corporate bond returns. Net Leverage & The Payback Period We would further argue that the CHM will almost certainly be in 'deteriorating health' territory once the yield curve is close to flat. In Chart 7 we see that net leverage (defined as: total debt minus cash, as a percent of EBITD) is not only positively correlated with spreads, but also has never reversed its uptrend unless prompted by a recession. In other words, the corporate sector never voluntarily undertakes deleveraging, it only starts to pay down debt when forced by a severe economic contraction. Chart 7The Uptrend In Leverage Will Only Be Broken By Recession Closer inspection of Chart 7 reveals that the period between 1986 and 1989 is the only period when corporate spreads tightened even though leverage remained in an uptrend. In the late 1980s, leverage and corporate spreads both shot higher as a collapse in the energy sector caused overall corporate earnings to contract (Chart 7, bottom panel). But then the energy sector recovered just as quickly, and earnings growth bounced back. This caused spreads to tighten for a couple of years, even though the trend in net leverage only ever managed to flatten-off. Debt growth stayed robust during this time, despite the wild fluctuations in earnings. If any of this sounds familiar, it should. The energy sector collapse of 2014 caused net leverage and spreads to shoot higher, and now spreads have started to tighten again as earnings have rebounded. Notice that just like in the late-1980s, net leverage has not reversed its uptrend. We believe that corporate spreads have entered a "payback period" very similar to the late 1980s. Spreads can tighten as earnings rebound, but because the economy is not in recession, debt growth will remain solid and leverage will continue to trend higher. Once inflationary pressures start to bite and Fed policy becomes less accommodative, the payback period will end and spreads will head wider. Debt Growth Chart 8Bond Issuance Is Back Although we have made the case that the corporate sector does not delever unless prompted by a recession, it is notable that net corporate bond issuance was negative in Q4 of last year and the growth rate in bank lending to the corporate sector has slowed sharply. We do not think this cycle is different, and expect corporate debt growth (both bonds and loans) to rebound in the coming months. We chalk up weak corporate bond issuance in 2016Q4 to uncertainty surrounding the U.S. election. In fact, we see that gross corporate bond issuance has already rebounded strongly in January and February of this year (Chart 8). Turning to bank loans, we observe that the outright level of outstanding bank loans only contracts following a recession, and that the rate of increase follows bank lending standards with a lag (Chart 9). In other words, Commercial & Industrial (C&I) loan growth is still responding to the surge in defaults that resulted from the energy sector's 2014 collapse. Now that defaults have waned, this process will soon be thrown into reverse. In fact, our model of the 6-month rate of change in C&I lending - based on private non-residential fixed investment, small business optimism and corporate defaults - points to an imminent bottoming in C&I loan growth (Chart 10). Chart 9Loan Growth Follows Lending Standards Chart 10BCA C&I Loan Growth Model Bottom Line: Corporate spreads are in a "payback period" from 2014's energy shock that will allow them to tighten as corporate profits rebound, even though corporate leverage continues to trend higher. The weakening state of corporate balance sheets means spreads are at risk once monetary policy turns less accommodative. Ratings Trends & Shareholder Friendly Activities Chart 11Shareholder Friendly Activity Has Ebbed Our assessment of the cyclical back-drop for corporate spreads is primarily based on the combination of balance sheet quality - as determined by our Corporate Health Monitor and its underlying components - and the stance of monetary policy - as determined by the slope of the yield curve and C&I lending standards (among other factors). However, ratings migration and "shareholder friendly" activities have also historically provided advance notice of turns in the credit cycle. Net transfers to shareholders, i.e. payments to shareholders in the form of dividends and buybacks, are a direct transfer of capital from bondholders to equityholders. These transfers tend to rise late in the cycle, just before defaults start to increase and spreads start to widen (Chart 11). Net transfers to shareholders had been moving higher, but have recently rolled over. Similarly, ratings downgrades related to shareholder transfers have also moderated (Chart 11, panel 2). Historically, ratings migration related to "shareholder friendly" activities has been a more reliable indicator of the credit cycle than overall ratings migration. It has tended to move into "net downgrade" territory later in the cycle, closer to the onset of recession (Chart 11, panel 3). Ratings trends and transfers to shareholders are not flagging any imminent risk of spread widening. However, there is the additional risk that downgrades have simply not kept pace with the actual deterioration in credit quality of the nonfinancial corporate sector. Using firm-level data, we calculated the percent of high-yield rated companies with net debt-to-EBITDA ratios above 5. We see that actual ratings migration is too low relative to the number of highly-levered firms (Chart 11, bottom panel). It is possible that ratings agencies have already incorporated the rebound in energy prices and profit growth into their assessments while the actual debt-to-EBITDA data are lagging, but this is still a risk that bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Reflation Window Still Open", dated April 4, 2017, available at usbs.bcaresearch.com 2 The U6 unemployment rate is a broader measure than the headline (U3) unemployment rate. It also includes those "marginally attached" to the labor force and those working part-time for economic reasons. 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet", dated February 28, 2017, available at usbs.bcaresearch.com 4 https://www.federalreserve.gov/newsevents/speech/brainard20170301a.htm 5 Please see U.S. Bond Strategy Weekly Report, "The Road To Higher Vol Is Paved With Uncertainty", dated February 14, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Keep Buying Dips", dated March 28, 2017, available at usbs.bcaresearch.com Appendix Chart 12Corporate Health Monitor Components Box 1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole (Chart 12). These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Fixed Income Sector Performance Recommended Portfolio Specification

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

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

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

Highlights Growth figures coming out of China in the coming months may be viewed as less market friendly, which could be taken as an excuse for a much-anticipated correction in risk assets. Cyclically, the Chinese economy will remain buoyant, even if year-over-year growth numbers begin to moderate. All three main sectors of the economy will likely be on more solid footing. China's inflation and growth dynamics do not warrant significant policy tightening. Leading indicators point to an immediate top in Chinese PPI. The economy would need to run a lot hotter for a lot longer for genuine inflation pressures to build up. Feature Most of the latest macro figures from China released over the past several days confirm that the mini-cycle upswing remains firmly in place. It is almost a sure bet at this point that Chinese GDP likely continued to accelerate in the last quarter, with the positive momentum having become well recognized and accepted among global investors. We have been travelling as of late talking to clients and taking the pulse of the market - collectively investors' concerns on China have eased along with strengthening growth numbers, but worries on some key macro issues remain deeply rooted.1 Looking forward, investors' delicate complacency on China will be tested in the coming months on two possible scenarios: Macro indicators based on year-over-year comparisons begin to moderate, rekindling investors' fears of another China-led global slowdown. Building inflationary pressures and policy tightening by the Chinese authorities ignites another economic downturn. For now, it is impossible to foresee how risk assets will react to these possible scenarios, especially at the moment when some major equity indexes have already become richly valued and the market could take any excuse for a long overdue correction. However, we maintain the view that the level of China's economic activity will likely stay reasonably buoyant, even if year-over-year growth numbers begin to moderate, and that the inflation and growth dynamics do not warrant significant policy tightening. A major relapse in activity is not in the cards, unless the Chinese authorities commit a policy mistake by stepping on the brakes prematurely, or a major disruption in global trade due to protectionism occurs. Reasons To Stay Positive The annual growth rates of Chinese macro indicators will likely roll over, as by definition these ratios cannot always accelerate. Meanwhile, the economy had already begun to improve in the second quarter of last year, which means the positive "base effect" will likely begin to fade going forward. These tedious technical factors aside, we expect business activity to remain buoyant, as all three main sectors of the economy will likely be on more solid footing. Chart 1Improving Labor Market And Strengthening Confidence ##br##Will Boost Consumption On the consumer sector, the labor market has continued to improve, as indicated by the improving employment component of the purchasing managers' surveys (PMIs). An improving labor market helps boost job creation and income, both of which bode well for consumer confidence and household demand. Indeed, various measures of consumer confidence have improved sharply in recent months to multi-year highs (Chart 1). Moreover, it appears that side effects of China's harsh anti-corruption campaign on economic growth have abated. The sudden collapse of luxury goods sales since late 2013 has run its course. Jewelry sales growth has been strengthening; high-end liquor prices have been rising rapidly; Swiss watch exports to China and Hong Kong have turned positive after a prolonged slump. Even though the anti-corruption drive remains in high gear, the "froth" of luxury goods consumption associated with bribing has been squeezed out, and demand for high-end products has been pushed higher along with rising income levels. All of this should support retail sales going forward. On the corporate sector, the destocking cycle is well advanced and companies will likely beef up inventories going forward (Chart 2). Albeit rising slowly, the inventory component of PMI surveys remains below 50, underscoring limited buildup of final products. In addition, the new orders-to-inventory ratio remains elevated by historical standards, underscoring very lean stock, which also limits the downside in industrial production even if the improvement in new orders stalls. More importantly, we expect China's capital spending cycle has likely bottomed out. An important change in China's macro conditions since last year has been the sharp turnaround in the corporate profit cycle, which has historically led Chinese capital spending, especially among private enterprises in the manufacturing and mining sectors (Chart 3). The recovery in producer prices and corporate profitability underscore tightened capacity utilization, which has historically preluded investment. It is premature to expect a major boom, but the case for a modest upturn in private capital spending is strengthening. Chart 2Inventory Restocking ##br##Has Further To Go Chart 3Profit Recovery Should Boost Private Capital Spending ##br##Profit The export sector remains a wildcard for China's growth performance,2 and President Donald Trump and President Xi Jinping's summit later this week will be closely watched for clues of the bilateral relationship between the world's two largest economies under the new U.S. administration. President Trump's executive order last Friday to launch investigations into countries against whom the U.S. runs a bilateral trade deficit suggests he may still unilaterally impose punitive tariffs on Chinese imports, which risks a sudden escalation of protectionism pressures with unpredictable consequences on global trade and financial markets. Barring such a bleak outcome, strengthening growth in the U.S. should also boost Chinese exports (Chart 4). The PMI New Export Orders index has remained above the 50 expansion/contraction threshold for five consecutive months, and the latest reading reached its highest level since early 2012, pointing to further acceleration in overseas sales, at least in the near term. Chart 4Exports Will Likely Continue To Accelerate Chart 5Market Is Anticipating Pboc Rate Hike Bottom Line: Domestic demand, both consumption and capital spending, will likely strengthen, and external demand is also on the mend. The risk of a major slowdown in China is low. Will Inflation Induce Tightening? The People's Bank of China (PBoC) has continued to guide money market rates higher by adjusting open-market operation tools. We remain skeptical that the central bank will hike its policy rate, but Chinese financial markets have begun to price in such a move. The two-year swap rate, which can be roughly viewed as the market's expectations of the PBoC policy rate, has edged up by around 20 basis points since early this year (Chart 5). This also means that the market impact may be muted, even if the PBoC does raise its benchmark rate. In fact, the significant growth improvement in recent months, especially in nominal terms, justifies tighter policy. In other words, higher rates are largely reflective rather than restrictive. Chart 6PPI Has likely Peaked Inflation risk has once again become a focal point of discussion in our recent client meetings. Investors appear increasingly concerned that the sharp surge in Chinese producer prices could lead to broader inflationary pressures, which could in turn force the PBoC to take more draconian measures. Historically, Chinese PPI and CPI have largely moved in sync, even though PPI has been a lot more volatile than the headline CPI. In our view, odds of an inflation-induced policy tightening cycle are low. At the onset, it is overly simplistic to extrapolate the recent PPI trend infinitely. In fact, after a sharp recovery since early last year, the acceleration in PPI has likely already peaked (Chart 6). The depreciation of the trade-weighted RMB has stalled, and the annual rate of change in commodities prices has also rolled over, both of which point to an immediate top in Chinese PPI. Meanwhile, the pace of improvement in corporate sector pricing power is also moderating (Chart 6, bottom panel). Moreover, the recent sharp decline in headline CPI is entirely related to food prices, which could stay volatile going forward (Chart 7), but Chinese core inflation remains low and stable, ranging between 1.5-2.5%. Such an inflation rate is arguably too low for a rapidly growing economy. The important point is that the Chinese economy is highly productive, which leads to constant downward pressure on prices. Chart 8 shows U.S. import prices from China have remained essentially flat since 2004, while costs of manufactured goods from other countries have all gone up, a remarkable development given the dollar has dropped by almost 20% against the RMB over this period while strengthening against almost all other major currencies. This means Chinese producers' faster productivity growth has enabled them to undercut their competitors in other countries in pricing to gain global market share. In this environment, deflation tends to be a bigger threat than inflation. Indeed, with the accumulation of debt in the economy, debt deflation is a much more dreadful situation to deal with than an inflation outbreak. The economy would need to run a lot hotter for a lot longer for genuine inflation pressures to build up. It is overly alarmist to warn of inflation risks at the moment. Chart 7Food Prices Still Dominate Headline CPI Chart 8Strong Productivity Growth Means ##br##China Is Less Prone To Inflation All in all, we remain cyclically positive on Chinese equities, especially H shares. Growth figures coming out of China in the coming months may be viewed as less market friendly, which could be taken as an excuse for a much-anticipated selloff in risk assets. However, the broad trend of growth improvement in the Chinese economy remains intact, which in the absence of a sudden eruption of protectionist backlash will reinforce the upturn in the global business cycle. Therefore, we tend to view any China-induced selloff, if it happens, as transitory and corrective in nature, and to be used as an opportunity to add positions. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see BCA Special Report, "The Great Debate: Does China Have Too Much Debt Or Too Much Savings?" dated March 23, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China: The 2017 Outlook, And The Trump Wildcard," dated January 12, 2017 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Special Report

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

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

Special Report

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

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