Asset Allocation

Highlights Animal spirits have soared, according to soft data from surveys. But 6-month credit impulses have slumped in the euro area, U.S. and China, according to hard data from the ECB, Federal Reserve and PBOC. The negative 6-month credit impulse - rather than soaring animal spirits - is more important for the cyclical direction of the global economy. A growth-pause would blindside financial markets. Lean against any rise in high-quality bond yields and equity prices until the conflict between soaring animal spirits and slumping credit impulses is resolved. Feature Animal spirits have soared since the surprise election of President Trump on November 8. For many investors, the heightened animal spirits - shown in surging sentiment and survey data (Chart I-2) - are a strong signal that the global economy is about to accelerate. Unfortunately, these investors could end up very disappointed. Chart of the Week6-Month Credit Impulses Have Slumped Chart I-2Animal Spirits Have Soared... The problem is that the hard data on bank credit are giving the exact opposite signal. Over the past few months, global credit flows have slumped (Chart of the Week, Chart I-3 and Chart I-4). Chart I-3...But Credit Impulses Have Slumped Chart I-4The Global 6-Month Credit Impulse Has Turned Negative Despite Heightened Animal Spirits The ECB's latest Monetary Developments in the Euro Area shows that the euro area 6-month credit flow has shrunk by €26 billion. The most recent 6-month credit flow fell to €321 billion from €347 billion in the previous period. The U.S. Federal Reserve's latest weekly H8 release paints an even starker picture. The U.S. 6-month credit flow has shrunk by $271 billion, equivalent to 3% of U.S. GDP (at an annualised rate). The most recent 6-month credit flow plunged to just $152 billion from $423 billion in the previous period. For completeness, look at the world's other major economy, China. Given the lower credibility of official bank credit data in China we prefer to focus on the broad money supply numbers. The People's Bank of China does not seasonally adjust this data, but it is straightforward to do ourselves using standard seasonal adjustment functions. The seasonally-adjusted data shows that the most recent 6-month flow, at 8.1 trillion yuan, was slightly higher than the preceding 7.7 trillion yuan. Nevertheless, the resulting marginally positive China 6-month impulse is sharply down from previous months. Why Optimism Is Up, But Borrowing Is Down Let's explain why sentiment data and credit flows have headed in polar opposite directions since the shock electoral success of Donald Trump. Imagine that firms (or households) are willing to borrow $1 billion for investment projects at a long-term borrowing cost of 1.5%. Then, an unexpected event causes animal spirits to surge. Suddenly, firms will become more optimistic about the expected profits from the investment projects. At this higher net1 profitability, firms might be willing to borrow and invest more than $1 billion, let's say $1.5 billion. In which case, the sentiment data will be higher and so will the credit flow, resulting in a credit impulse of +$0.5 billion. Chart I-5A Sharp Rise In Borrowing Costs Has##br## Countered Heightened Animal Spirits Now imagine that in response to this improved economic outlook, the financial markets expect the central bank to hike interest rates quicker and further. So the markets push up the bond yield to 2.0%. For firms, this higher cost of long-term borrowing might now exactly neutralise the expected profit boost from the investment projects. At this unchanged net profitability, firms will continue to borrow and invest $1 billion. In which case, the sentiment data will be higher but the credit flow will be unchanged, resulting in a credit impulse of zero. Finally imagine that in response to the improved economic outlook, the financial markets get carried away. They push up the bond yield to 2.5%. Now, the much higher cost of long-term borrowing will more than neutralise the expected profit boost from the investment projects. At a sharply lower net profitability, firms will borrow and invest less than $1 billion, let's say $0.5 billion. In which case, the sentiment data will be higher but the credit flow will fall, resulting in a credit impulse of -$0.5 billion. Note that in all three cases, animal spirits are up sharply. For credit flows, these heightened animal spirits in isolation are a tailwind. But any associated rise in the cost of long-term borrowing is a headwind. It follows that the net impact on credit flows depends on the relative strengths of the tailwind from heightened animal spirits and the headwind from higher long-term borrowing costs. Today, we would suggest that for global credit flows, the tailwind from heightened animal spirits is weaker than the headwind from the sharpest rise in bond yields in a decade (Chart I-5). The result is a negative 6-month global credit impulse. And it is this negative 6-month credit impulse - rather than heightened animal spirits per se - that is more important for the cyclical direction of the global economy. The History Of "Animal Spirits" In the early nineteenth century, the 'British Currency School', led by David Ricardo, postulated that expansions and contractions of bank credit and the broad money supply are the main cause of the economic cycle. We are very strong advocates of Ricardo's Currency School thesis. In opposition to the Currency School, the 'British Banking School' believed that expansions and contractions of bank credit are merely the passive effects of the economic cycle. The true cause of the economic cycle is fluctuations in business speculation and expectations of profit, which ultimately come from psychological mood swings. A century later in 1936, John Maynard Keynes wrote The General Theory of Employment, Interest and Money. In it, Keynes reiterated the Banking School's psychological mood swing explanation of the cycle. To describe these mood swings, he came up with the now very familiar phrase "animal spirits". Keynes blamed the Great Depression on the collapse of these animal spirits, and a consequent collapse in investment and consumption. But Keynes was only partly right. Animal spirits in isolation do not cause the cycle. As discussed in the previous section, borrowing costs lean against mood swings in both directions. Optimism results in higher borrowing costs, countering the desire to borrow. Pessimism results in lower borrowing costs, countering the reluctance to borrow. And it is the net impact on credit flows that drives the cycle. The specific problem in the Depression was a slump in asset prices. This depressed the value of households' and firms' balance sheet assets to below the value of the liabilities - an extreme event which economist Richard Koo calls a 'balance sheet recession'. Crucially, in a balance sheet recession, no amount of borrowing cost reduction can counter the reluctance to borrow, because households' and firms' single-minded objective is to regain solvency. Hence for us, the Ricardian bank credit cycle - rather than Keynesian animal spirits - is the better explanation for the Great Depression, as well as for Japan's post-1990 bust and for the 2008-09 Great Recession. The Ricardian bank credit cycle also explains the more common and garden variety of economic fluctuations (Box I-1). Readers should review our February 2 report Slowdown: How And When? for the compelling theoretical and empirical evidence. Right now, the important message is that the global bank credit cycle is weakening. Box I-1The Mathematics Of Mini-Cycles Credit Slumps While Animal Spirits Soar: What Should Investors Do? Many commentators and investors look at sentiment and survey data and note that animal spirits have soared. On this basis, they expect global growth to accelerate. But to reiterate, animal spirits in isolation do not cause the economic cycle. Heightened animal spirits do generate a tailwind for credit creation, but any associated rise in the cost of long-term borrowing generates a headwind (Chart I-6). And it is the net effect on the 6-month credit impulse - rather than heightened animal spirits per se - that determines the cyclical direction of the economy (Chart I-7). Chart I-6Higher Borrowing Costs Weaken Credit Flows... Chart I-7...And Weaker Credit Flows Slow The Economy Today, the hard data on bank credit in the euro area, the U.S. and China show that 6-month impulses have slumped. The risk is that this could generate an unwelcome surprise. Rather than accelerate in the coming months, global growth may level off or even decelerate. Even if it were a short-lived pause, major financial markets - including all of those in Europe - would be blindsided. The risk-on mode so far in 2017 would turn out to be incongruous. At the very least, until the conflict between soaring animal spirits and weakening credit impulses is resolved, we will lean against any rise in high-quality bond yields and equity prices. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Profitability net of borrowing cost. Fractal Trading Model* Excessive optimism in global equity prices reinforces our near-term caution towards stocks. We are expressing this through a short position in the AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive. The currency peg will stay and domestic prices will adjust as a release valve. Developing deflationary pressures and slowing rent growth may reinforce one other. Rising risk free interest rate calls for higher rental yield, which can only be achieved via lower home prices. Remain short HK government bonds relative to US Treasurys; Remain short HK property investors relative to benchmark. More evidence that China's profit cycle is in an upturn. Feature The election of Hong Kong's Chief Executive this past weekend garnered little coverage among the global mainstream media. Carrie Lam easily beat her competitors, purportedly with blessings from Beijing. However, she will face an uphill battle to reunite the citizens of Hong Kong, who have become increasingly divided in recent years. As a regional financial hub heavily exposed to global forces, local politics barely matter for Hong Kong's economy and financial markets. Nonetheless, the significance of politics has clearly been on an upward trajectory in recent years, which could impact investors' long-term risk perceptions for a market that has historically been largely viewed as an "apolitical" Laissez Faire system. On the economic front, also largely ignored has been Hong Kong's inflation statistics released early last week, which showed that headline consumer price inflation dropped by 0.1% in February, the first negative reading since August 2009. While one single data point certainly does not denote a trend, odds are high that deflationary forces are re-emerging in Hong Kong, with important implications for asset prices, particularly for the currency and local real estate market. Budding Deflation... Chart 1Deflation Is Coming Back The negative February CPI reading was largely attributed to some poverty relief factors, declining vegetable prices and the base effect due to the Chinese New Year holiday. However, headline CPI has been decelerating since the peak of 2011 (Chart 1). Indeed, after briefly dipping below zero at the height of the global financial crisis and then roaring back in the aftermath on improving growth, consumer prices in Hong Kong have been in a prolonged period of disinflation. In fact, February's negative CPI figure is just a continuation of a well-established trend rather than an anomaly caused by one-off factors. Moreover, falling inflation and developing deflation is rather broad-based. It is true that the nosedive in fresh food prices has clearly played a role in dragging down headline CPI. However, price inflation has been trending lower in almost all major components of the consumption basket such as housing, eating out and other miscellaneous services (Chart 1, bottom panel). Meanwhile, consumer durable goods inflation has been stuck in negative territory for more than 10 years. Interestingly, amid strengthening global growth momentum, most major economies have been experiencing bouts of reflation, particularly in sectors associated with commodities prices - intensifying disinflationary/deflationary pressures in Hong Kong are a notable exception. It means that inflation dynamics in Hong Kong are likely rooted in unique domestic factors. ...Indicates An Expensive Hong Kong Dollar In our view, a key factor behind Hong Kong's budding deflationary pressure is the exchange rate. As the Hong Kong dollar is pegged to the U.S. dollar, the relative shift in price levels between Hong Kong and the rest of the world cannot be adjusted through a change in the nominal exchange rate. Therefore, the adjustment must be achieved in real terms through price changes. Chart 2 shows that prior to 1983 when the currency board system was established, Hong Kong inflation largely followed that in the U.S., while the exchange rate fluctuated against the dollar. Since the 1983 currency peg, Hong Kong inflation has been swinging around the U.S. level, with the economy alternating between inflationary booms and deflationary busts. A new factor that has also become increasingly important in Hong Kong's inflation dynamics is China's price levels, which also relates to the exchange rate. Chart 3 shows Hong Kong headline inflation has outpaced Chinese inflation since 2013, and the RMB's depreciation against the Hong Kong dollar in recent years has put further downward pressure on local Hong Kong price levels. Chart 2Exchange Rate And Inflation Tango Chart 3Hong Kong Inflation: The China Factor In short, renewed deflationary pressures indicate that the Hong Kong dollar may have once again become expensive, and therefore domestic price levels have begun to adjust as the release valve. It remains to be seen how long the adjustment process will last. From investors' point of view, a few observations are in order: There is little risk that the Hong Kong dollar peg will break, unless it is a voluntary policy choice by the authorities. Hong Kong's solid banking sector is not prone to financial crises, and its massive fiscal and foreign exchange reserves give the government plenty of fire powder to defend the exchange rate in the event of a speculative attack, let alone the mighty official reserves held in mainland China (Chart 4). We remain convinced that Hong Kong's ultra-low interest rates compared with the U.S. are unjustified and unsustainable (Chart 5). Hong Kong 10-year government bond yields are still 84 basis points lower than their U.S. counterparts, which probably reflects upward pressure on the Hong Kong dollar to appreciate against the U.S. dollar, partially driven by Chinese capital outflows. In this vein, budding deflationary pressures in Hong Kong further diminish the odds of an upward move of the HKD against the U.S. dollar. Remain short Hong Kong government bonds against U.S. Treasurys with comparable durations. Historically Hong Kong's flexible and largely Laissez Faire system has been able to stomach drastic swings in domestic price levels induced by the currency peg. The rising grassroots anti-establishment movement in recent years suggests the side effects of the Hong Kong system may have become increasingly unpopular. It will be interesting to see if any deflationary growth downturn in Hong Kong triggers a populist backlash that leads to a change in Hong Kong's exchange rate scheme. Chart 4Ample Resources To Defend HKD Peg Chart 5HK Rates Should Move Higher Real Estate: Sky's The Limit? Another key reason behind Hong Kong's falling CPI inflation is rent, which has also turned sharply lower in recent months (Chart 1, bottom panel). This is in stark contrast to home prices, which have continued to rally strongly. After a temporary pullback last year, Hong Kong real estate prices have roared back to new record highs. Looking forward, the outlook for Hong Kong's real estate sector looks decisively bearish. First, Hong Kong's real estate market has become increasingly detached from economic fundamentals. Home prices have dramatically outpaced household income, in greater proportion than the previous housing bubble peak in the late 1990s (Chart 6). Therefore, it is not surprising that both transactions and construction activity have declined substantially to near-record lows. Thinning transaction activity suggests that ordinary local households may have been priced out, underscoring frothy market conditions. The saving grace is that the dramatic increase in prices has not led to euphoria in housing demand and transactions, which should limit financial sector risk should home prices decline. Second, developing deflationary pressures and slowing rent growth may reinforce one other, potentially creating a downward spiral. Meanwhile, risk-free interest rates, driven by Federal Reserve policy, will likely edge higher. This is an especially poor combination for Hong Kong real estate investors. Historically, higher risk-free yields should lead to higher rental yields (Chart 7). With falling rents, the only way for rental yields to go up is via lower prices. Chart 6Housing Market: Soaring Prices, Falling Volume Chart 7Rental Yield Will Be Pushed Higher From a big-picture vantage point, Hong Kong deflation and Fed tightening will lead to much higher real interest rates in Hong Kong, which amounts to significant tightening in monetary conditions. This will create further headwinds for both the Hong Kong domestic economy and property prices. The bottom line is that the risk in Hong Kong home prices is tilted to the downside. The market may have been boosted by an influx of capital from the mainland, which may sustain the bubble for a while longer. However, investors should not chase the market. Chart 8The Widening Valuation Gap Budding deflationary pressures also bode poorly for profits and equity prices. However, Hong Kong stocks are more heavily exposed to China and the global cycle than local business conditions, and therefore should not be impacted materially. Moreover, Hong Kong stock multiples historically have tracked their U.S. counterparts closely - the valuation gap has widened sharply since 2013 (Chart 8). This should further limit the downside in Hong Kong stocks. Meanwhile, we expect property owners such as REITs to underperform the broader market. A Word On Chinese Profits The latest numbers show Chinese industrial profits jumped by over 30% in the first two months of the year compared with a year ago, a sharp acceleration from recent months, as predicted by our model (Chart 9). The strong profit recovery has important implications. For equity earnings, the upturn in the profit cycle is also confirmed by bottom-up analysts. Net earnings revisions have been lifted, which has historically led to acceleration in forward earnings growth (Chart 10). Remain positive on Chinese H shares. From a macro perspective, rising earnings should lead to stronger investment, especially in the manufacturing and mining sectors. This should further boost domestic demand and prolong the ongoing mini cycle upturn. The profit recovery also helps alleviate financial stress in the banking system, as it will reduce the pace of accumulation of non-performing loans (NPL). Importantly, profits are rising particularly strongly in some of the hardest hit sectors in previous years, such as steelmakers and coal miners, which were precisely where the increase in NPLs were the most rampant. We will follow up on this issue in upcoming reports. Chart 9China's Profit Cycle Upturn Chart 10Chinese Equity Earnings Will Accelerate Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The financial market landscape has shifted over the past month with asset correlations changing and the so-called 'Trump trades' going into reverse. Equity valuation is stretched and plenty of risks remain. Nonetheless, we do not believe it is time to become defensive, scale back on risk assets, upgrade bonds and short the dollar. The economic data remain constructive for profits in the major countries. The risks posed by upcoming European elections have eased for 2017, now that the Italian election appears unlikely until 2018. The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. If a tax reform package proves too difficult to pass, then the GOP will settle for straight tax cuts and a modest amount of infrastructure spending. Market reaction to the FOMC's 'dovish hike' was overdone. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Not before September will the ECB be in a position to announce a further tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. In Japan, the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. Our views on U.S. fiscal policy and the major central banks paint a bullish picture for the dollar, and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Another key market development has been the continuing drop in risk asset correlations. This reflects falling perceptions of downside "tail risk", which is reflected in a declining equity risk premium (ERP). Absent further negative shocks, perceptions of downside risk should continue to wane, allowing risk premia and asset correlations to ease further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can focus more on long-term revenue generation rather than on guaranteeing their existence. Much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years. The only adjustment to asset allocation we are making this month is an upgrade for U.S. high-yield based on improved valuation. Feature The financial market landscape has shifted over the past month with asset correlations changing and a number of popular trades going into reverse. First, the failure to replace Obamacare triggered a pull-back of the so-called 'Trump trades.' Stock indexes are holding up well, but the U.S. dollar has given back most of the gains made in March and the 10-year Treasury yield has dropped back to the bottom of the post-U.S. election trading range. Moreover, the negative correlation between the U.S. dollar and risk assets has flipped (Chart I-1). Even oil prices have diverged from their usual negative trading relationship with the dollar. Second, investors are questioning the FOMC's appetite for rate hikes in the coming months. They are also wondering how much longer the European Central Bank (ECB) and the Bank of Japan (BoJ) can maintain current hyper-stimulative policy settings. The whole narrative regarding equity strength, a dollar overshoot and bond price weakness may be over if there is not going to be any fiscal stimulus in the U.S., the Fed is not going to hike more aggressively than the market currently expects, and monetary policy is near a turning point in Japan and the Eurozone. Is it time for investors to become defensive, scale back on risk assets, upgrade bonds and short the dollar? We believe the answer is 'not yet', although 2017 was always destined to be a rough ride given the ups-and-downs in the U.S. legislative process and the lineup of European elections. President Trump's first 100 days are turning out to be even more tumultuous than many expected. Allegations of wiretaps and the FBI investigation into the alleged interference of Russia in the U.S. election are costing the President political capital, as well as raising question marks over the Republican Party's wish list. Simply removing the possibility of corporate tax cuts would justify a healthy haircut on the S&P 500. The political situation has admittedly become more complicated, but our geopolitical team makes the following observations: The GOP base supports Trump: Until the mid-term elections, Trump's popularity with Republican voters remains strong, which means that the President still has political capital (Chart I-2). Chart I-1Changing Correlations Chart I-2Trump Not Dead To Republicans Yet Republicans want tax reform: Even if reform gets bogged down, there is broad support for cutting taxes at a minimum. Many deficit hawks appear willing to use the magic of "dynamic scoring" to justify tax cuts as revenue-neutral. Even the chairman of the Freedom Caucus has signaled that he is open to tax reform that is not revenue neutral. Tax reform not conditional on Obamacare: The failure to replace Obamacare does not mean that tax reform is necessarily going to be delayed. The Republicans will need to show success on at least one of their signature platforms before heading into the mid-term elections. The prospective savings from Obamacare's repeal are not needed to "fund" tax cuts. Infrastructure: We still expect that President Trump will get his way on additional spending on defense, veterans, infrastructure and the wall. The tax reform process will undoubtedly be full of drama and may be stretched out, adding volatility to the equity market. Our base case is that some sort of tax reform and infrastructure package will be passed by year end. However, if a reform package proves too difficult to pass, then we believe that the GOP will settle for straight-forward tax cuts and a modest amount of infrastructure spending (please see Table I-1 in the March 2017 monthly Bank Credit Analyst for the probabilities we have attached to the various GOP proposals). Tax cuts and increased spending will be positive for risk assets. The caveat is that we see little change in Trump's commitment to mercantilism. This means he will lean toward backing the border tax or tariff increases, which will offset some of the benefits for risk assets from reduced tax rates. Excess Reaction To FOMC Chart I-3FOMC & Market Disagree Beyond This Year Given the uncertainty on the fiscal side, one can't blame the FOMC for taking a "wait and see" approach. The range for the funds rate was raised to 0.75-1.00% at the March meeting, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50 bps of tightening is expected by the Committee this year, with 75 bps expected in both 2018 and 2019 (Chart I-3). The FOMC signaled in March that it was not yet prepared to adjust the 'dot plot,' sparking a rally in bond prices and a pullback in the dollar. This market reaction seemed excessive in our view. The key message from the March meeting was that the Fed now sees inflation as having finally reached its 2% target, as highlighted by the decision to strip the reference to the "current shortfall of inflation" from the statement. If the U.S. economy performs as we expect, the Fed will have to take a more hawkish tone later this year. Is The Dollar Bull Over? Still, recent market action suggests that the dollar may not get a lift from future Fed rate hikes because the outlook for global growth outside of the U.S. is brightening. Moreover, it could be that monetary policy in the Eurozone and Japan is at a turning point. There is increasing speculation that the ECB will have to taper the quantitative easing program sooner than planned. Some are even speculating the ECB will lift rates this year. The recent economic data for the euro area have indeed been stellar. The composite PMI surged to 56.7 in March, with the forward-looking new orders components hitting new cyclical highs. Capital goods orders continue to trend higher, which bodes well for investment spending over the coming months (Chart I-4). In addition, private-sector credit growth has accelerated to the fastest pace since the 2008-09 financial crisis. Our real GDP model for the Eurozone, based on our consumer and business spending indicators, remains quite upbeat for the first half of the year. With unemployment rapidly falling in many parts of the Euro Area, it is becoming increasingly difficult to establish a consensus view on the ECB policy committee. The Bundesbank has been quite vocal on this issue, especially given that Eurozone headline HICP inflation reached 2% in February. The core rate of inflation remains close to 1%, but the rising diffusion index suggests that budding inflation pressure is becoming more broadly based (Chart I-5). Chart I-4Solid Eurozone Economic Data Chart I-5Eurozone Inflation Broadening Out BCA's Global Fixed Income Strategy service recently compared the current economic situation to that of the U.S. around the time of the Fed's 2013 "Taper Tantrum."1 In Chart I-6, we show "cycle-on-cycle" comparisons for the Euro Area and U.S. In the Euro Area, the number of months to the first rate hike discounted in money markets peaked in July of last year right around the time of the U.K. Brexit vote. Interestingly, this indicator has converged with the U.S. path. There is less spare capacity in European labor markets today than was the case in the U.S. when the Fed first hinted at tapering its asset purchases. Nonetheless, the relatively calmer readings on Euro Area core inflation suggest that the ECB does not have to rush to judgment on asset purchases, especially given upcoming elections. Not before September will the ECB be in a position to announce another tapering of its asset purchases beginning in 2018. A "Bund Tantrum" could thus be the big story for the global bond market later this year. We do not believe that the ECB will raise short-term interest rates before it starts the tapering process. A rate hike would result in a stronger euro, downward pressure on inflation, and an unwanted tightening in financial conditions that would threaten the current economic impulse. This means that, between now and September, the window is still open for U.S./Eurozone interest rate spreads to move further in favor of the dollar. The European election calendar remains a risk to our view on currencies and risk assets. Widening OAT/Bund yield spreads highlight that investors remain concerned that the French election will follow last year's populist script in the U.K. and the U.S. However, our geopolitical team believes that Le Pen is unlikely to win since she trails in the polls by a 25-30% margin relative to Macron, her most likely opponent. Even if she were to pull off a win, she will not hold the balance of power in the National Assembly. Over in Germany, where the election is heating up, the fact that the Europhile SPD party is gaining in the polls means that the September vote is unlikely to be a speed bump for financial markets. The real political risk lies in Italy. While the election has been pushed off to February 2018, it appears that there will be genuine fireworks at that time because Euroskeptic parties have seized the lead in the polls (Chart I-7). In the meantime, European elections will be a source of volatility, but investors should ride it out until we get closer to the Italian election. Chart I-6Less Spare Capacity In Europe ##br##Now Vs. Pre-Taper Tantrum U.S. Chart I-7Italian Elections: The Big Risk Japanese Yield Cap To Hold Chart I-8Japanese Wages Still Disappointing Similar to our view on the ECB, we do not believe that the Bank of Japan (BoJ) will be in a position to begin removing monetary accommodation anytime soon. We expect that the 0% yield cap on the 10-year JGB to remain in place at least for the remainder of this year. True, deflationary forces appear to have eased somewhat. Japan is also benefiting from the faster global growth on the industrial side. Nonetheless, the domestic demand story is less positive, with consumer confidence and real retail sales growth languishing. Wages continue to struggle as well (Chart I-8). This year's round of Japanese wage negotiations was particularly disappointing, with many manufacturing companies offering pay raises only half as large as those of last year. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus making the yen weaken alongside increasingly unattractive interest rate differentials. Our views on U.S. fiscal policy and the outlook for the major central banks paint a bullish picture for the dollar and suggest that the other 'Trump trades' still have legs. The dollar has another 10% upside in trade-weighted terms and the global bond bear phase is not yet over. Admittedly, however, the next major move in global yields may not occur until the autumn when the ECB takes a less dovish tone. In the meantime, our fixed-income strategists remain underweight Treasurys within global currency-hedged portfolios. The team recently upgraded (low beta) JGBs to overweight at the expense of core European government bonds, which move to benchmark. Correlation, ERP And Hurdle Rates Chart I-9Market Correlations Are Shifting Another key market development has been the continuing drop in risk asset correlations, a trend that began before the U.S. election (Chart I-9). Elevated financial market correlations have been a hallmark of this expansion, making life difficult for traders and for investors searching for diversification. Correlations have been higher than normal across assets, across regions and within asset classes. However, the situation has changed dramatically over the past 6 months. A drop in asset correlations is important for diversification reasons and because it provides a better backdrop for those seeking alpha. But the reasons behind the decline in correlations may have broader financial and economic implications. One can only speculate on the underlying cause of the surge in asset correlations in the first place. Our theory has been that the large global output gap lingered because of the sub-par recovery that followed the most damaging macroeconomic shock since the Great Depression. The growth headwinds were formidable and many felt that the sustainability of the recovery hinged solely on the success or failure of radical monetary policy. Either policy would "work", the output gap will gradually close, the deflation threat would be extinguished and risk assets would perform well, or it would fail, and risk assets would be dragged down as the economy fell back into recession. Thus, risk assets fluctuated along with violent swings in investor sentiment in what appeared to be a binary economic environment. In the March 2017 Quarterly Review, the Bank for International Settlements described it this way: "In a global environment devoid of growth but plentiful in liquidity, central bank decisions appear to draw investors into common, successive phases of buying or selling risk." In previous research, we developed a model that helps to explain the historical movements in correlations. We chose to focus on the correlation of individual stocks within the S&P 500 (Chart I-10). The two explanatory variables are: (1) the equity risk premium (ERP; the difference between the S&P 500 forward earnings yield and the 10-year Treasury yield); and (2) rolling 1-year realized downside volatility.2 The logic behind the model is that a higher ERP causes investors to revalue cash flows from all firms, which in turn, causes structural shifts in the correlation among stocks. Conversely, a lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious include an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Volatility is included to explain the cyclical variation of correlations, but we use only below-average returns in the calculation because we are more concerned about the risk of equity market declines. It makes sense that perceptions of downside "tail risk" should affect investors' appetite for risk. The model almost completely explains the trend in stock price correlations over the past decade, highlighting the importance of the ERP in driving the structural change in correlations (Chart I-11). But why was the ERP so elevated after 2007? Chart I-10Market Correlation And The ERP Chart I-11Modeling The Stock ##br##Correlation Within The S&P 500 The preceding moderation in risk premia in the 1990s was likely due to a decline in macroeconomic volatility, a phenomenon that began in the early 1980s and has since been dubbed "The Great Moderation". A waning in the volatility of global inflation and growth contributed to a decline in the volatility of interest rates, which are used to discount future cash flows. This also reduced the perceived riskiness of investing in securities that are leveraged to economic growth, thus causing investors to trim their required excess returns to equities. Unfortunately, the Great Moderation contributed to complacency and bubbles in tech stocks and, later, housing.3 The bursting of the U.S. housing bubble brought the Great Moderation to a crushing end, ushering in an era of rolling financial crises and monetary extremism. Our measure of downside volatility soon returned to normal levels after the recession-driven spike. However, the ERP continued to fluctuate at a higher average level, which helps to explain the strong correlation among risk asset prices in the years since the recession. The ERP And Capital Spending Chart I-12Capex Hurdle Rates Never Came Down An elevated equity risk premium is consistent with the view that investors demanded a more generous premium to take risk in a post-Lehman world. This may also help to explain the disappointing rate of capital spending growth in the major countries in recent years. Firms demanded a fat "hurdle rate" when evaluating new investment projects. Sir John Cunliffe, a member of the Bank of England Monetary Policy Committee, recently cited survey evidence related to the dismal U.K. capital spending record since the recession.4 The main culprits were bank lending issues, the high cost of capital and elevated hurdle rates. Eighty percent of publically-owned firms in the survey agreed that financial market pressure for short-term returns to shareholders had been an obstacle to investment. This short-termism makes sense if investors feared that the recovery could turn to bust at any moment. The survey highlighted that market pressure, together with macro uncertainty among CEOs, kept the hurdle rate applied to new investment projects at close to 12%, despite the major drop in market interest rates. In other words, the gap between the required rate-of-return on new projects and the risk-free rate or corporate borrowing rates surged (Chart I-12). J.P. Morgan concluded that hurdle rates have also been sticky at around 12% in the U.S.5 This study blamed uncertainty over the cash-flow outlook (macro risk) and the fact that CEOs believed that low borrowing rates are temporary. It is rational for a firm to hold cash and buy back stock if perceptions of downside tail risk remain lofty. The bottom line is that uncertainty and higher risk aversion related to macro volatility kept the ERP elevated, curtailing animal spirits and lifting correlation among risk asset prices. The good news is that the situation appears to have changed since the U.S. election. Measures of market correlation have dropped sharply across asset classes, within asset classes and across regions. Animal spirits also appear to be reviving given the jump in consumer and business confidence in the major countries. We are not making the case that all risks have dissipated. The military situation in North Korea and upcoming European elections are just two on a long list, as highlighted in this month's Special Report on Brexit's implication for Scotland independence, beginning on page 19. Our point is that, absent further negative shocks, perceptions of downside tail risk and a binary economic future should wane further. And, if business leaders come to believe that deflation risk has finally been vanquished, they can now focus more on long-term revenue generation rather than on guaranteeing their existence. Does The ERP Have More Downside? It is difficult to determine the equilibrium equity risk premium, but back-of-the-envelope estimates can provide a ballpark figure. Let us assume that the ERP is not going back into negative territory, as was the case from 1980-2000. A more reasonable assumption is that the ERP instead converges with the level that prevailed during the last equity bull market, from 2003 to 2007 (about +200 basis points). The ERP is currently 3.2, which is equal to the forward earnings yield of 5.6 minus the 10-year yield of 2.4% (Chart I-13). The ERP would need to fall by 120 basis points to get back to the 2% average yield of 2003-2007. This convergence can occur through some combination of a lower earnings yield or a higher bond yield. If the 10-year Treasury yield is assumed to peak in this cycle at about 3%, then this leaves room for the earnings yield to fall by 60 basis points. This would boost the earnings multiple from 17.8 to 20. However, a rise in the 10-year yield to 3½% would leave no room for multiple expansion. We lean to the latter scenario for bonds, although it will take some time for the bond bear phase to play out. In the meantime, an equity overshoot is possible. The bottom line is that much of the normalization of the ERP since 2012 has been due to multiple expansion. Going forward, the lion's share of the remaining adjustment is likely to be in the bond market, with equity multiples trending sideways. This means that equity total returns will be roughly in line with dividends and earnings growth over the next couple of years, although that will be much better than the (likely negative) returns in the bond market. We continue to favor higher beta developed markets where value is less stretched, such as the euro area and Japan, over the U.S. on a currency-hedged basis. Europe is about one standard deviation cheap relative to the U.S. index, although the extra value in the Japanese market has dissipated recently (Chart I-14). Moreover, both Eurozone and Japanese stocks in local currency terms will benefit from weaker currencies in the coming months, as rising inflation expectations and stable nominal interest rates result in declining in real rates, at least relative to the U.S. Chart I-13Forward Multiple Scenarios Chart I-14Eurozone Stocks Are Cheap Conclusion We have reassessed our asset allocation given that several market calls have gone against us over the past month. However, three key views argue to stay the course for now: Recent economic data support our view that a synchronized global acceleration is underway. This is highlighted by an update of the real GDP growth models we introduced last month (Chart I-15). The implication is that earnings growth will be constructive for stocks; Tax reform is still likely to be passed this year in the U.S. Moreover, were a broad tax reform package to elude the Administration, the fallback position will involve (stimulative) tax cuts, some infrastructure spending and de-regulation; and The FOMC will shift to a more hawkish tone in the coming months, while the ECB, Bank of England and Bank of Japan will maintain extremely accommodative monetary policy at least into the fall. The result is that stocks will outperform cash and bonds, while the dollar still has another 10% upside potential. The only adjustment we are making this month is in the U.S. high-yield corporate bond allocation. According to our fixed-income strategists, value has improved enough that it is worth upgrading the sector to overweight at the expense of Treasurys. Some of the indicators that comprise our default rate model have become more constructive for credit risk, including lending standards, the PMIs and profits. The combination of wider junk spreads and an improving default rate outlook have resulted in a widening in our estimate of the default-adjusted high-yield spread to 219 basis points (Chart I-16). Historically, high-yield earns a positive 12-month excess return 81% of the time when the default-adjusted spread is between 200 and 250 basis points. Chart I-15GDP Models Are Bullish Chart I-16Upgrade U.S. High Yield Turning to oil markets, we expect recent price weakness to reverse despite dollar strength. Building inventories have weighed on crude, but this is a head fake according to our commodity experts. We expect to see a sustained draw in OECD storage volumes this year, now that the year-end surge on crude product from OPEC's Gulf producers has been fully absorbed. With global supply/demand fundamentals now dominating price movements, the recent breakdown in the inverse correlation between oil prices and the dollar should persist. Oil prices will rise back toward the US$55 range that we believe will be the central tendency over 2016 and 2017. Risks are to the upside. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Shift to benchmark in Eurozone government bonds and upgrade JGBs to overweight within currency-hedged portfolios. The U.S. remains at underweight. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks over bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues in the U.S.; upgrade U.S. high-yield to overweight, but downgrade European investment-grade to underweight due to fading support from the ECB. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. Favor oil to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst March 30, 2017 Next Report: April 27, 2017 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Will The Hawks Walk The Talk?" dated March 7, 2017, available at gfis.bcaresearch.com. 2 Downside volatility is calculated in a fashion similar to standard deviation, except only using below-average returns. 3 Of course, the Great Moderation was not the only factor that contributed to the financial market bubbles. 4 Are Firms Underinvesting - and if so why? Speech by Sir Jon Cunliffe, Deputy Governor Financial Stability and Member of the Monetary Policy Committee. Greater Birmingham Chamber of Commerce. February 8, 2017. 5 It's Time to Reassess Your Hurdle Rates. J.P. Morgan, November 2016. II. Will Scotland Scotch Brexit? This month's Special Report, on Scotland's role in Brexit negotiations, was penned by our colleagues Matt Gertken, Marko Papic, and Jesse Kurri of BCA's Geopolitical Strategy service. Scottish secessionist sentiment has increased in response to First Minister Nicola Sturgeon's decision to push for a second popular referendum on Scottish independence, tentatively set for late 2018 or early 2019, though likely to be denied for some time by Westminster. The outcome of a referendum on leaving the U.K., which eventually will occur, is too close to call at this point. The possibility will influence the U.K.'s negotiations with the EU, and vice versa. The risk of a U.K. break-up adds an important constraint to Prime Minister Theresa May's government in the Brexit talks. Since the EU also has an interest in avoiding a devastating outcome for the U.K., our geopolitical team believes that the worst version of a "hard Brexit" will be avoided. That said, independence for Scotland cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s divorce proceedings. I trust that you will find the report as insightful as I did. Mark McClellan Senior Vice President A second Scottish referendum will be "too close to call"; There is upside potential to the 45% independence vote of 2014; Scots may vote with their hearts instead of their heads; But the EU will not seek to dismember the U.K. ... ...And that may keep the kingdom united. "No sooner did Scots Men appear inclined to set Matters upon a better footing, than the Union of the two Kingdoms was projected, as an effectual measure to perpetuate their Chains and Misery." - George Lockhart, Memoirs Concerning The Affairs Of Scotland, 1714. British Prime Minister Theresa May has had a busy week. On Monday she met with Scotland's First Minister Nicola Sturgeon as part of a tour of the United Kingdom to drum up national unity. On Wednesday she communicated with European Council President Donald Tusk and formally invoked Article 50 of the Lisbon Treaty, initiating the process of the U.K.'s withdrawal from the European Union. And on that day and Thursday, she turns to the parliamentary battle over the "Great Repeal Bill" that will replace the 1972 European Communities Act, which until now translated European law into British law. Brexit is finally getting under way. As our colleague Dhaval Joshi puts it, the "Phoney War" has ended, and now the real battle begins.1 Indeed, the dynamic has truly shifted in recent weeks. Not because PM May invoked Article 50, which was expected, but rather because Scottish secessionist sentiment has ticked up in reaction to Sturgeon's decision to hold a second popular referendum on Scottish independence (Chart II-1), tentatively set for late 2018 or early 2019. Scottish voters are still generally opposed to holding a second referendum, but the gap is narrowing (Chart II-2). A sequel to the September 2014 referendum was always in the cards in the event of a Brexit vote. Financial markets called it, by punishing equities domiciled in Scotland following the U.K.'s EU referendum (Chart II-3). The timing of the move toward a second referendum is significant for two reasons. First, the odds of Scotland actually voting to leave have increased relative to 2014, even as the economic case for secession has worsened. Second, Scotland's threat of leaving will impact the U.K.'s negotiations with the EU, slated to end in March 2019.2 Chart II-1A Second Independence Referendum... Chart II-2...Is Looking More Likely Chart II-3Scottish Stocks Have Underperformed BCA's Geopolitical Strategy service believes that a second Scottish referendum will eventually take place. And as with the Brexit referendum, the outcome will be "too close to call," at least judging by the data available at present. In what follows we discuss why, and how Scotland could influence the Brexit negotiations, and vice versa. While the U.K. can avoid the worst version of a "hard Brexit," the high risk of a break-up of the U.K. will add urgency to negotiations with the EU. Why Scotland Rejected "Freedom" In 2014 In a Special Report on "Secession In Europe," in May 14, 2014, we argued that the incentives for separatism in Europe had weakened and that this trend specifically applied to Scotland:3 The world is a scary place: Whereas the market-friendly 1990s fueled regional aspirations to independence by suggesting that the world was fundamentally secure and that "the End of History" was nigh, the multipolar twenty-first century discourages those aspirations, with nation-states fighting to maintain their integrity. For Scotland, the Great Recession drove home the dangers of socio-economic instability. EU and NATO membership is difficult to obtain: Scotland could not be assured to find easy accession to the EU as it faced opposition from states like Spain, which wanted to discourage Catalan independence. Enlargement of the EU and NATO have both become increasingly difficult and Scotland would need a special dispensation. The United States and the European Union vociferously discouraged Scotland from striking out on its own ahead of the 2014 referendum. Domestic politics: The Great Recession revived old fissures in every country, including the old Anglo-Scots divide. The U.K. imposed budgetary austerity while Scotland opposed it. Left-leaning Scotland resented the rightward shift in the U.K., ruled by the Conservative Party after 2010. We also highlighted some of Scotland's particular impediments to independence: Energy: Scotland's domestic sources of energy are in structural decline. This would weigh on the fiscal balance and domestic private demand. The referendum actually signaled a top in the oil market, with oil prices collapsing by 58% in 2014. Deficits and debt: Scotland's public finances would get worse if it left the U.K. If that had happened in 2014, it was estimated that the country's fiscal deficit would have been 5.9% of GDP and that its national debt would have been 109% of GDP. (Today those numbers are 8% and 84% of GDP respectively) (Table II-1). A newborn Scotland would have to adopt austerity quickly. Table II-1Scotland Would Be A High-Debt Economy Central banking: If Scotland walked away from its share of the U.K.'s national debt, yet retained the pound unilaterally and without the blessing of the BoE, it would lose access to the English central bank as lender of last resort. And if it walked away from its U.K. debt obligation and the pound, then it would also lose its financial sector and much of its wealth, which would be newly redenominated into a Scots national currency. Scotland is every bit as reliant on the financial sector as the U.K. as a whole (Chart II-4), making for a major constraint on any political rupture that threatens to force it to change currencies or lose control of monetary policy. Chart II-4Highly Financialized Societies Politics: We also posited that domestic political changes in the U.K. could provide inducements to keep Scotland in the union, particularly if the Conservatives suffered in the 2015 elections. The opposite, in fact, occurred, sowing the seeds for today's confrontation. For all these reasons, we argued that the risks of Scottish secession were overstated. The September 2014 referendum confirmed our forecast. The economic prospects were simply too daunting outside the U.K. But the 45% pro-independence tally also left open the possibility for another referendum down the line. Bottom Line: Scottish independence did not make sense in 2014 for a range of geopolitical, political, and economic reasons. But note that while independence still does not make economic sense, the political winds have shifted. Scottish antagonism toward the Conservative leadership in England has only intensified, while it remains to be seen how the European Union will respond to Scotland in a post-Brexit world. The Three Kingdoms In our Strategic Outlook for 2017, we argued that the British public not only did not regret the Brexit referendum outcome, but positively rallied around the flag because of it. This helped set up an environment in which the ruling party could charge forward aggressively and pursue the outcome confirmed by the vote (Chart II-5). Brexit does indeed mean Brexit. We have since seen that the Tories have forced parliament's hand in approving the bill authorizing the government to initiate exit proceedings. Chart II-5Three Cheers For Brexit And The Tories It stood to reason that the crux of tensions would shift to the domestic sphere, i.e. to the troubling constitutional problems that Brexit would provoke between what were once called "the Three Kingdoms," England (and Wales), Scotland, and Northern Ireland.4 While 52% of the U.K. public voted to leave the EU, the subdivision reveals the stark regional differences: England and Wales voted to leave (53.4% and 52.5% respectively), while Scotland and Northern Ireland voted to stay (62% and 55.8% respectively). Scotland and the London metropolitan area were the clear outliers. The Scottish parliament is a devolved parliament subordinate to the U.K. parliament in Westminster, and it cannot hold a legally binding referendum on independence without the latter's permission.5 The May government is insisting that it will not allow a referendum to go forward until the Brexit negotiations are completed. This is an obvious strategic need. Although the Scottish National Party (SNP), the dominant party in Edinburgh, could hold a non-binding referendum at any time to apply pressure on London (reminder: the Brexit vote was also non-binding), it has an interest in waiting to see whether public opinion of Brexit will shift in England and what kind of deal the U.K. might get from the EU in the exit negotiations. Eventually, however, Scotland is likely to push for a new vote. The SNP is a party whose raison d'être is independence sooner or later. It faces a once-in-a-generation opportunity, with the 2014 referendum producing an encouraging result and Brexit adding new impetus. The party manifesto made clear in 2016 that a new independence vote would be justified in case of "a significant and material change in the circumstances that prevailed in 2014, such as Scotland being taken out of the EU against our will." Why have the odds of Scottish independence increased? First, Brexit removes a domestic political constraint on independence. After the Brexit vote, the SNP and other pro-independence groups can say that England changed the status quo, not Scotland. It is worth remembering that the Anglo-Scots union was forged in 1707 at a time of severe Scottish economic hardship, in which a common market was the primary motivation to merge governments. Today, Scotland's comparable interest lies in maintaining access to the European single market, which is now under threat from Westminster. In particular, as with the U.K. as a whole, Scotland stands to suffer from a decline in immigration and hence workforce growth (Chart II-6). Second, Brexit removes an external constraint. The EU's official opposition to Scottish independence, particularly European Commission President Jose Manuel Barroso's threat that Scottish accession would be "extremely difficult, if not impossible," likely affected the outcome of the 2014 referendum. Of course, many Scots rejected all such warnings as the vote approached, with polls showing a rally just before the referendum date toward the 45% outcome (Chart II-7). But if the EU's warnings even had a temporary effect, what happens if the EU gives a nod and wink this time around? While EU officials have recently reiterated the so-called "Barroso doctrine," we suspect that they are less likely to play an interventionist role under the new circumstances. Spain - which is still concerned about Scotland fanning Catalan ambitions - might be less vocal this time, since Madrid could plausibly argue that Brexit makes a material difference from its own case. Catalonians could not argue, like the Scots, that their parent country attempted to deprive them of access to the European Single Market. Chart II-6Immigration Curbs ##br##Threaten Scots Growth Chart II-7Scottish Patriots ##br##Only Temporarily Deterred To put this into context, remember that it is not historically unusual for continental Europe to act as a patron to Scotland to keep England in check. There is ample record of this behavior, namely French and Spanish patronage of the exiled Stuart kings after 1688. The situation is very different today, but the analogy is not absurd: insofar as Brexit undermines the integrity of the EU, the EU can be expected to reciprocate by not doing everything in its power to defend the integrity of the U.K. All is fair in love and war. Nevertheless, the economic constraints to Scottish secession are even clearer than they were in 2014: The North Sea is drying up: Scotland's North Sea energy revenues have essentially collapsed to zero (Chart II-8). Meanwhile the long-term prospects for the North Sea oil production remain as bleak as they were in 2014, especially since oil prices halved. Reserves of oil and gas are limited, hovering at around five to eight years' worth of supply - i.e. not a good basis for long-term independence (Chart II-9). Decommissioning costs are also expected to be high as the sector is wound down. England still foots many bills: Total government expenditures in Scotland exceed the total revenue raised in Scotland by about £15 billion or 28% of Scotland's government revenue (Chart II-10). Chart II-8No Golden Goose In The North Sea Chart II-9Limited Domestic Energy Supplies Chart II-10The U.K. Pays For Scotland's Allegiance Scottish finances stand at risk: Scotland's fiscal, foreign exchange, and monetary policy dilemmas are as discouraging as they were in 2014 (Chart II-11). Judging by the value of financial assets (which come under risk if Scotland loses the BoE's support or changes currencies), Scotland is incredibly exposed to financial risk (Chart II-12). Chart II-11Scotland's Deficits Getting Worse Chart II-12Scottish Financial Assets Need Currency Stability Thus, while key domestic political and foreign policy impediments may be removed, the country's internal economic impediments remain gigantic. Moreover, Scotland already has most of the characteristics of a nation state. It has its own legal and education system, prints its own banknotes, and has some powers of taxation (about 40% of revenue). It lacks a standing army and full fiscal control, but in these cases it clearly benefits from partnering with England. It also has a strong sense of national identity, regardless of whether it is technically independent. Why, then, do we believe Scottish independence is too close to call? Because Brexit has shown that "math" is insufficient! The Scots may go with their hearts against their heads, just as many English voters did in favor of Brexit. Nationalism and political polarization are a two-way street. History also shows that strictly materialist or quantitative assessments cannot anticipate paradigm shifts or national leaps into the unknown. Compare Ireland in 1922, the year of its independence from the U.K. Ireland was far less prepared to strike out on its own than Scotland is today. It comprised a smaller share of the U.K.'s population, workforce, and GDP than Scotland today (Charts II-13 and II-14). It was less educated and less developed relative to its neighbors, and it faced unemployment rates above 30%. Yet it chose independence anyway - out of political will and sheer Celtic grit. Ireland's case was very different than Scotland's today, but there is an interesting parallel. The U.K. was absorbed with continental affairs, the Americans played the role of external economic patron, and the Irish were ready to seize their once-in-a-lifetime opportunity. Today the U.K. is similarly distracted with Europe, and the SNP leadership is ready to seize the moment, having revealed its preference in 2014. But foreign support (in this case the EU's) will be a critical factor, even though the EU's common market is much less valuable to Scotland than the U.K.'s (Chart II-15). Chart II-13Irish Independence: ##br##Poverty Not An Obstacle Chart II-14Scotland: If The Irish ##br##Can Do It So Can We Chart II-15EU Market No ##br##Substitute For British Market Will the SNP be able to get enough votes? We know that more Scots voted to stay in the EU (62%) than voted to stay in the U.K. (55%), which in a crude sense implies that there is upside potential to the first referendum outcome. However, looking at the referendum results on the local level, it becomes clear that there is no correlation between Scottish secessionists and Europhiles, or unionists and Euroskeptics (Chart II-16). Nor is there any marked correlation between level of education and the desire for independence, as was the case in Brexit. Yet there is evidence that love of the Union Jack is correlated with age (Chart II-17). Youngsters are willing to take risks for the thrill of freedom, while their elders better understand the benefits from economic links and transfer payments. In the short and medium run, this suggests that demographics will continue to work against independence - reinforcing the fact that the SNP can wait to see what kind of deal the U.K. gets first.6 Chart II-16No Relationship Between IndyRef And Brexit Chart II-17Old Folks Loyal To The Union Jack The most striking indicator of Scottish secessionism is unemployment (Chart II-18). Thus an economic downturn that impacts Scotland, for example as result of uncertainty over Brexit, poses a critical risk to the union. The SNP will be quick to blame even a shred of economic pain on Tory-dominated Westminster. The British government and BoE have shown a commitment to use accommodative monetary and fiscal policy to smooth over the transition period, and they have fiscal room for maneuver (Chart II-19), but much will depend on what kind of a deal London gets from the EU and whether the markets remain calm. Chart II-18Joblessness Boosts Independence Vote Chart II-19The U.K. Has Room To Maneuver Bottom Line: Economics is an argument against Scottish independence, but history and politics are unclear. We simply note that independence cannot be ruled out, particularly in the context of any adverse economic shock stemming from the U.K.'s actual divorce proceedings. Will Scotland Scotch Brexit? From the beginning of the Brexit saga, BCA's Geopolitical Strategy service has argued that Britain, of all EU members, was uniquely predisposed and positioned to leave the union. Hence the referendum was "too close to call."7 This did not mean that the U.K. could do so without consequences. Leaving would be detrimental (albeit not apocalyptic) to the U.K.'s economy, particularly by harming service exports to the EU and reducing labor force growth via stricter immigration controls. In the event, upside economic surprises have occurred, though of course Brexit has not happened yet.8 How does the Scottish referendum threat affect the Brexit negotiations? This is much less clear and will require constant monitoring over the coming two years, and perhaps longer if the European Council agrees to extend the negotiating period (which would require a unanimous vote). Still, we can draw a few conclusions from the above. First, London is a price taker not a price maker. It cannot afford not to agree to a trade deal or transition deal of some sort upon leaving in 2019. Even if England were willing to walk away from the EU's offers, a total rupture (reversion to minimal WTO trade rules) would be unacceptable to Scotland after being denied a say in the negotiation process. Therefore Scotland is now a moderating force on the Tory leadership that is otherwise unconstrained by domestic politics due to the high level of support for May's government (see Chart II-5, page 24). To save the United Kingdom, the Tories may simply have to accept what Europe is willing to give. This supports our view that the risk of a total diplomatic war between Europe and the U.K. is unlikely and that expectations of cross-channel fireworks may be overdone. Second, Scotland is twice the price taker, because it can only afford independence from the U.K. if the EU is willing to grant it a special arrangement. This is possible, but difficult to see happen early in the negotiations process. It will be important to monitor Brussels' statements on Scottish independence carefully for signs that the EU is taking a tough stance on Brexit negotiations. Sturgeon has to play it safe and see what kind of a deal May brings back from Brussels. By waiting, she can profit from Scottish indignation over both May's use of prerogative to block the referendum in the first place and then over the Brexit deal itself, when it takes place. Third, the saving grace for both countries is that it is not in Europe's interest to dismantle the U.K., or to force it into a debilitating economic crisis. We have long differed from the view that the EU will be remorseless in its negotiations over Brexit. The EU seeks extensive trade engagements with every European country, from Norway and Switzerland to Iceland and Turkey, because its interest lies in expanding markets and forging alliances. Europe is not Russia, seeking to impose punitive economic embargoes on Ukraine and Belarus for failure to conform to its market standards. While free trade agreements usually take longer than two years to negotiate, and while the CETA agreement between the EU and Canada is a recent and relevant example of the risks for the U.K., the U.K. and EU are already highly integrated, unlike the two parties in most other bilateral trade negotiations. In addition, the U.K. is a military and geopolitical ally of key European states. The U.K.-EU negotiations are not being conducted in a ceteris paribus economic laboratory, but are occurring in 2017, a year in which Russian assertiveness, transnational terrorism and migration, and global multipolarity are all shared risks to both the U.K. and EU. Investment Implications Since January 17 - the date of Theresa May's speech calling for the exit from the common market - we have argued that the worst is probably over for the U.K.9 Yes, the EU negotiations will be tough and the British press - surprisingly lacking the stiff upper lip of its readers - will make mountains out of molehills. However, by saying no to the common market, Theresa May plays the role of a spouse who does not want to fight over the custody of the children, thus defusing the divorce proceedings. Our Geopolitical Strategy service has been short EUR/GBP since mid-January and the trade is down 2%. This suggests that the market has been in "wait and see mode" since the speech. We are comfortable with this trade regardless of our analysis on the rising probability of the Scottish referendum for two reasons: Hard Brexit is less likely: Many Tory MPs have had a tough time getting behind the "hard Brexit" policy, but until now they have had a tough time expressing their displeasure. However, the threat of Scottish independence and the dissolution of the U.K. will give the members of the Conservative and Unionist Party (as it is officially known) plenty of ammunition to push May towards a softer Brexit outcome. This should be bullish GBP in ceteris paribus terms. It's not the seventeenth century: We do not expect the EU to act like seventeenth-century France and subvert U.K. unity, at least not this early in the negotiations. For clients who expect the "knives to come out," we offer Scottish independence as a critical test of the thesis. Let's see if the EU is ready to play dirty and if it decides to alter the "Barroso doctrine" for Scotland. If they do, then our sanguine thesis is truly wrong. To be clear, we do not have high conviction that the pound will outperform either the euro or the U.S. dollar. Instead, we offer this currency trade as a way to gauge our political thesis that the U.K.-EU negotiations will likely go more smoothly than the market expects. Matt Gertken Associate Editor Geopolitical Strategy Marko Papic Senior Vice President Geopolitical Strategy Jesse Anak Kuri Research Analyst Geopolitical Strategy 1 Please see BCA European Investment Strategy Weekly Report, "Phoney War Ends. Battle Begins," dated March 16, 2017, available at eis.bcaresearch.com. 2 Article 50 allows for a two-year negotiation period, after which the departing party may have an exit deal but is not guaranteed a trade deal for the future. The negotiation period can be extended with a unanimous vote in the European Council. 3 Please see BCA Geopolitical Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy, "Brexit: The Three Kingdoms," in Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 5 The union of the kingdoms of Scotland and England is a power "reserved" to parliament and the crown in Schedule 5 of the Scotland Act of 1998. Altering the union would therefore require the U.K. and Scottish parliaments to agree to devolve the power to Scotland using Section 30(2) of the same act, which the monarch would then endorse. This was the case in 2012 when the 2014 referendum was initiated. 6 On the other hand, demographics also may work against Brexit in the long run, given that - as our colleague Peter Berezin has said in the past - many who voted to leave the EU will eventually pass away. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, and "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. III. Indicators And Reference Charts The S&P 500 index has pulled back from its recent highs, but it has not corrected enough to 'move the dial' in terms of the valuation or technical indicators. Stocks remain expensive based on our valuation index made up of 11 different measures. The technical indicator is still bullish. Our equity monetary indicator has dropped back to the zero line, meaning that it is not particularly bullish or bearish at the moment. The speculation index is elevated, however, pointing to froth in the market. The high level of our composite sentiment index and the low level of the VIX speaks to the level of investor complacency. Net earnings revisions remain close to the zero mark, although it is somewhat worrying that the earnings surprises index is slowly deteriorating. Our U.S. Willingness-to-Pay (WTP) indicator continues to send a positive message for the S&P 500. This indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. However, the widening gap between the U.S. WTP and that of Japan and Europe highlights that recent flows have favored the U.S. market relative to the other two. Looking ahead, this means that there is more "dry powder" available to buy the Japanese and European markets. A rise in the WTPs for these two markets in the coming months would signal that a rotation into Europe and Japan is taking place. U.S. bond valuation is hovering close to fair value. However, we believe that fair value itself is moving higher as some of the economic headwinds fade. The composite technical indicator for the 10-year Treasury shows that oversold conditions are unwinding, although the indicator is not yet back to zero. This suggests that the consolidation period for bonds is not yet complete. Oversold conditions are almost completely gone in terms of the U.S. dollar. The dollar is very expensive on a PPP basis, although it is less so by other measures. We believe the dollar has more upside. Technical conditions are also benign in the commodity complex. However, we are only bullish on oil at the moment. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation Chart III-5U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations Chart III-9U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield ComponentsChart III-12U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals Chart III-18Japanese Yen TechnicalsChart III-20Euro/Yen Technicals Chart III-19Euro TechnicalsChart III-21Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Chart III-23Commodity Prices Chart III-24Commodity Prices Chart III-25Commodity Sentiment Chart III-26Speculative Positioning Chart III-27U.S. And Global Macro Backdrop ECONOMY: Chart III-28U.S. Macro Snapshot Chart III-29U.S. Growth Outlook Chart III-30U.S. Cyclical Spending Chart III-31U.S. Labor Market Chart III-32U.S. Consumption Chart III-33U.S. Housing Chart III-34U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China

Geopolitical tensions in the South China Sea are here to stay; China has reached the ability to impose massive costs on any state that tries to roll back its control; U.S. advantages in the region are significant, but declining and overrated. We put together a portfolio of stocks that give investors exposure to the ongoing tensions in the South China Sea. Dear Client, Today's Special Report is jointly authored by BCA's Geopolitical Strategy and Emerging Markets Equity Strategy services and focuses on the tail risks around the South China Sea conflict. In this report, our colleagues Matt Gertken of the Geopolitical Strategy and Oleg Babanov of the Emerging Markets Equity Sector Strategy ask whether China has "won" the South China Sea, and what the implications might be for investors. At the end of the report, we provide detailed investment recommendations for both EM-dedicated as well as global investors. Kindest Regards, Garry Evans Senior Vice President EM Equity Sector Strategy Marko Papic Senior Vice President, Geopolitical Strategy "We're going to war in the South China Sea in five to 10 years ... There's no doubt about that." - Steve Bannon, prior to becoming President Donald Trump's Chief Strategist, Breitbart News, March 2016 The South China Sea is a headline grabber that has failed to produce any market-disruptions despite years of rising tensions. In fact, it would appear that the issue has been relegated to the backburner, with the Trump administration laying off its earlier aggressive rhetoric and America's Asian allies focusing on building a trade relationship with China. Compared to the Koreas, in particular, where geopolitical risk is spiking due to political turmoil in the South and weapons advances in the North, the South China Sea seems relatively calm.1 We are not so sanguine, however, and advise investors to take the tail-risk of a conflict in the South China Sea seriously. First, there has been a general "rotation" of global geopolitical risk from the Middle East to Asia Pacific, as BCA's Geopolitical Strategy has chronicled over the years.2 China's transformation into a "peer" or "near-peer" competitor to the United States, and the U.S.'s various reactions, are transforming the region and sowing the seeds of a new Cold War. Second, despite a thaw in the relationship between China and the Trump Administration, the latest positive signals have not extended to the South China Sea.3 In North Korea, China is offering to enforce sanctions. In Taiwan, Trump has backed away from hints of encouraging independence. But in the South China Sea, the two sides have increased activity even as they have made reassuring statements.4 Third, fact remains that despite headline grabbers, China has managed to expand its military installations in the region over the past half-decade and now possesses a layered-defense system in the region. In this report, we ask whether China has "won" the South China Sea, and what the implications might be for investors, particularly EM-dedicated investors, on the sectoral level. We find that China has reached the ability to impose massive costs on any state that should try to roll back its control of the disputed islands. We also do not think that the U.S. is ready to accept this new Chinese "sphere of influence." This means that the two countries are in a "gray zone" in which policy mistakes could occur. This uncertainty is driving the odds of a crisis higher. China is flush with recent victories in the islands, and yet the United States will continue to insist on free passage and the defense of allies and partners. Nationalism and rising jingoism in both countries also raises the odds of misunderstanding and miscalculation. Until the Trump and Xi administrations agree to a robust strategic deal that arranges for de-escalation, the South China Sea will remain a source of low-probability, high-impact geopolitical risk for investors. It is only one aspect of a broader deterioration in U.S.-China relations that we see as the ultimate driver of a secular rise in geopolitical risk in Asia Pacific.5 Unfortunately, history also teaches us that such "strategic resets" are normally motivated by a dramatic crisis. At the end of this report, we provide investment recommendations for investors in emerging markets (and a couple for the U.S. as well). Why Not Ignore The South China Sea? Map 1Nine-Dash Line Reaches Far Beyond China Maritime territorial disputes between China and several of its neighbors - Taiwan, Vietnam, the Philippines, Malaysia, Brunei, and partly Indonesia - have a long history. China declared its "Nine Dash Line," an expansionist claim of sovereignty over almost the entirety of the sea, in 1947 (Map 1). Since then, conflicts have flared up sporadically. The most notable skirmishes illustrate that the maritime disputes are always simmering but tend to boil over only when larger geopolitical issues heat up.6 Since the 1990s, China and the other claimants have raced to "grab what they can," particularly in the Spratly Islands. However, conflicts have especially intensified since the mid-2000s (Charts 1 and 2). A major factor has been the rise in competition for subsea resources: Chart 1Territorialism Rising In South China Chart 2Rising Number Of Confrontations Energy and minerals - Although estimates vary widely, the South China Sea contains respectable reserves of oil and natural gas (Chart 3) and there are also hopes of extracting other minerals from the sea floor. Most of the region's states are net importers. Several conflicts have been sparked by exploration, test drilling, and unilateral development.7 It is a fact that the past decade's buildup in tensions has coincided with a global bull market for energy prices and offshore energy investment and capex (Chart 4). Chart 3Not Insignificant Reserves Of Oil And Gas In South China Sea Fishing Grounds - The South China Sea holds vast fish resources, a source of food security, exports, and jobs for littoral countries. It is estimated that over 10% of global fishing catches come from here. Fishing as a whole accounts for about 1-3% of GDP for the countries involved in the disputes (Chart 5), and the South China Sea is a large chunk of that. A quick glance at recent skirmishes reveals that fishing rights are a major cause of conflict (Table 1). Chart 4Offshore Oil Production In Decline Chart 5Fisheries Non-Negligible For Asian States Table 1Notable Incidents In The South China Sea (2010-16) Nevertheless, resource extraction is not the main driver of discord. Frictions spiked in 2015-16 despite the collapse in China's and other countries' offshore rig counts (Chart 6). And fishing rights are also clearly a pretext for attempts to assert control over waters and rocks.8 Chart 6Energy Interest Declining, Tensions Still Elevated Moreover, China's conversion of the sea's various geographical features into artificial islands through a process of land reclamation, and its construction of military facilities and stationing of armaments on these islands, points not to strictly economic interests but to broader strategic security interests. Similarly, the United States' enforcement of international rights of free navigation and overflight is not related to oil and fish. What is really at stake is national security, supply-line control, and international prestige. First, the United States has long executed a grand strategy of preventing any country from forming a regional empire and denying the U.S. access. China has the long-term potential to make this happen, and the South China Sea is its earliest foray into empire-building abroad. (Taiwan, Xinjiang, and Tibet are all old news and expand Chinese hegemony into the largely useless Eurasian hinterland.) Second, the main global trading lines from Eurasia and Africa to and from Asia mostly go through the South China Sea and the Spratly Islands. We illustrate this process through our diagram of the sea as a large traffic roundabout (Diagram 1). China is attempting to control the centerpiece of the roundabout, which - in combination with China's southern mainland forces - would eventually give it veto power over transit. Diagram 1South China Sea As A Vital Supply Roundabout The economic value of the trade potentially affected by power struggles is what makes this all highly market relevant if a full-blown war ever occurs. We estimate that roughly $4.8 trillion worth of trade flowed through this area in 2015, which is comparable to the $5.3 trillion estimate from 2012 frequently cited in news media.9 Moreover, the trade does not consist merely of manufactured goods from Asian manufacturing centers but also basic commodities vital to the Asian countries' economic and political stability. Essential commodities account for about 20-35% of Northeast and Southeast Asian imports, and almost all of this by definition flows through the South China Sea (Charts 7 and 8). Chart 7Commodity Imports Go Through South China Sea... Chart 8...And Greatly Affect Asian Economies The numbers belie how vital the supply lanes are for individual countries: Japan, for instance, gets 80% of its oil via the South China Sea. A total cutoff would be devastating after strategic reserves were exhausted; and even a marginal hindrance of energy imports would bite into the current account surpluses that grease the wheels of high-debt Asian economies. The South China Sea is therefore vital even to countries like Japan and South Korea that are not party to the maritime-territorial disputes. A commerce-destroying war could strangle their economies. Military access is another reason states seek control. This is separate but related to the need to secure economic supplies. Chinese military planners are clear that they want to be able to deny access to foreign powers if need be, in order to secure the southern half of the country, or cut off Taiwan's or Japan's supply lines. American military planners are equally clear that they will not allow a state to deny them access to international commons, or to coerce others through supply-lane control.10 Finally, there are political and legal aspects to the South China Sea disputes. China's successful alteration of the status quo in the face of opposition from the U.S., Asian neighbors, and a high-profile international tribunal (the Permanent Court of Arbitration at the Hague), has undermined international legal institutions and the U.S. prestige in the region. Over time, regional states, perceiving that "might makes right," may feel the need to cling more closely to China or the U.S., giving rise to proxy battles.11 With supply security and national defense at risk - and China in the process of "militarizing" the islands - there is a rising probability of a major "Black Swan" incident. The involvement of a number of major powers and minor allies means that a small incident could escalate into something significant. The friction between U.S. global dominance and China's rising regional sway is the chief source of instability. China could agree to a "Code of Conduct" with the Asian states possibly as early as this year. But without improvement in U.S.-China relations, the geopolitical consequences of such a code will be moot. Southeast Asian risk assets could benefit temporarily, but the chief tail-risks of the U.S. and China falling out would be unresolved. Bottom Line: He who controls the sea routes controls the traffic. China has made an overt bid for the ability to govern the sea routes and deny foreign powers access to the sea. The U.S. has threatened forceful responses to acts of "area-denial" or military coercion. Thus, geopolitical uncertainty and risks in the region remain elevated. How Do The Contenders Size Up? If China had clearly achieved full control of the waterways, airways, and geographical features of the South China Sea, then geopolitical risk over the area might decline. Countries would adjust to Beijing's rules of the game and the region would enter a period of hegemonic stability. The reason we are in a gray area today is that China has not yet reached dominance. China's advantages are significant, growing rapidly, and underrated; meanwhile the U.S.'s advantages are significant, declining, and overrated. A simple comparison of the U.S.'s and China's military advantages and disadvantages will make this clear. China Considering that the South China Sea is China's backyard, the country has a major advantage of playing on its "home court" versus the United States. China can afford to concentrate its military capabilities and planning specifically on its near seas, whereas American resources are dispersed globally and reduced to an "expeditionary force" when operating in China's neighborhood.12 Even so, the People's Liberation Army (PLA), Navy (PLAN), and Air Force (PLAAF) have major obstacles to overcome if they are to contend with American forces. Until relatively recently, China's defense buildup focused on traditional ground capabilities, creating weak spots in its ability to project military power over the South China Sea. What matters is whether China has addressed these shortfalls sufficiently to raise the costs of U.S. intervention to a prohibitive level. So far, it is attempting to do so in the following ways: Sea Power - China's naval capabilities have generally lagged far behind those of the U.S. and Japan. An important step was the commissioning of China's first aircraft carrier, the Liaoning, in 2012. It is a renovated Soviet carrier of the type that Russia has recently used in Syria. A second carrier, Shandong, is 85% complete and set to be commissioned in 2018 - it is an indigenously produced copy of the former. It is set to be stationed in Hainan, which will influence the balance of power given that the U.S. only has one carrier permanently in the region (though several more dock in San Diego). A third carrier is slated for 2022 and expected to be stationed in the South China Sea. The navy has also significantly increased China's logistic and support capabilities in the area, with amphibious warships and air cover. China has also vastly expanded its destroyers and smaller ships. Only its submarine capabilities face serious doubts about the degree of improvement and capability. Air Transport - China's naval and air force lifting capabilities, necessary to transport troops and equipment quickly to disputed territories, were initially very limited. But in recent years, China has improved these capabilities. Considering satellite pictures of the Spratly and Paracel Islands with new hangars and landing strips, China has made considerable progress toward the goal of quick material and troop supply for the islands. Of course, it is notoriously difficult to resupply small scattered islands amid enemy disruptions, but it is also difficult to disrupt without committing more than one aircraft carrier wing to the problem. Clearly China's capacity has improved. Infrastructure - China has converted Hainan, its southernmost island (and smallest province) into a major military and logistics base. Its new Yulin Naval Base can host up to 20 nuclear submarines as well as two carrier groups and several assault ships. This is China's "Pearl Harbor," and unlike the American version, it is in the South China Sea. Meanwhile, on the disputed islands, China had not built infrastructure until very recently. It was in fact the last of the island claimants to pave an airstrip. But its construction has been bigger, faster, and more ambitious - including for air transport, fighter jets, and surface-to-air and anti-ship missiles, all of which have added greatly to its ability to deny the U.S. access to the sea. Air Power - One of the main issues the PLAAF had over the years was the limited radius of its fighter planes, which would not allow full air superiority in the South China Sea. Airfield infrastructure was built on the disputed islands so that fighter planes could be stationed closer to the area. China therefore does not possess just one aircraft carrier, but rather numerous ones if we think of islands as aircraft carriers. Also, Russia is delivering to China a number of multirole fighters that can cover the South China Sea from bases on the mainland. And China's fifth-generation fighter is coming along. By far the most significant military development in China's arsenal, however, is its development of short- and medium-range missiles. This development greatly increases the danger to American ships and aircraft seeking access to the region. First, China has concentrated on building short-range, DF-21D "Carrier Killer" anti-ship missiles, which pack enough punch to take out an American aircraft carrier with one hit, and which the U.S. has limited means to defend against.13 China has also paraded around the DF-26 intermediate-range ballistic missile, or "Guam Killer," which can reach as far as Guam, can carry a nuclear charge, and has a mobile launch platform that would be difficult for U.S. forces to detect and knock out before the launch. In turn, the U.S. has deployed Terminal High-Altitude Area Defense (THAAD) missile systems in Guam and South Korea in preparation for precisely this kind of attack.14 Second, China has amassed around 500 surface-to-air missiles on Hainan Island, waiting to be shipped to the disputed rocks. The armory consists of a combination of short-, medium-, and long-range missiles to create a layered air-defense perimeter. Satellite images of the islands show that China has also positioned short-range and medium-range missile systems on some of the islands, namely Woody Island in the Paracels. Finally, China has fielded better radar systems to gain full coverage of the South China Sea (as well as other nearby waters) in order to find or guide friendly or hostile ships or planes and to support the various activities of its air and ship defenses. This combination of radar and missile capabilities amounts to a game changer. They make it possible for China to raise the costs of conflict to such a level that the United States might balk. Will the U.S. seek to change the balance of power with force? No. But Washington has reaffirmed its "red lines" in the region, namely freedom of passage. This was the takeaway from Secretary of Defense James Mattis's first foreign trip, not incidentally to Japan and South Korea. Mattis indicated that freedom of passage is "absolute" not only for the U.S. merchant fleet but also for the navy. However, he also said the U.S. will exhaust "diplomatic efforts" and eschew "any dramatic military moves" in the South China Sea, while maintaining the U.S.'s neutrality on sovereignty disputes. This is status quo, and the status quo favors China's rapidly growing ability to deny others' access to the area. The United States The U.S. has several bases in the Indo-Pacific area, with ground, air, naval, and marine assets. It also has extensive experience conducting wars and special operations in East Asia. Yet despite this dispersed and historic basing, China poses a challenge the likes of which it has not seen in the region. The distances to be covered, the complexities of the logistics, and China's growing strengths, make any U.S. intervention in the South China Sea harder than is typically assumed. The U.S.'s key five bases make these advantages and disadvantages clear: Guam, with almost 6,000 troops, will most likely be the first base to respond to a threat in the South China Sea, or to become engaged in a conflict there. It hosts part of the Seventh Fleet, including a ballistic-missile submarine squadron. It would be a key launch pad for regional operations. It could also be an early target for China's long-range ballistic missiles in a major conflict. Guam sits almost 3,000km from the South China Sea. South Korea hosts one of the U.S.'s oldest and largest regional deployments, with about 28,000 troops. Korea hosts the Eighth U.S. Army and Seventh Air Force, as well as Special Operations Command Korea. Its chief advantage is its proximity to China. However, assuming a conflict involves no direct engagement with mainland China, Korea comes with some disadvantages. Most of the ground staff is located around the North Korea border. The U.S. command in the region will be wary of lifting troops from the border and exposing its northern flank. North Korea (or conceivably China itself) could take advantage of U.S. distraction in the South China Sea. At the same time, the operational radius of planes on the Osan Air Base would not allow direct engagement in the South China Sea, though they could cover the southeast to hinder any maneuvers of the Chinese air force. Japan is the United States' largest overseas deployment with about 49,000 troops - heavily tilted toward naval and air power. The Fifth U.S. Air Force is spread across three main bases in Misawa, Yokota, and Kadena, while the Seventh Fleet is the largest forward-deployed U.S. fleet. It has several powerful task forces including the aircraft carrier USS Ronald Reagan and naval special warfare, amphibious assault, mine warfare, and marine expeditionary forces. The strong presence and firepower of this fleet as well as its maneuverability make it the prime candidate for any sort of engagement in the South China Sea (or East China Sea for that matter). The air bases around Tokyo and Okinawa can provide air support down to Taiwan and run airlift operations down to China's Hainan Island, the base of China's southern fleet. The only disadvantages stem from vulnerability to layered air defense and long supply lines for the navy, which will become targets after any lengthy engagement. Moreover, U.S. Forces Japan lack large ground units to organize landing operations, which will need to be sourced from South Korea or Hawaii. Hawaii is the home of the U.S. Pacific Command, which oversees regional forces, and contains sizable ground units to reinforce regional bases. It hosts the U.S. Army Pacific, U.S. Pacific Air Forces, and the U.S. Pacific Fleet stationed in Pearl Harbor (with a second base in San Diego). Hawaii has a large ground troop presence, which, together with U.S. air-lift capabilities, would provide the main ground forces for offensive operations. The large fleet secures U.S. presence in the region. Hawaii would host and resupply the core of any naval operations in the South China Sea. The only disadvantage is geographic: the distance to any U.S. ally's territory is significant, and main operational areas in the South China Sea cannot be reached in a single lift. This means that troop and equipment movement will take time and will not go unmolested. In any scenario involving land operations, the redeployment of troops will give the other side time to prepare. Alaska is also worth mention as it houses infantry brigades and air force combat units, albeit no significant naval presence. We only give small consideration to the base here because of its proximity to Russia. Assuming the neutrality of Russia during a hypothetical conflict, the U.S. would still be unlikely to draw resources from Alaska to aid operations in the South China Sea, since that would leave its own territory exposed to some degree. Other Allied Bases - We do not feature other allied bases in the region mainly because of the small numbers of troops that can be deployed and the low capabilities of U.S. allies. Some countries, such a Singapore, which has a respectably army, could disappoint the U.S. by trying to remain neutral. The most reliable help would come from Japan and Australia, but even Australia would face a very intense internal dilemma as a result of its economic dependency on China. South Korea would also be preoccupied with North Korea's ability to take advantage. A quick survey of the "order of battle" of the U.S. and China in the region would make our assertion that China has gained supremacy laughable. Then again, geopolitics does not work in ceteris paribus terms. Yes, the U.S. maintains military hegemony in the region, but China's abilities to impose real pain on American naval forces creates a complicated political dilemma for the U.S.: is Washington prepared to expend blood and treasure to defend allies and their supply lines in case of a conflict over this area? China is not yet looking to project power globally. It is not actively trying to compete for supremacy with the U.S. in the Persian Gulf, Indian Ocean, or Caribbean Sea. As such, it can concentrate its forces in the South and East China Seas and dedicate its entire naval strategy to the sole purpose of denying the U.S. navy access there. The U.S., meanwhile, has to plan for a global confrontation and then dedicate a portion of its forces to China's home court. Japan may very well hold the balance of power in a potential conflict over the region. Its import dependency is at the core of its national psyche and it would view a Chinese blockade of the South China Sea as an existential threat - not unlike the American threat of oil embargo that precipitated war in the early 1940s. Japan is not likely to go rogue, but it would be a tremendous addition to the American effort, even in a situation where other states refrained from action out of fear. However, while China will see the above as a reason not to initiate armed conflict with the United States, it will not be able to retrench in the South China Sea in the face of domestic nationalism either. These pressures virtually ensure that it is locked into the assertive foreign policy it has pursued over the past ten years. Bottom Line: A simple analysis of the current disposition shows that the military capabilities of the two countries - in this limited theater - are not as disparate as one might think. Both sides have weaknesses: the U.S. is bound to a handful of distant bases and has a global range of obligations and constraints, while China lacks technology, experience, and cooperation among its military branches. Nevertheless, China is approaching full air and sea cover of the area within the Nine Dash Line (Map 1) and is rapidly gaining greater ability through radar and missiles to inflict politically unacceptable damage on the U.S. The U.S.'s interest in the South China Sea is ultimately limited to free passage and the defense of treaty allies. The Trump administration is primed to strengthen the country's rights and deterrence, namely through a large increase in defense spending that focuses heavily on the navy - aiming at a 600-ship fleet - and likely on Asia Pacific. In the context of a massive new assertion of U.S. regional presence and power, it is significant that China has not yet given any concrete indication of slowing down its island reclamation, militarization, or control techniques. Investment Implications BCA's Geopolitical Strategy has been warning clients of the rising risks in the South China Sea, and East China in general, since 2012. However, it has been a challenge to construct an investment strategy based on our view. For starters, it is unclear when the crisis could emerge. It is difficult to know when accidents and miscalculations will happen. What we can say with some degree of certainty, however, is that the window of opportunity for any realistic campaign to reverse the militarization of the disputed islands will probably be closed by the end of this year. By "realistic," we mean operations that would promise control over the disputed territory with a calculated degree of risk and an acceptable degree of casualties. At the same time, the U.S. still has the ability to win a full-blown war with China. We have not addressed scenarios like cutting off China's oil supplies at the Strait of Hormuz, for instance, but have limited our discussion to a conflict in the South China Sea over control of the newly militarized islands. In that context, the American threshold for pain is low and its military advantages are narrowing. We are therefore entering a danger zone now because both China and the U.S. stand at risk of becoming overly assertive in the near future: Chart 9Will Trump Seek Political Recapitalization Via Conflict? China because it has domestic nationalist pressures that the Communist Party needs to vent as the economy slows; The U.S. because it has an unpopular (Chart 9), nationalist leadership that seeks to increase its defense presence in the region and may fall to brinkmanship in order to extract major trade concessions from Beijing. The tail-risk in the South China Sea suggests that global investors should also continue to hedge their exposure to risk assets with exposure to safe-haven assets receptive to geopolitical risk, like gold, Swiss bonds, though perhaps not U.S. Treasuries. The persistence of Sino-American distrust - beyond whatever happy encounter Trump and Xi may have at Mar-a-Lago in April - suggests that Chinese economic policy uncertainty will remain elevated and global financial volatility to rise. U.S.-China tension also feeds our broader narrative of rising mercantilism and protectionism. Investors will want to overweight domestic-oriented economies, consumer-oriented sectors, and small cap companies relative to their export-oriented, manufacturing, and large cap counterparts. We also recommend that EM-dedicated investors be wary about Asian states caught in the middle of de-globalization and vulnerable to geopolitical tail-risks. We are neutral to bearish on South Korea, Taiwan, and the Philippines. Our long Vietnam equities trade has been downgraded to tactical. We prefer Thailand and Japan, U.S. allies that are removed from conflict zones (Thailand) or domestically oriented and reflationary (Japan). We are also long China relative to Hong Kong and Taiwan, given the risks of both de-globalization and Chinese political troubles for the latter two. We are bullish on U.S. defense stocks.15 The U.S. defense establishment is conducting extensive reviews of the navy's force structure and future strategic needs - the fleet peaked in 1987 and fell below 300 battle force ships in 2003, but has projected that 355 battle force ships is necessary. This would require a major injection of funds in the coming decade. The Trump administration has endorsed this assessment in principle and is planning a significant increase in defense spending, marked by a requested increase of $50 billion in his first annual budget. Trump has signaled that defense manufacturing, notably shipbuilding, will be one of the ways in which he seeks to boost American manufacturing and jobs. This plays to his blue-collar base of support and could move the needle in battleground states like Virginia. It should be beneficial on the margin for U.S. defense companies.16 Below are our corporate-level recommendations for both EM-dedicated and global investors. The Companies Given the likelihood that tensions in the SCS will continue, and the projected build up in defense spending in both the U.S. and China, EMES recommends investors look to take exposure to defense stocks. We have put together a portfolio of such stocks that is intended to give exposure to the developments between China and the U.S. in the South China Sea. We recommend the following basket of companies: AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). The basket consists of four Chinese defense companies, mostly centered around the aviation industry. The choice of listed companies in China is constrained and hence we have been forced to gain exposure through aviation companies rather than naval. We recommend two companies in the U.S. that are involved in military vessel production for the U.S. Navy. We believe that the main ramp-up in defense spending from the U.S. side will come through a significant increase in the number of ships in the Asian region. Chart 10Performance Since March 2016: ##br## AviChina Vs. MSCI EM AviChina Industry & Technology (2357 HK): Chinese aviation holding company (Chart 10). AviChina is the listed subsidiary of the government-controlled Aviation Industry Corporation of China (AVIC). Airbus is another large shareholder, with over 11% of the free float. The company produces dual-purpose aircraft - civil and military -- including helicopters, trainers, parts and components (including radio-electronic), avionics and electrical products and components. AviChina itself is a holding company with a rather complicated structure, which makes it difficult for investors to access its market value. Listed subsidiaries include AVIC Helicopter Company (600038 CH), China Avionics (600372 CH), AVIC Jonhon Optronic (002179 CH) and Hongdu Aviation (600316 CH). In terms of the revenue stream, 49% is generated from whole aircraft production, 28% from engineering services and another 23% from parts and components manufacturing. The company reports semi-annual results. The latest full-year report released on March 15 came out mixed. Revenues were strong, up 39% year over year, but costs accelerated at a faster pace (+45% year over year). Operating income was still strong, growing 12.3% year over year, but margins declined across the board. EBITDA margin contracted by 257 basis points to 9.94%, while operating margin fell by 170 basis points to 7.32%. Despite this, the bottom line still managed to grow by 18.75% year over year. AviChina is currently trading at a forward P/E of 21.2x, whilst the market estimates an EPS CAGR of 9.5% for the next three years. Chart 11Performance Since March 2016: ##br## AVIC Jonhon Optronic Vs. MSCI EM AVIC Jonhon Optronic (002179 CH): Profiting from growing military and EV spending (Chart 11). A subsidiary of AVIC and AviChina, the company specializes in production of optical and electric connectors (third largest in China), and cable components. Jonhon is unrivalled in the defense market. It profits from rising electronic content and from supplying major components to other parts of the AVIC group, shipbuilders, railways and aerospace. It is also successfully developing its civil offering, specifically for the fast-growing electric vehicle market and the 4G space in the telecoms industry. Looking at the revenue composition, 54% is generated by sales of electric connectors, a further 24% from fiber-optic cables, and 19% from conventional cable and assembly products. As for the civil-military split, the company is expected to receive 60% of total revenues from its civil applications, growing approximately 10% per annum. Jonhon Optronics reported its full-year results on March 15. Revenues saw a strong increase, jumping 23.7% year over year. Cost growth was also higher, though it slowed from the previous year (up 23.8% year over year). This led to an operating profit increase of 19.7%, but slight margin deterioration. EBITDA margin fell by 77 basis points to 16.98%, and operating margin was down 5 basis points to 14.32. On the other hand, profit margins improved to 12.6% (up 54 basis points) as the bottom line grew by 29.8% year over year. Jonhon Optronics is currently trading at a forward P/E of 24.4x, whilst the market estimates an EPS CAGR of 15.2% for the next three years. Chart 12Performance Since March 2016: ##br## AVIC Helicopter Company Vs. MSCI EM AVIC Helicopter Company (600038 CH): AVIC's helicopter arm (Chart 12). As the name already suggests, the company specializes in helicopter production, which accounts for almost 100% of the overall revenue stream. The main helicopters currently marketed are from the AC series, in particular the AC311, AC312 and AC313, the Z series - Z-8, Z-9 and Z-11. We expect further tailwinds for the company stemming from China's future defense budget. The country's helicopter fleet is still only a tenth of the size of the U.S.'s fleet. It will continue to ramp up production. Export contracts will also support revenue growth for AVIC Helicopter Co. With a strong advance on the Asian military helicopter market, the company is looking to expand in the region. Furthermore, we see some promising developments in the civil helicopter space, with Chinese emergency services and the Civil Aviation Administration ramping up demand. The main headwind might come from the transition to new models, with the new production cycle to be in full force in 2018. AVIC Helicopter Co reported full year results on March 15, which came out weaker than expected. Revenues were virtually flat, contracting by 0.3% year over year, while cost of revenue grew 1.3% year over year. Operating income was also stable relative to last year, contracting 0.4% year over year, helped by an operating expense reduction of 12% year over year. Nevertheless, EBITDA margin declined slightly by 19 basis points to 6.77%, while operating margin fell by 131 basis points to 13.99%. A marginally lower income tax in FY16 allowed the firm to eke out 1.3% year-over-year bottom-line growth. AVIC Helicopters is currently trading at a forward P/E of 48.2x, whilst the market estimates an EPS CAGR of 13.8% for the next two years. Chart 13Performance Since March 2016: ##br## AVIC Aviation Engine Vs. MSCI EM AVIC Aviation Engine Corporation (600893 CH): Sole leader in Chinese engine production (Chart 13). Aviation Engine Corporation is part of the government-controlled Aeroengine Corporation of China (AECC), which was established in August 2016 and contributes just under 50% to Being in a monopolistic position on the Chinese market, the company profits from rising military aircraft procurement and prices. As part of the AECC, the company also receives tailwinds from scale effects within the company as well as cost savings in the supply chain. AVIC Aviation Engine Corporation reported weak full year results on March 16. Revenue slid 5.5% year over year, but management kept costs under control (down 7.3% year over year). Operating expenses grew only marginally (up 5.2% year over year), which left operating profit flat compared to last year. Margin trends have been strong; EBITDA margin improved by 78 basis points to 13.05%, while operating margin grew by 42 basis points to 7.78%. However, high net interest expense depressed the bottom line, which fell 13.3% year over year. At the same time the company managed to decrease its debt level for the fourth year in a row. AVIC Aviation Engine Corporation is currently trading at a forward P/E of 52.0x, whilst the market estimates an EPS CAGR of 14.4% for the next two years. Chart 14Performance Since March 2016: ##br## China Avionics Systems Vs. MSCI EM China Avionics Systems (600372 CH): Leading developer and producer of avionics equipment (Chart 14). China Avionics Systems is also a subsidiary of AviChina, which controls 43% of the free float. The company is active in R&D, running several research institutes in the fields of radar, aviation and navigation control as well as aviation computers and software. China Avionics enjoys a near-monopoly on the Chinese aviation electronics market, and also controls over 90% of the military market for air data systems. Looking at the revenue breakdown, 80% of total revenues come from military contracts, while it is expected that the share of civil revenues will increase with the development of civil aircraft in the country. Aircraft data acquisition devices contribute the most to overall revenue, at 25% of total, followed by airborne sensors at 15%, auto-pilot systems at 14%, distance-sensing alarm systems at 9.5%, and air data systems at 9%. The company reported full year results on March 16. Revenues experienced a mild increase of 1.9% year over year, while costs increased at the same pace (2% year over year). On the operating side, costs increased by 3% year over year, suppressing income by 1% year over year. EBITDA margin fell 37 basis points to 15.15%, while operating margin contracted 30 basis points to 10.60%. The bottom line contracted 3.5% year over year. China Avionics Systems is currently trading at a forward P/E of 55.0x, whilst the market estimates an EPS CAGR of 13% for the next two years. Chart 15Performance Since March 2016: ##br## Huntington Ingalls Industries Vs. S&P 500 Huntington Ingalls Industries (HII US): Largest listed U.S. military shipbuilder (Chart 15). Initially a part of Northrop Grumman, Huntington was spun off and listed in 2011. Huntington enjoys a monopolistic market position, as over 70% of the current U.S. Navy fleet was designed and built by the company's Newport News or Ingalls divisions in Virginia and Mississippi. Huntington is currently the sole designer, builder and re-fueler of nuclear-powered aircraft carriers in the U.S. In the nuclear submarines space, the company has one competitor: the Electric Boat unit of General Dynamics. The company also provides a range of services through its Technical Solutions division, centered around fleet support, integrated missions solutions and nuclear and oil and gas operations. Huntington reported full-year results on February 16. Full year revenue was virtually flat (+1% on quarterly basis), while costs increased slightly by 1.6% year over year. The company managed to reduce operating expenses, which fell by 16% to the lowest level since 2010. This helped boost operating profit by 13% year over year. EBITDA margin improved by an impressive 125 basis points to 14.77%, and operating margin was up by 119 basis points to 12.14%. New orders grew by US$5.2 billion, bringing the total pipeline to US$21 billion. The bottom line jumped by 45% year over year, helped by a lower income tax bill and a one-off after-tax adjustment. Huntington Ingalls Industries is currently trading at a forward P/E of 18.1x, whilst the market estimates an EPS CAGR of 4.2% for the next two years. Chart 16Performance Since March 2016: ##br## General Dynamics Vs. S&P 500 General Dynamics (GD US): Primary contractor for U.S. Navy submarines (Chart 16). General Dynamics is a multinational defense corporation and currently the fourth-largest defense company in the world. The company has four business segments, from which we are mainly interested in the marine systems segment, contributing 25% of overall group revenue. The marine systems segment is represented by General Dynamics' unlisted subsidiary, GD Electric Boat. Electric Boat has long been the main builder of nuclear submarines for the U.S. Navy out of Connecticut, and is expected to be one of the main beneficiaries of the U.S. Navy expansion program under the Trump administration. General Dynamics reported full-year results on January 27, which generally came in flat. Revenue fell by a marginal 0.4% year over year (after the adoption of a new revenue-recognition standard), but the company did a good job in managing costs, which contracted by 1% year over year. Operating income grew by 4% year over year, helped by lower operating costs. Margins improved across the board; EBITDA margin went up 45 basis points to 15.19%, while operating margin was up 54 basis points to 13.74%. The bottom line grew 5% year over year. Management seem confident in their guidance through 2020, including detailed but conservative estimates. Especially promising was the good pipeline visibility in the marine segment, driven by the company's Columbia-class submarine sales. General Dynamics is currently trading at a forward P/E of 19.3x, whilst the market estimates an EPS CAGR of 6.5% for the next two years. How To Trade? The GPS/EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of five Chinese companies and two U.S. companies. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). ETFs: At current time there is one listed ETF covering the China defense sector: Guotai CSI National Defense ETF (512660 CH); And three listed ETFs covering the U.S. defense sector: iShares U.S. Aerospace & Defense ETF (ITA US); SPDR S&P Aerospace & Defense ETF (XAR US); PowerShares Aerospace & Defense Portfolio (PPA US). Funds: At current time there are no funds with significant defense sector exposure. Please note that the trade recommendation is long-term (1Y+) and based on a straight long trade. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equally-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To The Investment Case The largest risk to our investment case - leaving aside company-specific risks - would be an unexpected fading away of the tensions in China's near seas, and of China's and America's military spending ambitions. Such a development - which would require a robust diplomatic agreement and an about-face from what the leaders have stated - would hit the weapons producers. Though such a settlement would not necessarily occur overnight, or receive immediate publicity, it would be observable over the course of negotiations between the Trump and Xi administrations. A key event to watch is the upcoming April summit between the two leaders. At the same time, the large momentum in the defense industry (with very long production pipelines), and the very low flexibility of defense budgeting, means that we are comfortable in terms of timing an exit should geopolitical tensions begin to recede. Another risk might come from a slowdown in economic growth in China or the U.S., which could lead to cuts in defense budgets. Nevertheless, in a case of a further escalation in China's near-abroad, we would most likely see defense spending continue to grow despite any weak economic performance, warranted by strategic needs. This is a key dynamic that investors should understand. Strategic distrust between the U.S. and China has worsened since the Great Recession, indicating that the preceding period of strong growth helped keep a lid on U.S.-China tensions. Now the two countries have entered a dilemma in which relations have soured despite their economic recoveries, since both sides are using growth to fuel military development, yet an economic relapse would fuel further distrust. Only a high-level political settlement can break this spiral and such settlements between strategic rivals traditionally require a "crisis." Matt Gertken, Associate Editor mattg@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, and Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 4 The United States sent the USS Carl Vinson carrier group to the South China Sea as part of Freedom of Navigation Operations that the Trump administration may intensify; China is involved in a new spat about "environmental" monitoring stations in the Paracel Islands and in Scarborough Shoal, and is also increasing activity east of the Philippines; it is threatening to impose a new law that would govern foreign ships' access; the question of a Chinese Air Defense Identification Zone lingers; and China has also begun sending large tourist groups to the Paracels. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2017, and Geopolitical Strategy Special Reports, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013 and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 6 Most notably in 1971, 1974, 1988, 1995, 2001, and 2011-14. In the two biggest "battles," 1974 and 1988, China kicked Vietnamese forces out of the Paracel Islands and parts of the Spratly Islands, respectively. These conflicts took place in the context of Vietnam's wars with itself, the U.S., and China, just as the recent rise in tensions takes place in the context of China's emergence as a global power - in other words, international tensions are the cause and maritime-territorial disputes are but a symptom. 7 Most notably the HS981 showdown between China and Vietnam in 2014, which occurred when China National Offshore Oil Corporation (CNOOC) moved a large mobile drilling rig into the farthest southwest island of the Paracel Islands, near Triton Island, triggering a months-long skirmish with Vietnamese coast guard ships and fishermen that involved Chinese warships and aircraft and the sinking of at least one Vietnamese fishing boat. 8 In fact, officers from China's People's Liberation Army-Navy's southern fleet have recently written publicly and approvingly of the well-known Chinese tactic of fighting "behind a civilian front" to establish control over the sea - which has involved a host of private and public actions covering fishing, energy, coast guard, administration, science and environment, and tourism. Please see "Chinese Military's Dominance in S. China Sea Complete: Report," Kyodo News, March 20, 2017. 9 Please see Bonnie S. Glaser, "Armed Clash In The South China Sea," Council on Foreign Relations, Contingency Planning Memorandum No. 14, April 2012, available at cfr.org. Separately, an American diplomatic estimate from 2016 claims that "more than half the world's merchant fleet tonnage" passes through these waters; see Colin Willett, "Statement ... Before the House Foreign Affairs Committee ... 'South China Sea Maritime Disputes,'" July 7, 2016, available at docs.house.gov [http://docs.house.gov/meetings/AS/AS28/20160707/105160/HHRG-114-AS28-Wstate-WillettC-20160707.pdf]. A Chinese study estimates that 47.5% of China's total foreign trade in goods transited the sea in 2014; see Du D. B., Ma Y. H. et al, "China's Maritime Transportation Security And Its Measures Of Safeguard," World Regional Studies 24:2 (2015), pp. 1-10. 10 When President Trump's Secretary of State Rex Tillerson clarified remarks at his senate confirmation hearing in which he threatened that the U.S. would deny China's access to the islands in the South China Sea, he reformulated his statement to say that in the event of a contingency the U.S. needed to be "capable of limiting China's access to and use of its artificial islands" to threaten the U.S. and its allies and partners. 11 Please see footnote 3 above. Another potential implication might be a weaker U.S. position in the partition of the Arctic shelf (which has far more hydrocarbon reserves than the South China Sea), which U.S. rivals like Russia will pursue next against the claims of the U.S. and its allies Norway, Canada, and Denmark. 12 Please see Robert Haddick, Fire on the Water: China, America, and the Future of the Pacific (Annapolis, MD: Naval Institute Press, 2014). 13 It is understood by multiple sources that these missiles cannot be defended successfully against by current anti-missile technology, with one potential exclusion - the recently tested SM-6 Dual I. Otherwise, possible defense methods would lie in the realm of electronic countermeasures. 14 We believe, with medium conviction, that the incoming administration in South Korea will remove the THAAD missile defense sometime in 2017 or 2018 in what would be a major diplomatic quarrel between Seoul and Washington. This is because the soon-to-be ruling Minjoo Party (Democratic Party) will seek to engage North Korea and mend relations with China, and the latter countries' top demand will be removal of the missile defense system that was only put in place in a rushed manner in the final days of the discredited and impeached Park Geun-hye administration. Such a removal would illustrate the U.S.'s disadvantages relative to China in having to deal with alliances, basing, and force structure in a foreign region. 15 Please see BCA Geopolitical Strategy and Global Alpha Sector Strategy Joint Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com. 16 Please see "2016 Navy Force Structure Assessment (FSA)," dated December 14, 2016, and Ronald O'Rourke, "Navy Force Structure and Shipbuilding Plans: Background and Issues for Congress," Congressional Research Service, September 21, 2016.

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

Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor Chart 5Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Chart 7Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Chart 9A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Chart 14... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Chart 16Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Beyond the healthcare vote and its implication for Trump's fiscal stimulus, other risks lurk in the background. Market complacency is at historical extremes but Chinese reflation is rapidly dissipating. The euro could benefit in this environment, especially as markets price in a Macron victory. Longer-term, the euro remains hampered by its two-speed recovery, which will limit the capacity of the ECB to lift rates. Stay long EUR/AUD, short USD/JPY and NZD/JPY. Feature The dollar correction continues. The recent wave of dollar weakness has been dubbed a reversal of the "Trump trade". There is some truth to this. The difficulty President Trump and House Speaker Ryan are facing to pass the American Health Care Act (their replacement for Obamacare) is raising questions about how much tax cuts and infrastructure spending Trump will actually be able to implement. Even if the House votes in favor of the new bill (which is still an unknown at the time of writing), the Senate remains a question mark. So the narrative goes, if the Trump stimulus is at risk, the economy will be weaker, the Fed will not hike interest rates as much as anticipated, and the dollar will falter. While there is validity to this thesis, we think the picture is more nuanced. The potential for less fiscal stimulus in the U.S. is a real worry, but our main concern is that the global industrial sector's growth improvement does not continue the way investors expect. In this environment, the dollar is likely to perform poorly against European currencies and the yen, but hold its own against EM and commodity currencies. We are positioned for such a development. These trends would be reminiscent of the kind of dollar dynamics that emerged in late 2015 / early 2016. Chinese Reflation Matters Too! What underpins our thesis? As our sister service, Global Alpha Sector Strategy, has highlighted in this week's report, the Yale Crash Confidence index has hit 100%, indicating that all of the respondents surveyed expect the stock market to go up in 2017. Moreover, the Minneapolis Fed's market-based implied probability of a 20% or more selloff in the S&P 500 has fallen below 10%, the lowest level since 2007.1 With this high degree of complacency, a rollover in the global economic surprise index represents a major risk for the asset most levered to the global industrial sector (Chart I-1). To us, the key behind the 2016 rebound in global industrial activity was China. While Chinese growth is not about to experience a sharp slowdown, it is unlikely to improve further. To begin with, Chinese monetary conditions are already rolling over (Chart I-2). The big improvement in this indicator in 2016 was the crucial ingredient behind the rebound in global trade, global industrial activity, and all the assets levered to these phenomena. Chart I-1Surprises Are Not ##br##Growing Anymore Chart I-2Chinese Monetary Conditions ##br##Are Tightening We are seeing tentative signs of a mini liquidity crunch emerging in the Chinese interbank system. Seven-day repo rates, a key benchmark for Chinese lending terms, have surged from 3.8% at the end of last week to 5.5% on Tuesday, before settling at 5%, the highest level in two and a half years (Chart I-3). By allowing this volatility, policymakers are most likely sending a warning shot to the Chinese real estate sector, which has been a key driver of Chinese metal demand in 2016. This sector alone accounts for 20% and 32% of global refined copper and steel consumption, respectively. Also, as we have highlighted previously, fiscal stimulus was another key factor behind the floor put under Chinese industrial production and fixed asset investment last year. However, Chinese fiscal spending peaked at a 25% yoy growth rate in November 2015 and is now near 0%. This suggests that a key source of stimulus in China has been removed. It is true that Chinese fiscal stimulus is heavily conducted through credit policy. In this context, the recent rise in Chinese borrowing rates does indicate that the Chinese authorities are not intent in jacking up growth anymore. The reduced growth target for this year is a clear re-affirmation of this change in focus. We are seeing signs that these adjustments are starting to bite. The growth rate of new capex projects started has rolled over and is now flirting with the zero line. As Chart I-4 highlights, this indicator provided a very positive signal for the AUD last year and is now forewarning potential risks. Chart I-3Is The PBoC Sending A Message##br## To The Real Estate Industry? Chart I-4Big Risk For##br## The AUD Additionally, the Canadian venture exchange, an index of high risk, small-cap Canadian equities has historically displayed a tight correlation with Chinese GDP growth (Chart I-5). This market is experiencing a negative divergence between its MACD and prices, potentially an early sign that investors are beginning to worry about China. Risk assets globally are not ready for these developments. In fact, EM spreads are hovering near cycle lows, junk spreads are extremely narrow, the VIX is also near cycle lows, and our global complacency indicator suggests that investors are not ready for negative Chinese surprises (Chart I-6). Not only would a negative surprise out of China cause a repricing of all these factors, but periods of market stress - even shallow stress - are associated with rising correlation among assets and among individual equities. The low level of correlation among S&P 500 constituents has been an important factor behind the fall in the VIX and the rise in margin debt. A rise in risk aversion could get turbo-charged by a rectification of these low correlations, prompting a temporary wave of debt liquidation (Chart I-7). Chart I-5A Key China Gauge Is Losing Momentum Chart I-6Complacency Abounds Chart I-7Correlation Risk In this environment, U.S. stocks could easily correct by 5% to 10%. EM stocks may have even more downside as they are more directly exposed to the biggest risk factor: China. From a currency market perspective, this means that defensive currencies could outperform pro-cyclical ones. This is why we remain long the USD against a basket of commodity currencies, but short against the yen - the most countercyclical currency of all. We also are long the euro against the AUD. These views make our publication more cautious about the near-term outlook than BCA's house view. Bottom Line: Risks beyond the outlook for tax cuts in the U.S. lurk in the background. The Chinese authorities have moved away from stimulating the economy, and some early cracks are showing. A collapse is not in the cards, but given the high degree of complacency present across markets, a disappointment in a supposedly perfect environment would create a headwind for EM and commodity currencies but boost the defensive EUR and JPY. Why Long EUR/AUD Tactically? While the negative view on the AUD fits cleanly in the narrative described above, our motivation to be long the euro is more multifaceted: The euro area has negative nominal interest rates and a current-account surplus of 3.3% of GDP, meaning it exhibits key characteristics of a funding currency. In a risk-off event where unforeseen FX market volatility rises, funding currencies perform well. We expect a further normalization of the French OAT / German bunds spread as we get closer to the French election. Macron is beating Le Pen by more than 20% in second-round polling (Chart I-8). This gap is five times greater than the advantage Clinton held over Trump at a similar point in the U.S. presidential campaign. As we argued in a joint Special Report co-published with our Geopolitical Strategy team seven weeks ago, this kind of advantage is highly unlikely to be overcome by May 7. Thus, the euro area break-up risk premium can narrow between now and then.2 Finally, the number of investors expecting rising short and long rates has bottomed in Europe relative to the U.S. Historically, this indicator has provided valuable lead on EUR/USD. It is currently painting a tactically bullish story for the euro (Chart I-9). Moreover, in the event of market stress, with investors pricing in two more rate hikes by year end in the U.S., but none in Europe, the scope for temporary downward revisions in the U.S. is higher than in Europe. This could put more upward pressure on this indicator and therefore, the euro. Chart I-8Macron: En Marche! Chart I-9Short-Term Euro Upside Together, these factors suggest that the euro could rebound toward 1.12 before the middle of 2017. Again, our favored currency to play this move is against the AUD. EUR/USD: Short-Term Gain But Long-Term Pain Chart I-10Monetary Policy Is The ##br##Common Shock In Europe What about the longer term dynamics for the euro? We are more skeptical of the common currency's ability to rally durably, and we are expecting the euro to fall below parity by mid-2018. Based on our months-to-hike indicator, the market expects the ECB to hike by the fall of 2018. We disagree and think the first hike could come much later. While the economic rebound in Europe is real, it seems to be very dependent on the high degree of easing that has been put in place by the ECB. As Chart I-10 illustrates, the credit impulse - a measure underpinning domestic economic activity - and the euro have moved very closely together. While we do not imply that the credit impulse's rebound has reflected the fall in the euro, their tight co-movement has been driven by a similar factor: easy money. Thus, a removal of that easy money could prompt a reversal of that domestic improvement. Even more crucially, the conditions in the periphery are what really matters to the ECB. At the beginning of the millennium, the ECB was acting as Germany's central bank, keeping rates too low for the periphery, but alleviating Germany's deflationary tendencies. Today, the ECB behaves as the periphery's central bank. Germany seems ready to handle higher interest rates, but the same is not true for most other European countries. To begin with, even within the core, wage dynamics remain tepid. French and Dutch wages continue to slow while Austrian wage growth has collapsed near 0% (Chart I-11A). If the situation is poor in most core countries, it is dismal in the periphery. Wages are still contracting in Greece and Portugal, and growing at a sub 1% pace in Spain and Italy (Chart I-11B). These differentiated wage trends reflect the fact that worker shortages in the periphery are simply inexistent, while in Germany, they are commonplace (Chart I-12). Chart I-11AOnly Germany Is Witnessing##br## Strong Wages... Chart I-11BOnly Germany Is Witnessing ##br##Strong Wages... Chart I-12...Because Germany Has The##br## Tightest Labor Market.... As a result, the dynamics in core inflation remain muted. German core inflation has been extremely stable near 1% for six years now, but is hitting record lows levels of 0.3% in France (Chart I-13A and Chart I-13B). Core inflation also remains near 0% in most peripheral nations. Chart I-13A...Explaining Europe's Bifurcated Core Inflations Chart I-13B...Explaining Europe's Bifurcated Core Inflations When the Fed first increased rates in 2015, U.S. wages were growing at 2%. This is a far cry from current levels in Europe. Moreover, the first U.S. rate hike was a mistake considering the subsequent deceleration in growth and poor performance of risk assets. Thus, the Fed experience is probably not an example for the ECB to emulate. Moreover, rising interest rates represent a risk for debt servicing ratios in many European countries, limiting the ECB's ability to hike if nominal growth does not pick up further. The Netherlands, Belgium, Portugal, and France rank amongst the countries with the highest private-sector debt servicing costs as a percent of income. Meanwhile Italy and Portugal score extremely poorly when this metric is applied to the public sector (Chart I-14). The Italian and Portuguese cases are especially worrisome as rising stress caused by rising rates will further lift government rates. An argument has also been made that for the ECB, what matters is the headline rate of inflation. We would argue that since Draghi became the leader, this inflation measure is less relevant. But nonetheless, let's temporarily entertain this premise. It has also been argued that if European and U.S. statistical agencies treated housing similarly, inflation on both sides of the Atlantic would be the same. As Chart I-15 illustrates, this is no longer true. Chart I-14Debt Service Payments Are ##br## A Problem In Europe Chart I-15European Inflation Is Lower, ##br##No Matter What This line of reasoning also forgets that since 2014, the U.S. has endured a 22% appreciation in the trade-weighted dollar, which could have already curtailed nearly 1% to U.S. GDP growth, a significant amount of monetary tightening. However, the euro has greatly depreciated over this time frame, representing a large monetary easing. Due to these highly divergent monetary backdrops, one can deduce that endogenous inflationary pressures are much greater in the U.S. than in the euro area. All these factors suggest that it will be hard for the ECB to increase rates by the end of 2018. Thus, on a cyclical basis we would fade this recent massive fall in the ECB's months-to-hike metric (Chart I-16). On the U.S. ledger, the labor market is clearly tightening and the U6 unemployment rate is now congruent with levels where wages have gained traction in previous cycles (Chart I-17). This suggests that the market is correct to expect the Fed to hike much more aggressively in the coming years. In fact, while the near future might be filled with political complexity, we continue to expect fiscal stimulus to materialize in the U.S by 2018, suggesting upside risk to the Fed's forecast. Chart I-16Too Soon! Chart I-17The U.S. Labor Market Is Tight Finally, equilibrium real rates in Europe are probably substantially lower than in the U.S. Not only have European interest rates been historically lower than in the U.S., but also, slower population growth alone would justify lower neutral rates. This highlights that the scope for the ECB to hike is limited compared to the Fed. These bifurcated monetary dynamics will continue to support the USD on a 12-18 months basis, and as a corollary, hurt the euro despite its apparent cheapness on a PPP basis. Bottom Line: The months-to-hike in the euro area has fallen to less than 20 months. While Germany could handle higher rates, poor wage and core inflation dynamics in the rest of the euro area suggest it is still much too early to increase rates. Moreover, without a more significant pick-up in growth, many European nations will face dire debt-servicing situations if the ECB hikes rates durably. Meanwhile, the U.S. is moving closer to full employment, a situation warranting higher rates. The euro could fall below parity by mid-2018. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Alpha Sector Strategy Weekly Report, "Caveat Emptor" dated March 24, 2017 available at gss.bcaresearch.com 2 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 March weakness has been because of a mix of monetary and fiscal disappointments. The Fed's "unhike" initiated the downtrend as markets were surprised by the dovish tone of the Fed's communications. Now, President Trump and his team are facing difficulties passing the American Health Care Act. Markets are extrapolating this difficulty to the realm of fiscal policy in general. Nevertheless, it is unlikely for the DXY to breach the 98-99 support level this month. The stronger current account number of USD -112.4 billion was supported by high foreign income, suggesting a key warning sign for the USD cyclical bull market is not present. Stronger new home sales monthly growth of 6.1% highlights that domestic economic activity remains robust, meaning the Fed is unlikely to disappoint over the life of the business cycle. Report Links: USD, Oil Divergences Will Continue As Storage Draws - March 17, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Political risks have been exaggerated in Europe, with the Dutch and Austrian elections confirming that populist successes in Europe are overstated. As such, the French election will likely be market-bullish with a Le Pen defeat. This entails a further normalization of OAT / Bund spreads, and a short-term bullish outlook for the euro, which is likely to settle above 1.10. Corroborating this view, the MACD is currently above 0 and outpacing the signal line, a bullish development. Inflationary pressures are building up in Europe with German PPI at 3.1% annually in February. However, outside Germany, even the core, let alone the periphery, seems to be struggling, with poor wage growth. The ECB will therefore need to stay easy for longer to protect the euro area's weakest members, capping the long-term upside to rates and the euro. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has continued to rally, with USD/JPY trading below 111 over the last couple of days. We continue to be bullish on the yen on a tactical basis, as we believe that the global industrial sector will fall short of investors' expectations. This is an environment where the dollar will probably appreciate against EM currencies, but falter against the yen. On a cyclical basis we remain yen-bearish, as U.S. rates should continue to go up, while Japanese rates will continue to be anchored around 0%. The Bank of Japan will continue with this policy, as the depreciation of the yen has given a boost to exports, which are now growing at 11.3% on a yearly basis, as well as to the economy as a whole, which should yield higher inflation expectations over time. Report Links: Et Tu, Janet? - March 3, 2017 JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The British pound rallied on Tuesday following the unexpected surge in headline inflation in February from 1.8% to 2.3%. This number is significant, because inflation has broken through the BoE's target. The central bank remains cautious, as the MPC pointed out that the rise in inflation is not domestic, but rather a reflection of the fall in the pound. However, we believe that internal inflationary pressures might start to emerge: the U.K. economy is doing much better than expected and the labor market is tight. Recent data highlights this, and opens the possibility that the pound could rally, particularly against the euro: Retail sales growth and retail sales ex fuel growth came in at 3.7% and 4.1% respectively, outperforming expectations. The CBI Distributive Trades Survey monthly growth also beat expectations, coming in at 9%. 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 As mentioned last week, the AUD's strength was a temporary feat. Before declining, the Aussie was initially lifted by high house price growth of 7.7% annually for 4Q2016, really surpassing expectations. The RBA minutes highlighted a need for the current monetary policy to remain very accommodative: labor market conditions remain mixed, household perceptions of personal finances is at average levels, wage growth remains subdued, and inflation is expected to rise only slowly. The outlook for the AUD is therefore likely to remain poor. Corroborating this view is a contracting Westpac Leading Index number of -0.1% that may be foretelling weak data. Report Links: AUD And CAD: Risky Business - March 10, 2017 Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Yesterday, the RBNZ kept its policy rate unchanged at 1.75%. Governor Graeme Wheeler once again asserted that the kiwi remains overvalued, although he welcomed the recent depreciation of the trade-weighted kiwi. More depreciation might be in the cards, particularly against the U.S. dollar and the yen. Global FX Vol stands at very low levels, thus any uptick could severely hamper the NZD, a carry currency. Furthermore, the tightening in Chinese monetary conditions will likely weigh on commodity currencies. Nonetheless, the NZD could perform well against the AUD as domestic inflationary pressures in Australia are much weaker than in New Zealand. Additionally, the tightening in Chinese monetary conditions should be more harmful for the AUD, given that iron is more sensitive to economic activity than dairy products. Report Links: Et Tu, Janet? - March 3, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The oil-based currency has sustained the recent oil shocks well, helped by the USD's weakness. Indeed, Canadian data has generally been positive: Manufacturing shipments increased 0.6% monthly in January, much above the expected -0.4%; Wholesale sales increased 3.3% in January on a monthly basis; Monthly retail sales picked up to 2.2% and 1.7% when autos are excluded; The 2017 government budget marginally loosened fiscal policy. As the greenback is likely to display further downside, the short-term outlook for USD/CAD is negative. This is corroborated by the negatively trending MACD line. However, Governor Poloz is likely to maintain a dovish tilt relative to the Fed, signifying longer-term CAD weakness. 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 Following the surge in the Euro, EUR/CHF has moved back to 1.07. This has eased some pressure off the SNB, which was active in the foreign exchange market to preserve the floor in this cross. The early returns of this policy seem positive, as data is showing a gradual recovery in Switzerland: The SNB's trimmed mean core inflation measure (TM15) is now in positive territory and continues to rise. Swiss PMI has surged so far this year, and now stands at the highest level since 2011. So far these improvements are not enough to prompt a change in policy by the SNB, as inflation needs to be sustained at a higher level and corroborated by wages. Nevertheless, we will continue to monitor economic developments in Switzerland to assess whether the SNB could remove its floor under EUR/CHF. 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 has been relatively flat this week, as the sharp decline in oil has been offset by a downturn in the U.S. dollar. The outlook for the krone remains poor though, as the economy is weak, and inflation is falling quickly. Recent data illustrates this: After a gradual slowdown, non-financial business credit is now heading into outright contraction. Employment is contracting at a 1% rate, while wages are contracting at a 4% pace. Core inflation has plunged to 1.5% from its peak of 4% around 6 months ago. This poor economic outlook leads us to believe that the dovish bias of the Norges Bank will stay entrenched for the time being, putting downward pressure on the krone. 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 Inflationary pressures continue to emerge in Sweden. We believe these pressures are likely to pick up further. USD/SEK has broken down below a key trend line that has underpinned its rally since May 2016, suggesting that as the euro continues to rebound, the SEK will also outperform the USD. However, it remains to be seen if the SEK can outperform the euro: while the SEK tends to be more sensitive to the dollar's weakness than the euro, the Riksbank is likely to want to make sure that the early signs of inflation in Sweden do indeed generate a durable way out of any deflationary tendencies in this economy. This means that the Swedish central bank is likely to try to weigh on any strength in the SEK, especially against the euro. However, as inflation is indeed coming back, the Riksbank will likely be forced to abandon its super-dovish stance later this year. The SEK will ultimately rally further against the euro on a 12-18 months basis. 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 Either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though our preferred long euro expression is long euro/pound near term and long euro/yuan structurally). All three of the above are just one big correlated trade. Long-term equity investors should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. But near term, remain cautious on risk-assets. Feature On the face of it, the ECB has committed to leave interest rates where they are for a very long time. "The Governing Council continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases"1 But take a closer look at this commitment, and an extended period of time could mean as little as a year. As things stand, "the horizon of the net asset purchases" has only nine more months to run, and "well past" could justifiably mean just six months or less beyond that. Furthermore, at the last press conference Draghi emphasized that forward guidance "is an expectation" and that the probabilities of the ECB's expectations are constantly changing. Remember also that the ECB has three policy interest rates:2 the deposit rate (-0.4%), the repo rate (0%) and the marginal lending rate (0.25%) - and the ECB doesn't have to move all three in tandem. Indeed in 2015, the ECB cut the deposit rate before the other two rates (Chart I-2). So it is quite conceivable that the ECB could hike the deposit rate before the other two rates and as soon as a year or so from now. Chart of the WeekGermany/Sweden Combination Has Run A Good Race With The U.S. Chart I-2The ECB Could Hike Its Deposit Rate Early ECB council member Ewald Nowotny hinted as much in a Handelsblatt interview last week, saying that all interest rates wouldn't have to be increased simultaneously nor to the same extent. "The ECB could raise the deposit rate earlier than the prime rate." A Major Mispricing: ECB Versus Fed This neatly brings us to one of the most extreme pricings in financial markets at the moment. The expected difference between ECB looseness and Fed tightness two years ahead stands at a 20-year extreme (Chart I-3). Chart I-3An Extreme Pricing: ECB Versus Fed Yet the percentage of the euro area population in employment is at an all-time high (Chart I-4), while on an apples for apples comparison, there is no difference between economic growth, inflation, or inflation expectations in the euro area and the U.S.3 Moreover, Draghi points out that "the risks surrounding euro area growth relate predominantly to global factors." If these global risks do materialise, it would prevent both the ECB and the Fed hiking rates through 2018. But if these global risks do not materialise, allowing the Fed to continue hiking through 2018, is it really conceivable that the ECB just sits pat? We think not. On this basis, investors should either go long Eurodollar / short Euribor June 2019 interest rate futures. Or long the U.S. 5-year T-bond / short German 5-year bund. Or long euro/dollar (though we prefer long euro/pound near term and long euro/yuan structurally). We say "either or" because all three positions are just one big correlated trade (Chart I-5). Chart I-4Percentage Of Euro Area Population In##br## Employment Near An All-Time High! Chart I-5Correlated Trade: Interest Rate Futures,##br## Bond Yield Spreads, Ans EUR/USD The French Election: "System 1" And "System 2" The looming risk to this big correlated trade takes the form of the upcoming French Presidential Election. Two data points do not make a trend, but some people are worried that the same dynamic that delivered shock electoral victories for Brexit and Donald Trump in 2016 could propel Marine Le Pen to the Elysée Palace in 2017. This worry is overdone. In explaining the Brexit and Trump shock victories, an important point has been understated. These days many voters care more about politicians' personalities than policies. Emotional appeal arguably matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Both the Brexit and Trump campaigns resonated strongly with emotional System 1. A lot of voters warmed to Boris Johnson, a leader of the Brexit campaign, and to Donald Trump. By contrast, the Bremain and Hillary Clinton campaigns tried to appeal mainly to cold rational System 2. But as Kahneman explains, when cold rational System 2 competes with emotional System 1, emotional System 1 almost always wins. In this regard, the dynamic of the French Presidential election is very different to the U.K.'s EU Referendum and the U.S. Presidential Election. Charles Grant, director of the Centre for European Reform, points out that "Emmanuel Macron's personality, and notably his charm, calm authority and courage may well (emotionally) appeal to more voters than Marine Le Pen's simplistic remedies and bitterness." Therefore, a final run off between Le Pen and Macron - as now seems highly likely - does not give us sleepless nights. But we would be concerned if the final run off were between Le Pen and the much less emotionally appealing François Fillon (Chart I-6 and Chart I-7). Chart I-6A Final Run Off Between Le Pen & Macron... Chart I-7...Does Not Give Us Sleepless Nights Incidentally, both Daniel Kahneman and Charles Grant will be speaking at our forthcoming New York Conference on September 25-26, and promise to provide fascinating investment insights from their areas of expertise. So book your places now! A Better Way To Invest In Europe: Germany And Sweden All of this might suggest that the Eurostoxx50 should outperform the S&P500. Not necessarily. Extreme economic and political tail-events aside, there is almost no connection between national or regional economic relative performance and stock market relative performance. As we demonstrated in the Fallacy Of Division,4 by far the biggest driver of Eurostoxx50 versus S&P500 performance is its sector skew. The Eurostoxx50 has a major 15% weighting to banks and a minor 7% weighting to tech. The S&P500 is the mirror image; a minor 7% weighting to banks and a major 22% weighting to tech. Furthermore, this overarching driver is captured in just the three largest euro area banks versus the three largest U.S. tech stocks. So relative performance simply reduces to whether Banco Santander, BNP Paribas and ING outperform Apple, Microsoft and Google,5 or vice-versa. Everything else is largely irrelevant. But this begs the question: can a different combination of European markets neutralise the sector skew and thereby provide a fairer head-to-head contest with the tech-heavy S&P500? At first glance, the answer seems to be no. Europe simply does not have the same type of technology companies that the U.S. has. So no combination of European markets can match the S&P500 tech exposure. On the other hand, Europe is the world-leader in a different type of technology: innovative industrial equipment and materials. It turns out that a 50:50 combination of Germany (DAX) and Sweden (OMX) matches the exposure to European industrial equipment and materials with the exposure to American tech. At the same time, the DAX/OMX combination largely removes Europe's bank overweight. The upshot is that the DAX/OMX combination has run a very good race with the S&P500 through the past 10 years, while the Eurostoxx50 has failed to keep the pace (Chart of the Week). In effect, DAX/OMX versus S&P500 reduces to Siemens, Bayer and Atlas Copco versus Apple, Microsoft and Google (Chart I-8). Compared to the euro area banks, Europe's innovative industrial equipment and materials are a much better long-term match-up against U.S. tech (Chart I-9). Indeed, my colleague, Brian Piccioni, BCA Technology strategist, points out that Bayer is a good play on the revolutionary new genetic modification technology CRISPR-Cas9.6 Chart I-8DAX/OMX Vs. S&P500 = Siemens, Bayer & Atlas Copco ##br##Vs. Apple, Microsoft & Google Chart I-9European Innovative Industrial Equipment & Materials ##br##Is A Good Match-Up Against American Tech Investors who want a long-term equity exposure to Europe should consider a 50:50 combination of Germany (DAX) and Sweden (OMX) as a superior alternative to the Eurostoxx50 or Eurostoxx600. Nevertheless, those who can fine-tune their timing should await a better entry-point for all risk-assets. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 From the ECB introductory statement to the press conference, March 9 2017. 2 The deposit rate (-0.4%) is the rate at which commercial banks park their excess liquidity; the repo rate (0%) is the usually quoted policy rate for the ECB's standard money market operations; and the marginal lending rate (0.25%) is the rate at which commercial banks borrow from the central bank, usually when they cannot access interbank funding. 3 Please see the European Investment Strategy Weekly Report 'Fake News In Europe' January 26, 2017 available at eis.bcaresearch.com 4 Published on March 9, 2017 and available at eis.bcaresearch.com 5 Listed as Alphabet. 6 Please see the Technology Strategy and Global Investment Strategy Special Report 'CRISPR-Cas9: Investment Implications' March 17, 2017 available at www.bcaresearch.com Fractal Trading Model* There are no new trades this week. We are expressing a tactical short position in equities through a short exposure to the Netherlands AEX. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Please note that today we are publishing an abbreviated Weekly Bulletin as tomorrow we will publish Great Debate: Does China Have Too Much Debt Or Too Much Savings? The latter report will elaborate on long-standing view differences on China within BCA. I will be debating my colleagues Peter Berezin and Yan Wang on the issues surrounding China's savings and debt as well as the growth outlook. Arthur Budaghyan Feature Singapore: MAS Will Cap Interest Rates Higher U.S. interest rates will temporarily place upward pressure on Singaporean local interest rates (Chart I-1). However, Singapore is not in position to tolerate higher borrowing costs due to lingering credit excesses and deflationary pressures that currently prevail in its economy. The Monetary Authority of Singapore (MAS) will therefore respond by injecting liquidity to keep interbank rates low. The MAS operates monetary policy by guiding the exchange rate - and by default - often allowing interest rates to fluctuate freely. Yet higher interest rates are not an optimal policy option at the moment. If and as U.S. interest rates and the U.S. dollar rise, the MAS will intervene to cap local rates even if it entails a weaker Singapore dollar. While there is a recovery going on in non-oil export volumes and narrow money (M1) (Chart I-2), many other cyclical indicators are still negative. Chart I-1Rising Libor Rates Will Exert ##br##Upward Pressure On Singaporean Rates Chart I-2Singapore: Non-Oil ##br##Exports Are Picking Up The exchange rate-targeting system was introduced in the early 1980s when exports stood at 150% of GDP. Today, exports relative to GDP have fallen substantially to 115% of GDP (Chart I-3). On the other hand, total private non-financial sector debt levels have risen to 180% of GDP (Chart I-3). Therefore, the Singaporean economy has become much more leveraged to interest rates and somewhat less exposed to global trade. Improving exports will not be sufficient to offset the negative impact of rising borrowing costs. Moreover, our proxy for interest payments on domestic debt has also surged and now stands at close to 10% of GDP (Chart I-4). What is precarious is that the rise in interest payments relative to income has occurred in a period when rates are close to record-low levels. Chart I-3Singapore: Debt Is ##br##Overshadowing Exports Chart I-4Singapore: Interest Payments Are ##br##Large Despite Record Low Rates If borrowing costs rise, it will likely cause major debt deflation concerns. The MAS will not allow this to happen. Employment is stagnating, while employment in the construction and manufacturing sectors is contracting (Chart I-5). Weak employment has weighed on the consumer sector. Retail and department store sales are still shrinking (Chart I-6). Chart I-5Singapore: Employment Is Weak Chart I-6Retail Spending Is Contracting Importantly, the real estate sector, one of the major pillars of the Singapore economy, is depressed. Property prices across the board are deflating, while vacancy rates are rising (Chart I-7). Bank loan growth to property developers has also stalled (Chart I-7, bottom panel). Weak economic growth should be reflected on banks' balance sheets. Surprisingly, non-performing loans (NPLs) among Singapore's three largest banks still stands at a low 1.4%. If and as loan losses begin to rise, commercial banks will rush to increase provisioning for these losses, which will hurt their profits and keep credit growth subdued. Furthermore, Singaporean banks are also very exposed to Malaysia. Singapore's largest banks have extended loans to Malaysia of approximately 67 billion Singapore dollars - or 16% of GDP. Aggregate external loans stand at 137% of GDP (Chart I-8). Economic fundamentals are currently very weak and will continue to deteriorate in Malaysia. This warrants more assets write-offs among Singapore banks and less appetite to expand their balance sheet. Chart I-7Property Sector In Singapore Chart I-8Singaporean External Loans Are Enormous On the whole, if Singaporean interest rates begin to rise due to either depreciation of the Singapore dollar or higher U.S. interest rates, the central bank will intervene to bring local rates down. It would not be the first time the MAS has intervened to bring down interest rates. In 2015 when EM risks escalated, local interbank rates spiked. The MAS promptly injected liquidity in the banking system by buying back its outstanding MAS bills, and by also purchasing government securities, supplying liquidity to the banking system. This essentially placed a cap on interbank rates. Chart I-9Go Long Singapore Real ##br##Estate Stocks Vs. Hong Kong What is noteworthy is that the Singapore dollar weakened as a result of the intervention, although the MAS's official monetary policy stance was not stimulative - i.e. the monetary authorities did not target to weaken the trade-weighted SGD. In that instance, the MAS decided to focus on interest rates/funding market stability and ignore the exchange rate's response. This highlights that despite the MAS's official monetary policy framework of guiding the exchange rate, it will not allow interest rates to rise. Unlike Singapore, Hong Kong does not operate an independent monetary policy and as such will be forced to import higher U.S. rates. As a bet on higher interest rates in Hong Kong and the U.S. relative to Singapore, investors should consider going long Singaporean real estate stocks and shorting Hong Kong real estate stocks. Chart I-9 shows that Singaporean real estate stocks outperform Hong Kong's when the latter's interest rates/bond yields rise relative to Singapore and when Singapore's M1 growth accelerate relative to Hong Kong. As discussed above, the MAS has the capacity and will to inject liquidity to lower interest rates. Hong Kong, however, does not have this privilege due to the currency's peg to the greenback. Besides, Singapore's property correction is now much more advanced than Hong Kong's. In fact, Hong Kong property prices are still rising, i.e., the real estate market adjustment in Hong Kong has not yet started. While both city states are vulnerable to a potential slowdown in Chinese inflows, Hong Kong real estate prices will ultimately fall from a higher starting point. Bottom Line: A rising U.S. dollar and U.S. interest rates may exert upward pressure on Singaporean local interest rates. However, the Singaporean central bank will respond by injecting liquidity, which will cap rates relative to the U.S. and Hong Kong. This opens a tactical trade opportunity (for the next 3 months): Long Singapore real estate stocks / short Hong Kong real estate shares. Asian equity portfolio investors should have a neutral allocation to Singapore stocks within the EM/emerging Asian benchmarks. Ayman Kawtharani, Research Analyst ayman@bcaresearch.com Colombia: Not Out Of The Woods Yet Even though global economic growth has been improving and commodities prices have rallied, Colombia's growth is still bound to disappoint. We remain structurally bullish on the nation's longer-term prospects. That said, there will still be more downside this year. Credit growth will continue to decelerate, despite the beginning of a rate cut cycle (Chart II-1). Interest rates are still high, both in nominal and real terms (Chart II-2). This along with poor consumer and business confidence (Chart II-3) will depress credit demand and spending. Chart II-1Colombia: Negative Credit Impulse Chart II-2Borrowing Costs Are Still High Chart II-3Consumer & Business Confidence Are Weak Furthermore, the central bank's liquidity injections into the banking system have dropped considerably (Chart II-4). In the past few years, abundant liquidity provisioning by the central bank had allowed commercial banks to sustain robust credit growth. Hence, a withdrawal of banking system liquidity will cap loan origination. The current account deficit remains wide at $12.5 billion, or 5.2% of GDP. Financing such a wide deficit will prove challenging. Besides, BCA's Emerging Markets Strategy team believes oil prices are at risk of additional declines. Hence, we are bearish on the Colombian peso. Fiscal policy is set to tighten as the budget deficit has ballooned due to strong spending and shrinking revenues (Chart II-5). Recently introduced tax reforms represent a step forward with respect to the country's structural reforms agenda, as it will simplify the tax code and reduce corporate tax rates. Chart II-4Withdrawal Of Liquidity Will Cap Credit Growth Chart II-5Government Fiscal Balance Is Deteriorating However, redistributing the tax burden onto individuals, mainly by increasing the VAT from 16% to 19%, will reinforce the slump in household spending. In terms of high frequency data, there are little signs of economic revival (Chart II-6). Retail sales volume remain tame. The latest bounce in this series most likely reflects consumers front running the impending VAT hike. Furthermore, oil production is likely to decline further, and non-oil exports are still contracting. In terms of financial markets, we recommend the following: We are closing our bet on yield curve flattening - receive 10-year/pay 1-year swap rates. Initiated on September 16, 2015, this trade has produced a 190 basis-point gain (Chart II-7). At the moment, the risk-reward for this position is no longer attractive. Chart II-6Cyclical Economic Activity Remains Subdued Chart II-7Take Profits On The Yield Curve Trade We remain neutral on Colombian equities and sovereign credit relative to their respective EM universes. Even though our long Colombian bank stocks/short Peruvian banks bet has been deep in the negative, we are reluctant to cut it. The basis is that Colombia's central bank may opt to cut rates further, even if the peso depreciates anew. In contrast, the Peruvian central bank is more likely to hike rates if its currency comes under downward pressure. Bank share prices will likely react to marginal shifts in relative interest rates between the two countries. Andrija Vesic, Research Assistant andrijav@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. Treasuries: The surprisingly positive response from financial markets to last week's Fed rate hike should force the Fed to quickly shift back to a hawkish bias. Maintain an underweight exposure to U.S. Treasuries, and an overall below-benchmark portfolio duration stance. Bearish Fed Trade: As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade low-beta Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Feature Chart of the WeekAre Central Banks OK With This? The major central banks all had a chance to send a more hawkish message to the markets in the past couple of weeks, and every one took a pass. Even the Fed, who actually hiked rates, signaled that U.S. monetary policy would not be tightened more aggressively than previously planned, which financial markets took very bullishly. With the global economy finally enjoying a synchronized upturn after several years of sluggishness, policymakers are showing no interest in hitting the brakes too hard, too soon and risking a sudden downturn in growth The current backdrop of improving economic momentum, with central banks remaining accommodative, is sustaining the strong performance of growth-sensitive assets like equities and corporate debt over government bonds. This should continue over the next 6-12 months. Inflation rates, both realized and expected, continue to rise across the developed economies alongside faster economic growth, putting upward pressure on government bond yields (Chart of the Week). Central bank dovishness is looking increasingly non-credible as long as this dynamic persists, but policymakers will likely be slow to respond without a more rapid rise in inflation. Bond yields will continue to climb higher against this backdrop, first from continued increases in inflation expectations and, later, from a shift to less restrictive monetary settings. We continue to recommend a below-benchmark duration stance, while underweighting government bonds versus corporate debt, particularly in the U.S. This week, we are making a significant portfolio shift to get even more defensive within our government bond allocation, upgrading low-beta Japan to above-benchmark while downgrading core Europe (Germany, France & the Netherlands) to neutral. The Fed Declares Victory Over "Low-flation" The market response to last week's Fed tightening was consistent with the idea of a "dovish hike", with U.S. equity and bond markets rallying while the U.S. dollar sold off and overall U.S. financial conditions actually easing. There was heightened nervousness heading into the meeting that the Fed could signal a faster or steeper trajectory for interest rates. That turned out to be a false alarm, as not much was changed from the Fed's prior guidance to markets. The range for the funds rate was raised to 0.75-1.00%, as expected, but there was virtually no change to any of the median FOMC member projections for GDP growth, inflation or interest rates out to 2019. Another 50bps of increases are expected this year, with 75bps in both 2018 and 2019 (Chart 2). This would bring the funds rate to 3% in 2019, which is the median FOMC member's assessment of where the terminal rate lies. The pricing from the U.S. Overnight Index Swap (OIS) curve shows that market expectations for the funds rate are in line with the Fed's projections for this year, but lower for the next two years. Our proxy measure for the market's assessment of the terminal rate - the 5-year OIS rate, 5-years forward - sits at 2.25%, 75bps below the Fed's number. Our bias is closer to the market on this point, as we do not see a need for the funds rate, in real terms, to end this tightening cycle much above 0% against a backdrop of still very high U.S. debt levels and low U.S. productivity growth. A 0% real funds rate would be the result of the Fed successfully getting U.S. inflation expectations back to its 2% target level, with a nominal funds rate of 2%. That inflation goal has not yet been reached, however, as inflation expectations are still below levels consistent with the Fed's inflation target (Chart 3, bottom panel). Chart 2FOMC & Market Disagree Beyond This Year Chart 3Few Signs Of An Overheating U.S. Economy The FOMC has made it clear that they believe the U.S. economy is running very close to full employment. Yet the recent modest deceleration in the various measures of wage inflation (middle panel) suggests that there could still be some excess slack in the U.S. labor market - even with the recent Payrolls reports showing job growth of over 200k per month. If that pace is sustained for several months, however, the unemployment rate will likely fall further and wage pressures will intensify. In the near-term, the Fed will continue to focus on financial markets to get a sense of whether current policy settings are too restrictive or too accommodative. One recent development on this front is that the correlation between the U.S. dollar (USD) and risk assets has flipped, with a stronger USD now positively correlated to global equities and credit (Chart 4). This shift was already starting to happen before the election of Donald Trump and his pro-growth agenda last November, likely because the global economy was improving as evidenced by the accelerating trend in our global purchasing managers' index (PMI, bottom panel). We have written extensively about the Fed being stuck in a "policy loop" in the past couple of years, where a shift to a more hawkish bias would sharply drive up the USD and cause a risk-off move in global financial markets. This unwanted tightening of financial conditions would cause the Fed to back off from its hawkishness, causing the USD to soften and markets to rally. We have argued that the way to break out of this loop would likely be a rise in non-U.S. economic growth that would allow the Fed to continue slowly normalizing U.S. monetary policy without disrupting global markets. We seem to be in that period now. One implication of this is that the longer risk assets can withstand rising U.S. interest rates and a stronger USD, the more the fed funds rate and U.S. Treasury yields must rise in response to U.S. economic strength. For this reason, we continue to recommend a below-benchmark duration stance on U.S. Treasuries on a 6-12 month horizon. We also maintain our bias towards a bear-steepening of the Treasury curve through our butterfly trade, long the 5-year bullet versus a duration-matched 2-year/10-year barbell. The curve will remain positively correlated to inflation expectations until those reach the Fed's target level, after which any additional Fed rate hikes will likely flatten the yield curve in a more typical pattern during the latter stages of a tightening cycle. It is possible, though, that because markets shrugged off the latest rate increase, the Fed could return to sending hawkish signals in the near term. To play for this possibility, our colleagues at BCA U.S. Bond Strategy recommend that investors add a tactical trade: going short the January 2018 fed funds futures contract (Chart 5). We are today adding this trade to our list of Tactical Overlay Trades (see page 12). Chart 4The Strong USD Is Not A Problem Chart 5Go Short January 2018 Fed Funds Futures We calculate that this trade will return 11bps in a scenario where the Fed lifts rates twice more before the end of the year and 37bps in a scenario where the funds rate is raised a more aggressive-than-expected three times. However, we do not expect to hold this trade until the end of the year. Rather, we expect the Fed will nudge rate expectations higher in the next month or two in response to the latest easing of financial conditions, and that these gains will be realized over a much shorter horizon. We also add a caveat that, in the present environment, it is safer to implement any "hawkish Fed trades" in either fed funds futures or the OIS market. The Eurodollar market does not provide the same potential for gains because the LIBOR / OIS spread is currently elevated and could tighten to offset the profits from rising rate expectations. Bottom Line: The surprisingly positive response from financial markets to last week's Fed rate hike could force the Fed to quickly shift back to a hawkish bias. Maintain below-benchmark exposure to U.S. Treasuries. As a new tactical trade, go short the January 2018 fed funds futures contract to benefit from the Fed ramping up the hawkish language again. Japan: A Weaker Yen Is Still The Only Way Out The Bank of Japan (BoJ) stayed on hold last week, as expected. There had been some increased speculation of late that the BoJ could start to signal a potential increase in its 0% target for the 10-year Japanese Government Bond (JGB) yield, given the rising trend in global yields and signs of better growth in Japan. At the press conference following the BoJ meeting, however, Governor Kuroda shot down that notion, saying that the current accommodative policy stance must be maintained given how far Japanese inflation is below the central bank's 2% target. It remains far too soon for the central bank to signal any shift to a less accommodative stance, as both the pace of economic growth and inflation are not only modest but lagging the current global upturn. In Chart 6, we show some Japanese growth variables relative to an aggregate of the same data for the major developed economies.1 What is clear from the chart is that Japan is benefitting from faster global growth on the industrial side, with the manufacturing PMI above 50. However, the domestic demand story is not as positive, with consumer confidence and real retail sales growth languishing. The lack of real income growth remains the biggest drag on Japanese consumers, as we show in another set of international comparisons in Chart 7. Japan's unemployment rate, currently at 3%, is below the OECD's estimate of the full employment level (consistent with stable domestic inflation pressures). This is in contrast to the other major economies, which are either at, or close to, full employment. Yet Japanese wages continue to struggle, both in nominal terms (a year-over-over growth rate of 1%) and real terms (a year-over-year growth rate of 0.4%). The current annual spring round of Japanese wage negotiations is showing that downward pressure remains powerful, with many manufacturing companies offering pay raises only half as large as those of last year.2 Chart 6Japan Is Lagging The Global Upturn Chart 7Still No Wage Growth In Japan Japan is still struggling to generate positive rates of inflation, even as price growth is accelerating in the other major economies (Chart 8). This is keeping Japanese inflation expectations, which the BoJ believes are mostly a function of the recent performance of actual inflation, subdued. As always, the only reliable source of Japanese inflation seems to be yen weakness. We continue to see this as the only way out of the low-inflation trap for Japan - keeping Japanese interest rates depressed versus the rest of the world, thus weakening the yen through increasingly unattractive interest rate differentials. The BoJ's 0% yield curve targeting framework has been successful in keeping rate differentials wide enough to soften up the yen, especially against the USD (Chart 9). Given our expectations of additional Fed rate hikes, and higher U.S. Treasury yields, over the rest of the year, the yen will likely depreciate further as long as the BoJ sticks with its current interest rate targets. A similar argument holds for the yen versus the Euro, given the increasing likelihood that the European Central Bank (ECB) will be forced to signal a less accommodative monetary policy stance later this year. Against this backdrop, JGBs are likely to outperform the major global government bond markets over the rest of 2017. We upgraded our recommended stance on JGBs from underweight to neutral last October after the BoJ introduced its yield curve targeting framework. In Chart 10, we show the relative performance of JGBs versus some other bond benchmarks, on a duration-matched and common-currency (hedged into USD) basis. We broke up the returns into two periods, from our October 11, 2016 Japan upgrade to January 31 of this year when we upgraded our U.S. corporate bond exposure and cut our overall portfolio duration stance to below-benchmark. The chart shows that JGBs were a good defensive hedge during the latter part of 2016 when global yields were rising, led by U.S. Treasuries. The more recent period, however, shows a much more negligible relative performance, both against other government bonds and corporate debt, during a period where global bond yields have generally traded sideways. Chart 8Japan Inflation Still A No-Show Chart 9A Weaker Yen Is Still Necessary Chart 10Relative Performance Of JGBs Given our views that U.S. Treasury yields will continue to move higher in the next 6-9 months, and that the performance of core European government bonds will suffer over the same period as the ECB signals a slower pace of asset purchases for next year, a return to the late 2016 relative performance of JGBs is very likely. Thus, we are upgrading Japan to an above-benchmark stance in our model portfolio this week, while downgrading core Europe (Germany, France, the Netherlands) to neutral. This is purely a move to get even more defensive in our overall country exposures, by allocating into JGBs which are low-beta to both U.S. Treasuries (where we are already below-benchmark) and core European government debt. Bottom Line: Japanese inflation remains too low for the Bank of Japan to move away from its 0% target on JGB yields anytime soon, even with signs of better Japanese growth and rising pressure on global bond yields. Upgrade Japan to above-benchmark in global hedged bond portfolios, while downgrading core Europe (Germany, France, the Netherlands) to neutral. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The U.S., Euro Area, U.K., Canada & Australia 2 https://www.ft.com/content/0895c4ee-eb3b-11e5-888e-2eadd5fbc4a4 The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns