Canada

Special Report

Highlights The U.S. basic balance is the strongest it’s been in decades. However, the White House’s profligacy threatens this positive. The euro area basic balance is also healthy. Now that the European Central Bank has ended its asset purchasing program, aggregate portfolio flows in Europe have much scope to improve, creating long-term support for the euro. Australia, Canada and New Zealand are likely to suffer deteriorating balance-of-payments trends, which will hamper their performance. Norway is the commodity driven economy that is likely to buck this trend. Stay positive the NOK against the SEK and the EUR as well as against other commodity currencies. Feature Balance-of-payments dynamics can often be overplayed when forecasting G10 FX. While their capacity to forecast FX moves is small on a 12-month horizon, the state of the balance of payments can occasionally take primacy over any other consideration. This is particularly true when global liquidity conditions deteriorate, as it makes financing current account deficits more expensive, often requiring sharp adjustment in currency valuations. Since we have experienced a period of rising financial market volatility and global liquidity has deteriorated, this gives us a momentous occasion to review balance-of-payments conditions across the G10. While the balance-of-payments situation for the U.S. is not as dire as is often argued, the deteriorating fiscal balance suggests that this situation is temporary. This means that balance-of-payments risks are likely to grow for the dollar over the coming years. Meanwhile, depressed portfolio flows into the euro area have a lot of scope to improve, which point to a bullish long-term outcome for the euro. Finally, other than Norway, the commodity currency complex sports tenuous balance-of-payments dynamics, which are likely to deteriorate. This suggests that the CAD, AUD and NZD have downside. As a long-term allocation, selling these currencies against the NOK makes sense as well. The U.S. Despite a strong economy that is lifting import growth, the U.S. trade and current account balances have remained stable since 2014, hovering near -3% of GDP and -2.3% of GDP, respectively. This stability is a consequence of the shale revolution, which has curtailed U.S. oil imports by 3.3 million bpd since 2006. However, thanks to robust growth due in large part to the Trump administration’s deregulatory push as well as last year’s tax cut, the U.S. has been the recipient of large FDI inflows, amounting to 1.4% of GDP, the highest level since 2006. Consequently, the U.S.’s basic balance of payments has rebounded, hitting a record high (Chart 1). Chart 1U.S. Balance Of Payments A strong basic balance of payments has been an important factor behind the greenback’s strength this cycle as net portfolio flows in the U.S. have not been particularly strong, having mostly been driven by weaker official purchases. In this context, the current M&A wave bodes well for the dollar as the U.S. has historically been the recipient of such flows. The U.S. equity market’s overweight towards tech and healthcare stocks strengthens this view. From a balance-of-payments perspective, the biggest risk for the dollar is Washington’s profligacy, which is forcing the world to digest a large stock of USD-denominated liabilities. However, if history is any guide, this risk is likely to drive the dollar lower only once U.S. real rates begin to become less appealing compared to their peers. Since BCA expects U.S. real rates to increase more, widening real rate differentials in the process, the dollar should continue to remain supported this year, especially as investors continue to expect a shallower path for rates than we do. The Euro Area After peaking at 2.4% of GDP, the euro area trade balance has softened to 1.8% of GDP. Rebounding economic activity in the European periphery explains this small deterioration as rising domestic demand tends to lift imports growth, hurting trade balances in the process. Despite this worsening trade balance, the euro area current account surplus remains as wide as ever, clocking in at 3.4% of GDP. This reflects both recent improvements in the European net international investment position as well as the fact that low European rates are curtailing the costs of liabilities. Poor FDI performance mitigates the benefits of the large European current account surplus. Hampered by low rates of return, lingering worries about European cohesion and banks’ health, long-term investors have flown out of the euro area – not in. Nonetheless, despite this negative, the euro area basic balance remains in surplus, creating a small positive for the euro (Chart 2). Chart 2Euro Area Balance Of Payments The biggest problem for the euro in recent years has been portfolio outflows, especially in the fixed income sphere. While the weakness in portfolio flows has been a crucial factor preventing the good value in the euro – EUR/USD trades at a 12% discount to its purchasing-power parity equilibrium – from realizing itself, the outlook on this front is improving. The European Central Bank’s negative interest rate policy coupled with its Asset Purchase Program have created a powerful repellent for private fixed-income investors. However, the APP is now over, and European policy rates should move back above zero by year-end 2020. As a result, euro area portfolio flows have room to improve considerably. Once this happens, since the basic balance is already in surplus, the euro will have scope to rally significantly. Japan Burdened by slowing exports to both China and emerging markets, the Japanese trade balance is vanishing quickly. However, it still remains at a wide 3.8% of GDP. This is a direct artefact of Japan’s extraordinarily large net international investment position of 60% of GDP, which generates such large net investment income that even when Japan runs a trade deficit of more than 2% of GDP, as it did in 2014, the current account remains balanced (Chart 3). Chart 3Japanese Balance Of Payments The flipside of Japan’s structural current account surplus is an FDI balance constantly in deficit. The Japanese private sector generates more savings than the country can use, even after the profligacy of the government is satiated. Essentially, Japanese firms are reluctant to expand capacity in ageing, expensive and deflationary Japan. They prefer to do so outside of the national borders, closer to potential new customers. As a result of this dichotomy between the current account surplus and FDI deficit, Japan’s basic balance of payments is a much more modest 1.1% of GDP. Thus, the long-term and stable components of the Japanese balance of payments are mildly positive for the yen. In terms of stock and bond flows, Japan is currently experiencing significant outflows, driven by Japanese investors moving funds outside the country. Historically, these portfolio flows have been a poor indicator for the yen’s direction, often moving into deficit territory as the yen strengthens. This is because Japanese investors are often hedging their foreign asset purchases. Consequently, money market flows will likely once again determine the yen’s fate. For now, the Bank of Japan remains firmly on hold and U.S. rates are rising, suggesting USD/JPY has room to rally this year. However, the JPY’s cheapness and the favorable balance-of-payments picture of Japan argue that the yen’s weakness is in its final innings. The next big structural move in the yen is higher. The U.K. Despite the post-referendum cheapening of the pound, the U.K. continues to run a massive trade deficit of 6.7% of GDP. The current account looks a bit better but remains at a large deficit of 3.9% of GDP. A current account deficit is not a problem for a currency so long as it can be financed cheaply. Historically, the U.K. has been attractive to long-term foreign investors, with a widening current account deficit often met with a growing net FDI balance, leaving only a small basic balance to finance through other channels (Chart 4). Chart 4U.K. Balance Of Payments This time around, the current account remains wide but net FDI flows have collapsed, from 8% of GDP in 2017 to 1.8% of GDP today. The uncertainty surrounding Brexit explains this deterioration. The financial services sector accounts for more than 50% of the stock of inward foreign investments in Great Britain. As financial services will suffer the brunt of Brexit, those investments have also melted. This means the U.K. will have to depend on portfolio flows to finance its current account deficit. Portfolio investments in the U.K. have grown since mid-2017, explaining the stability in the pound. However, this masks some heightened short-term volatility for the GBP against both the dollar and the euro. In the short-term, as the Brexit deadline quickly approaches, this volatility in both flows and the currency will remain high. On a long-term basis, we expect a benign resolution to Brexit. While large FDIs into the financial sector are forever something of the past, flows into British market securities are likely to improve, as the Bank of England will have room to increase rates once economic activity picks up again after the Brexit fog lifts. Canada The Canadian trade balance never recovered from its pre-Great Financial Crisis health. The rebound in oil prices since January 2016 has done little to help the Canadian trade balance, as Canadian oil trades at a large discount to global benchmarks – a consequence of a lack of pipeline capacity that has trapped Canadian oil where it is not needed. The Canadian current account balance offers little solace, and at -2.7% of GDP is in even worse shape than the trade balance (Chart 5). However, the Canadian basic balance is currently in better condition, as Canada continues to attract net FDIs equal to 2% of GDP. The problem for the country is that FDI inflows have become much more limited by the fact that Canadian oil sands generate little profits at current oil prices – a problem amplified by the lack of exporting capacity. This trend is unlikely to change anytime soon. Chart 5Canadian Balance Of Payments Portfolio flows remain positive, but at 1.1% of GDP, they are falling sharply. The poor profitability of Canadian resources stocks is obviously a problem there, but the growing risks to the Canadian housing market are also likely to hurt banks’ profitability as well as the aggregate financial sector, which accounts for nearly 40% of the country’s stock market capitalization. As a result, with Canadian yields still lagging the U.S., portfolio flows could also deteriorate further. This combination implies that the balance-of-payments picture for Canada is becoming a growing headwind. Australia Two factors are lifting the Australian trade balance, which stands at a surplus of 0.6% of GDP. As the exploitation of Australia’s large mineral deposits mature, the need for mining capex has declined, which has been limiting the growth of Australian machinery imports. On the other hand, this same maturity means that more minerals are being exported out of Australia. Consequently, since iron ore prices have rebounded 88% since their December 2015 lows, representing a generous boost to Australian terms of trade, the country’s trade balance has significantly improved. The current account balance has mimicked this improvement; however, it remains at a deficit of 2.6% of GDP (Chart 6). Much of the investment required to develop the mineral deposits present in the country came from outside Australia’s borders. As a result, foreign investors are receiving large amounts of income from their investment, generating a negative income balance for the country. Nonetheless, the Australian basic balance is now positive as net FDI flows represent more than 3% of GDP. Chart 6Australian Balance Of Payments Going forward, we worry that China’s slowdown has not fully played out. This means that Australia’s nominal exports could suffer under the weight of falling metals prices, generating a deterioration in the trade balance, the current account and the basic balance. Worryingly, portfolio inflows into the country would also suffer. Finally, Australian households’ high indebtedness, coupled with pronounced overvaluation evident in key cities like Sydney and Melbourne, could further impede capital inflows into the country. This suggests that from a balance-of-payments perspective, the AUD could witness further depreciation, especially as AUD/USD still trades 10% above its purchasing-power-parity fair value. New Zealand The New Zealand trade balance has fallen to -1.8% of GDP, its lowest level in 10 years. This principally reflects stronger imports growth, as exports are currently growing at a 11% annual rate. A consequence of this worsening trade balance has been a widening current account deficit, which now stands at 3.6% of GDP. New Zealand has not been able to attract enough FDI to compensate for its structural current account deficit. As a result, its perennially negative basic balance currently stands at 2.6% of GDP (Chart 7). This lack of structural funding for its current account deficit is linked to its interest rates, which always stand above the G10 average. Thanks to immigration, New Zealand has an economy with an elevated potential growth rate, and thus a higher neutral rate. This means that on average it tends to run a capital account surplus that is matched by a current account deficit. Inversely, the perennial current account deficit requires higher interest rates in order to be financed via capital inflows. Chart 7New Zealand Balance Of Payments The problem facing the NZD is that kiwi rates, both at the long and short end of the curve, currently stand below U.S. rates. With a negative basic balance of payments, this creates a natural downward bias to the NZD. The kiwi needs to cheapen enough today that its future returns will be expected to be large enough to compensate for the lower yields offered by domestic securities. Since the real trade-weighted NZD currently trades at a 7% premium to its long-term fair value, so long as the interest rate handicap remains, the path of least resistance points south. Only a sustained rebound in global activity will be able to revert this trend in a durable manner. So far, a sustained rebound in global growth is not in the cards. Consequently, any tactical rally in the kiwi will be temporary. Switzerland The Swiss trade surplus may have declined, but it still remains at a very healthy 4.2% of GDP. This deterioration reflects a pick-up in imports, which have been boosted by a rebound in domestic activity in place since late 2015, as well as the expensive nature of the CHF. The Swiss current account surplus is even larger, standing at 10% of GDP. This large surplus is mainly the consequence of Switzerland’s extremely large net international investment position, which stands at almost 120% of GDP. Such a large pool of foreign assets yields a large income balance, which boosts the current account. After a sudden pickup in net FDI flows last year to 10% of GDP, these flows have violently morphed into a net outflow of 8.3% of GDP. Last year’s positive FDI balance was odd, as countries like Switzerland, which run persistent large positive current account balances, tend to export capital, not import it. A consequence of this sudden reversal was to push the basic balance from a surplus of 17% of GDP to a small surplus of 1.5% of GDP (Chart 8). Chart 8Switzerland Balance Of Payments In contrast, Swiss portfolio flows have moved back into a very small surplus, reflecting investors’ desire for safety in a 2018 year full of volatility and global growth disappointments. These flows suggest that generally, investors have been parking their funds in Switzerland, explaining the strengthening of the CHF last year against the EUR. Now that global financial conditions are easing, setting the stage for stabilization in global growth, the expensive CHF is likely to depreciate. The more dovish tone of the Swiss National Bank is likely to catalyze this change. Sweden Since 2016, the Swedish trade balance has been in negative territory, currently standing at 0.6% of GDP. This is a phenomenon not experienced in this country for more than three decades. Two forces have hurt the trade balance. On one hand, boosted by negative interest rates, Swedish consumers have taken on debt and consumed aggressively. This has lifted domestic demand, propping up imports in the process. On the other hand, Sweden is very sensitive to global trade and industrial activity. The slowdown witnessed at the end of last year has dampened Swedish exports. In response to these developments, the Swedish current account balance has declined meaningfully, from 8.3% of GDP in 2007 to 2.2% today. Since Sweden’s net FDI balance is at zero, the basic balance stands at 1.8% of GDP. However, this is toward the low end of its historical distribution (Chart 9). If the deterioration in the current account continues, something we expect as the Riksbank is keeping interest rates at extraordinarily accommodative levels of -0.25%, thus ensuring that import growth will remain robust, the krona will face an increasingly onerous balance-of-payments backdrop. Chart 9Swedish Balance Of Payments The saving grace for the SEK is likely to come from portfolio flows into securities. The trade-weighted krona is cheap, trading at a nearly 2-sigma discount to its long-term fair value, implicitly boosting expected returns from holding SEK-denominated assets. Moreover, the combination of a Riksbank having finally abandoned its efforts to dampen the krona, and some signs of rebound in economic domestic economic activity such as strong PMI readings, points to a high probability of funds flowing into the country. Norway Thanks to rebounding oil prices since 2016, the Norwegian trade balance has also recovered, having moved from a low of 3.8% of GDP to 6.9% of GDP today. This is still well below the levels that prevailed from 2001 to 2013, when the trade balance averaged 14% of GDP. Meanwhile, the Norwegian current account has followed the trend in the trade balance. However, since Norway sports a massive net international investment position equal to 207% of GDP, the current account stands at 7.9% of GDP, boosted by a large income stream from foreign investments. As a country sporting a structural current account surplus, Norway is also an exporter of capital, which means its FDI balance is normally negative. Even though net FDIs today are -4.6% of GDP, the basic balance is nonetheless in surplus at 3% of GDP (Chart 10). This is still a much smaller basic balance than what prevailed from 2001 to 2013. This means that the long-term component of the balance of payments is not as supportive to the NOK as it once was. Chart 10Norway Balance Of Payments Norway also tends to suffer from portfolio outflows. This again is a consequence of the country’s large current account surplus, which is a channel outward via Norway’s massive sovereign wealth fund. Today, the portfolio balance is quite narrow, a consequence of declining oil receipts. However, Norwegian oil production is expected to increase by 50% by 2022. This means that the Norwegian current account will rebound, and portfolio outflows will once again grow. But since portfolios outflows are the mirror image of the current account dynamics, this is likely to be a neutral force for the NOK. Ultimately, we like the NOK because it is very cheap: the real trade-weighted NOK enjoys a one-sigma discount to its long-term fair value. Due to trade-weights, this means the NOK is cheap versus both the EUR and the SEK. Hence, with BCA’s positive view on oil prices and the positive outlook for Norwegian oil production, we would anticipate the NOK performing well against these two currencies on a 12- to 18-month basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8).   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors   We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Chart 4BCanadians And Australians Make Americans Look Frugal Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year.   Chart 11Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We recently upgraded our recommended investment stance on global corporate bonds to overweight on a tactical (3 to 6 months) basis.1 Feature That change was mostly based on our view that global financial conditions had tightened enough in late 2018 – both through lower equity prices and wider corporate credit spreads – to force central banks (most notably, the Fed) to shift to a less hawkish policy bias. Our opinion that global growth expectations had grown too pessimistic, particularly in the U.S., also played a role in the upgrade (Chart 1). Chart 1Global Corporates: Too Much Bad News Now Discounted One other supporting factor for the upgrade to corporates: the prior bout of spread widening was not justified by a significant worsening of the underlying financial health of companies. With that in mind, this week we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on Pages 15-16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement, but with divergences starting to open up among individual regions. The U.S. has delivered the biggest improvement in corporate health, thanks largely to the boost to profitability from the Trump corporate tax cuts. Euro area corporates still appear to be in decent health, but are now exposed to the sharp slowing of European growth and the end of the ECB’s buying of corporates through its Asset Purchase Program. Meanwhile, corporate health in the U.K. and Japan is showing some strain from weaker growth in both countries. Given those regional divergences, we continue to prefer U.S. corporates over non-U.S. equivalents, even within that tactical overweight recommendation on global corporate exposure. Beyond that tactical timeframe, however, there are growing risks for corporate bond performance. Our base case scenario is that resilient U.S. growth and inflation will prompt the Fed to restart the rate hike cycle later in the year, creating a more challenging backdrop for corporates from U.S. growth uncertainty and rising volatility. Yet if the U.S. (and global) economy surprises to the downside, that is even worse for corporate bond returns given how the only real improvements in our global CHMs have come from cyclical variables like profit margins and interest coverage. U.S. Corporate Health Monitors: Strong Profits “Trump” High Leverage Our top-down CHM for the U.S. has ever so slightly flipped into the “improving health” zone, after flashing “deteriorating health” since mid-2014 (Chart 2). The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. Chart 2Top-Down U.S. CHM: Supported By Cyclically Strong Profits There are clear uptrends in the ratios that go into the top-down CHM that are directly related to corporate profits – return on capital, profit margins, interest coverage and debt coverage. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also shown meaningful cyclical progress, with the HY indicator now firmly in “improving health” territory. This confirms that the signal from our top-down CHM is being reflected in both higher rated and lower quality companies. Yet the longer-term issues related to high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. Chart 3Bottom-Up U.S. IG CHM: Steady, But Have Margins Peaked?   Chart 4Bottom-Up U.S. High-Yield CHM: Only A Cyclical Improvement Interest coverage remains the key ratio to watch in both the IG and HY bottom-up U.S. CHMs. For IG, the fact that interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates, is worrisome. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate revenues, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or if U.S. earnings growth slows sharply – likely from rising labor costs eroding high profit margins. For HY, interest coverage remains depressed by historical standards, with the liquidity ratio down to levels last seen prior to the 2009 recession. This suggests that U.S. HY companies are at risk of a severe default cycle when the current U.S. economic expansion ends, with fewer liquid assets available to meet current liabilities. Given these more medium-term fundamental concerns, we do not plan on overstaying our current tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). We anticipate cutting our recommended exposure once the Fed begins signaling a need to restart the rate hikes, likely around mid-year. For those with an investment horizon beyond the next six months, the more prudent decision may be to sell into the corporate bond outperformance that we are expecting. The medium-term outlook for U.S. corporates is far more challenging given the advanced age of the U.S. monetary, business and credit cycles. Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY Euro Corporate Health Monitors: Stable, But Slowing Growth Is A Problem The CHMs remain a core part of our suite of bond market indicators, reliably proving their usefulness in helping evaluate the fundamental risks in owning corporate bonds. That does not, however, mean that there is no room for improvement in the CHM methodology from time to time. This is the case for our top-down CHM for the euro area, which has been behaving in a manner inconsistent with our bottom-up CHMs for the region – which are based on actual reported financial data from publicly traded companies – for some time. This is not the case in the U.S., where our bottom-up and top-down CHMs continue to move broadly in lockstep. Thus, we are taking our top-down euro area CHM “into the garage” for repairs. We will revisit all aspects of the methodology, from calculations to data sources, to try and improve the signal from the top-down euro area CHM. We plan on introducing a new and (hopefully) improved indicator sometime in the next few months. The message from our bottom-up CHMs for euro area IG and HY is still generally positive for overall European corporate health. Yet there are noticeable divergences within the sub-components of those individual CHMs that paint a more worrisome picture. For IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former worsening on the margin (Chart 6). While interest/debt coverage has improved for domestic issuers, operating margins and return on capital remain low and leverage has been inching higher. These trends have not been matched by foreign issuers. Perhaps most ominously, the short-term liquidity ratio has fallen quite sharply for domestic IG issuers in the euro area. Chart 6Bottom-Up Euro Area IG CHMs: Stable, But Watch Liquidity Ratios For HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined and operating margins have improved for both sets of issuers, but interest/debt coverage and liquidity are worse for domestic issuers. Chart 7Bottom-Up Euro Area High-Yield CHMs: Cyclically Healthier Within the euro area, our bottom-up IG CHMs for Core and Periphery countries show that both remain in the “improving health” zone (Chart 8). Yet the CHM for the Core now sits on the edge of the “deteriorating health” zone, led by higher leverage, lower debt coverage and a sharply falling liquidity ratio. Notably, there is no gap between the profitability metrics of the Core and Peripheral companies used in our bottom-up CHMs. Chart 8Bottom-Up Euro Area IG CHMs: Trending In Wrong Direction Peripheral European issuers continue to have much higher leverage and much lower interest coverage, the latter suggesting that Core issuers have benefitted more from the ECB’s super-easy monetary policies that have lowered borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Despite the lack of a major negative signal from the CHMs, we are concerned that the combination of slowing euro area economic growth and the end of ECB corporate bond buying will negatively impact the performance of euro area corporates (Chart 9). We are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates. In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Euro area corporates have not enjoyed the same rally that U.S. corporates have seen so far in 2019, and for good reasons. In Chart 10, we show an overall bottom-up CHM for the U.S. and euro area, combining both IG and HY are combined into a single measure for each region.2 The obvious visible trend is that U.S. corporate health has been steadily improving, while it is starting to worsen in the euro area. The gap between those two CHMs is strongly correlated to the difference in credit spreads between European and U.S. issuers (middle panel), suggesting that relative corporate health is favoring U.S. names. At the same time, the relatively stronger U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe U.K. Corporate Health Monitor: A Brexit-Fueled Deterioration Our top-down U.K. CHM indicates that U.K. companies remain in the “improving health” zone, but just barely as the indicator has been drifting towards “deteriorating health” over the past two years. All the components of the U.K. CHM have contributed to this worsening trend (Chart 11). Even short-term liquidity, which has been in a powerful uptrend for almost a decade, has started to roll over. Chart 11U.K. Top-Down CHM: Cyclical Hit From Brexit Worries The cause for this deterioration can be reduced to six letters: B-R-E-X-I-T. Two years of political uncertainty over the details of the U.K.’s future relationship with the European Union have eroded confidence among U.K. businesses and consumers. The result is slowing economic growth and diminished corporate profitability that has hit all earnings-related ratios in the U.K. CHM. Perhaps most disturbingly for U.K. credit performance, even the interest coverage ratio has rolled over – at a historically low level – despite the Bank of England keeping U.K. interest rates at deeply depressed levels. The toxic combination of political uncertainty and weaker economic growth has resulted in a substantial widening of U.K. credit spreads. The spread on U.K. HY corporates has widened by 293bps since September 2017 and now sits at the widest level since September 2012. U.K. IG has not seen the same degree of spread widening, but has underperformed even more on an excess return basis versus duration-matched U.K. Gilts (Chart 12). Chart 12U.K. Corporates: Brexit Uncertainty = Stay Underweight We are currently recommending an underweight stance on U.K. corporates, even as we have become more tactically positive on overall global corporate exposure. While credit spreads have widened to levels that appear to offer value, U.K. economic momentum is fading steadily and leading economic indicators are pointing to even slower growth in 2019. With Conservative Prime Minster Theresa May now in a dramatically weakened position after losing the recent vote on her Brexit deal with the EU, there are no immediate options that will solve the Brexit uncertainty in a way that will provide a lasting boost to U.K. business confidence. In fact, the only realistic options – postponing Brexit, fresh U.K. elections, even a second Brexit referendum – all involve a period of even more uncertainty that will weigh on the performance of U.K. corporate debt.  Japan Corporate Health Monitor: A Negative Signal Our bottom-up Japan CHM3 has consistently stayed in the “Improving health” zone since 2010; however, the most recent data shows that the health of Japanese corporates has started to deteriorate as the last data point from Q3/2018 is just above the zero line (Chart 13). The overall Japanese economy has generally performed well (by Japanese standards) over the past few years, boosted by “Abenomics” economic stimulus combined with the extraordinarily easy monetary policies of the Bank of Japan. Yet the slowing of global growth momentum seen in 2018 has weighed on the performance of the Japanese corporate sector, which is still heavily geared to exports and global growth. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Looking at the components of the CHM, there was a modest deterioration of all the ratios last year, except for profit margins which have been virtually unchanged since 2015. On an absolute basis, the CHM components do not suggest any major problems with Japanese credit quality. Japanese companies are not highly levered and liquidity remains near the highest level seen since at least the mid-2000s. Interest coverage is still high on a historical basis and is much higher than the ratios seen in the other major developed markets. Yet at the same time, return on capital and profit margins remain very low compared to those same other major economies. Japanese companies remain cash-rich with low debt levels – a sharp contrast to the other countries show in this report. There are many potential cyclical risks for Japanese corporates in 2019: even weaker demand for Japanese exports, the drag on Japanese capital spending from firms worried about slowing global growth and the spillover effects from the U.S.-China trade war, even a possible hike in the consumption tax that the Abe government is still considering for October of this year. Yet these all would prevent any adjustment of the interest rate policy of the Bank of Japan, which remains the biggest factor to consider when looking at the investment prospects of Japanese corporate bonds. Japanese corporate spreads did not widen much compared to other countries’ corporate spreads in the 2018 selloff, due to their relative illiquidity and the extreme low level of interest rates in Japan. As the central bank is under no pressure to move off its current hyper-easy monetary policy settings, government bond yields and corporate spreads will remain low, even if the Japanese economy continues to slow. Therefore, for those investors who have access to the relatively small Japanese corporate debt market, we continue to recommend an overweight stance on Japanese corporates vs Japanese government bonds (Chart 14). Chart 14Japan Corporates: Stay Overweight Vs JGBs Canada Corporate Health Monitor: Now Even Healthier Both our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health (Chart 15). Steady above-trend economic growth, combined with some increases in realized inflation, have helped boost the profitability and interest/debt coverage ratios. Yet not all the news is good - leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are low. This may be building up risks for the next Canadian economic downturn but, for now, Canadian companies look in decent shape. Chart 15Canada CHMs: Supported By Solid Growth With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next 6-9 months, which will further underpin the health of Canadian oil companies. Canadian corporates were not immune to the period of global spread widening seen at end of 2018, but the magnitude of the move was modest (Chart 16). This is a function of the still-low interest rate environment in Canada, where the Bank of Canada has not yet lifted policy rates to its own estimate of neutral (2.5-3.5%). Easy monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds on a tactical basis. Spreads have been in a very stable range since the 2009 recession, ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a sharp deterioration of Canadian economic growth or several more rate hikes from the Bank of Canada – neither outcome is likely over at least the next six months. Yet given how closely the Bank of Canada has been tracking the Fed’s current tightening cycle, we anticipate downgrading Canadian corporates at the same time do the same for U.S. corporates, likely around mid-2019.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th, 2019, available at gfis.bcaresearch.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 3 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 4 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns