BCA Indicators/Model

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. When the chartbook was last published in September 2017, the main message was that less accommodative monetary policy was required in the developed economies. This was largely driven by solid global growth and diminishing economic slack visible in measures like falling unemployment rates and rising capacity utilization. Since then, there have been multiple rate hikes in the U.S., single rate increases in Canada and the U.K., and a slowing of the pace of central bank asset purchases in the euro area and Japan. No other central banks have made any moves, however, with inflation still struggling to return to policymaker targets in most countries. A new element that central banks are dealing with is the increased financial market volatility seen in 2018. Yet the BCA Central Bank Monitors continue to point to a need for tighter monetary policy in all countries (Chart of the Week). This means policymakers are unlikely to "come to the rescue" of less stable financial markets through more dovish (and bond bullish) policy without evidence that slower global growth was leading to an easing of cyclical inflation pressures. Chart of the WeekGreater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Greater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Greater Divergences Between Our Central Bank Monitors Now Versus 2016/17 Feature An Overview Of The BCA Central Bank Monitors Chart 2The Cyclical Backdrop Remains Bond Bearish The Cyclical Backdrop Remains Bond Bearish The Cyclical Backdrop Remains Bond Bearish The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). Currently, the Monitors are above the zero line for all countries for which we have built the indicator. This implies that the conditions are not yet present to expect a period of declining global bond yields driven by more dovish central banks. Yet differences in the trajectories of the Monitors have opened up. The BoE, RBA and RBNZ Monitors have fallen well off their peaks, while the Fed, ECB, BoC and even the BoJ Monitors are all still at or close to recent highs. In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the Monitors plotted against our 12-Month Discounters, which measure the expected change in interest rates over the following year taken from OIS curves. Fed Monitor: Market Turbulence Not Yet Enough To Change Fed Plans Our Fed Monitor remains in the "tight money required" zone, signalling that cyclical pressures are still pointing toward additional Fed rate hikes (Chart 3A). FOMC officials are now expressing strong conviction that the Fed's growth and inflation forecasts for 2018 will be realized, and even upgraded those projections last month. That increased confidence comes amid signs that core inflation is finally moving higher after last year's surprising slump (Chart 3B). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BNo Spare Capacity In The U.S. No Spare Capacity In The U.S. No Spare Capacity In The U.S. The growth and inflation subcomponents of the Fed Monitor have both accelerated since our last Central Bank Monitor Chartbook was published last September. In particular, the inflation subcomponent is on the cusp of breaching the zero line for the first time since 2011 (Chart 3C). The Fed Monitor (unlike the other Central Bank Monitors) includes a Financial Conditions component that is rolling over from very elevated (i.e. supportive) levels. Chart 3CSteady Pressure On The Fed To Tighten, But More From Growth Than Inflation Steady Pressure On The Fed To Tighten Steady Pressure On The Fed To Tighten The sharp sell-off in U.S. equity markets seen since early February is a development that would typically give the Fed pause on the need to tighten monetary policy further. Yet there are no real signs - yet - that any slowing of U.S. growth is in the cards for the next few quarters. Leading indicators are still climbing, employment growth has been accelerating in recent months, and both consumer and business confidence remain around multi-year highs. The Fed is likely to deliver on its projection of an additional 50bps of rate hikes in 2018, which is already discounted in money markets (Chart 3D). Additional increases beyond that in 2019 are still likely to occur, barring any signs that the current financial market volatility is altering the current rising trends in growth and inflation. Chart 3DThe Fed Will Continue To Hike In 2018 & 2019 The Fed Will Continue To Hike In 2018 The Fed Will Continue To Hike In 2018 BoE Monitor: Diminishing Pressures To Hike The Bank of England (BoE) Monitor is drifting lower, but remains in the "tighter money required" zone as it has since late 2015 (Chart 4A). Despite that persistent signal, the BoE has raised the base rate only once over that period - in November of last year. On the surface, inflation pressures remain strong. The U.K. unemployment rate is well below NAIRU with an output gap that is now estimated to be closed (Chart 4B). Yet realized inflation has peaked, largely because the British pound is now up 9% off the post-Brexit 2016 lows. Rapid declines in pipeline price pressures (PPI, imported goods price inflation) point to additional slowing of CPI inflation in the next several months. Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BTight Capacity In The U.K. Tight Capacity In The U.K. Tight Capacity In The U.K. Meanwhile, the economic picture looks mixed. Leading economic indicators have rolled over, as have cyclical measures like the manufacturing PMI and industrial production. Yet at the same time, recent readings on both consumer and business confidence have shown modest improvement. Looking at the breakdown of our BoE Monitor, both the growth and inflation sub-components of the indicator are now falling (Chart 4C). Given the decelerating path of leading economic indicators, and with the currency-fueled rise in U.K. inflation now starting to reverse, we think the BoE will be hard pressed to deliver more than the 41bps of rate hikes over the next year currently discounted in U.K. money markets (Chart 4D). Chart 4CGrowth & Inflation Components Of The BoE Monitor Are Slowing Growth & Inflation Components Of The BoE Monitor Are Slowing Growth & Inflation Components Of The BoE Monitor Are Slowing Chart 4DThe BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted The BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted The BoE Will Not Deliver More Hikes In 2018 Than Currently Discounted We continue to recommend an overweight stance on Gilts, which continue to trade as a "defensive" lower-beta alternative to U.S. Treasuries and core European debt, within dedicated global government bond portfolios. ECB Monitor: Tapering? Yes. Rate Hikes? No. Our European Central Bank (ECB) Monitor has been grinding higher over the past couple of years and broke sustainably above zero in July 2017 (Chart 5A). The broad-based cyclical economic upturn in the euro area has continued to absorb spare capacity, with the unemployment rate for the entire region now down to 8.6%, right at the OECD's NAIRU estimate (Chart 5B). Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Economy Now At Full Capacity Euro Area Economy Now At Full Capacity Euro Area Economy Now At Full Capacity Despite strong growth, headline (1.1%) and core (1.0%) inflation remain well below the ECB's target of "just below" 2%. This lack of upward momentum flies in the face of the inflation subcomponent of our ECB Monitor, which has been steadily moving higher for the past three years (Chart 5C). Chart 5CRising Pressure On ECB To Tighten Monetary Conditions Rising Pressure On ECB To Tighten Monetary Conditions Rising Pressure On ECB To Tighten Monetary Conditions The ECB remains on track to deliver some of the monetary tightening that our ECB Monitor is calling for later this year, but it will not be through interest rate hikes (Chart 5D). ECB officials have made it clear that a tapering of asset purchases will take place when the current program ends this September. However, it will take more evidence that inflation will sustainably return to the ECB's target before rate hikes will commence. Chart 5DECB Will Deal With Tightening Pressures First By Tapering Asset Purchases ECB Will Deal With Tightening Pressures First By Tapering Asset Purchases ECB Will Deal With Tightening Pressures First By Tapering Asset Purchases The recent softening of cyclical euro area economic data like manufacturing PMIs, combined with underwhelming inflation prints, justifies the ECB's cautiousness on rates. Although leading economic indicators are still pointing to another year of above-trend growth in 2018. The likelihood of a taper later this year leads us to recommend a moderate underweight stance on core European government bonds, but with a neutral stance on Peripheral European debt which benefits from an expanding economy. BoJ Monitor: Still Far Too Soon To Expect Any Policy Changes The Bank of Japan (BoJ) Monitor has inched into the "tighter money required" zone for the first time since 2007 (Chart 6A), thanks largely to a robust economy. Yet while growth has been enjoying strong momentum, inflation remains stuck below the BoJ's 2% target - even with record low unemployment and a positive output gap (Chart 6B). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BJapanese Inflation Still Too Low Japanese Inflation Still Too Low Japanese Inflation Still Too Low Japanese businesses remain reluctant to boost wages despite robust profitability and a tight labor market. This makes it difficult for the BoJ to hit the 2% inflation target even using extreme policy tools like negative interest rates and asset purchases. Yet even these policies are approaching limits. Liquidity in the Japanese government bond (JGB) market is severely impaired with the BoJ now owning nearly one-half of all outstanding JGBs. This is the main reason why the BoJ shifted from targeting a 0% yield on the 10-year JGB back in September 2016, aiming to target the price of bonds purchased instead of the quantity. With both the inflation and growth components of our BoJ Monitor are now above the zero line (Chart 6C), a case could be made for the BoJ to consider raising its yield target on the 10-year JGB. In our view, any shift in the BoJ yield curve target will only happen if the yen is much weaker (the 115-120 range), core inflation and wage growth both hit at least 1.5%, and global bond yields hit new cyclical highs (i.e. the 10-year U.S. Treasury yield approaching 3.5%). Chart 6CGrowth & Inflation Pressures Have Picked Up In Japan Tight Labor Market, But Still No Inflation Tight Labor Market, But Still No Inflation We continue to recommend an overweight stance on Japan, as the BoJ remains a long way from signaling to the markets that interest rate expectations must begin to rise (Chart 6D). Chart 6DThe BoJ Will Not Signal Any Change In Policy In 2018 The BoJ Will Not Signal Any Change In Policy In 2018 The BoJ Will Not Signal Any Change In Policy In 2018 BoC Monitor: Still Following The Fed The Bank of Canada (BoC) Monitor has stayed above the zero line since the beginning of 2017 (Chart 7A). The BoC has hiked rates three times since last summer, with Canada's robust growth justifying the tightening of monetary policy. Real GDP expanded by 3% in 2017, enough to push Canada's output gap into positive territory and drive the unemployment rate (5.8%) to below NAIRU (6.5%). As a result, both headline and core inflation are now back to the midpoint of the BoC's 1-3% target range (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BNo Spare Capacity In The Canadian Economy No Spare Capacity In The Canadian Economy No Spare Capacity In The Canadian Economy Growth has cooled a bit recently, though, most notably in consumer spending and housing data. In addition, the inflation component of the BoC Monitor has slowed and is diverging from the rising growth component (Chart 7C). These developments may be a sign that previous BoC hikes are starting to have an impact, although overall GDP growth remains well above trend and leading economic indicators are not slowing. Chart 7CA Divergence In The Growth & Inflation Components Of The BoC Monitor A Divergence In The Growth & Inflation Components Of The BoC Monitor A Divergence In The Growth & Inflation Components Of The BoC Monitor Looking ahead, the Trump administration's rising protectionist rhetoric is a potential threat to both Canada's economy and the value of the Canadian dollar. However, Canada was exempted from the recent tariffs imposed on U.S. steel and aluminum imports, suggesting that Trump may only seek a renegotiation, rather than a tearing up, of NAFTA. We continue to recommend an underweight stance on Canadian government bonds. Only 51bps of rate hikes are discounted over the rest of 2018 (Chart 7D), a pace that can be surpassed if the BoC follows its typical behavior of following the policy lead of the U.S. Fed, which is still expected to deliver 2-3 more rate hikes this year. Chart 7DThe BoC Will Continue Its Hiking Cycle This Year The BoC Will Continue Its Hiking Cycle This Year The BoC Will Continue Its Hiking Cycle This Year RBA Monitor: Lagging Behind While our Reserve Bank of Australia (RBA) Monitor remains in "tighter policy required" territory, it has pulled back considerably over the past four months and is now near the zero line (Chart 8A). This move suggests that there is no imminent need to adjust monetary policy, given tepid inflation pressures. Despite the recent surge in employment growth, labor markets still have plenty of slack. Part time employment as a percentage of total employment and the underemployment rate are both near all-time highs. Wage growth is weak and a substantial recovery is unlikely given that real GDP growth slowed in Q4 and the output gap is still wide (Chart 8B). Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BAustralian Inflation Remains Subdued Australian Inflation Remains Subdued Australian Inflation Remains Subdued Looking ahead, consumption is at risk. Real wage growth has been nonexistent, so households have supported their spending by reducing savings. However, the rate of increase for house prices has slowed and prices in Sydney actually declined in Q4. If overall house prices were to decline going forward, then the lack of a wealth effect boost would force already massively-indebted consumers to reverse the savings downtrend and cut spending. Both headline and underlying inflation remain below the RBA's target range of 2-3%, with policymakers expecting underlying inflation to reach 2% only in June of 2019 with just a gradual improvement in labor markets. The inflation component of our RBA Monitor has already declined significantly on the back of collapsing iron ore prices, softening survey-based inflation measures and cooling house prices (Chart 8C). Chart 8CThe Inflation Component Of The RBA Monitor Has Plunged The Inflation Component Of The RBA Monitor Has Plunged The Inflation Component Of The RBA Monitor Has Plunged As such, we maintain our overweight position on Australian government debt, as the RBA will not even deliver the one 25bp rate hike in 2018 currently discounted by markets (Chart 8D). Chart 8DThe RBA Will Not Deliver The Discounted Rate Hikes In 2018 The RBA Will Not Deliver The Discounted Rate Hikes In 2018 The RBA Will Not Deliver The Discounted Rate Hikes In 2018 RBNZ Monitor: No Inflation, No Rate Hikes Our Reserve Bank of New Zealand (RBNZ) Monitor, which was the most elevated of all our Central Bank Monitors in last September's update, has plunged sharply since then (Chart 9A). Inflation remains stubbornly below the midpoint of the RBNZ's 1-3% target range, even with a tight labor market and no spare capacity in the New Zealand economy (Chart 9B). Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ At Full Employment, But Inflation Peaking NZ At Full Employment, But Inflation Peaking NZ At Full Employment, But Inflation Peaking Both the growth and inflation sub-components have fallen sharply, with the inflation measure now down below the zero line (Chart 9C). A firmer New Zealand dollar, the flipside of the weaker U.S. dollar, has played a large role in dampening traded goods price inflation. Chart 9CStrong NZ Inflation Pressures, But Growth May Be Peaking Strong NZ Inflation Pressures, But Growth May Be Peaking Strong NZ Inflation Pressures, But Growth May Be Peaking The February RBNZ Monetary Policy Report expressed an optimistic view on growth supported by elevated terms of trade, population growth, fiscal stimulus and low interest rates. Headline CPI inflation, however, is not projected to rise back to 2% level until 2020. Unsurprisingly, the RBNZ is signaling no change in policy rates until then, even with the central bank projecting the New Zealand dollar to weaken in the next couple of years. We have been recommending long positions in New Zealand government debt versus other developed market debt since last May. New Zealand bonds have outperformed strongly over that period, as markets have priced in no change in rates from RBNZ (Chart 9D) unlike other countries where rate hikes were repriced and, in some cases, delivered. With the RBNZ on hold for at least this year and likely much of 2019, we our staying long New Zealand government bonds. Chart 9DRBNZ Will Stay On Hold In 2018 RBNZ Will Stay On Hold In 2018 RBNZ Will Stay On Hold In 2018 Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Patrick Trinh, Associate Editor Patrick@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Policymakers Are In A Tough Spot BCA Central Bank Monitor Chartbook: Policymakers Are In A Tough Spot Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Continue to underweight the most cyclical sectors - Banks, Basic Materials, and Energy. As predicted, global growth is losing steam. This implies that the Eurostoxx50 will struggle to outperform the S&P500. Continue with a currency pecking order of "yen first, euro second, pound third, dollar fourth." The sell-off in bonds is due a retracement, or at least a respite. Stock markets' rich valuations are contingent on low bond yields. Feature The views in this report do not necessarily align with the BCA House View Matrix. Chart I-2Cyclicals Were Underperforming##br## Long Before The Trade Skirmishes Cyclicals Were Underperforming Long Before The Trade Skirmishes Cyclicals Were Underperforming Long Before The Trade Skirmishes Stock markets have experienced turbulence this year, and it would be very simple to blame the first skirmishes of a global trade war. It would also be simplistic. The sharp underperformance of cyclical stocks started in January, well before any inkling of the Trump tariffs (Chart I-2). The trade skirmishes have merely accelerated a process that was already underway. In this week's report, we make sense of the market turbulence from three broad perspectives: the global economic mini-cycle; market technicals; and valuation. The Economic Mini-Cycle Has Likely Turned Down When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but this headwind is felt with a delay. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but the tailwind is felt with a delay. This delay occurs because credit supply lags credit demand by several months. But if credit supply lags demand, an economic theory called the Cobweb Theorem1 points out that both the quantity of credit supplied and its price (the bond yield) must undergo 'mini-cycle' oscillations. The theory is supported by compelling empirical evidence (Chart I-3). Furthermore, as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same mini-cycle oscillations (Chart I-4). Chart I-3Compelling Evidence For Mini-Cycles In##br## Credit Supply And The Bond Yield... Compelling Evidence For Mini-Cycles In Credit Supply And The Bond Yield... Compelling Evidence For Mini-Cycles In Credit Supply And The Bond Yield... Chart I-4...And ##br##Economic Activity ...And Economic Activity ...And Economic Activity These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months. Their regularity creates predictability. And as most investors are unaware of these cycles, the next turn is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the predictability. Mini half-cycles average eight months, and the latest mini-upswing started last April. Hence, on January 4 we predicted that "contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018." The predicted deceleration is precisely what we are now witnessing, and we expect this to continue through the summer months. From an equity sector perspective, the relative performance of the most cyclical sectors - Banks, Basic Materials, and Energy - very closely tracks the regular mini-cycles in global growth. In a mini-downswing these cyclical sectors always underperform (Chart of the week). Accordingly, continue to underweight these sectors through the summer months. Chart of the weekCyclicals Always Underperform In An Economic Mini-Downswing Cyclicals Always Underperform In An Economic Mini-Downswing Cyclicals Always Underperform In An Economic Mini-Downswing For the time being, this implies that the Eurostoxx50 will struggle to outperform the S&P500 - because euro area bourses have an outsize exposure to the most cyclical sectors. From a currency perspective, the stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. In essence, as the ECB and BoJ are at the realistic limit of ultra-loose policy, long-term expectations for their policy rates possess an asymmetry: they cannot go significantly lower, but they can go significantly higher. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they can go either way, lower or higher. Hence, on January 18 we advised a currency pecking order of "yen first, euro second, pound third, dollar fourth." This currency pecking order has also worked perfectly this year, and we expect it to continue working through the summer months. Cyclical Sectors Had Bullish Groupthink Groupthink in any investment is a warning sign that the investment's trend is approaching exhaustion, because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when market participants disagree with each other. Consider a stock whose price is rising strongly: a momentum trader wants to buy it, while a value investor wants to sell it. Hence, the market participants trade with each other with plentiful liquidity. Liquidity starts to evaporate when too many market participants agree with each other. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders fuel the trend. But when all the value investors have become momentum traders, the trend reaches a tipping point. If a value investor suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, our proprietary fractal analysis measures whether groupthink in a specific investment has become excessive, signalling the end of its price trend. Furthermore, using a 130-day groupthink indicator (fractal dimension), the fractal framework provides a powerful and independent reinforcement of our mini-cycle framework. This is because 130 (business) days broadly aligns with the mini half-cycle length. Fractal analysis reinforces our decision to underweight cyclical sectors, because it shows excessive (bullish) 130-day groupthink in these economically sensitive sectors (Chart I-5). Chart I-5Excessive Bullish Groupthink In Cyclical Sectors Excessive Bullish Groupthink In Cyclical Sectors Excessive Bullish Groupthink In Cyclical Sectors It also shows excessive (bearish) 130-day groupthink in government bonds, suggesting that the sell-off in bonds is due a retracement, or at least a respite (Chart I-6). Chart I-6Excessive Bearish Groupthink In Government Bonds Excessive Bearish Groupthink In Government Bonds Excessive Bearish Groupthink In Government Bonds Rich Valuations Are Contingent On Low Bond Yields On price to sales, world equities are as richly valued as they were at the peak of the dot com boom in 2000. The observation is important because price to sales has proved to be a near-perfect predictor of future 10-year returns. It shows that in 2010, world equities were priced to generate 8% a year compared with 4% a year available from global bonds. Today, richer valuations mean that both world equities and global bonds are priced to generate a paltry 2% a year (Chart I-7). Chart I-7World Equities As Richly Valued As At The Peak Of The Dot Com Boom World Equities As Richly Valued As At The Peak Of The Dot Com Boom World Equities As Richly Valued As At The Peak Of The Dot Com Boom Nevertheless, this makes perfect sense, because when bond yields are at 2%, bonds and equities are equally risky as each other. It follows that they must offer the same return as each other. One of the biggest errors in finance is to define an investment's risk in terms of its (root mean squared) volatility. This is incorrect because nobody fears sharp gains, they only fear sharp losses. Consider an investment whose price goes up sharply one day and then sideways the next day ad infinitum. The investment has a very high volatility, but it has no risk. You can never lose money, you can only make money. This leads us to the correct definition of risk, as defined by Professor Daniel Kahneman. He proved that investors are not concerned about volatility per se, they are concerned about the ratio of potential short-term losses versus short-term gains, a measure known as 'negative skew'. The important point is that at low bond yields, bond returns start to exhibit negative skew. Intuitively, this is because the lower bound to yields forces an unattractive asymmetry on bond returns: prices can fall a lot, but they cannot rise a lot. Specifically, at a bond yield of 2%, theoretical and empirical evidence shows that bonds and equities possess the same negative skew (Chart I-8). And as the two asset classes are equally risky, they must offer the same return, 2% (Chart I-9). Chart I-8At A 2% Bond Yield, 10-Year Bonds##br## Have The Same Negative Skew As Equities... Market Turbulence: What Lies Ahead? Market Turbulence: What Lies Ahead? Chart I-9...So At A 2% Bond Yield, ##br##Equities Must Also Offer A 2% Return Market Turbulence: What Lies Ahead? Market Turbulence: What Lies Ahead? Therefore, equities find themselves in a precarious equilibrium. Rich valuations are justified if bond yields remain at low levels or fall, but rich valuations become increasingly hard to justify if bond yields march higher. Seen through this lens, the rise in bond yields at the start of the year is one important reason why equities have experienced a turbulent 2018 so far. What lies ahead? The combination of our economic mini-cycle, market technicals and valuation perspectives suggests that the equity sector and currency trends established since the start of the year should persist into the summer. As for equities in aggregate, the greatest structural threat would arise if bond yields gapped upwards. But for the time being, this is not our expectation. Happy Easter! Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. Fractal Trading Model Given the Easter holidays, there are no new trades this week. But we are pleased to report that our long global utilities versus market trade achieved its 3.5% profit target and is now closed. Out of our four open trades, three are in profit with the short nickel / long lead trade already up sharply in its first week. 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 Nickel vs. Lead Nickel vs. Lead * 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 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

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

Highlights We re-examine our Yield and Protector portfolios to find out which assets will hold up best if there is a material correction. Our tactical view on gold is neutral, but the risk in gold prices will remain skewed to the upside this year. Are tariffs on aluminum and steel the start of a trade spat or a trade war? Feature Fears of a trade war and a hawkish tone from Fed Chair Jay Powell at his first Humphrey Hawkins testimony to Congress pushed the U.S. equity market lower last week. The ten-year Treasury yield barely budged however, buffeted by a more hawkish Fed on one side and a trade-induced slowdown in global growth on the other. The dollar was modestly higher last week, but oil and gold prices moved lower. The S&P 500's 4% loss in February was the worst single month since October 2016 and worst February since 2009. Both investment-grade and high-yield credit spreads widened last week, and have yet to return to their late January lows. Moreover, at 22, the VIX remained elevated relative to start of the year, consistent with our view that markets have entered a more volatile, late-cycle phase. With the 2.8% run-up in the S&P 500 since the February 8 low, investors are less concerned that the early February pullback in risk assets was a signal that the equity bull market is over and a recession is right around the corner. Nonetheless, some clients with a more strategic outlook are considering paring back risk now. Others want to know how to protect gains while still participating in the bullish tone for the market BCA expects in the next 12 months. Our Yield and Protector portfolios might provide a way for investors to protect against the downside while still participating in the S&P 500. Preparing For A Pullback BCA recommends investors stay overweight on equities and U.S. spread product, but expects that positions should be moved to neutral later this year and then to underweight sometime in 2019.1 Long-term investors should already consider paring back their exposures to both asset classes given that valuations are stretched. We have periodically recommended that a variety of investments be added as portfolio "insurance" to help guard against a material correction in equities. We recently highlighted two forms of insurance: our Yield and Protector Portfolios. We introduced the Yield Portfolio in October 20142 and first discussed the Protector Portfolio in October 2015.3 This week, we revisit the issue by comparing both portfolios with a more common form of insurance: shifting from cyclical to defensive stocks within an equity allocation. The Yield Portfolio (YP) emphasizes "high quality carry", along with some protection via TIPS (25% of the Portfolio), if inflation begins to surprise on the upside after investors are conditioned to expect only deflation shocks. The YP performs well in an environment of slow nominal growth, no recession and gradual interest-rate hikes. On the other hand, the Protector Portfolio (PP) is designed to provide insulation against both deflationary (gold and trade-weighted dollar) and inflationary (TIPS) tail risks. Therefore, the PP may underperform risk assets for a time if tail risks keep receding. Still, it has done well during the equity rally and conservative investors should consider adopting it. As discussed in the section below, our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. Charts 1, 2, and 3 show a breakdown of the relative performance of S&P 500 defensives along with our Yield and Protector Portfolios. Panels 2 and 3 of Charts 1, 2 and 3 present the rolling one-year beta and alpha of each strategy versus the S&P 500. Alpha is presented as the difference between the actual year-over-year excess return of the portfolio (versus short-term Treasury bills) and what would have been expected given the portfolio's beta. This measure is also referred to as "Jensen's alpha." Chart 1S&P 500 Defensives##BR##A Modestly Low Beta Option S&P 500 Defensives A Modestly Low Beta Option S&P 500 Defensives A Modestly Low Beta Option Chart 2A Lower Beta##BR##Than Defensives A Lower Beta Than Defensives A Lower Beta Than Defensives Chart 3A Beta Near Zero,##BR##And Positive Alpha A Beta Near Zero, And Positive Alpha A Beta Near Zero, And Positive Alpha Based on the historical beta of the three portfolios versus the S&P 500, defensive stocks are the most correlated with the overall equity market. Our PP had a negative correlation to the broad market until earlier this year, when it turned slightly positive. BCA's YP is somewhere in between, with a positive but relatively low beta. This is consistent with the equity composition of the three portfolios (shown in Table 1). Note that our protector portfolio is composed entirely of non-equity assets. Table 1A Breakdown Of Three##BR##Portfolio Insurance Options A Golden Opportunity? A Golden Opportunity? After accounting for their lower betas, all three portfolios have outperformed the S&P in risk-adjusted terms since the onset of the global economic recovery. However, the three portfolios have experienced a relative decline versus the S&P 500 since Trump's election. This has occurred due to passive rather than active underperformance. In other words, they have underperformed because they failed to keep up with the S&P 500 rather than because of losses in absolute terms. We draw two important conclusions from Charts 1, 2 and 3 for U.S. multi-asset investors. First, the lower beta of our YP and PP compared with S&P defensives means that the former represent a better insurance against a sell-off in the equity market rather than the latter. Secondly, the persistently positive volatility-adjusted returns for our insurance portfolios highlights an investor preference for these assets in the past few years. However, since late 2017 when investors began to significantly upgrade the prospects for global growth and U.S. corporate profits, all three portfolios struggled to outperform the S&P 500 on a risk-adjusted basis. BCA's forecast implies that these portfolios may continue to struggle in the next year or so. For now, our investment bias towards equities over government bonds makes us less inclined to favor a low beta position within a balanced portfolio. Our analysis suggests that clients who anticipate the need for portfolio insurance in the coming year should back our YP and PP over a defensive-sector allocation. We would likely extend this recommendation to all clients if there is any material progression towards the sell-off triggers identified in the Bank Credit Analyst's February 2018 publication.4 Bottom Line: Investors seeking protection against a potential equity market sell-off should look to our Yield and Protector Portfolios over defensive-sector positioning. We do not currently recommend these portfolios for all clients, but we may do so if our key sell-off triggers are breached. Gold Bugged Our tactical view on gold is neutral, but the BCA Commodity & Energy Strategy notes that the risk in gold prices will remain skewed to the upside this year. The yellow metal is supported by increasing inflation and inflation expectations, heightened geopolitical risks and greater volatility in equity markets.5 However, the higher inflation and inflation expectations will be countered by Fed rate hikes, which will boost the U.S. dollar and lift real rates in our base case. Strategically, we expect that gold will provide a good hedge against any downturn in equities when the bull market turns bear in 2H19. Chart 4 shows that the price of gold in real terms is still very expensive. On a nominal basis, gold is at the top end of a trading channel initiated in early 2012 (Chart 5). There has been a significant gap between the model value and the actual price of gold for the past four years. The real price of gold remains elevated, although inflation has been well contained. Chart 4Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Model Suggests Gold Is Overvalued Chart 5Testing Top End Of A Downward Channel Testing Top End Of A Downward Channel Testing Top End Of A Downward Channel However, the macro environment BCA envisions for 2018 is also supportive for gold (Table 2). Gold tends to perform well when oil prices rise and as the 2/10 Treasury curve steepens. Moreover, gold prices tend to go up when the U.S. economy benefits from fiscal thrust and tax cuts. Furthermore, the soundings on the February ISM manufacturing index support higher gold prices. When the headline index is above 60 as it was in February (60.8), gold climbs by an average of 31%. Even 12 months after ISM is above 60, gold returns are over 20%. The elevated level of ISM new orders (64.2) and price (74.2) indices in February also suggest solid increases for gold. Finally, gold prices climb in the late stages of an economic expansion, such as the current one that began in 2009.6 Even so, our 6 to 12-month view on gold is that it will take its cues from Fed policy and policy expectations. The Fed is not behind the curve on inflation, and inflation expectations and measured inflation remain low. Our CPI and PCE models (Chart 6) show only a modest acceleration in inflation by year-end, which will be sufficient to keep the Fed on track this year as it continues to shrink its balance sheet and boost rates four times. Thus, there is no pressing need to hold gold as a hedge against inflation in the next year. Nonetheless, for those investors too concerned about a pullback that turns into a correction or a bear market, we note that gold has a 33% weight in our Protector Portfolio. Table 2Favorable Macro Backdrop For Gold A Golden Opportunity? A Golden Opportunity? Chart 6BCA's Inflation Models Show Only##BR##Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End BCA's Inflation Models Show Only Modest Acceleration Through Year-End Bottom Line: Gold is expensive in real terms relative to a set of fundamentals that have explained its real price since 1970. However, it may have a better value on a strategic basis or as part of a portfolio designed to protect against falling equity prices. Moreover, our macro backdrop forecast for the next 12 months supports higher gold prices. Keep gold as a strategic portfolio hedge. Trade Off BCA's Geopolitical Strategy team has long argued that two sources of geopolitical risk this year are China's trade surplus and Trump's position on trade relations with China, Canada and Mexico. Specifically, the view is that weak poll numbers may lead Trump to trigger trade disputes with important trading partners such as China, Mexico and Canada. However, our geopolitical analysts also point out that investors should not confuse a trade spat with a trade war. There are very few legal or constitutional constraints on Trump over trade issues (Table 3). It will be his decision whether to adopt sweeping tariffs (trade war) as opposed to a more targeted approach (trade spat). Clearly, the former is more disruptive and raises more uncertainty, so this is the key distinction to keep in mind. Presidents Nixon, Reagan, Bush (II) and Obama all imposed temporary tariffs on items (including steel and aluminum, and including by citing national security concerns) without triggering a trade war. Late last week, Trump indicated that he would announce tariffs on steel and aluminum this week. He implied that he would go for a broad-based approach of penalizing all steel and aluminum imports, which points toward the more aggressive approach. But the details (whether he exempts U.S. allies and partners or narrows the scope of goods) will not be certain until he issues his official proclamation. Table 3Trump Faces Few Constraints On Trade A Golden Opportunity? A Golden Opportunity? Steel and aluminum get the headlines, but account for only a small share of U.S. trade and GDP7 (Chart 7). BCA is more concerned about the Administration's stance on more deeper issues, like the WTO, NAFTA, or (in China's case) intellectual property and state-owned enterprises.8 The issues here are harder to quantify, have few precedents, and have more structural and ideological issues which are at stake. The U.S. has a massive trade surplus in services and in intellectual property,9 so a prolonged disruption would pose a serious threat to the U.S. economy, at least in the short term. Trump's decision on intellectual property trade with China is due on August 12, but could occur earlier. BCA's stance on U.S.-China relations is bearish in the long run.10 We place high odds on an eventual trade war, but the timing is a tougher call. Investors should not view China's proportional retaliation on an item-by-item basis as the start of a trade war. BCA's view is that China's leadership will try to offer reforms and investment opportunities to pacify Trump. However, there is a risk either that China offers no reforms (in which case Xi Jinping's rampant Communism exacerbates trade conflicts) or that Trump may introduce broad sweeping measures that give China no choice but to respond in kind, leading to a trade war. Our Geopolitical Strategy service notes that the probability of Trump abrogating NAFTA is as high as 50%. The seventh round of NAFTA talks concludes this week; an eighth round is scheduled for late March. Negotiations could drag on right to the Mexican election on July 1, but if they are not looking more optimistic by this spring then the risk of the U.S. (or Mexico) walking away will rise. The U.S. economy has been largely unaffected by NAFTA and would likely experience no disruption if Trump abrogated the deal and began negotiations on bilateral trade agreements with Canada and Mexico (Chart 8). Chart 7Steel And Aluminum In Perspective Steel And Aluminum In Perspective Steel And Aluminum In Perspective Chart 8U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA U.S. Economy: Largely Unaffected By NAFTA Bottom Line: Elevated trade tensions with China,11 Canada and Mexico are near-term risks to global growth. From now through April could be a decisive time for the Trump Administration with China and NAFTA. We are bearish on U.S.-China relations in the long term. If Trump abandons NAFTA, the implications for the U.S. economy would be muted, although U.S. inflation may push higher. Such a decision would also send a clear signal to other key U.S. allies. However, if Trump stands by NAFTA, then it signals that he has sided with the establishment on trade. This would be bullish for risk assets and would lower geopolitical risk premia. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report, "The Next Recession: Later But Deeper," published February 23, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Ice Storm", published October 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Tenuous Relief Rally", published on October 12, 2015. Available at usis.bcaresearch.com. 4 Please see BCA Research's Bank Credit Analyst Monthly Report, February 2018. Available at bca.bcaresearch.com. 5 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Gold Still Shines Despite Threat Of Higher Inflation", published February 1, 2018. Available at ces.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View", published October 16, 2017. Available at usis.bcaresearch.com. 7 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Global Aluminum Deficit Set To Ease", published March 1, 2018. Available at ces.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Weekly Report, "America Is Roaring Back", published January 31, 2018. Available at gps.bcaresearch.com. 9 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?", published June 5, 2017. Available at usis.bcaresearch.com. 10 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin", published January 18, 2017. Available at gps.bcaresearch.com. 11 Please see BCA Research's Geopolitical Strategy Weekly Report, "Politics Are Stimulative, Everywhere But China", published February 28, 2018. Available at gps.bcaresearch.com.

The GAA DM Equity Country Allocation model is updated as of February 28, 2018. After the large upgrade in January, the model has furthered upgraded the U.S. to a small overweight of 3.3 percentage points from neutral in January. This change is mainly financed by a reduction in the large overweight in the Netherlands. Directionally, the model is becoming more defensive in the sense that the sizes of large bets have shrunk two months in a row, as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 55 bps in February, largely driven by the Level 2 model which underperformed by 131 bps. The large underweight in Japan hurt the performance the most because in USD terms Japan was the best performer thanks to the strength of JPY versus USD. Since going live in January 2016, the overall model has outperformed the benchmark by 102 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 345 bps. The Level 1 model has performed on par with the MSCI benchmark. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates Table 2Performance (Total Returns In USD) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2018. Table 3Allocations GAA Quant Model Updates GAA Quant Model Updates Table 4Performance Since Going Live GAA Quant Model Updates GAA Quant Model Updates Chart 4Overall Model Performance Overall Model Performance Overall Model Performance The model has turned negative on cyclical sectors by sending negative signals from the growth component. Additionally, the recent correction in equity markets has also created unfavorable momentum signals. From being overweight on cyclical sectors by 10%, the model has now turned underweight by 1.3%. However, energy stocks have seen their overweight increase by 3% on the back of favorable valuations. The biggest change was an upgrade to overweight for the utilities sector on the back of the weaker growth outlook and not so negative momentum. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline March 2018 March 2018 Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots U.S. Inflation Green Shoots U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset February's Volatility Reset February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration ... Partly Due to Capex Acceleration ... Partly Due to Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating Government Bond Supply is Accelerating Government Bond Supply is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment U.S. Net International Investment U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing Oil Inventory Correction Continuing Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends March 2018 March 2018 Chart II-2Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 Chart II-3Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs March 2018 March 2018 The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM BOTTOM-UP IG CHM BOTTOM-UP IG CHM Chart II-5Bottom-Up HY CHM BOTTOM-UP HY CHM BOTTOM-UP HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging March 2018 March 2018 Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta March 2018 March 2018 Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta March 2018 March 2018 Chart II-8Interest Coverage Ratio Vs. Earnings Beta March 2018 March 2018 Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) March 2018 March 2018 Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Interest Coverage Ratio Headed To New Lows Interest Coverage Ratio Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Stage 1: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. Stage 2: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by expectations for the terminal fed funds rate. Assuming a 3% terminal rate, we would expect the 10-year Treasury yield to peak somewhere between 3.08% and 3.59%. Risks: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Feature Some degree of calm returned to financial markets last week. The S&P 500 bounced back above 2700 and the VIX fell back below 20. Corporate bond spreads also tightened somewhat - the average High-Yield index spread tightened from 369 bps to 341 bps and the investment grade spread tightened from 95 bps to 93 bps - but the factors we are monitoring to determine the end of the credit cycle continue to send warning signs (Chart 1). We view the recent turmoil as markets adjusting to a Fed that must now become less responsive to financial conditions because inflationary pressures are mounting. As we discussed in last week's report, this dynamic is best explained using our Fed Policy Loop.1 It follows from our Fed Policy Loop analysis that we should track measures of inflation and inflation expectations and start taking credit risk off the table as these indicators rise. In that regard, neither TIPS breakeven inflation rates nor commodity prices - an indicator of pipeline inflation pressure - corrected much in the past few weeks (Chart 1, bottom panel). This suggests that the end of the credit cycle is approaching. We reiterate our view that it will soon be time to scale back the credit risk in our recommended portfolio. We will likely begin this process once both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We discuss the intuition behind this target range in the section titled "A Fair Value For TIPS Breakevens" below. Currently, the 10-year TIPS breakeven inflation rate sits at 2.09% and the 5-year/5-year forward rate is 2.18%. Unlike credit spreads, the sell-off in Treasuries did not abate at all last week. Volatility also returned to the rates market, coinciding with a steeper yield curve (Chart 2). We are not nearly as anxious to increase the duration of our recommended portfolio as we are to scale back on credit risk, and believe that Treasury yields still have considerable cyclical upside. Chart 1No Correction In Breakevens No Correction In Breakevens No Correction In Breakevens Chart 2No Correction In Bond Yields No Correction In Bond Yields No Correction In Bond Yields In this week's report we discuss how we see the Treasury bear market proceeding in two stages, and also start the process of thinking about how high the 10-year Treasury yield can get before the next recession hits. We also highlight several near-term risks that could temporarily derail the cyclical bond bear market. The Two-Stage Treasury Bear Market. Stage 1: Re-Anchoring Of Inflation Expectations For some time it has been our view that the economic recovery is unlikely to end before inflation returns to the Fed's 2% target. This is simply because when inflation is very low the Fed has an incentive to keep policy accommodative, and restrictive monetary policy is typically a pre-condition for recession. It therefore struck us as odd that as recently as June 2017 the 10-year TIPS breakeven inflation rate was only 1.66%, well below levels consistent with the Fed's target. It was as though the market expected that inflation would never move higher no matter how long the Fed maintained an easy policy stance. That notion always seemed far-fetched, and this is why the first stage of the cyclical bond bear market was always likely to be driven by the re-anchoring of inflation expectations. This is the stage we are in currently, and indeed it is almost complete. We will deem that inflation expectations have become re-anchored (and the first stage of the cyclical bond bear market is complete) when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. This means that, assuming unchanged real yields, the nominal 10-year Treasury yield has another 21 bps to 41 bps of upside in Stage 1. A Fair Value For TIPS Breakevens To arrive at our fair value target for the inflation compensation embedded in the 10-year Treasury yield, we looked back to the last period when inflation was well-anchored around the Fed's 2% target. This occurred between July 2004 and June 2008. We note that during this timeframe the 10-year TIPS breakeven inflation rate spent 56% of its time between 2.3% and 2.5%. The 5-year/5-year forward TIPS breakeven rate spent 73% of its time in that range (Chart 3).2 The 2.3% to 2.5% range therefore seems like a good starting point, but we must also consider whether something has changed since the mid-2000s that might lead to a different fair value range today. One possible difference would be if the spread between CPI and PCE inflation changed significantly. The Fed targets 2% PCE inflation, but TIPS are linked to CPI inflation. CPI inflation was somewhat higher than PCE inflation in the mid-2000s, and this is one reason why TIPS breakevens were somewhat higher than 2% throughout that period. At present, we observe that the spread between CPI and PCE inflation is only slightly above where it was in the mid-2000s (Chart 4), and note that it will probably trend lower in the coming months. Chart 3TIPS Breakevens When Inflation Is ##br##Anchored (July 2004 to June 2008) The Two-Stage Bear Market In Bonds The Two-Stage Bear Market In Bonds Chart 4CPI Versus ##br##PCE CPI Versus PCE CPI Versus PCE The two biggest reasons for divergences between PCE and CPI inflation are: The different treatment of medical care inflation in the two indexes. CPI includes only out-of-pocket medical care expenses. PCE includes spending by the government on a person's behalf. The greater weight of shelter in CPI. Lately, the difference in medical care inflation between the two indexes has narrowed considerably and our models suggest that shelter inflation will continue to moderate in the months ahead (Chart 4, bottom 2 panels). This suggests that the spread between CPI and PCE inflation will continue to tighten. If the spread were to fall much below its average level from the mid-2000s, then we would revise our target range for TIPS breakevens down accordingly. The second reason why the fair value range for TIPS breakevens might be different than it was in the mid-2000s is if the inflation risk premium has undergone a structural shift. The compensation for inflation priced into bond yields can be split into (i) an expectation for future inflation and (ii) a risk premium to compensate investors for the uncertainty in that expectation. Other factors, such as changes in the post-crisis regulatory environment that impact the attractiveness of TIPS as an investment vehicle, could also potentially cause a structural shift in the inflation risk premium. We addressed this possibility in a report last year, but so far we see no conclusive evidence that such a structural shift has occurred.3 Indeed, the fact that breakevens have risen back close to their pre-crisis range in recent months suggests that the inflation risk premium is probably not structurally lower. Bottom Line: The first stage of the bond bear market is being driven by a re-anchoring of inflation expectations. This stage will be complete when both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach our target range of 2.3% to 2.5%. The nominal 10-year Treasury yield has another 21 bps to 41 bps of upside before this phase of the bear market is complete. The Two-Stage Treasury Bear Market. Stage 2: Fed Rate Hikes & The Terminal Rate Debate Once inflation expectations are re-anchored the cyclical bond bear market will shift into Stage 2. With no further upside in the cost of inflation protection the emphasis in this stage will be on the path of real yields. The main question will be: How high will the Fed have to lift the real interest rate to contain inflationary pressures? Or alternatively: What is the terminal fed funds rate in this cycle? The answers to the above questions will ultimately determine how high the real 10-year Treasury yield can rise, and provide us with an end-of-cycle target for the nominal 10-year yield. Anchoring Around The Fed's Projections Chart 5Stage 2 Is All About The Terminal Rate Stage 2 Is All About The Terminal Rate Stage 2 Is All About The Terminal Rate At the moment, most FOMC participants estimate the terminal fed funds rate to be in the range of 2.75% to 3%. This may or may not be proven correct, but at least for now the market is likely to anchor around that expectation. In other words, the only way we will find out if that projection is too low is if the fed funds rate is lifted close to the 2.75% to 3% range but inflation continues to rise and economic growth shows no signs of slowing. With the fed funds rate still at 1.42%, we are at least four rate hikes away from that range. This means that any potential upward revisions to the Fed's terminal rate projections are more likely a story for late-2018 or early-2019. Notice in Chart 5 that the Fed has responded to falling inflation by lowering its median projected terminal fed funds rate, but has been more hesitant to increase its projection in response to rising inflation. This means the Fed could wait until inflation is much closer to its target before making any significant upward revisions to its terminal rate projection. The market would likely react more quickly than the Fed, but not by much. Notice that the decline in the 5-year/5-year forward overnight index swap rate was more or less coincident with the downward revisions to the Fed's projected terminal rate between 2014 and 2016 (Chart 5, bottom panel). Our view is that the market will anchor around the Fed's terminal rate projections for at least the next six months. With that in mind, we can make some back-of-the-envelope calculations for how high the 10-year Treasury yield will get before the end of the cycle. To do this we consider that the nominal 10-year yield consists of four components: Inflation expectations Inflation risk premium Real rate expectations Real risk premium Our target range of 2.3% to 2.5% for the 10-year TIPS breakeven inflation rate encompasses both the inflation expectations and inflation risk premium components. If we then assume a terminal fed funds rate of 3%, we get a real rate expectation of 1% (we subtract the Fed's 2% inflation target). This means that even if we assume no real risk premium, we get a conservative estimate for the end-of-cycle level of the nominal 10-year Treasury yield of 3.3% to 3.5%. Turning To The Models As a check on our back-of-the-envelope calculations we created simple fair value models for both the 2-year and 10-year Treasury yields (Chart 6). Both models have three independent variables: The fed funds rate Our 12-month fed funds discounter (to capture expectations for future changes in the fed funds rate) The MOVE index of implied interest rate volatility (as a proxy for the term premium) These models allow us to input various scenarios for the expected path of rate hikes and implied volatility, and then come up with appropriate fair value targets for the 10-year and 2-year Treasury yields. The results from various scenarios are shown in Table 1. Chart 6Treasury Yield Models Treasury Yield Models Treasury Yield Models Table 1End-Of-Cycle Treasury Yield Projections Under Different Scenarios The Two-Stage Bear Market In Bonds The Two-Stage Bear Market In Bonds For example, let's assume that the terminal fed funds rate is 3%. Let's also assume that the Fed delivers four rate hikes this year and the market moves to expect another two rate hikes in 2019. That would mean the market is pricing-in a fed funds rate of 2.92% by the end of 2019 - very close to a 3% terminal rate assumption. If we further assume that implied rate volatility stays flat at its current level, then our model gives us a target of 3.59% for the 10-year Treasury yield. This would seem like a reasonable end-of-cycle target for the 10-year Treasury yield in an environment with a 3% terminal fed funds rate. Table 1 also demonstrates the importance of interest rate volatility. If we assume the exact same scenario for rate hikes but also allow the MOVE index to return to its recent lows, then our end-of-cycle target for the 10-year Treasury yield falls to 3.08%. Conversely, if we allow the MOVE index to rise to its historical average, the target for the 10-year yield rises to 4.25%. As we discussed in last week's report, interest rate volatility is more likely to fall than rise between now and the end of the cycle.4 This is due to the strong correlation between interest rate volatility and the slope of the yield curve. As the Fed tightens and the curve flattens, implied volatility tends to decline. In fact, because of its strong correlation with the slope of the yield curve, any scenario where implied rate volatility increases significantly would coincide with an environment where the terminal fed funds rate is being revised higher. If 3% turns out to be a reasonable estimate for the terminal fed funds rate, then implied rate volatility is much more likely to fall than rise. All in all, if we assume that the fed funds rate will only return to 3% before the next recession, then we should expect the 10-year Treasury yield to eventually settle into a range between 3.08% and 3.59% by the end of the second stage of the cyclical bond bear market. We plan to explore whether 3% is a reasonable expectation for the terminal fed funds rate in future reports. Bottom Line: How high Treasury yields rise in Stage 2 of the bond bear market will be determined by how expectations for the terminal fed funds rate evolve. If, for now, we assume that the Fed's 3% terminal rate projection is roughly correct, then the 10-year Treasury yield will peak somewhere between 3.08% and 3.59%. Three Risks To The Bond Bear Market It is important to point out that the two-stage cyclical bond bear market described above may not play out un-interrupted. In this section we highlight three potential risks that could cause us to, at least temporarily, increase the duration of our recommended portfolio. Risk 1: Positioning One risk that could flare up in the near-term is that short positioning in the Treasury market has ramped up significantly in recent weeks. Since the financial crisis, net short positions in 10-year Treasury futures have often coincided with a lower 10-year Treasury yield three months later (Chart 7). Similarly, we have also seen positioning in oil futures become extremely net long (Chart 7, bottom panel). In a recent report we analyzed the strong correlation between oil prices and TIPS breakeven inflation rates and concluded that the correlation would likely persist throughout Stage 1 of the bond bear market.5 A significant relapse in oil prices would very likely filter through to lower bond yields. Chart 7Risk 1 = Positioning Risk 1 = Positioning Risk 1 = Positioning Risk 2: Unrealistic Expectations Much like how consensus is forming around short bond positions, consensus economic expectations are also being revised higher. This is what happens when the economic data surprise positively for a significant period of time. Expectations eventually ratchet up and then become too optimistic for the data to surpass. It is this dynamic that causes the Economic Surprise Index to be mean reverting (Chart 8). In previous reports we have shown that months with negative data surprises tend to coincide with falling Treasury yields, and vice-versa.6 While negative data surprises are not an imminent risk - a simple auto-regressive model of the Economic Surprise Index shows we should expect an index reading of +15 in one month's time - the surprise index will eventually move below zero and this will likely coincide with at least some pull-back in bond yields. Risk 3: Global Growth Slowdown A third risk to the cyclical bond bear market is that we see a relapse in global growth that derails the economic recovery before Treasury yields reach our target range. At the moment our 2-factor Treasury model - based on Global Manufacturing PMI and bullish sentiment toward the dollar - still posits a fair value 10-year Treasury yield of 3.01% (Chart 9), but a significant growth scare emanating from outside the U.S. would cause both the Global PMI to fall and bullish sentiment toward the dollar to rise. Both of those factors are bullish for U.S. bonds. Chart 8Risk 2 = Economic Surprises Risk 2 = Economic Surprises Risk 2 = Economic Surprises Chart 9Risk 3 = China/EM Slowdown Risk 3 = China/EM Slowdown Risk 3 = China/EM Slowdown For now there is no strong signal that global growth is about to slow, but some trends in China and other emerging markets bear monitoring. Our Foreign Exchange strategists' Carry Canary Indicator tracks the performance of EM / JPY carry trades.7 These trades go short the Japanese Yen and long an emerging market currency with a high interest rate (Brazilian Real, Russian Ruble or South African Rand), and as such they are highly geared to a positive global growth back-drop. Historically, a deterioration in the performance of these carry trades has often coincided with a slowdown in global growth and we notice that the outperformance of these trades has moderated in recent weeks (Chart 9, panel 2). Further, we have also seen some coincident and leading indicators of Chinese economic activity start to roll over (Chart 9, bottom 2 panels). The slowdown appears relatively benign for now but could eventually morph into a significant global event. This could occur if the growth deterioration accelerates and infects the Global PMI, or if Chinese policymakers react too strongly to slowing growth and engineer a sharp depreciation of the currency (as in August 2015). The latter scenario would impart increased bullish sentiment to the U.S. dollar and cause U.S. bond yields to fall. Both risks seem low at the moment, but are still worth monitoring during the next few months. Bottom Line: If our model suggests that economic surprises are likely to turn negative at a time when we also see extended net short bond positioning, then that would likely present an opportunity to tactically increase portfolio duration even though the cyclical bond bear market would remain intact. The risk of a growth slowdown emanating from China or other emerging markets also bears monitoring. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 2 Percentages calculated using daily values. 3 Please see U.S. Bond Strategy Weekly Report, "Will Breakevens Ever Recover?", dated April 25, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "On The MOVE", dated February 13, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "It's Still All About Inflation", dated January 16, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 7 Please see Foreign Exchange Strategy Weekly Report, "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy Investors Are Giddy Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E February 2018 February 2018 As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Profit Growth Still Accelerating Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) Timing The Exit (I) Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) Timing The Exit (II) Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist February 2018 February 2018 To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes February 2018 February 2018 We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes February 2018 February 2018 U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 February 2018 February 2018 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC February 2018 February 2018 Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 February 2018 February 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Robots Are Getting Cheaper Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Global Robot Usage Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) February 2018 February 2018 As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Stock Of Robots By Country (I) Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) February 2018 February 2018 While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots U.S. Investment in Robots U.S. Investment in Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density February 2018 February 2018 Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity February 2018 February 2018 Chart II-10U.S.: Unit Labor Costs Vs. Robot Density February 2018 February 2018 In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density February 2018 February 2018 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed February 2018 February 2018 The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density February 2018 February 2018 The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density February 2018 February 2018 Chart II-16Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood OF Robots? Japan: Where Is The Flood OF Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 White Paper: Introducing Our U.S. Equity Sector Earnings Models White Paper: Introducing Our U.S. Equity Sector Earnings Models Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear All Clear All Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... What EPS Are Priced In... What EPS Are Priced In... Chart 5...Per Sector For 2018 ...Per Sector For 2018 ...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Financials (Overweight) Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Energy (Overweight) Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Industrials (Overweight) Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Telecom Services (Neutral) Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Materials (Neutral) Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Real Estate (Neutral) Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Health Care (Underweight) Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Utilities (Underweight) Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.