Economy

Highlights The Federal Reserve stuck to its guns, which lifted the U.S. dollar despite a disastrous CPI report. We agree with the Fed's assessment and expect U.S. inflation to pick up, clearing the way for higher interest rates and a stronger dollar. With three dissenters voting in favor of higher rates, the Bank of England meeting delivered a hawkish surprise. However, the inflation surge will continue to weigh on consumer spending, limiting the capacity of the BoE to increase rates. Stay short cable, but use any rally in EUR/GBP above 0.88 to short this cross. The Canadian economy is strong, and the CAD should perform well on its crosses. However, USD/CAD downside is limited. Go short EUR/SEK. Feature This week was replete with central bank meetings, most crucially the Federal Reserve and the Bank of England, which provided much-needed color on the near-term future direction of global monetary policy. While the BoE does face a serious rise in inflation, it is still focused on the risks to U.K. growth. In contrast, the Fed mostly ignored the disastrous inflation report released the morning before its policy announcement and kept its focus on the underlying strength in the U.S. economy. We believe both institutions are pursuing the appropriate strategy for their respective economies. The Fed: Straight Ahead Fed Chair Janet Yellen and her gang increased the fed funds rate by 25 basis points to 1-1.25% and pre-announced the parameters around the reduction in the Fed's balance sheet size. On the balance sheet front, the Fed removed any doubt that it will begin reducing its asset holdings this year. Additionally, the Fed provided its new set of forecasts for growth, inflation, unemployment, and interest rates. While it increased its growth forecast for 2017 to 2.2% from 2.1%, it curtailed its core PCE deflator forecast for 2017 by 0.3 percentage points to 1.6%. However, in line with its conviction that the soft patch in inflation is temporary, it kept its 2018 and 2019 core PCE forecasts at 2%. The Fed did also acknowledge that the equilibrium unemployment rate was lower than it believed in March, decreasing its long-term estimate by 0.1% to 4.6%. However, despite recognizing that NAIRU has fallen, the Fed still thinks the labor market is tight. It proceeded to curtail its unemployment rate forecasts by 0.2% in 2017 to 4.3%, and by 0.3% in 2018 and 2019 to 4.2%. Congruent with these forecasts, the Fed did not adjust its intended path for interest rates. It still expects to hike rates once more in 2017, and three more times in both 2018 and 2019. As a result of these policy changes and the intentions associated with the new set of forecasts, the dollar recouped its CPI report-induced decline, and gold suffered. Most interestingly, the market seems to believe that the Fed is entering the realm of policy mistakes as the 2-10-year yield curve flattened considerably, and inflation expectations plunged to their lowest levels since November 4, 2016 (Chart I-1). But is the Fed really making a mistake? We do not think so. Simply put, we agree with the Fed that underlying economic momentum in the U.S. is real, and that both wage growth and inflation will turn the corner this summer. To begin with, our composite capacity utilization gauge, based on both industrial capacity and labor market utilization, is now fully into "no slack" territory. Historically, this has given the Fed the green light to increase interest rates. There is no mystery behind this relationship: when this indicator is above the zero line, inflation pressures emerge and wage growth accelerates (Chart I-2). This time is unlikely to prove different. Chart I-1A Policy ##br##Mistake? Chart I-2Conditions In Place For Higher##br## Inflation And Rates Supporting this assessment, many indicators show that the recent slowdown in wage growth will prove a temporary phenomenon. First, the spread between the Conference Board's "jobs plentiful" and "jobs hard to get" series still points to accelerating average hourly earnings (Chart I-3). Second, the labor market is likely to remain healthy. True, the fastest pace of job creation is behind us, a key symptom that labor market slack is vanishing, but some of our favorite employment indicators - such as Janet Yellen's labor market condition index and the NFIB job openings and hiring plans subcomponents - have picked up again (Chart I-4). In an environment of little slack, this might not translate into impressive nonfarm payroll numbers, but most likely faster wage growth. Chart I-3Wages Will Pick Up Chart I-4Yes, The Labor Market Is Healthy Third, capex intentions are still perky. Historically, capex intentions have tightly correlated with wages, and even the recent softness in wages was forecast by these intentions. This is simply because capex tends to require labor. When corporate investment materializes as worries about the durability of final demand hits cyclical lows, this is generally an environment that requires bidding up the price of labor - i.e. wages. This is precisely the current economic backdrop (Chart I-5). While the slowdown in bank credit to enterprises has caused many commentators to worry about the outlook for capex, we do not share these concerns. For one, although businesses may not have been tapping bank loans in Q1, they have been aggressively borrowing in the bond market (Chart I-6, top panel). Moreover, credit standards are now easing anew, and small firms are reporting little difficulty in accessing credit (Chart I-6, bottom panel). Chart I-5Good Outlook For Growth And Wages Chart I-6I Need Credit; No Problem! With respect to consumption, weren't retail sales on the soft side as well? Here again, we need to step back. Real retail sales continue to grow at a healthy 4.2% annual pace; meanwhile, the so-called control group - which affects GDP computations - was flat in May, but the April number was revised to 0.6% month-on-month, suggesting real consumption will be robust in Q2. In fact, federal income tax withholdings, a good proxy for household income growth, is also accelerating, further supporting consumption (Chart I-7). Overall, we agree with the Fed that the economy is on its way to escaping from its recent soft patch and that wage growth will accelerate. Ryan Swift, who writes our sister U.S. Bond Strategy service, has also recently argued that the U.S. Philips curve remains alive and well, and that wages and inflation will thus pick up again.1 Our own work does highlight the potential for not just wage growth but core CPI to also perk up. U.S. real business sales have been very strong of late, which historically has been a good leading indicator of core inflation (Chart I-8, top panel). Labor market dynamics tell a similar story. Our unemployment diffusion index is also a good leader of core CPI, and after a soft patch is now pointing to firming underlying inflation (Chart I-8, bottom panel). Chart I-7Real Consumption Will Trudge Along Chart I-8Inflation Soft Patch Will End Therefore, we expect the recent negative inflation surprise in the U.S. to reverse. Moreover, inflation surprises in the U.S. are also likely to beat those of the euro area. To a very large extent, Europe's positive inflation surprise, especially relative to the U.S., reflected the 2014 collapse in the euro. The recent stability in the euro since March 2015 further reinforces that the boost to European relative monetary conditions is dissipating, and that European inflation surprise will not outpace the U.S. going forward (Chart I-9). Chart I-9U.S. Inflation Surprises ##br##Will Pick Up Versus Europe's Chart I-10Diverging Policy ##br##Expectations This is very important, as these relative inflation surprise dynamics have been the key factor underpinning divergent expectations behind ECB policy and the Fed's path. While investors have increasingly brought forward the ECB's first hike, they have aggressively curtailed the number of hikes expected in the U.S. over the next two years (Chart I-10). If, as we expect, relative inflation surprises do once again move in favor of the U.S., this gap will disappear, supporting the dollar in the process. Bottom Line: The Fed is right to stay the course. The economy continues to display momentum, and the inflation soft patch should soon dissipate. Moreover, U.S. economic surprises are bottoming. As such, we expect market expectations for inflation and interest rates to move back toward the Fed's forecast, lifting the U.S. dollar in the process. BoE Dissenters Grab The Headlines, But... The poor BoE is in an infinitely more tenuous situation than the Fed. Core inflation continues to pick up, but economic uncertainty is also on the rise. This dichotomy is most pronounced when it comes to wages. At 2.6%, core inflation is now outpacing wage growth, thus real income levels are contracting (Chart I-11). This is problematic because at 65% of GDP, the U.K. is an economy fundamentally driven by consumer spending. As Chart I-12 illustrates, when inflation picks up and puts downward pressure on real wages, consumption sags. Therein lies the BoE's conundrum. Chart I-11U.K.: Inflation Everywhere, But Not In Wages Chart I-12The BOE's Dilemma Despite the three dissenters who voted in favor of a hike this week, we expect the BoE to continue to favor not lifting rates, leaving its accommodation in place.2 Household inflation expectations remain well moored, but a further relapse in growth could prompt a widening of the output gap and produce entrenched deflationary expectations down the line - something BoE Governor Mark Carney and his colleagues want to avoid at all costs. Chart I-13U.K. FDI At Risk Some investors have been wondering out loud about the likelihood of a "soft Brexit" coming back on the agenda, arguing that it would support the pound. Remaining in the common market is, after all, an unmitigated positive for the U.K. But to be part of the common market, the U.K. also has to adopt the sacrosanct freedom of movement of people. We remain unconvinced that the British will budge on this point. Brexit was first and foremost a rejection of neo-liberal ideals that have been perceived as detrimental to the British middle class. And no point has been and continues to be more contentious than immigration. With the EU absolutely unwilling to dilute freedom of movement, access to the common market for the U.K. remains a distant dream. Moreover, with the British median voter switching to the left, a topic discussed in last Friday's Geopolitical Strategy Service Special Report on the election, British politics are likely to become less business friendly.3 Compounding this issue, U.K. industrial production is flat on an annual basis, bucking the global improvement seen last year and implying that the falling pound has not boosted competitiveness in the U.K. manufacturing sector. Together these forces suggest that the recent upsurge in FDI inflows into the U.K. could reverse in coming quarters (Chart I-13), a big problem for a country with a current account deficit of more than 4% of GDP and deeply negative real rates. Ultimately, the pound is cheap, trading at a one-sigma discount to its fair value. This means the market is well aware of the negatives that are weighing on sterling. Thus, the risks to GBP are well balanced. As a result, we expect GBP/USD to finish the year toward 1.2 because of our expectation of USD strength. EUR/GBP has limited upside, and rises above 0.88 should be used to build short positions. Bottom Line: The BoE decision was in line with expectations, but the market was nonetheless surprised by the fact that three MPC members dissented and voted for a rate hike. Sure, British inflation is on the rise, but this is hurting household real incomes, and thus consumption. These dynamics limit the upside risk to policy rates. We think that GBP could weaken against the USD; we would use moves above 0.88 to short EUR/GBP. The Bank Of Canada Volte Face Despite a 5% fall in oil prices this week, the CAD has appreciated 1.2% against the USD. Behind this impressive move has been Monday's speech by Senior Deputy Governor Carolyn Wilkins, in which she hinted that the Bank of Canada's next move will be a hike, coming sooner than investors have been anticipating. The BoC assessed that the negative impact of the fall in oil prices in 2014-'15 has passed, and that domestic strength in the Canadian economy has become self-sustaining. With the output gap expected to close in Q2 2018, the logical path for policy is tighter. Do the indicators warrant such a view? Yes: Canadian employment is quite strong, growing at a 1.8% annual pace. Unemployment too has fallen substantially. Capacity utilization is elevated in the manufacturing sector, thanks to a decade of low corporate investment. If our assessment of the U.S. capex cycle is correct, Canadian goods exports should pick up, adding to capacity and inflationary pressures in the country (Chart I-14). Our Canadian economic diffusion index - based on retail trade, manufacturing sales, building permits, and employment data in the 10 provinces - has sharply accelerated, pointing to a continued rise in GDP growth. Canadian LEIs and PMIs are all strong. Canadian house prices continue to forge ahead, growing at a 14% annual rate, which will additionally support Canadian consumption. This picture highlights that the BoC does have room to adjust its forward guidance, especially if the Fed stays on its desired path. Today, not only are investors the most short CAD since early 2007, but the loonie is cheap relative to real rate differentials (Chart I-15). As a result of these distortions, CAD could respond very positively to continued reaffirmation by the BoC that policy may become tighter. Chart I-14O Canada Chart I-15CAD At A Discount To Rates Practically, due to our broad bullish outlook on the USD, we find the most interesting way to play CAD strength is through its various crosses. Thus, we remain short EUR/CAD, short AUD/CAD, and long CAD/NOK. Bottom Line: The Canadian economy has escaped its funk. True, the long-term risks associated with the housing bubble will ultimately come home to roost. However, in the short term, the BoC is finding room to lift its forward guidance. As a result, CAD is likely to move higher on non-USD crosses. EUR/SEK Is A Short EUR/SEK should weaken in the coming quarters. To begin with, EUR/SEK is trading at a 7% premium against its PPP fair value. Additionally, the real trade-weighted SEK stands at a one-sigma discount to its long-term fundamental fair value, which further highlights the SEK's upside potential versus the euro, the main trading counterparty of Sweden (Chart I-16). Valuations are not enough to motivate a position. Economics need to join the ball. Today, the Swedish output gap is positive while that of Europe remains negative. Unsurprisingly, Swedish core inflation has overtaken that of the euro area (Chart I-17). Moreover, while we have argued at length why euro area core inflation is likely to disappoint going forward,4 pressure on Swedish resources is such that Swedish core inflation is likely to display additional upside (Chart I-18). Chart I-16SEK Is Cheap Chart I-17Swedish Core Inflation Is Outpacing Europe's Chart I-18Swedish Core Inflation Will Rise Further This means there will be attractive relative policy dynamics between the Riksbank and the ECB in the coming months. If the ECB has to tighten policy, the Riksbank has an even better case to be hawkish. If, however, the global economic environment prevents the ECB from tightening and forces it toward an easing bias, these global deflationary pressures should prove more muted in Sweden. Thus, we expect that Swedish policy will tighten relative to the ECB's, despite the economic and inflation environment. Chart I-19CPI Expectations Differential Will Push ##br##Policy Toward A Lower EUR/SEK Additionally, inflation expectations are pointing toward a lower EUR/SEK. The recent Swedish Prospera inflation survey showed that economic agents are expecting a pickup in inflation. As a result, market-based inflation expectations in Sweden have outperformed those in Germany, pointing to a lower EUR/SEK (Chart I-19). Essentially, this reflects potential changes in the relative direction of policy between the two currencies. The big risk to this view is that Stefan Ingves, the Riksbank governor, continues to be one of the most dovish policy makers in the world. However, his term ends on January 1, 2018, and unless he is renewed for another six years, his words and desires will increasingly lose their ability to affect markets. Bottom Line: The Swedish economy is increasingly moving closer to an inflationary environment. This cannot yet be said about the euro area. With inflation expectations sharply moving up in Sweden versus the euro zone, investors should begin betting against EUR/SEK. Housekeeping We are closing our short USD/JPY trade this week at a 4.2% profit. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report titled, "Low Inflation And Rising Debt", dated June 3, 2017, available at usbs.bcaresearch.com 2 Moreover, one of the dissenters was Kristin Forbes, who was attending her last meeting as a member of the MPC. 3 Please see Geopolitical Strategy Special Report titled, "U.K. Election: The Median Voter Has Spoken", dated June 9, 2017, available at gps.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report titled, "ECB: All About China?", dated April 7, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Chairwoman Janet Yellen has halted the dollar selloff for now, with the DXY finally seeing some upside. Following the press conference, the greenback sits 1.2% above the lows seen prior to the Fed policy meeting. We share the view of the Fed and the expect markets to converge over time toward the Fed's forecasts. Additionally, Yellen confirmed that there is still one more hike on the table this year. We believe the market continues to underprice these factors, concentrating too much on what amounts to a temporary soft patch. As we have said in the past, these factors will continue to widen rate differentials between the U.S. and its G10 counterparts. Report Links: Look Ahead, Not Back - June 9, 2017 Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 EUR/USD dropped on the news of a weak trade balance figure of EUR 19.6 bn, below the expected EUR 27.2 bn. Generally, EUR/USD has remained reasonably static as euro weakness was muted by equal dollar weakness, but recent Fed hawkishness has broken this trend. Draghi's hawkishness is tepid at best and the Fed hiking rates this Wednesday, as well as Yellen reiterating that another hike will be seen later this year will continue to help U.S. policy anticipations relative to Europe. As a result, rate differentials are likely to widen, and the euro to soften. The little appreciation in the euro earlier this week, was a result the following positives: German ZEW Survey's Current Situation went up to 88, beating expectations of 85; Euro Area ZEW Survey's Current Situation also went up to 37.7 from 35.1. Report Links: Look Ahead, Not Back - June 9, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been negative: Domestic corporate goods prices grew by 2.1% YoY, against expectations of 2.2%. Machinery orders yearly growth came in at 2.7%, underperforming expectations by a wide margin. Industrial production yearly growth stayed flat at 5.7%. Ultimately, economic activity in Japan will largely depend on the currency. With the yen appreciating for most of 2017, it will be difficult for the Japanese economy to improve sustainably. At this point, we are closing our USD/JPY trade, as the correction in the U.S. dollar has run its course. Meanwhile, we remain bearish on NZD/JPY, as the rising dollar and the tightening in Chinese monetary conditions will deliver a formidable one-two punch to risk assets, and thus weigh on this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Industrial Production contracted by 0.8% on a YoY basis, underperforming expectations. Manufacturing production yearly growth stayed flat, also underperforming. Meanwhile, both core and headline inflation came in above expectations, at 2.6% and 2.9% respectively. Yesterday the BoE came in more hawkish than expected, as Ian McCafferty and Michael Saunders joined Kristin Forbes voting and dissented in favor offor a hike. Meanwhile, in their monetary policy summary the BoE stated that inflation will stay above target for an "extended period". Following the report, EUR/GBP plunged by about 0.8%. We are now not positive on the pound, as core inflation is now outpacing wage growth, a development that should weigh on demand due to the decline in real income. This development could cause GBP/USD and EUR/GBP to reach 1.2 and 0.92 respectively to reach 1.2 by year end, but any move in EUR/GBP above 0.88 should be used to short this cross. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Data out of Australia was mixed this week: National Australia Bank's Business Confidence declined to 7 from 13; Westpac Consumer Confidence fell to -1.8% from -1.1%; However, the unemployment rate dropped to 5.5%, with full-time employment growing by 52,100, and part-time employment shrinking by 10,100. Most of the movement in the AUD was dominated by the employment data, seeing a broad-based increase versus other G10 currencies. While oil prices kept the CAD and NOK at bay, Chinese industrial production and retail sales increased at a 6.5% and 10.7% annual rate, respectively. Iron ore and copper, commodities important to Australia, however, saw little action, but coal saw a slight upside. The above dynamics resulted in the AUD outperforming other currencies versus the USD, and EUR/AUD weakened massively. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: Electronic card retail sales grew by 5.2% year-on-year, increasing from 4.2% the month before. However, the current account deficit came in at 3.1% of GDP against expectations of 2.7%. Meanwhile, yearly GDP growth came in at 2.5%, underperforming expectations. The kiwi rallied this week as expectations of a dovish fed weighed on the dollar, although most of these gains vanished following the FOMC press conference. We continue to be positive on the NZD relative to the AUD, given that the kiwi economy is in much better footing than the Australian one. However, upside for NZD/USD is limited, as this cross has reached highly overbought levels. Furthermore, the tightening in Chinese monetary conditions will become a headwind for a sustainable rally in the NZD. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The downside in oil continues as EIA crude oil stocks decreased by 1.661 million barrels, less than the expected 2.739 million. AUD/CAD and NZD/CAD rallied on the news, while CAD/NOK levelled off. In the commodity space, we remain most positive on the Canadian economy. While oil prices are a hurdle, business and consumer confidence, as well as PMIs remain robust, and the BoC expects the output gap to close in Q2 2018. Our Commodity and Energy Strategy team continues to believe that OPEC cuts and increased oil demand will eventually curtail inventories. We therefore expect our short AUD/CAD trade to prove profitable as markets begin to digest these developments. While the CAD looks good on its crosses, the resumption of the dollar bull market will limit the USD/CAD's downside. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Yesterday, in their monetary policy statement, the SNB reasserted its dovish bias, pledging to keep its extremely accommodative monetary policy in the years to come. Their inflation outlook changed little, upgrading the near term slightly while downgrading the longer term outlook. It is important to consider that when the SNB states that they expect that inflation will reach only 1.5% by the first quarter of 2020, they do so assuming the LIBOR rate stays at -0.75%. Meanwhile, they also signaled that they will stay active intervening in the currency market, with SNB president Thomas Jordan reiterating that the Franc “remains significantly overvalued”. We had previously stated that the implied floor put under EUR/CHF by the SNB could be removed by the end of this year. However, this scenario now seems unlikely, given the strong commitment by the SNB to remain accommodative. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Following a sell-off for most of the beginning of the week, USD/NOK has rebounded sharply, following the FOMC interest rate decision. Furthermore, the disappointing draw in oil inventories also contributed to the surge in USD/NOK. We continue to be bearish on the NOK, given that inflation is still receding in Norway. Recent data supports this, with core inflation and producer prices falling from anewApril. Furthermore, any surge in the U.S. dollar will provide a tailwind to USD/NOK given that this cross is highly sensitive to the dollar. Another cross where we are positioned towe use to take advantage of gain from Norway's economic weakness difficulties is CAD/NOK. The Canadian economy is on ain much stronger footing than the Norwegian one, and the rally in the dollar has historically been a tailwind for this cross. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Sweden's economy is developing as expected, with headline inflation reading at the expected level of 1.7%, with a 0.1% monthly increase. Although inflation decreased from the previous 1.9% reading, the Riksbank's Resource Utilization Indicator - historically, a reliable indicator for core inflation - continues to point up, indicating that core inflation will accelerate further. We are putting on a short EUR/SEK trade on the basis of long-term valuations being in the favor of the krona. With a closed output gap, Sweden's economy is more advanced in its business cycle than the euro area', which points to a further bifurcation in inflation rates between the two. These factors will also warrant a quicker removal of policy support from the Riksbank than the ECB. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The FOMC statement reaffirmed that the Fed remains in hiking mode. If the Fed keeps raising rates in line with the "dots," monetary policy will move into restrictive territory by early 2019. By then, the unemployment rate will have fallen to a level where it has nowhere to go but up. Unfortunately, history suggests that once unemployment starts rising, it keeps rising. The good news is that today's economic imbalances are not as formidable as those that existed in the lead-up to the past few recessions. The bad news is that cracks are starting to form. We are especially worried about the health of the U.S. commercial real estate sector. Remain overweight global equities for now, but look to significantly pare back exposure next summer. Feature The U.S. Expansion Is Getting Long In The Tooth Chart 1How Low Can It Go? The current U.S. expansion has now reached eight years, making it the third longest in the post-war era. History teaches that expansions do not die of old age. Rather, they are usually murdered by some combination of Fed tightening and the unwinding of the imbalances that were built up during the boom years. Thinking about the present, there is good and bad news on both fronts. Let's start with the Fed. This week's FOMC statement reaffirmed that the Fed remains in hiking mode. The good news is that real rates are still very low by historic standards, suggesting that the economy is unlikely to stall out this year. The bad news is that the Fed has less scope to raise rates than in the past. Chart 1 shows estimates of the real neutral rate developed by Fed researchers Thomas Laubach and Kathryn Holston, along with John Williams, President of the San Francisco Fed and Janet Yellen's close confidante. Their calculations suggest that the real neutral rate has plummeted over the past decade in the U.S. and the euro area, with lesser declines recorded in Canada and the U.K. In the U.S., the real neutral rate currently stands at 0.4%. Assuming the Fed raises interest rates in line with the "dots," rates will move into restrictive territory in early 2019. Given that monetary policy affects the real economy with a lag of 12-to-18 months, the Fed may not realize that it has raised rates too much until it is too late. The Downside Of A Low Unemployment Rate One might argue that this justifies a "go-slow" approach to tightening monetary policy. There is certainly validity to this view, but it is not without its drawbacks. The unemployment rate has now fallen to 4.3%, 0.4 points below the Fed's estimate of NAIRU. As Chart 2 illustrates, the odds of a recession rise when the unemployment rate reaches such low levels. Some commentators have argued that the headline unemployment rate understates the amount of economic slack. We are skeptical that this is the case. Table 1 compares a wide variety of measures of labor market slack with where they stood at the height of the business cycle in 2000 and 2007. The main message of the table is that the unemployment rate today is broadly where one would expect it to be based on these collaborating indicators. Taken together, these indicators suggest that slack is comparable to what it was in 2007, albeit still above the levels seen in 2000. Table 1Comparing Current Labor Market Slack With Past Cycles As we noted last week, the easing in U.S. financial conditions over the past six months is likely to boost growth in the second half of this year (Chart 3). If growth does accelerate, the unemployment rate - which is already 0.2 points below where the Fed thought it would be at the end of this year when it made its December 2016 projections - will fall below 4%. There is a high probability that this will fuel inflation, reversing the largely technically-driven decline in most core inflation measures over the past few months. Chart 3U.S.: Easy Financial Conditions Will Support Growth In H2 2017 The market is not pricing this in at all. In fact, 2-year breakeven inflation rates have tumbled by 87 basis points since March. A bit more inflation would be a welcome development. Not only have market-based projections of inflation fallen since the Great Recession, but long-term survey-based measures have dipped as well (Chart 4). Of course, one can have too much of a good thing. The experience of the 1960s is illustrative in that regard. Chart 5 shows that much like today, inflation in the first half of that decade was well anchored at just below 2%. However, once the unemployment rate fell below 4%, inflation soared. Core inflation rose from 1.5% in early 1966 to nearly 4% in early 1967, ultimately making its way to 6% by 1970. Chart 4Inflation Could Use A Boost Chart 5Inflation In The 1960s Took Off ##br##Once The Unemployment Rate Fell Below 4% If the Fed today wants to avoid the same fate, it will have to take steps to lift the unemployment rate back up to NAIRU. Unfortunately, history suggests that it is difficult to raise the unemployment rate a little bit without inadvertently raising it by a lot. Once unemployment starts to rise, a vicious circle tends to erupt where increasing joblessness leads to slower income growth, falling confidence, and ultimately, less spending and higher unemployment. In fact, there has never been a case in the post-war era where the three-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 6). Chart 6Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Imbalances Are Growing The vicious circle described above tends to be amplified when there are large imbalances in the economy. The good news is that today's imbalances are not as formidable as those that existed in the lead-up to the past few recessions. The bad news is that cracks are starting to form. The ratio of household debt-to-disposable income is still close to post-recession lows, but this is largely because mortgage debt continues to be weighed down by a depressed homeownership rate (Chart 7). In contrast, consumer credit is rebounding: Student debt is going through the roof and auto loans are nearly back to pre-recession levels as a share of disposable income (Chart 8). Not surprisingly, this is starting to translate into higher default rates (Chart 9). The fact that this is happening at a time when the unemployment rate is at the lowest level in 16 years is a cause for concern. Chart 7Low Homeownership Rate Keeping A Lid On Mortgage Debt Chart 8Consumer Credit: Making A Comeback... Chart 9...With Defaults Starting To Rise In Some Categories Meanwhile, the ratio of corporate debt-to-GDP has risen above 2000 levels and is closing in on its 2007 peak (Chart 10). Contrary to the widespread notion that "wages aren't rising," real wages are increasing more quickly than corporate productivity (Chart 11). As the labor market continues to tighten, corporate profitability could suffer, setting the stage for rising defaults and increasing layoffs. Chart 10U.S. Corporate Sector Has Been Feasting On Credit Chart 11Real Wages Now Increasing Faster Than Productivity Worries About Commercial Real Estate We are particularly worried about the health of the commercial real estate (CRE) market. CRE prices currently stand 7% above pre-recession levels in real terms, having risen by a staggering 82% since the start of 2010 (Chart 12). Financial institutions hold $3.8 trillion in CRE loans, $2 trillion of which are held by banks. As a share of GDP, the outstanding stock of CRE bank loans in most categories is near pre-recession levels (Chart 13). Chart 12Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Chart 13CRE Debt Is Rising Going forward, the fundamental underpinnings for the CRE market are likely to soften. The retail sector is already under intense pressure due to the shift in buying habits towards eCommerce. CMBX spreads in this space are rising. Vacancy rates in the apartment sector have started to tick higher and rent growth has slowed (Chart 14 and Chart 15). The number of apartment units under construction stands at a four-decade high according to Census data, despite a structurally subdued pace of household formation (Chart 16). Most of these units are likely to hit the market in 2018, which will result in a further increase in vacancy rates. Chart 14Vacancy Rates Are Bottoming Outside The Industrial Sector... Chart 15...While Rent Growth Is Losing Steam Chart 16Apartment Supply Is Surging, But Will There Be Enough Demand? There are fewer signs of overbuilding in the office sector. Nevertheless, vacancy rates are likely to rise, given the recent increase in the number of new projects in the pipeline. On the flipside, demand growth for new office space is set to weaken, as a tighter labor market leads to slower payroll gains. The Fed estimates that the U.S. needs to add only 80,000 workers to payrolls every month to keep up with a growing labor force, down from about 150,000 in the two decades preceding the Great Recession.1 The secular shift towards increased office density and teleworking will only further depress office demand over time. Chart 17Tighter Lending Standards Could Lead To Lower CRE Prices The one bright spot is industrial real estate. Thanks to a revival in U.S. manufacturing, vacancy rates remain low and rent growth is rising. However, if the U.S. economy does accelerate over the remainder of the year, the dollar is likely to strengthen, putting a dent in the profitability of U.S. manufacturing companies. Standing back, how worried should investors be about the CRE sector? For now, there is limited cause for concern. U.S. financial institutions have been tightening lending standards on CRE loans for seven straight quarters. Consequently, the average loan-to-value ratio for newly securitized loans has fallen about four points to 60% since 2015, and is now down eight points compared to 2007. However, if vacancy rates keep rising, real estate prices will fall, leading to a decline in the value of the collateral backing CRE loans. This could prompt lenders to pull back credit, causing prices to fall further (Chart 17). Seasoned real estate investors are no strangers to such vicious cycles, and if the next one begins at a time when growth is slowing because the economy is running out of spare capacity and financial conditions are tightening, it could easily trigger a recession. Fiscal Policy To The Rescue? Could looser fiscal policy delay the day of reckoning? The answer is yes, but much will depend on when the stimulus arrives and what form it takes. The best-case scenario is that fiscal policy is eased just as the economy is beginning to slow of its own accord. A burst of stimulus that arrives on the scene too early would be less desirable, although not necessarily counterproductive, since it would allow the Fed to step up the pace of rate hikes, thereby giving it more scope to cut rates later in response to slower growth. In practice, however, calibrating the amount of monetary tightening that is necessary to offset a given amount of fiscal loosening is difficult to achieve. This is especially the case in today's environment where another fight over the debt ceiling looms large, a new health care bill is making its way through the Senate, and Trump's tax agenda remains heavy on promises but short on specifics. Our expectation is that Congress will pass a "balanced" budget which equates revenues with expenditures over the 10-year budget horizon. How this affects growth is hard to predict with any certainty. On the one hand, spending cuts tend to depress aggregate demand more than tax cuts raise demand. In economic parlance, the fiscal multiplier for government spending is larger than for taxes. On the other hand, the tax cuts are likely to be front-loaded, while the spending cuts will be back-dated. If history is any guide, this means that the latter will never see the light of day. In addition, some of the budgetary impact from cutting statutory tax rates will be paid for through dynamic scoring, the questionable practice of assuming that lower personal and corporate tax rates will significantly spur growth. On balance, we expect fiscal policy to turn modestly stimulative over the next few years. However, given the uncertainty involved, there is a risk that the Fed either raises rates too much - thereby choking off growth - or by not enough, causing the unemployment rate to fall to a level where it has nowhere to go but up. Both outcomes could trigger a recession. Investment Conclusions Right now, our recession timing model, as well as the models maintained by various regional Fed banks, assign a low probability of a severe slowdown in the coming months (See Box 1 for details). These models, however, tend to send reliable signals only over a fairly short horizon. Looking further ahead, we see a heightened probability of weaker growth in the second half of 2018, which could set the stage for a recession in 2019. The good news is that today's economic imbalances are not as daunting as they were in the late innings of many past economic expansions. Thus, the 2019 recession is not likely to be especially severe. The bad news is that valuations across most markets are quite stretched. Thus, like the 2001 recession, the financial market impact could be disproportionally large compared to the economic impact. We are still overweight global equities, but will be looking to significantly reduce exposure by next summer. Once the equity bear market begins - most likely late next year - a 20%-to-30% retracement in U.S. stocks is probable. Given that correlations across stock markets tend to rise when risk sentiment is deteriorating, it is likely that other global bourses will also suffer if U.S. stocks weaken. Indeed, considering that most stock markets have a beta to the S&P 500 that exceeds one, other regions could suffer even more than the U.S. As the U.S. economy falls into recession, the Fed will stop raising rates. This will cause the dollar to weaken, although not before it has appreciated by about 10% in trade-weighted terms from current levels. Thus, while we remain bullish on the dollar over the next 12 months, we are much less sanguine about the greenback over the long haul. As the dollar weakens, the yen and euro will strengthen, imparting deflationary pressures on those economies. If our timing for the next recession proves correct, neither the ECB nor the BoJ will hike rates for the remainder of the decade. The Bank of England is a tougher call. The neutral rate of interest is higher in the U.K. than in continental Europe. Last week's election results represented a clear rejection of fiscal austerity. A more expansionary fiscal stance would give the BoE some scope to raise rates. A weaker pound has also given the economy a much needed competitive boost. With inflation picking up, it is not surprising that the BoE struck a more hawkish tone this week. Nevertheless, Brexit negotiations are liable to drag on for some time, which will constrain the ability of the BoE to tighten monetary policy. Stay long GBP/EUR and GBP/JPY over the next 12 months, but remain short GBP/USD. Housekeeping Note: Closing Our Tactical S&P 500 Short Hedge As noted above, we remain cyclically overweight global equities over a 12-month horizon. However, on occasion, we have put on a tactical hedge whenever equities appeared to be technically overbought. Such a situation arose six weeks ago. While the stock market did dip briefly shortly after we initiated the trade, it subsequently rallied back. At the time of initiation, we indicated that the trade would have a lifespan of six weeks. The clock has now run out, and we are closing the trade for a loss of 2%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Rhys Bidder, Tim Mahedy, and Rob Valletta, "Trend Job Growth: Where's Normal?" FRBSF Economic Letter, 2016-32, Federal Reserve Bank Of San Francisco (October 24,2016), and Daniel Aaronson, "Estimating The Trend In Employment Growth," Chicago Fed Letter, No. 312, Federal Reserve Bank Of Chicago (July 2013). BOX 1 The Message From Our Recession Timing Model Chart Box 18Near-Term Recession Risk Remains Low Our recession timing model is based on eight variables: The Conference Board's Leading Economic Indicator, the Coincident Economic Indicator, the fed funds rate, inflation expectations, the unemployment rate, oil prices, credit spreads, and the yield curve. We use a logistic regression framework to model the probability of a recession. Currently, our model shows that the odds of a recession are low (Chart Box 18, panel 1). Only one of the components, namely, a rising fed funds rate, is signaling a risk of a recession. The various models developed by regional Federal Reserve banks also show very low near-term odds of a recession (panels 2 and 3). Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. 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 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Trump's failures have helped fuel the bull market; Yet inflation and Trump legislative wins will embolden the Fed; The U.K. will have yet another election by 2019; Dodd-Frank repeal is a no go ... but small banks may get relief; The Tea Party just found its hard constraint ... in Kansas. Feature Investors in South Africa surprised us last week. The first question on everyone's mind was "Will Trump be impeached?" Our answer that impeachment is highly unlikely at least until the midterm elections was received with suspicion.1 The perspective of our South African clients is understandable. Their domestic assets have been underpinned since Trump's election by a phenomenon we like to call "the Trump put." The thesis posits that U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively. The result is a weak dollar, lower 10-year Treasury yields, and a rally in global risk assets (Chart 1). Of course, stubbornly weak inflation and disappointing Q1 GDP numbers bear responsibility as well as Trump (Chart 2). Chart 1The 'Trump Put' Chart 2Weak Inflation Fueling Bull Market For our South African clients, the fate of President Trump is irrelevant. What matters is that the American political imbroglio continues, reducing the likelihood of a hawkish mistake from the Fed, and thus keeping EM risk assets well bid. The market has generally agreed. Several assets associated with Trump's populist agenda have reversed their gains since the election. The yield curve, small caps, and high tax rate equities have all shown signs of disappointment with the Trump agenda (Chart 3). If the Trump put were to continue, we would expect U.S. bonds and stocks to rally, DXY to continue to face headwinds, and international stocks to outperform U.S. stocks. That said, the proxies for Trump's agenda in Chart 3 are starting to perk up. They may be sniffing out some positive political signs, such as the movement in the Senate on the bill repealing the Affordable Care Act (Obamacare). The budget reconciliation procedure - a process by which Republicans in Congress intend to avoid the Democrat filibuster in the Senate - requires Obamacare to be resolved before the House and the Senate can take up tax reform.2 If Obamacare clears Congress's calendar by the August recess, the odds of tax reform (or merely tax cuts) being passed by the end of 2017 will rise considerably. Second, former Director of the FBI James Comey's testimony was a non-event. We refused to cover it in these pages as we expected it to be theatre. The market had already digested everything that Comey was going to say, given that he had leaked the juiciest components of his testimony weeks ahead of the event. Chart 3Consensus On Trump Policy Failure? Third, President Trump's approval rating with Republican voters remains resilient (Chart 4). If the worst has passed with the Russian collusion investigation - which we expect to be the case now that Comey's testimony has come and gone with little relevance - we could see GOP voters rally around the president. Several clients have pointed out that our measure is less relevant given the decline in voters who identify as Republicans (Chart 5). We disagree. As long as Republican voters vote in Republican primaries, they can act as a constraint on GOP members in Congress who are thinking of abandoning the president's populist agenda. This brings us to the main event: the economy. Our colleague Ryan Swift, who writes BCA's U.S. Bond Strategy, could not care less about the ongoing political drama. As Ryan has argued in a cogent report that we highly recommend to clients, the Fed's median projection for two more 25 basis point rate hikes before the end of the year, and for PCE inflation to reach 1.9% (Chart 6), is not going to happen if inflation continues to disappoint over the summer.3 The market seems to be saying that a PCE of 1.9% is unlikely. Core PCE inflation is running at only 1.54% year-over-year through April, and will probably stay low in May given that year-over-year core CPI fell from 2% in March to 1.89% in April. Chart 5Fewer People Call Themselves Republicans Chart 6Inflation Relapse Would Scratch Fed Hikes Ryan's Philips Curve model, however, disagrees with the market. The model looks to approximate Chair Yellen's own philosophy for forecasting inflation, which she outlined in a September 2015 speech.4 Specifically, BCA's U.S. Bond Strategy models core PCE as a function of: 12-month lag of core PCE; Long-run inflation expectations from the Survey of Professional Forecasters; Resource utilization; Non-oil import prices relative to overall core PCE. BCA's core PCE model is sending a strong signal that the market's inflation expectations are overly pessimistic (Chart 7). Even after stressing the model under several adverse scenarios, Ryan concludes that it is very likely that core PCE inflation will indeed approach the Fed's 1.9% forecast by year-end. The U.S. economy is quickly running out of slack, with unemployment at a 16-year low of 4.3%. The broader U-6 rate, which includes marginally attached workers and those in part-time employment purely for economic reasons, has dropped to its pre-recession print of 8.4% (Chart 8). Chart 7Market Too Pessimistic On Inflation Chart 8U.S. Labor Market Running Out Of Slack Wages are also rising, with the underlying trend in wage growth having accelerated from 1.2% in 2010 to 2.4% (Chart 9). The acceleration has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 10). Chart 9Wages Heating Up Chart 10Wage Improvements Broad-Based BCA's Chief Global Strategist, Peter Berezin, therefore expects the Fed to raise rates in line with its own expectations. In fact, the Fed could expedite the pace of rate hikes if aggregate demand accelerates later in the year.5 It will be difficult for the Fed to ignore macroeconomic data, even if, from a political perspective, the Trump put continues. The analogy we use with clients in meetings is that of the U.S. economy as a camp fire around which the various market participants - bond and equity investors, foreign and domestic, etc. - are huddled. According to our sister publications that conduct macroeconomic research, that campfire is well lit. And according to our political research, "Uncle Donny" had a few too many drinks and is about to pour some bourbon on the fire to show the kids a good time. Chart 11Bond Bulls Feeding On Trump Failures For the Trump put to continue, we would have to see a combination of the following: GOP voters begin to abandon President Trump; Congress remains embroiled in Obamacare debates through FY2017, only seriously picking up on tax reform and other agenda items in FY2018. Greater doubts would undermine the recent uptick in assets tied to Trump's policy agenda (Chart 11). Impeachment concerns heat up again due to new revelations that implicate President Trump directly. So far impeachment talk has not correlated with the rally in Treasuries but it could do so if new evidence comes to light. Perhaps Robert Mueller, the former FBI director and special counsel investigating Russia's role in the election, will drop another bombshell later this year. In addition, for the Trump put to continue our colleagues Ryan and Peter would have to be wrong about the economy and inflation. For investors interested in playing the Trump put, and allocating funds to EM assets in particular, we would caution against it. However, given that BCA's bond and FX views have been challenged over the past several months by the Trump put, we understand why many of our clients are itching to chase the global asset rally. The summer months will be critical. Does Brexit Still Mean Brexit? We posited last week that the extraordinary election in the U.K. was about austerity and, more importantly, about repudiating the Conservative Party's fiscal policies.6 This remains our view. The most investment-relevant message to take from the election is that U.K. fiscal policy will become easier over the life of the coalition government, while monetary policy remains stuck in D - for dovish. This should weigh on the pound over the course of the year. That said, investors will begin to wonder about the longevity of the coalition between the U.K. Conservative Party and Northern Ireland's Democratic Unionist Party (DUP). In practice the coalition will have only a five-seat majority, which would be tied for the second-smallest margin since Harold Wilson in 1964 (Chart 12). Technically it is an even smaller one-seat majority. U.K. governments with a majority of fewer than ten seats are rare and usually only last one-to-two years (Harold Wilson's four-seat 1974-79 run is an exception). This bodes ill for May's government - that is, if she survives today's brewing leadership challenge from within her party. We have no idea if the election means a softer Brexit as we have no idea - and neither does anyone else - what that means. Generally speaking, the wafer-thin majority for the Tories means the following: "No deal is better than a bad deal" is no longer going to be acceptable to the government or the public; London will end up paying a larger "exit fee" than it probably thinks it will; There will be no favorable deal for the U.K.'s financial industry. In essence, the U.K. clearly has the weaker hand in the upcoming negotiations. Cheers went up in Brussels. Does this change anything? First, we never bought the argument that the U.K. had a strong negotiating position because continental Europeans want to export BMWs to consumers in Britain. The EU is a far bigger market for the U.K. than the U.K. is for the EU (Chart 13). On this measure alone, the U.K. was always going to be the underdog in the negotiations. Chart 13The U.K. Lacks Leverage Second, the influence of Tory Euroskeptics has been reduced. That might appear counterintuitive, given that May wanted to reduce their influence by getting a bigger majority. However, it is highly unlikely that she will get the ultimate EU deal through Westminster, with a five-seat majority, without at least some votes from the opposition. Euroskeptics will therefore either remain quiet and compliant or force May to seek a deal that Labour MPs could agree to. Which brings us to the very likely scenario that the final deal will not pass Westminster without a new election. As we argued right after the referendum, the U.K. will likely have a "Brexit election" sometime in 2019.7 There is no way around it now. At very least the ruling alliance will face a contradiction in trying to soften Brexit while maintaining a strict stance on immigration. And given the weak majority, if Labour does not play ball, the Tories will have to call a new election on the basis of the deal they conclude. The good news for the Conservative Party is that the polls continue to show that a majority of U.K. voters support Brexit (Chart 14). Furthermore, the two Brexit-lite campaign promises by the Labour Party and the Liberal Democrats were the least preferred policies ahead of the election (Chart 15, see next page). However, the election also saw a complete collapse in support for Euroskeptic-leaning parties, in terms of share of the overall vote (Chart 16). Could Brexit ultimately be reversed? Certainly the odds have risen. Furthermore, there does appear to be some regret amongst U.K. voters, with a recent survey showing a decline in national identification: now more Britons identify as "also European" than ever (Chart 17). Nonetheless, a full reversal of Brexit will still require an exogenous shock, such as a recession or a geopolitical calamity that convinces the U.K. that they need Europe. Investors should remain vigilant of the polls. A clear trend reversal in Chart 14 would constitute a political opportunity for the opposition parties to campaign on a new referendum. Chart 16Euroskeptics Collapsed In The U.K. Bottom Line: Odds of a softer Brexit have certainly risen as the Tories face considerable domestic constraints in their negotiating strategy with the EU. We continue to believe that the negotiations will not be acrimonious and therefore the pound will not fall below its lows on January 16. However, it may re-test that 1.2 level due to a coming mix of easy fiscal and monetary policy over the course of the year. U.S.: Doing A Number On Dodd-Frank Better put a strong fence 'round the top of the cliff, Than an ambulance down in the valley! - Joseph Malins, "The Fence or the Ambulance," 1895 The Republican-controlled U.S. House of Representatives passed the Financial CHOICE Act of 2017 by a vote of 233-186 on June 8. This is the GOP's second major attempt, after the Affordable Care Act, to rewrite a signature law of President Obama's administration. This time it is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known simply as "Dodd-Frank," that is on the docket. The bill's prospects in the Senate are dim. President Trump promised to "do a number" on Dodd-Frank shortly after coming into office, by which he meant dismantling the law. The so-called "CHOICE Act" put forward by Jeb Hensarling (R-TX) now goes to the Senate, where it faces a high hurdle because Democrats can filibuster it, forcing the GOP to summon 60 votes. So the question is what kind of a "number" can the GOP actually do to Dodd-Frank, and does it matter? First a little bit of background.8 Dodd-Frank cleared Congress in the wake of the subprime financial crisis, July 2010. It had both a quixotic and a more pragmatic aim: the first to reduce the likelihood of future financial crises, and the second to improve the ability of regulators to stem risks as they emerge. The law has never been fully implemented and is best understood as a work in progress. The law grants the Federal Reserve and other agencies greater powers of oversight, prevention, and crisis management. In particular it ensures that the Fed would regulate not only banks but also non-bank investment companies and other financial firms (such as the giant insurance company AIG that had to be bailed out at the height of the crisis). It also frees the Fed of the responsibility to rescue failing institutions or dismantle them, handing those duties over to others, while still enabling the Fed to act as lender of last resort. The key provisions are as follows: Impose tougher capital standards: In keeping with the international Basel III banking reforms,9 Dodd-Frank tried to ensure that banks were better fortified against liquidity shortages in future. The new standards would apply both to domestic banks and foreign banks with American subsidiaries. Orderly Liquidation Authority: The Federal Deposit Insurance Corporation (FDIC), a major institution born amidst the Great Depression, would take over the responsibility of liquidating failing firms in the event of a crisis - assuming Treasury's go-ahead due to the systemic importance of the failing firm. Additional measures would hold the entire financial sector responsible for the bill if the FDIC made losses in the process. Each firm would have to maintain a "living will" to make the resolution process easier in the event of disaster. A new Financial Stability Oversight Council: Chaired by the Treasury Secretary and consisting of the various financial regulatory bodies, this council would identify systemically important financial companies, monitor them, and take actions to prevent crises. A new Consumer Financial Protection Bureau: The brainchild of Senator Elizabeth Warren (D-MA), the anti-Wall Street firebrand, the bureau would be funded by the Fed but otherwise entirely independent of it, and tasked with patrolling the banks on behalf of consumers. The Volcker Rule: The rule, named after former Fed Chair Paul Volcker, would force banks to curtail a number of short-term, high-risk trading activities on their own accounts, including derivatives, futures, and options, unless to hedge risks or serve bank customers. This was viewed as a partial reinstatement of the Glass-Steagall law, a Depression-era law that separated commercial and investment banking but was repealed by President Clinton in 1999. Republicans want to overturn Dodd-Frank to increase financial sector profits, credit growth, economic growth, and animal spirits. Lending has arguably suffered as a result of the new regulations (Chart 18). The share of bank loans to overall bank credit has remained subdued, reflecting bank behavior under QE and possibly also risk-aversion under tighter regulation (Chart 19). Chart 18Lending Growth Hampered By Dodd-Frank? Chart 19Banks Holding Reserves Instead Of Lending Republicans would also satisfy an ideological goal of reducing state involvement, which grew as a result of the law. In addition, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over a ten-year period.10 A very small amount, but again in line with GOP's political bent. The way the CHOICE Act would work is to create an "escape hatch" that would allow banks that maintain capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills, and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. This is supposed to boost lending, earnings, and growth. About 70% of the $18 trillion in U.S. banking assets belongs to banks defined by Dodd-Frank as "systemically important." The eight U.S. banks defined as "globally systemic important banks" account for about $9 trillion in assets and are unlikely to take advantage of the Republicans' escape hatch because they would then have to raise new capital and yet would still be subject to international Basel III regulations even if exempted from Dodd-Frank. The CBO estimates that banks holding about 2% of the bank assets held by systemically important banks (i.e. $252 billion) would opt out of Dodd-Frank (Chart 20). Further, the CBO estimates that, among non-systemically important banks (30% of $18 trillion total banking assets), the banks that both meet the 10% leverage ratio and would opt out of Dodd-Frank account for about 7% of U.S. banking assets ($1.26 trillion) (see Chart 20 above). Community banks (with assets under $10 billion each) and credit unions are especially likely to do so. Therefore, if the Republican bill were to become law, banks comprising something like $1.5 trillion in U.S. banking assets would become less restricted and eligible to adopt riskier trading practices free of Dodd-Frank policing. The greatest impact will be in areas with a higher concentration of small banks and credit unions than elsewhere. These U.S. banks would also, arguably, become more likely to take excessive risks and fail at some future point. Using probabilistic models for bank failures, the CBO found that the U.S.'s Deposit Insurance Fund would only suffer an additional $600 million in losses over the next ten years as a result of this increase in risk. It is a credible estimate but the reality could be far costlier if more and more banks gain the ability to bypass regulation or if banks significantly change their behavior to take advantage of the regulatory loophole. Other aspects of the bill would: Repeal the FDIC's orderly liquidation fund: The private sector would largely take over the responsibility for managing liquidations. The CBO estimates that the federal government would save an estimated $14.5 billion in liquidation costs over ten years. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: Within one year of passage, the Government Accountability Office (GAO) would audit the Fed's board of governors and the Federal Reserve regional banks, including their handling of monetary policy. The Fed's open market committee (FOMC) would also have to establish a new interest rate target, based on economic parameters, which the GAO would monitor. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. It would be re-branded as the Consumer Law Enforcement Agency and have its power to oversee institutions with more than $10 billion in assets taken away, making it, in effect, a monitor of small banks only. Cut penalties for violating regulations: However, outright criminality would be punished more severely. Various authorities and institutions would be tweaked, mostly in accordance with the general aim of reducing regulatory burdens on the financial sector. So, what options do the Republicans have going forward?11 Republicans either need 60 votes to defeat a Senate filibuster or they need procedural work-arounds like budget reconciliation. Chart 21Small Banks Benefit From Dodd-Frank Repeal Some Republicans claim that certain elements of the rewrite can be tucked into a reconciliation bill. However, reconciliation requires a single, concentrated policy focus. The GOP is currently undertaking an unprecedented two budget reconciliation bills in a single year: first, the FY2017 reconciliation procedure to repeal Obamacare, and second, the FY2018 procedure to cut taxes. Rewriting Dodd-Frank is a far cry from either health care or tax reform. Dodd-Frank measures crammed into either of these bills would likely be revoked under the so-called "Byrd Rule" which keeps the reconciliation process focused and excludes extraneous material.12 So it is unlikely that this method will work. The FY2018 budget resolution will be a critical signpost. Second, it is hard to see how a bipartisan rewrite of Dodd-Frank is possible. Dodd-Frank was the Democrats' signature response to the subprime mortgage debacle and broader financial crisis. They will not participate in dismantling it. We cannot see eight Democrats joining Republicans in the Senate for what Senator Sherrod Brown (D-OH) has called "collective amnesia." However, there is one general principle that could find its way into law: the idea of giving small, regional banks a reprieve from Dodd-Frank requirements. Even Fed Chair Janet Yellen has tentatively supported giving these banks a break.13 These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio. Politicians could at least attempt to make a popular argument for easing the burden on small community banks and credit unions, which are often vital to local communities. The same cannot be said for the Dodd-Frank rewrite as a whole, which smacks of granting impunity to Wall Street. Still, we think that even a bill focused exclusively on helping small banks would have trouble passing on its own. The legislative agenda is too busy in 2017; while 2018 will see midterm elections, when few candidates will want to appear soft on Wall Street. Instead, a provision helping small banks could pass if tacked onto the larger budget bill or bills for FY2018, if not later. It would have to be made palatable to Democrats, or else it would be perceived as a "poison pill" and risk adding to the numerous risks of government shutdown over the budget this fall. Other than these legislative options, the Trump administration can ease regulation, or relax enforcement, through executive action, as it has already promised to do. Assuming America's financial sector will get a reprieve, investors could capitalize on it by favoring small U.S. bank equities over large bank equities. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to fall back in the subsequent months, has recently perked up (Chart 21). Relative earnings have been flat over the same period. If Dodd-Frank is partially watered down, these banks should see earnings improve, which should drive up their share prices. Our colleagues at BCA's U.S. Equity Strategy are positive on global bank equities, particularly European and American ones. The latter are still relatively affordable as they undertake the long trek of recovery after a once-in-a-generation crisis (Chart 22). U.S. banks have notably better fundamentals than peers in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates (Chart 23).14 Chart 22The Long, Hard Road Of Recovery Chart 23U.S. Banks Well Positioned Globally In addition, the FiscalNote Financial Sector Index suggests that the flow of legislative and regulatory proposals has been steadily getting less onerous on the financial sector.15 Chart 24 is an aggregation of the favorability scores - which assess whether the bill is likely to be favorable or unfavorable to the sector - for all U.S. Congressional legislation that is determined to be relevant to the financial sector since 2006. It provides a snapshot of the regulatory environment for the financial sector at any given point in time. Chart 24Financial Sector Scrutiny Softening Risks to the view? Republicans could somehow squeeze a broader Dodd-Frank rewrite through the budget reconciliation process. We think the probability of this is less than 10%. Financially, this would deliver a bigger jolt to the financial sector, and financial stocks, than currently expected. But it would still benefit small banks more than large ones. Politically, a full repeal could add to Republican woes in 2018 - particularly if it is their only legislative achievement. It may well be political suicide to contest the 2018 midterm election on two pieces of legislation: one that denies millions of Americans health insurance and another that favors Wall Street. A full rewrite would also probably increase systemic financial risks. Even deregulation just for the small banks would do so. Lawmakers, focused on restraining the "too big to fail" giants, could end up clearing the way for excesses among the pygmies. That said, excessive regulation can also fuel shadow banking, a risk in itself. And the next crisis may well emanate from somewhere other than the financial sector. Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked onto the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The Trump election rally for bank stocks has mostly fallen back. Now is an opportunity to favor small banks versus large ones on expectations of Trump getting tax cuts passed and regulatory easing of some kind. Kansas: Where Seldom Is Heard A Discouraging Word A chill went through the Tea Party's collective spine on June 6 when two-thirds of the GOP-controlled Kansas legislature overrode the veto of GOP Governor Sam Brownback to repeal a 2012 budget law that slashed taxes on income, small business, and retail sales. You heard that right: Republicans in one of America's reddest states just overrode their leader in order to increase taxes. And it was the largest tax hike in state history. We will spare our readers the nitty-gritty details of the Brownback saga. Suffice it to say that the Tea Party-friendly Kansas legislature slashed state taxes and spending under Brownback's leadership in May 2012. Brownback called it a "real live experiment" of conservative economic principles and argued that the tax cuts would pay for themselves through faster growth. Art Laffer, of "Laffer Curve" fame, allegedly consulted on these measures via the conservative American Legislative Exchange Council. The medicine proved more dangerous than the illness. Since 2012, the state has burned through a budget surplus and growth has slowed (Chart 25). Both Moody's and S&P downgraded Kansas debt. Employment gains have lagged those of neighboring states. Beginning in October 2013, Brownback began to slip in public opinion polls (Chart 26). Cuts to core government services, especially education, caused a tide of criticism. In an extraordinary development, a hundred establishment Republicans supported his Democratic opponent in the 2014 gubernatorial election. He won by a margin of 3.7% but soon afterwards fell out of favor with the public. A series of confrontations with the Kansas Supreme Court hastened his decline, mostly over education funding, which is guaranteed by the state constitution. Brownback, the legislature, and various activist groups attempted to strong-arm the courts, including by ousting four members of the Supreme Court in the 2016 elections. All four retained their posts. The new budget law raises $1.2 billion in income taxes over two years by revoking swathes of the 2012 law, particularly the income tax exemption for business owners and professionals. Brownback duly vetoed the legislation and was promptly overridden by two-thirds of a legislature that is 70% Republican. This is a remarkable event for a state as ideologically conservative as Kansas. What does it mean nationally? There are two reasons that the Kansas experiment will have a limited impact on Republican thinking nationally: Kansas has a balanced budget law (Section 75-3722), while D.C. does not ... and this helped increase the pressure on the administration; Brownback is the least popular governor of any governor in the United States (Chart 27). The blame for the whole fiasco may fall on him personally, distracting from the policy failure. Nevertheless, we think Kansas has set the high-water mark for an aggressive Tea Party agenda in the U.S. that focuses on fiscal conservativism to the exclusion of everything else. Republicans will take note that even as conservative of a state as Kansas has a limit when it comes to spending cuts. It was the cuts to education - which resulted in shorter schoolyears in some districts, and various other disruptions - that fatally wounded Brownback's public standing. Thus public demand for core services is a real constraint on the extent to which taxes can be slashed. Bottom Line: We expect the Trump administration to go forward with tax cuts. But we also think that Trump will get far less in spending cuts than his budget proposals pretend. As such, we expect the GOP tax reform agenda to blow out the budget deficit, a path that Kansas could not legally (or politically) take. This will be the path of least resistance for Congressional Republicans who want to slash taxes yet fear they may not survive the spending cuts necessary to pay for them.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 4 Please see Janet L. Yellen, "Inflation Dynamics and Monetary Policy," Philip Gamble Memorial Lecture, University of Massachusetts-Amherst, September 24, 2015, available at www.federalreserve.gov. 5 Please see BCA Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, and Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Brexit - Next Steps," dated July 1, 2016, available at gps.bcaresearch.com. 8 We are particularly indebted to Ben S. Bernanke's account in The Courage To Act: A Memoir Of A Crisis And Its Aftermath (New York: Norton, 2015), pp. 435-66. 9 Please see BCA U.S. Investment Strategy Special Report, "Preparing For Basel III: Who Will Win, Who Will Lose?" dated September 12, 2011, available at usis.bcaresearch.com. 10 Congressional Budget Office, "H.R. 10, Financial CHOICE Act of 2017," CBO Cost Estimate, May 18, 2017, available at www.cbo.gov. 11 The Republicans managed to repeal one aspect of Dodd-Frank with a simple majority via the Congressional Review Act, an option that is now closed. U.S. oil, gas, and mineral companies can now be somewhat less transparent about payments made to foreign governments to gain access to resources. Proponents claim U.S. resource companies will gain competitiveness; opponents claim corruption will increase, particularly in foreign countries. 12 Please see Bill Heniff Jr., "The Budget Reconciliation Process: The Senate's 'Byrd Rule,'" Congressional Research Service, November 22, 2016, available at fas.org. 13 Please see Yellen's February testimony to the Senate Banking Committee, e.g. "Yellen Wants To Ease Regulations For Small Banks," Associated Press, February 14, 2017, available at www.usnews.com. 14 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout," dated May 1, 2017, available at uses.bcaresearch.com, and Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, and "Wind Of Change," dated November 11, 2016, available at gss.bcaresearch.com. 15 The FiscalNote Policy Index measures regulatory risk daily for sectors, industries, and individual companies from every legislative and regulatory proposal. Using proprietary machine-learning-enabled natural language processing algorithms, FiscalNote ingests and processes thousands of legislative and regulatory policy events, scoring each for relevance, favorability, and importance to affected sectors. 16 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com.

Highlights Global Growth: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. Global Inflation: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Feature Have bond investors now become too pessimistic on global growth and inflation prospects? This is a question worth asking after the sharp decline in longer-dated government bond yields witnessed since the peak in mid-March. The benchmark 10-year yield has fallen during that period by -43bps in the U.S., -21bps in Germany, -24bps in the U.K., -45bps in Canada and -54bps in Australia. Granted, there has been a bit of softer news on both growth and, more importantly, inflation readings in several economies in the past couple of months. Those pullbacks, however, have been relatively modest compared to the severe bull-flattening bond rally seen in most developed economies (Chart of the Week). Chart of the WeekAn Overreaction From Bond Investors Global leading economic indicators are still pointing to faster growth over the latter half of the year, led by easing financial conditions given booming equity and credit markets. With most major economies either at full employment (U.S., U.K., Japan, Australia) or approaching full employment (Euro Area, Canada), accelerating growth will ensure that the recent downtick in global inflation will not persist for long - especially if oil prices begin to move higher again as our commodity strategists expect. This week brings several major central bank meetings with an opportunity to change the bullish tone in the bond markets. The Federal Reserve, the Bank of England (BoE) and the Bank of Japan (BoJ) all meet, although only the Fed is expected to deliver another rate hike that is now heavily discounted in the markets. The BoE's hands are now effectively tied, even with high U.K. inflation, after last week's election outcome where the ruling Conservatives lost their majority government, thus ensuring even more uncertainty over the contours of the Brexit process. The BoJ is also stuck in a bind, with surprisingly strong Japanese economic growth but shockingly weak inflation. This is also the situation that the European Central Bank (ECB), Bank of Canada and Reserve Bank of Australia are facing, to a lesser extent: solid domestic growth but without enough inflation to force any immediate tightening of monetary policy. These sorts of mixed messages and conflicting signals also exist in the bond markets in the developed world, as we discuss in this Weekly Report. Our conclusion is that yields have now priced in too much pessimism and the balance of risks points to yields rising again in the months ahead, led by U.S. Treasuries. A Big Move In Yields For Such A Small Change In Growth... Looking at the change in government bond yields within the major developed markets since the peak on March 13th (Table 1) shows a few important facts: Table 1A Bull Flattening Of Global Yield Curves Since March The largest yield declines were in the U.S., Canada & Australia; The smallest declines were in the U.K., the Euro Area and Japan - unsurprisingly, the countries where central banks are engaged in large bond purchase programs; Lower market-based inflation expectations have played a role in the bond rally, coinciding with softer energy prices and declines in realized inflation outcomes; Real yields (i.e. nominal yields minus inflation expectations) have fallen sharply in the U.S., Canada & Australia; Yield curves have bull-flattened everywhere; Breaking the curve moves into real yield and inflation expectations components shows that both contributed to the flatter yield curves. The U.S. Treasury action stands out compared to the others. There has also been a 103bp flattening in the 2-year/10-year TIPS real yield curve, while the TIPS breakeven curve has steepened by 64bps. This is the result of the -89bp drop in 2yr breakevens, which now sit at 1.38% - well below the current U.S. headline CPI inflation rate of 2.2%. Even allowing for any potential liquidity issues that can distort the precise interpretation of shorter-dated TIPS breakevens, the market appears to be expecting a bigger drop in inflation in the next couple of years than both the Fed and the Bloomberg consensus of economic forecasters (Table 2).1 This U.S. move stands out relative to the other countries, where there has been very little change in 2-year inflation expectations (using CPI swaps instead of breakeven rates from inflation-linked bonds). With the headline U.S. unemployment rate now at a cyclical low of 4.3%, and with the broader U-6 measure, now down to a decade low of 8.4%, we anticipate a recovery in realized inflation, and TIPS breakevens, in the next few months. The source for the broader downturn in global inflation expectations is a bit of a mystery. While some cyclical global growth indicators like manufacturing PMIs have fallen a bit in some countries, most notably the U.S. and China, they are still at strong levels above 50 that point to faster economic growth (Chart 2). Leading economic indicators (LEIs) are also still pointing to some acceleration in the latter half of 2017 although, admittedly, the list of countries with rising LEIs has been diminishing in recent months. We see that as a potential sign of slower growth next year, but not for the rest of 2017. Table 2Consensus Growth & Inflation Forecasts Chart 2Global Economic Upturn Still Intact Bottom Line: Global bond yields have fallen in a coordinated fashion among the major economies, even with only a modest cooling of growth momentum and realized inflation outcomes. With little sign of an imminent downturn in growth on the horizon, government bonds now look a bit expensive. ...And Inflation Of course, some of the decline in inflation expectations can be attributed to softer readings on realized inflation over the past few months. Yet the markets seem to have overreacted a bit to that move, as well. The run of stronger-than-expected inflation outcomes has taken a breather in both the developed and emerging world, as evidenced by the rolling over of the Citigroup inflation surprise indices (Chart 3). Yet those indices remain at high levels and are not pointing to a meaningful, extended pullback in realized inflation. Chart 3Global Inflation Data Has Cooled A Bit The pullback in global energy prices since March has played a role in softer headline inflation in most countries. That decline has been part of a broader move lower in commodity prices that is likely related to less reflationary monetary and fiscal policies out of the world's biggest commodity consumer, China. However, our colleagues at BCA Commodity & Energy Strategy have noted that export and import volumes in the emerging economies accelerated sharply in the first quarter of 2017. Given that there is a strong correlation between trade volumes and oil demand in the emerging markets, this bodes well for a rebound in global oil demand. Combined with the "OPEC 2.0" production cuts, the demand-supply balance in world oil markets is likely to turn positive in the months ahead, which will allow oil prices to return to a range close to $60/bbl by year-end.2 A move in oil prices back to that level would help arrest the downturn in overall commodity price indices, and help stabilize goods CPI inflation in the developed economies in the latter half of 2017 (Chart 4). This should help boost global inflation expectations, and eventually bond yields, as the downturn in energy prices has shown very little pass-through into non-energy inflation in the developed world (Chart 5). Chart 4Disinflationary Impulse##BR##From Energy Will Soon Fade... Chart 5...Although The Impact On##BR##Inflation Has Been Modest Yet that stability of non-energy inflation visible in the charts masks many of the cross-currents seen across countries and within countries. Services CPI inflation remains strong in the U.S. at 3%, and has accelerated to 2% in both the U.K. and the Euro Area (Chart 6). Yet at the same time, both services and core inflation are falling rapidly towards 0% in Japan, despite a solid economic upturn and tight labor market. The situation is even more confusing in Canada, where wage inflation has fallen to below 1% but services inflation has picked up to 3%. Australia is in a similar boat, with services inflation above 3% but wages growing at only 2%. The divergence between the inflation outcomes across the countries can also be seen in our headline CPI diffusion indices, which measure the number of CPI sectors that are witnessing accelerating rates of inflation. The diffusion indices in the U.S., Japan and Canada are all at low levels, with the majority of CPI components seeing slowing rates of inflation, yet overall inflation seems to be holding up well despite the breadth of the "downturn", at least based on past correlations (Chart 7). The opposite is true in the Euro Area and Australia, where a majority of inflation components are growing faster, yet overall inflation is only moving slowly higher. Only in the U.K. is there a clear robust rise in the breadth of inflation (90% of CPI components accelerating) and overall inflation (headline CPI expanding at around 3%). Chart 6Underlying Inflation Has Not##BR##Slowed Much (Except In Japan) Chart 7Mixed Signals From The##BR##Global CPI Diffusion Indices Given all these diverging signals within the national inflation data, we are surprised that there has been such a uniform decline in inflation expectations across the major bond markets. That leads us to look to the oil price decline as the main cause of the lower expectations, rather than a more pernicious drop caused by expectations of slowing economic growth and cooling domestic inflation pressures. Given the BCA view that oil prices have likely reached bottom and will begin to move higher, the decline in global inflation expectations is likely to also end soon. Bottom Line: Inflation expectations in the major economies have fallen too far relative to underlying non-energy inflation pressures. With oil prices likely to begin rising again as the demand-supply balance in global energy markets tightens up, both realized inflation and expectations should move higher in the latter half of the year, especially in the U.S. Bond Market Strategy For The Second Half Of 2017 The outlook for government bond yields in the remaining months of the year will be driven by decent global growth and rising inflation expectations. Our Central Bank Monitors continue to point to the need for tighter monetary policy in every major developed market excluding Japan (Chart 8), leaving bond yield exposed to any unexpected moves from central bankers. This is especially problematic in the U.S., where fed funds futures now discount only a 25-30% probability of a Fed rate hike in September and December after the expected hike at this week's FOMC meeting (Chart 9). With the U.S. OIS curve pricing in only 48bps of hikes over the next 12 months, the Treasury market is exposed to a Fed moving more aggressively in meetings later in 2017. Chart 8Our Central Bank Monitors Still##BR##Calling For Tighter Policy (Ex Japan) Chart 9Markets Will Be Surprised##BR##By The Fed Later This Year In Europe, the ECB talked up a more positive economic growth story at last week's policy meeting, eliminating the language suggesting that rate cuts would be necessary because the growth recovery was still fragile. No signal was given about slowing the pace of ECB asset purchases, which was not a surprise given the still-low readings on core inflation in the Euro Area. The ECB did slightly downgrade its inflation projections for the next two years, with core inflation now expected to rise to 1.8% by 2019. Our Months-to-Hike measure for the Euro Area now out to 29 months, indicating that the first ECB rate hike is now expected in November of 2019 (Chart 10). Our view remains that the ECB will look to taper asset purchases before contemplating any rate hikes, and will likely signal a move to slow the pace of bond buying at the September policy meeting. While we agree that a rate hike is unlikely until 2019, the current market pricing does leave European bond markets exposed to any upside surprises in inflation over the next year. For now, we continue to recommend a neutral allocation to core European government bonds, with a curve steepening bias, while focusing Peripheral exposure on Spain relative to Italy. We envision moving to underweight Europe over the summer if the growth and inflation data continue to point to an eventual ECB taper, especially given the strong comparisons between Europe now and the pre-Taper Tantrum period in the U.S. in 2012-13 (Chart 11). Chart 10No ECB Hikes##BR##Expected Until 2019 Chart 11Bunds Still Following The U.S.##BR##Post-QE Experience In Japan, we expect the BoJ to continue to target a 0% 10yr JGB yield for some time, in order to ensure that there is enough currency weakness to keep headline inflation from decelerating (Chart 12). This will especially be true if our call for higher U.S. interest rates comes to fruition and USD/JPY begins moving higher again. We continue to recommend an overweight position on Japan with government bond portfolios, given the low yield beta of JGBs to the other bond markets (Chart 13). Chart 12The BoJ Will Do "Whatever It Takes"##BR##To Keep The Yen Soft Chart 13Stay Overweight##BR##Low-Beta JGBs Finally, we continue to recommend long CPI swaps positions in both the Euro Zone and Japan, and an overweight in U.S. TIPS versus nominal Treasuries, as a way to play for the rebound in global inflation expectations that we are expecting over the balance of 2017. However, given the disturbing downturn in core inflation readings in Japan, we are implementing a tight stop-loss level at 0.4% on our long 10yr Japan CPI swaps position (Chart 14). Chart 14Stay Long CPI Swaps##BR##In Europe & Japan (With A Stop) Bottom Line: Markets are pricing in too few rate hikes in the U.S., leaving U.S. Treasuries exposed to higher yields in the next 3-6 months. Yields should also rise in core Europe, although not by as much as in the U.S. with the ECB not yet ready to turn less dovish. Stay underweight U.S., neutral core Europe and overweight Japan in global government bond portfolios. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 The FOMC projections for growth in the headline Personal Consumption Expenditure (PCE) deflator from the latest set of forecasts released in March called for inflation of 1.9% in 2017 and 2.0% in 2018. The gap between the headline measures of CPI inflation and PCE deflator inflation has averaged about 50bps in recent years, so that implies that the Fed is expecting CPI inflation to be much higher than the 1.38% 2-year TIPS breakeven. 2 Please see BCA Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8 2017, available at ces.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The main driving force behind EM risk assets this year has been downshifting U.S. interest rates and a weak U.S. dollar. These factors have more than offset the relapse in commodity prices and the deteriorating growth outlook for China/EM. Going forward, odds favor a rise in U.S. interest rates and a stronger dollar. If this scenario materializes, the EM rally will reverse. Meanwhile, China's liquidity conditions have tightened, warranting a meaningful slowdown in money/credit and economic growth. Altogether, the outlook for EM risk assets is extremely poor, and we reiterate our defensive strategy. In Argentina, we continue favoring local currency bonds and sovereign credit, especially relative to their EM counterparts. Feature What Has Not Worked In This Rally Financial market actions of late have been rife with contradictions, and momentum trades have been prevalent. In the past few months we have been highlighting that EM risk assets - stocks, currencies and bonds - have decoupled from most of their historically reliable indicators such as commodities prices, China's money and credit impulses and China/EM manufacturing PMI.1 This week we highlight several additional indicators and variables that EM risk assets have diverged from. Chinese H shares - the index that does not contain internet/social media stocks - have decoupled from the Chinese yield curve (Chart I-1). The mainstream press have been focused on inversion in the 10/5-year Chinese yield curve, but we do not find it to be a particularly credible or useful indicator for the economy. Our preference is the 5-year to 3-month yield curve to gauge the cyclical growth outlook. Chart I-1China's Yield Curve Heralds Lower Share Prices Not only has the yield curve been flattening, but it has also recently inverted, suggesting an impending downturn in China's business cycle (Chart I-2). Chart I-2China's Yield Curve Inversion Points To A Growth Slump In China, commercial banks' excess reserves at the People's Bank of China (PBoC) have begun shrinking since early this year, reflecting the PBoC's liquidity tightening (Chart I-3, top panel). Banks' excess reserves are the ultimate liquidity constraint on banks' ability to originate new credit/money and expand their balance sheets. Meanwhile, Chinese commercial banks are stretched and overextended, as illustrated by the record-high ratios of both M2 and commercial banks' assets-to-excess reserves (Chart I-3, bottom panel). These are true measures of the money multiplier, and they have surged to very high levels. Besides, financial/bank regulators are clamping down on speculative activities among banks and other financial intermediaries, and are also forcing banks to bring off-balance-sheet assets onto their balance sheets. Faced with dwindling liquidity (excess reserves), rising interest rates and a regulatory clampdown, banks will slow down credit / money origination. Slower credit growth will cause a considerable slump in capital spending, and overall economic growth will downshift. On a similar note, interest rates lead money/credit growth in China, as evidenced in Chart I-4. Chart I-3China: Dwindling Excess Reserves ##br##Will Cause A Credit Slowdown Chart I-4China: Interest Rates ##br##And Money Growth The considerable - about 200 basis points - rise in Chinese money market and corporate bond yields since November heralds a deceleration in money/credit growth. Historically, interest rates affect money/credit growth and ultimately economic activity with a time lag. There is no reason why this relationship will not hold in China this time around. Given that Chinese companies are overleveraged, credit growth is likely to be more sensitive to rising than falling interest rates. Hence, the lingering credit excesses in China make rising interest rates more dangerous. Industrial commodities prices have reacted to liquidity tightening in China sensibly by falling since early this year (Chart I-5A and Chart I-5B). Chart I-5AWidespread Decline In Commodities Prices (II) Chart I-5BWidespread Decline In Commodities Prices (I) The weakness in commodities prices since early this year is especially noteworthy because it has occurred at a time of U.S. dollar weakness and dissipating Federal Reserve tightening concerns. When and as the U.S. dollar gains ground again, the selloff in commodities will escalate. Outside commodities, there are early signposts that another Chinese slowdown is beginning to unfold - slowing exports in May from Korea and Taiwan to China, being one glaring example (Chart I-6). This chart corroborates our argument that the surge in Chinese imports in late 2016 and the first quarter 2017 was a one-off growth boost, and appeared very strong because of the low base from a year ago. Consistently, Taiwan's manufacturing shipments-to-inventory ratio has rolled over, which correlates well with the tech-heavy Taiwanese stock index (Chart I-6, bottom panel). With respect to the broader EM universe, EM equities and currencies have decoupled from U.S. inflation expectations (Chart I-7). Chart I-6Shipments To China Have Rolled Over Chart I-7EM And U.S. Inflation Expectations: ##br##Unsustainable Decoupling? Historically, falling U.S. inflation expectations have reflected dropping oil prices and caused real rates (TIPS yields) to rise. In turn, lower oil prices and/or rising TIPS yields weighed on EM risk assets. The decline in U.S. Treasurys yields since last December has been largely due to inflation expectations rather than real rates. Such a mixture has historically been ominous for EM risk assets. Notwithstanding, EM risk assets have rallied a lot, despite such a hostile backdrop year-to-date. Finally, the Brazilian and South African exchange rates and their bonds have been among the more stellar performers in the past 12 months. Nevertheless, first quarter GDP releases in Brazil and South Africa have confirmed that there has been little domestic demand recovery in either country. Remarkably, in both countries, agriculture and mining volumes boomed in the first quarter, boosting GDP growth, yet final domestic demand remained shockingly depressed, as illustrated in Chart I-8. This discards the popular EM rally narrative that improving global growth will lift EM economies. Neither a poor domestic growth backdrop and political volatility nor falling commodities prices have prompted a meaningful plunge in either the Brazilian or South African exchange rate. Chart I-9 portends that the BRL and ZAR have historically been correlated with commodities prices but have recently shown tentative signs of decoupling. Chart I-8Not Much Recovery In Brazil ##br##And South Africa's Domestic Demand Chart I-9BRL And ZAR And Commodities Bottom Line: EM financial markets have veered away from many traditional indicators. These constitute important contradictions and raise the question of whether this time is different. We do not think so. What Has Driven This EM Rally: U.S. Rates And The U.S. Dollar The variables that have explained the EM rally in the past six months have been falling U.S. interest rate expectations and a weaker U.S. dollar, as well as the global technology mania. We elaborated on the tech rally in recent weeks,2 and this week re-visit EM's link with U.S. interest rates and the greenback. The main driving force behind EM risk assets, year -to-date, has been U.S. TIPS yields and the greenback (Chart I-10). In short, it has been the carry trade that has transpired since the Fed's meeting on December 15, 2016 - regardless of EM growth dynamics and fundamentals. Going forward, barring a major growth relapse in China/EM growth and an associated U.S. dollar rally, the odds favor a rise in U.S. interest rates in general and U.S. TIPS yields in particular: The U.S. composite capacity utilization gauge (Chart I-11, top panel) - constructed by our Foreign Exchange Strategy team based on the unemployment gap and industrial capacity utilization - is moving above the zero line, denoting that there is little slack in the U.S. economy. Chart I-10U.S. TIPS Yields, Dollar And EM Chart I-11The U.S. Economy: Is It The Time To Bet On Higher Bond Yields? Any time the indicator has moved above the zero line in the past 55 years - the shaded periods on Chart I-11 - inflationary pressures, wages and bond yields have typically risen, and vice versa. The message from this indicator is unambiguous: U.S. inflationary pressures will become evident soon, and interest rates will rise. In this context, U.S. interest rate expectations are too low. Re-pricing of U.S. interest rates will shake off lingering complacency across many financial markets worldwide. Notably, the U.S. mortgage purchase index is surging, job openings are very elevated (Chart I-12), financial and property markets are buoyant and the dollar has been weak. If the Fed does not normalize interest rates now, when will it? Finally, both nominal and inflated-adjusted U.S. bond yields are at their technical support, and will likely bounce from these levels (Chart I-13). Chart I-12Are U.S. Rate Expectations Too Low? Chart I-13U.S. Bond Yields Are At A Critical Juncture Chart I-14U.S. Growth Underperformance Is Late Rising U.S. interest rates will trigger another up leg in the U.S. dollar. Notably, the relative economic surprise index between the U.S. and the G10 is close to its post-crisis lows (Chart I-14). The relative U.S. growth underperformance versus DM is late and will turn around very soon. While it does not always define the fluctuations in the U.S. dollar, we would still expect it to lend some support to the greenback. BCA's Emerging Markets Strategy service believes the broad trade-weighted U.S. dollar is still in a bull market, especially versus EM, DM commodities currencies and Asian currencies. We have less conviction on the magnitude of the downside in the euro, but the latter at minimum will not rally above 1.14 -1.15 for now. Finally, various EM currencies are facing an important technical resistance (Chart I-15A and Chart I-15B). We expect these technical levels to mark their top. Chart I-15AEM Currencies Are Facing Technical Resistance (II) Chart I-15BEM Currencies Are Facing Technical Resistance (I) At the same time, the precious metals index seems to be rolling over at its 200-day resistance level (Chart I-16). A top in the precious metals index would be consistent with a bottom in U.S. TIPS yields and the U.S. dollar. Chart I-16Precious Metals Are Facing ##br##A Major Resistance Bottom Line: U.S. interest rate expectations are too low and are set to rise. Rising interest rates will remove a major support underpinning the EM rally. A Resolution There are three potential scenarios as far as the ongoing EM rally is concerned: The goldilocks scenario of low interest rates in the U.S., a weaker dollar and steady-to-improving growth in EM/China. The markets have already priced in a lot of good news, but the rally could feasibly continue for some time if this scenario transpires. Re-pricing of the Fed. U.S. interest rates will rise and the dollar will get bid up. The rationale is the modest U.S. inflationary pressures will become evident amid solid U.S. growth. This will weigh on EM risk assets, even if EM/China growth does not falter. The basis for this is the EM rally year-to-date has been driven by diminishing U.S. interest rates expectations. Deflation trade redux. China/EM growth will deteriorate meaningfully (for reasons discussed above), causing a considerable downshift in commodities prices and EM risk assets. This could well occur even if U.S. rates stay low. In fact, this is the main plausible reason to bet against a rise in U.S. interest rate expectations from current levels. Investing is about assigning probabilities. We assign much lower probability to the first scenario (no more than 20%), while we see the odds of either the second or third scenarios playing out in the short term at closer to 40%. In the medium term (nine-to 12 months), scenario 3 will be the most prevalent one. If conditions in scenario 2 (rising U.S. bond yields) coincide with a deflationary shock emanating from China, EM financial markets will face a perfect storm. Bottom Line: We continue to recommend a defensive investment strategy for absolute-return investors, and recommend an underweight allocation towards EM within global portfolios across stocks, credit and currencies. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, 2017, link available on page 19. 2 Please refer to the Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?", dated May 17, 2017, and Emerging Markets Strategy Weekly Report titled, "EM: Is This Time Different?", dated June 7, links available on page 19. Argentina: Favor Local Bonds And Sovereign Spreads EM fixed-income portfolio should continue to overweight Argentine local currency bonds and sovereign credit based on the following reasons: Policymakers continue pursuing credible orthodox policies. The central bank has been accumulating foreign exchange as a part of its explicit program to increase international reserves from 10% to 15% of GDP and keep the peso competitive. At the same time, the monetary authorities have partially siphoned off liquidity via reverse repos (Chart II-1). On a net-net basis, monetary stance is rather tight as evidenced by money and credit contraction in real (inflation-adjusted) terms (Chart II-2). Chart II-1Argentina: Rising Reserves ##br##And Reverse Sterilization Chart II-2Argentina: Inflation-Adjusted Money ##br##And Credit Are Contracting Rapid disinflation is proving difficult to achieve due to inflation inertia and high inflation expectations. However, the authorities are holding their position steady in wage negotiations. Wages in both the public and private sectors are contracting in real terms (Chart II-3). Provided wages are a major driver of inflation, employee compensation growing at a slower pace than inflation signals lower inflation ahead. The economy is not yet recovering as evidenced by Chart II-4 and lingering economic stagnation will foster disinflation. Chart II-3Argentina: Lower Wage Growth ##br##Is Critical To Anchor Inflation Chart II-4Argentina: The Economy ##br##Is Still In Doldrums A change in our fundamental view on inflation would require an irresponsible central bank tolerating run away money and credit growth. We find this scenario unlikely and hold the view that the inflation outlook will improve (Chart II-5). Chart II-5Argentina: Inflation Is On The Right Track In regard to the currency, the Argentine central bank will allow the peso to depreciate as maintaining a competitive exchange rate is a major policy priority for them. This is especially true if commodities prices fall and the regional currencies (BRL and CLP) depreciate versus the greenback. The current account and fiscal deficits are large but Argentina is seeing significant FDI and foreign portfolio capital inflows. Hence, funding will not be a problem for some time. The eventual economic recovery and the cheap currency, as well as slow but progressing reforms, will make Argentina a more attractive destination for foreign investors and ensure foreign capital inflows. Overall, there are many challenges, but the outlook for Argentina is much better compared with EM economies in general, and Brazil in particular. Hence, we recommend staying long Argentinian assets on a relative basis versus EM counterparts, particularly Brazil. Specifically, we maintain the following positions: Long ARS versus BRL. We do not expect the currency to depreciate more than what the NDF market is pricing in the next 12 months, and believe it will outperform the BRL on a total return basis (including carry). Stay long Argentine 7-year local currency government bonds. Stay long Argentine / short Brazilian and Venezuelan sovereign credit. Overweight Argentine stocks within the emerging and frontier market universes. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Duration & TIPS: The recent downtrend in nominal Treasury yields has been driven entirely by inflation that has come in weaker than expected. We are inclined to view inflation's weakness as transitory and suggest investors maintain a below-benchmark portfolio duration stance, as well as an overweight allocation to TIPS versus nominal Treasury securities. Corporate Debt & The Economy: High corporate debt levels are not indicative of over-investment on the part of the corporate sector. As such, they do not suggest an elevated risk of recession. Corporate Debt & Credit Spreads: While a supportive Fed will keep corporate spreads low for the time being, rising leverage is starting to send a worrying message. Feature It's All About Inflation Chart 1End Of The Trump Trade? Treasury securities have reversed a lot of their post-election sell off during the past few weeks, and the 10-year yield is now only 38 basis points above where it was last November (Chart 1). A quick glance at the 10-year's real and inflation components reveals that weaker inflation is the culprit. The real 10-year Treasury yield remains 31 bps above its pre-election level, but the 10-year TIPS breakeven inflation rate is now only 7 bps higher (Chart 1, bottom panel). This explains a lot about the broader financial environment. Stable growth and low inflation create a fertile breeding ground for risk assets, and corporate bond spreads are indeed considerably tighter than prior to the election. The average spread on the investment grade corporate bond index is currently 113 bps, down from 135 bps in November. The average junk spread is currently 365 bps, down from 489 bps. What explains the large drop in inflation breakevens? One reason is that they had simply overshot the fair value implied by other financial instruments (Chart 2). Our financial model- based on the oil price, the exchange rate and the stock-to-bond total return ratio - shows that the 10-year breakeven rate was around 20 bps too high earlier this year. It is now almost exactly in line with our model's fair value. The most likely explanation for the overshoot is that markets started to discount a much more stimulative fiscal policy in the immediate aftermath of the election. The potential for large tax cuts at a time of already tight labor markets caused investors' inflation expectations to ramp up. While tax cuts are still likely, it now appears as though they will occur much later and be smaller in scale than was originally thought. Falling oil prices have also exacerbated the drop in breakevens by causing the fair value reading from our model to roll over (Chart 2, bottom panel). Our commodity strategists do not think oil prices will stay this low for much longer.1 OPEC 2.0 production cuts and sustained growth in emerging market trade volumes will cause oil inventories to fall this year, leading to a rebound in prices. The second explanation for this year's drop in the inflation component of yields is that the core inflation data have disappointed during the past couple of months. After reaching 1.8% in February of this year, 12-month trailing core PCE inflation has deviated sharply from the uptrend that had been in place since mid-2015. As of April, it had fallen back to 1.5%, well below the level implied by our Phillips Curve inflation model (Chart 3). Chart 2TIPS Financial Model Chart 3A Phillips Curve Inflation Model With the labor market continuing to tighten and the dollar having depreciated in recent months, we are inclined to view the recent drop in core inflation as transitory. In fact, even after making some adjustments to the estimation interval (see Box), our Phillips Curve inflation model still projects that core PCE inflation will reach 2% by the end of this year in a base case scenario where the unemployment rate, the exchange rate and survey inflation expectations are all unchanged. Box: Incorporating Different Regimes Into Our Inflation Model As has been explored in depth in prior reports,2 we have been modeling core PCE inflation using a Phillips Curve model that is inspired by one that Janet Yellen mentioned in a 2015 speech.3 Essentially, we model core inflation using lagged inflation, the gap between the unemployment rate and the Congressional Budget Office's estimate of the natural unemployment rate, relative non-oil import prices and a survey measure of inflation expectations. Previously we estimated the coefficients for this model using the longest time interval we could obtain - starting in October 1979. However, a recent Fed paper by Jeremy Nalewaik4 motivated us to refine this approach. Nalewaik shows that core PCE inflation has been driven by different factors in different regimes, and that those regimes can be defined by whether inflation expectations were well-anchored or highly volatile. Specifically, in the 1970s, 1980s and early 1990s, inflation expectations were highly volatile and explained much more of the variation in actual core inflation than they did in the 1960s or from the mid-1990s until the present day. We confirmed this result by splitting our sample into two periods - 1979 to 1995, and 1995 to present. Our results show that inflation expectations were a much more significant driver of core inflation in the 1979-1995 regime than they are in the current regime (Table 1). As such, we have decided that the coefficients calculated using the 1995-present interval are probably more representative of the current environment. Applying these coefficients to the four scenarios we examined in our May 2 report, our model now projects that core PCE inflation will reach 2.03% by year end in our "base case" scenario, 1.93% in our "strong dollar" scenario, 1.97% in our "bad NAIRU" scenario and 1.87% in our "deflation case" scenario. Table 1BCA Phillips Curve Model* Of Core** PCE Inflation Under Different Regression Intervals Where Are Yields Headed From Here? We see two potential scenarios that could play out between now and the end of the year. The first is that core inflation rebounds during the next few months and ends the year closer to our model's fair value estimate. The inflation component of yields would move higher in this scenario and real yields would probably also increase. The 10-year real yield closely tracks our 12-month fed funds discounter, which measures the number of rate hikes the market expects during the next year (Chart 4). The discounter currently sits at 49 bps, meaning that the market expects fewer than 2 rate hikes during the next 12 months. This would certainly be revised higher if inflation were to rebound. Chart 4Fed Wants Wider Breakevens The second possible scenario is that while U.S. growth stays close to its current 2% pace, inflation simply does not bounce back. In other words, core PCE ends the year closer to 1.5% than to 2% and a large residual opens up between inflation and our Phillips Curve model. While TIPS breakevens would be unlikely to rise in this scenario, the downside is also probably limited unless inflation were to fall below its current 1.5%. If this second scenario plays out the Fed would also probably react by adopting a more dovish policy stance. This would cause the market's rate hike expectations, and 10-year real yields, to fall. But even here the downside would appear to be limited. With the market currently priced for a mere 39 bps of hikes between now and the end of 2017 and only another 24 bps for all of 2018, there simply isn't much scope for a large dovish re-rating of the Fed. Additionally, if the Fed were to adopt a sufficiently dovish reaction function in the face of persistently low inflation, it is possible that lower rate hike expectations could spur a recovery in long-maturity TIPS breakeven inflation rates. If the market believes that the Fed will stay dovish enough for inflation to recover to target, then the positive correlation between real yields and inflation breakevens could reverse. There are recent precedents for this (Chart 4, bottom panel). In 2011 and 2012, the Fed's Operation Twist caused rate hike expectations and real yields to fall, but also led to wider TIPS breakevens. The reverse scenario played out in 2015 when the market decided that the Fed was adopting an overly hawkish policy stance. This caused TIPS breakevens to fall as real yields rose. The conclusion here is that even if inflation stays stubbornly low for the remainder of the year, and the Fed responds by guiding the market toward a shallower rate hike path, then it is possible that some of the downside in real yields will be mitigated by rising TIPS breakevens. In our view, the risk/reward trade-off between the two scenarios outlined above suggests that investors should maintain a below-benchmark duration stance. Bottom Line: The recent downtrend in nominal Treasury yields has been driven entirely by inflation that has come in weaker than expected. We are inclined to view inflation's weakness as transitory and suggest investors maintain a below-benchmark portfolio duration stance, as well as an overweight allocation to TIPS versus nominal Treasury securities. Even in a scenario where inflation stays low despite continued above-trend economic growth, we view the downside in yields from current levels as limited. It's Late In The Game For Corporate Credit With last week's release of the U.S. Financial Accounts (formerly Flow of Funds) we are able to update some of our preferred credit cycle indicators. One concerning development is that net corporate leverage - defined as total debt less cash as a percent of EBITD - ticked higher for the second consecutive quarter in Q1 (Chart 5). Chart 5Corporate Balance Sheets Continue To Add Leverage As we have observed in previous reports,5 there is a strong correlation between net leverage and spreads. In fact, we are only able to identify one other period in which spreads were able to tighten as leverage rose. That period was in the late 1980s, immediately following the crash and subsequent rebound in oil prices. As is shown in Chart 5, net leverage correlates strongly with both corporate spreads and the default rate. However, in the late 1980s the collapse of the energy sector caused spreads to widen too far. Spreads then benefited from a "payback period" as energy prices recovered and defaults ebbed during the following two years. But in the background, net leverage only managed to level-off for a brief period before continuing to trend higher. The uptrend in leverage culminated in the 1990 default cycle and recession. We see a similar dynamic playing out at the moment. Spreads (and the default rate) are currently benefiting from the payback period following the 2014 collapse and subsequent recovery in commodity prices. But so far leverage has not managed to cease its upward march. What Is Leverage Telling Us Right Now? As was mentioned above, net leverage has now increased for two consecutive quarters. To see what this has meant historically, we looked at excess investment grade corporate bond returns over 6-month periods following different changes in net leverage. For example, we found that after leverage has increased for two consecutive quarters, the average (annualized) 6-month excess return to investment grade corporate bonds has been -190 bps, and also that corporate bonds outperformed Treasuries in 45% of those 6-month periods (Table 2). Table 26-Month Investment Grade Corporate Excess Returns* ##br##Following A Rise In Net Corporate Leverage** (1973 To Present) Conversely, in 6-month periods after leverage has declined for two consecutive quarters, average (annualized) excess returns came in at +120 bps, and corporate bonds outperformed Treasuries in 61% of those episodes (Table 3). Table 36-Month Investment Grade Corporate Excess Returns* ##br##Following A Decline In Net Corporate Leverage** (1973 To Present) Not surprisingly, the late 1980s episode was one that defied the above statistics. In fact, investment grade corporate bonds outperformed Treasuries by an annualized 5% in the 6-month span between September 1986 and March 1987, even though leverage had previously increased for 4 consecutive quarters. For this reason we remain comfortable with our overweight in corporate bonds for now, especially since the Fed is likely to remain sufficiently accommodative to support higher inflation and hence continued economic growth. However, it is obvious that trends in leverage will be critical to monitor going forward. Where Is Leverage Heading? A rebound in corporate profits would help stem the uptrend in leverage, and the outlook for that is good. Not only did our measure of EBITD diverge negatively from S&P 500 operating profits in the first quarter, but other leading profit indicators such as the growth in business sales less inventories suggest that EBITD should catch up to S&P 500 profits, and not the reverse (Chart 6). What remains unclear is whether the looming rebound in profit growth will be enough to cause leverage to fall. While debt growth has been rolling over (Chart 5, bottom panel), we think it will remain at a reasonably high level going forward. Meanwhile, the historical evidence suggests that net leverage does not usually reverse its uptrend unless first prompted by a recession. Turning to debt, the ratio of corporate debt to GDP is definitely eyebrow raising (Chart 7), as it is now very close to levels observed at the peak of the past two cycles. However, one important caveat is in order. While corporate debt levels have grown quickly, corporate investment has not. Chart 6Profit Growth Will Improve Chart 7Investment Is Coming Back The corporate financing gap - capital expenditures less internally generated revenue - is a good proxy for the amount of debt issued to fund investment. In the second panel of Chart 7 we see that it has only just moved into positive territory and is well below the levels observed at the end of the last two recoveries. The obvious conclusion is that most corporate debt issuance has not been used to finance investment, but rather has been used to buy back equities. This is bad news from the perspective of corporate bondholders who would certainly prefer more people below them in the capital structure, but it also means that high corporate debt levels are not indicative of over-investment on the part of the corporate sector. As such, high corporate debt levels do not suggest that the risk of recession is elevated. They merely suggest that corporations' capital structures have shifted in favor of shareholders over bondholders. Going forward, we see potential for a moderation in the amount of corporate debt issuance used to fund buybacks. This has already started to occur as evidenced by our buyback proxy (Chart 7, panel 3) - simply the difference between net issuance and the financing gap shown in panel 2. Not surprisingly, this buyback proxy is highly correlated with the difference between the equity risk premium and corporate bond spreads. However, any moderation in share buybacks will be at least partially offset by an increase in debt issuance to fund investment. Corporate investment has seen a revival during the past few quarters, and leading indicators such as ISM New Orders surveys suggest it will continue trending up (Chart 7, bottom panel). Bottom Line: While a supportive Fed will keep corporate spreads low for the time being, rising leverage is starting to send a worrying message. Unless strong profit growth causes leverage to reverse course, it will likely be appropriate to scale back on credit risk either later this year or early next year, once the monetary back-drop becomes less supportive. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report, "Strong EM Trade Volumes Will Support Oil", dated June 8, 207, available at ces.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers", dated May 3, 2017, and "The Fed Doctrine", dated May 30, 2017, both available at usbs.bcaresearch.com 3 https://www.federalreserve.gov/newsevents/speech/yellen20150924a.htm 4 https://www.federalreserve.gov/econresdata/feds/2016/files/2016078pap.pdf 5 Please see U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds", dated April 11, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The current economic and profit environment supports our stance of favoring stocks over bonds. The Fed will need to see more evidence to alter its gradual path for rates. Although valuations remain elevated, they are not a great market timing tool. Margins are expanding according to the S&P 500 data, and we expect this to continue in the second half of the year. But a peak in margins next year could be the justification to scale back on overweight positions in stocks, in anticipation of slower EPS growth. Corporate balance sheets continued to deteriorate in the first quarter, but that is not enough to warrant cutting back on corporate bond positions within fixed-income portfolios. Watch real short-term rates and bank C&I lending standards, as an exit warning. Feature Environment Remains Supportive For Stocks Over Bonds Investors are wondering whether the equity and currency/bond markets are living on different planets. The dollar and Treasurys seem to be priced for sluggish economic growth, less inflation and no fiscal stimulus. Yet, the S&P 500 is stubbornly holding above the 2,400 level. Many believe that the only reason that stocks got to this level in the first place is the prospect of tax cuts, deregulation and infrastructure spending. If true, then it is only a matter of time before equity investors capitulate. We look at it another way. Yes, equities initially received a boost following the U.S. election on hopes for tax reform. But indicators such as the ratio of small-to-large-cap stocks, or high-tax companies relative to the S&P 500, suggest that the stock market has priced out all chances of any tax reform. The overall stock market has performed well despite this because of the favorable profit backdrop. The fact that Corporate America can generate such profits despite a lackluster economy is impressive. Moreover, the recent softening in inflation has led many to believe that the Fed can proceed even more slowly than the market previously believed, leading to a bond rally. This is quite a bullish backdrop for equities. One does not have to conclude that the bond and stock markets are living on different planets. The backdrop is also positive for corporate bonds versus Treasurys, despite the fact that corporate health continues to deteriorate (see below). Turning to politics, the political consequences of the extraordinary U.K. general election are still not clear. The outcome of the election does not change our core views on the U.S. dollar, equity or bond markets. The dollar has rallied, Treasury yields are higher and U.S. equity prices moved up as this report was being prepared on Friday, June 9. Looking ahead, the coalition-building process in the U.K. will take time as the horse-trading between parties proceeds. Nonetheless, our high conviction view is that the investment implications are in fact already self-evident and do not require foresight into the eventual make-up of the U.K. government. A key takeaway for investors is that, aside from Brexit, domestic fiscal policy is the driving issue in British politics. Austerity is dead in Britain and investors should expect its economic policy - under whatever leadership ultimately gains power - to swing firmly to the left on fiscal, trade, and regulatory policy. Moreover, the Brexit process will continue, albeit of a potentially more "softer" variety and with a somewhat higher probability of eventual reversal.1 Will They Or Won't They? A 25-basis point rate hike is likely this week, but the FOMC will need more evidence on the direction of inflation and the economy before significantly changing the timing and pace of rate hikes or economic forecasts. The market is fully pricing in the anticipated 25-basis point rate bump, but beyond that, there is not much agreement between the Fed and the market on interest rates or economic projections. Nonetheless, as the Fed prepares its June forecast and dot plots, policymakers and the market are on the same page in terms of the labor market, inflation, and the economy in the next few years. The unemployment rate (4.3% in May 2017) is below the Fed's forecasts for 2017 (4.5%) and longer run (4.7%). The consensus outlook for the unemployment rate keeps it below the Fed's path through the end of 2018 (Chart 1, panel 3). Even assuming that the 120,000 pace of job growth in the past three months persists, the unemployment rate would remain below the Fed's view of NAIRU (Chart 2). Our unemployment rate projections are based on a stable labor force participation rate and a 1% gain in the working age population. Chart 1Fed, Market And Reality##BR##Not Too Far Apart Chart 2The Unemployment Rate##BR##Under Various Monthly Job Count Scenarios However, a closer look at what policymakers have said about prices and the trajectory of inflation in recent years suggests that the market and the Fed are not that far apart. At +1.7% in April, the PCE deflator remains near the FOMC's projection of 1.9% for this year and 2.0% in the long run. Bloomberg consensus estimates for inflation for this year and next are above the top end of the Fed's forecast range (Chart 1, panel 2). The FOMC's May minutes state that "participants generally continued to expect that inflation would stabilize around the Committee's two percent objective over the medium run as the effects of transitory factors waned." The market is still concerned that the traditional Phillips curve model may be broken and that inflation may never accelerate even with the economy below the Fed's estimate of full employment. We will discuss the Phillips curve in a post-GFC world in an upcoming edition of The Bank Credit Analyst. As we discussed in last week's report,2 GDP growth in 2017 is on track to exceed the Fed's 2017 target (2.1%) and is already running ahead of the Fed's GDP projection (1.8%) for the long term. The consensus forecast for GDP in 2018 and 2019 is at the upper end of the Fed's range set in March (Chart 1, panel 1). Despite the general agreement between the Fed and the market on certain aspects, they diverge on the outlook for the fed funds rate in the next 18 months (Chart 3). As of June 9, the Fed sees a total of six quarter-point rate hikes by the end of 2018. The market sees just two in the same period. The Fed and market are still far apart on rates in 2019. However, the disconnect between the Fed and the market is not as large as it was in early 2015. This disagreement was a major factor in the equity market pullback in the first few months of 2016 (Chart 3). Neither the recent weakness in the economic data nor softer-than-expected inflation readings will be enough to prompt a significant shift from the Fed in terms of the 'dot plot'. The economic surprise index has been declining for 63 days since peaking in early- to mid-March, but remains consistent with slow growth, not a recession. Economic data tends to disappoint for an average of 90 days after the economic surprise index is above 40, as it was in late 2016/early 2017 in the wake of the U.S. election (Chart 4). Chart 3Disconnect Between Fed##BR##And Market On Rates Chart 4Economic Surprise Index Has Rolled Over##BR##Since Early To Mid March Bottom Line: It would take a significant deterioration in the economy and labor market and in the benign inflation environment to alter the Fed's gradual rate hike plan. A backdrop of gradual hikes and eventually, a smaller balance sheet, will continue to foster the conditions under which stocks have outperformed bonds since 2009. We believe that the recent Treasury rally is overdone because the market has gone too far in revising down the path of Fed rate hikes. A re-evaluation of the outlook could see bond yields jump, sparking a small equity correction. This is not enough of a risk to scale back on equities versus bonds. Valuations, Earnings And Margins: An Update U.S. equities remain overvalued and would be even more extended if not for low rates. However, they are attractively priced relative to competing assets, such as corporate bonds and Treasurys. Valuation is not a great tool to time market turning points and, absent a significant deterioration in the economic, profit and margin environment, we don't foresee a sustained pullback in stocks. Looking beyond our tactical 6-12 month window, above-average market multiples alone imply below-average returns for stocks across a strategic time horizon. Our BCA valuation indicator has deteriorated since we last published it in March 2017 and shows that U.S. equities remain expensive.3 Individually, two of the three components of the Valuation index remain in overvalued territory. The Earnings Group remains at a record high (aside from the tech bubble). The Balance Sheet group shows the same profile. Only the Yield Group, which compares stock prices with various nominal and real interest rates, suggests that equities are undervalued. Thus, U.S. stock prices are vulnerable to a sharp jump in rates, which supports our view that U.S. equity markets will perform well in an economic and inflation backdrop that allows the Fed to raise interest rates and unwind its balance sheet gradually (Chart 5). While tax cuts and infrastructure spending might provide the equity market with a "sugar high", it probably would not last long because fiscal stimulus would bring forward Fed rate hikes. Moreover, Chart 6 shows that U.S. stocks remain favorably priced relative to competing assets such as corporate bonds, Treasurys and residential housing. That said, equity valuation measures such as price-to-book or price-to-sales make the market vulnerable to shocks. Chart 5U.S. Stocks##BR##Are Overvalued... Chart 6Stocks Look Less Expensive##BR##Relative To Competing Assets Inflated valuations alone are not enough to trigger a bear market or even a significant correction in U.S. equities. Outside of aggressive Fed tightening, we will become more defensive when profits come under pressure. On this score, the decline in Q4 profits according to the NIPA data is concerning. We are in a period where margins based on the NIPA data are diverging from the S&P's measure. Like corporate earnings, there is more than one data source for profit margin data, and the data itself is a mix of art and science. In the long run, the S&P-based margin data and the data derived from the NIPA accounts tend to move together. Over shorter time horizons, however, these two metrics may diverge. The NIPA margins peaked in 2014 and have moved steadily lower since then, but the BEA-derived profit data are not closely watched by investors and are subject to significant revision. On the other hand, margins based on S&P data are followed closely by the markets, are not subject to revision and have been moving higher since end of 2015. In the past 55 years, the peak in NIPA margins has often led the S&P data at peaks; the caveat is that it is unclear whether the NIPA data led in real time because of the endless revision process for GDP and profit data.4 The margin series based on S&P data tends to lead heading into margin troughs, but it is not a reliable signal. During the long economic expansion in the 1960s, both indicators topped out around the same time (1966-67). The NIPA derived margins peaked in 1975 as the S&P margins troughed, and later in the decade, the zenith in NIPA margins peaked three years before the S&P version. Similar to the current decade the long expansion in the 1980s saw a mid-decade collapse in oil prices and margins. In the late 80s, NIPA and S&P measures peaked almost simultaneously, which was three years before the crest in equity prices. The 1990s saw unabated margin expansion through 1997 for NIPA margins; the expansion in S&P-based margins lasted until 1999 (Chart 7). Chart 7Margins, Like Profits Are Mix Of Art & Science History also shows that falling margins do not always mean declining EPS growth. In the past 40 years, when the U.S. economy was not in recession, corporate EPS growth was very high on average when margins rose. It was mostly a wash when margins dropped, with slightly negative EPS growth on average. There were two episodes (late-1990s and mid-2000s) when margins fell, but EPS growth was strongly positive (Chart 8). The stock market can also rise significantly even after margins peak for the cycle. Chart 8EPS Can Grow Even As Margins Contract According to S&P data we are in a phase of climbing margins and we expect EPS growth to further accelerate into year end, peaking at just under 20%, before moderating in 2018. If profit growth decelerates in 2018 and the S&P measure of margins begins to narrow again, it would send a strong signal to trim exposure, especially given lofty equity valuations (Chart 9). Chart 9Profit Growth And Margins Both Rising Bottom Line: Rich valuations in U.S. equities will be overlooked as most investors are focused on the S&P and not the NIPA margins. EPS growth will decelerate sharply when margins resume their mean reversion, which could be the catalyst for a major correction or bear market in stock prices. We do not expect this scenario to play out until 2018 at the earliest. Meanwhile, rising margins and profits trump expensive multiples for U.S. equities. Stay long. Corporate Bonds: Kindling And Sparks Last week's U.S. Flow of Funds release allows us to update BCA's Corporate Health Monitor (CHM) for the first quarter (Chart 10). The level of the CHM moved slightly deeper into "deteriorating health territory." The deterioration in the Monitor over the past few years is largely reflected in the profit-related components of the CHM, including the return on capital, cash flow coverage and free cash flow-to-total debt. Chart 10Deteriorating Since 2015, But... The Monitor has been a reliable indicator for the trend in corporate bond spreads over the years. Indeed, it is one of the oldest and most reliable indicators in BCA's stable of indicators. However, spreads have trended tighter over the past year even as the CHM began to signal deteriorating health in early 2015. Why the divergence? The CHM is only one of three key items on our checklist to underweight corporate bonds versus Treasurys. The other two are tight Fed policy (i.e. real interest rates that are above the neutral level) and the direction of bank lending standards for C&I loans. On its own, balance sheet deterioration only provides the kindling for a spread blowout. A blowout requires a spark. Investors do not worry about high leverage or a profit margin squeeze, for example, until the outlook for defaults sours. The latter occurs once inflation starts to rise and the Fed actively targets slower growth via higher interest rates. Banks see trouble on the horizon and respond by tightening lending standards, thereby restricting the flow of credit to the business sector. Defaults start to rise, buttressing banks' bias to curtail lending in a self-reinforcing negative feedback loop. The three items on the checklist usually occurred at roughly the same time in previous cycles because a deteriorating CHM is typically a late-cycle phenomenon. But this has been a very different cycle. High stock prices and rock-bottom bond yields have encouraged the corporate sector to leverage up and repurchase stock. At the same time, the subpar, stretched-out recovery has meant that it has taken longer than usual for the economy to reach full employment. Even now, inflationary pressures are so muted that the Fed can proceed quite slowly. It will be some time before real short-term interest rates are in restrictive territory. As for banks, they tightened lending standards a little in 2015/16 due to the collapse of energy prices, but this has since reversed. As an aside, recent weakness in the growth rate of C&I loans has contributed to concerns over the health of the U.S. recovery. However, the easing in lending standards this year points to an imminent rebound in C&I loan growth (Chart 11). Our model for C&I loans, based on non-residential fixed investment, small business optimism and the speculative-grade default rate, supports this view. Chart 11C&I Loan Growth Set To Rebound The implication is that, while corporate health has deteriorated, we do not have the spark for a sustained corporate bond spread widening. Indeed, Moody's expects that the 12-month default rate will trend lower over the next year, which is consistent with constructive trends in corporate lending standards, industrial production and job cut announcements (all good indicators for defaults). Chart 12 presents a valuation metric that adjusts the HY OAS for 12-month trailing default losses (i.e. it is an ex-post measure). In the forecast period, we hold today's OAS constant, but the 12-month default losses are a shifting blend of historical losses and Moody's forecast. The endpoint suggests that the market is offering about 200 basis points of default-adjusted excess yield over the Treasury curve for the next 12 months. This is roughly in line with the mid-point of the historical data. In the past, a default-adjusted spread of around 200 basis points provided positive 12-month excess returns to high-yield bonds 74% of the time, with an average return of 82 basis points. It is also a positive sign for corporate bonds that the net transfer to shareholders, in the form of buybacks, dividends and M&A activity, has eased on a 4-quarter moving average basis (although it ticked up in Q1 on a 2-quarter basis; Chart 13). As a result, ratings migration has improved (i.e. easing net downgrades), especially for shareholder-friendly rating action, which is a better indicator for corporate spreads. The moderating appetite to "return cash to shareholders" may not last long, but for now it supports our overweight in both investment- and speculative-grade bonds versus Treasurys. That said, excess returns are likely to be limited to the carry given little room for spread compression. Chart 12Still Some Value In##BR##High-Yield Corporates Chart 13Net Transfers To Shareholders##BR##Eased In Past Two Quarters Within balanced portfolios, we recommend favoring equities to high-yield at this stage of the cycle, for reasons we outlined in the April 17, 2017 Weekly Report. In a nutshell, value is not good enough in HY relative to stocks to expect any sustained period of outperformance in the former, assuming that the bull market in risk assets continues. Bottom Line: Corporate balance sheets are still deteriorating but risk assets, including corporate bonds, should continue to outperform Treasurys and cash in the near term. We will look to downgrade risk assets when core inflation moves closer to the Fed's 2% target, which would trigger a more aggressive FOMC tightening campaign and tighter bank lending standards. Favor equities to high yield, but within fixed-income portfolios, overweight investment- and speculative-grade corporates versus Treasurys. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see the Geopolitical Strategy Client Note "U.K. Election: The Median Voter Has Spoken, published on June 9, 2017. Available at gps.bcaresearch.com. 2 Please see U.S. Investment Strategy Weekly Report, "Can The Service Sector Save The Day?" June 5, 2017. Available at usis.bcaresearch.com. 3 Please see U.S. Investment Strategy Weekly Report "How Expensive Are U.S. Stocks", dated March 13, 2017 available at usis.bcaresearch.com. 4 Please see U.S. Investment Strategy Weekly Report, "Growth, Inflation and the Fed", May 8, 2017. Available at usis.bcaresearch.com.

Highlights The ECB's meeting was in line with expectations, the governing council increased its growth forecast, decreased its inflation forecast, removed it easing bias, but maintained that easy policy was key to support its objectives. Going forward, growth will have to remain just as strong for European inflation dynamics to emerge. Financial conditions between the U.S. and the euro area are moving in favor of U.S. growth, and thus, the USD. EUR/USD momentum is stretched, but it can rise further. EUR/USD at 1.15 in the coming weeks is a risk to our view. However, EUR/USD forecasts have already been ratcheted upward, and their capacity to lift the euro is losing steam. Feature The European Central Bank hit the mark yesterday with a performance that was bang on in terms of expectations, as illustrated by the euro's muted response. The governing council increased its growth forecast by 0.1% each year and curtailed its inflation forecast by an average of 0.2% until 2019, inclusively (Table I-1). Moreover, while the ECB statement removed its future easing bias, in the press conference ECB President Mario Draghi made it crystal clear that this was because deflationary risks were evaporating, but the economy still needed extremely easy conditions in order to stay on the trajectory envisioned by the ECB. As a result, despite this adjustment in forward guidance, the ECB elected to keep its asset purchases in place, even leaving the door open for time extensions and size increases if conditions warrant. After all, in the eyes of the ECB - and it is an assessment we share - the great performance of the European economy has been and remains dependent on the continuation of a very easy policy stance. In this optic, we study the outlook for growth dynamics in Europe, especially in relation to the U.S., as this is what will determine the future path of relative policy. If European policy can move in a more hawkish fashion relative to the Federal Reserve as well as current expectations, then the euro bear market will be over. Growth And Financial Conditions For the euro to rally further, the ECB has to be able to beat market expectations and the Fed has to continue to underwhelm. So far this has not happened, but markets are forward looking and are behaving as if both central banks will follow these paths. To expect a tightening of ECB policy relative to the Fed's, European growth will have to continue outperforming U.S. growth. As we argued last week, the slack in the European jobs market is much greater than that in the U.S.1 Without outstanding growth, European inflationary dynamics will remain hampered by low wage growth. Meanwhile, the Fed is facing an environment congruent with high rates (Chart I-1), something that markets are ignoring as they are only anticipating two more hikes into June 2019, beyond the one anticipated next week. So what kind of future growth dynamics are we anticipating? World growth may not be about to plunge, but global activity is set to soften as China and the U.S. have been tightening monetary conditions in an environment replete with excess capacity. Indicators are already responding to this policy shift. Our diffusion index of global leading economic indicators has already rolled over sharply, a precursor to softening global LEIs (Chart I-2). This is a bigger problem for Europe than the U.S. Since 2010, the beta of euro area LEIs to global LEIs has been around 0.8, while for the U.S. the sensitivity is around 0.2. Thus, deteriorating growth conditions are a greater handicap for Europe, a region still much more reliant on trade and manufacturing as sources of growth. Chart I-1The Fed And Its Mandate Chart I-2Global Growth Passing Its Zenith Meanwhile, purely domestic economic conditions have been buoyant in the euro area and quite morose in the U.S., though the picture seems to be reversing. To make this judgment, we begin by evaluating a global growth factor, a global economic force that lifts or pulls down all boats, similar to a tide. Such a global growth factor should not just affect various countries through trade, but it should also impact their economies through financial linkages. In order to evaluate this phenomenon, we conducted a Principal Component Analysis (PCA) of the LEIs of 21 countries. We found that the combined factor 1 and factor 2 explains nearly 50% of global growth dynamics (Chart I-3). Once we estimated this global growth factor, we then proceeded to estimate how much it contributes to LEI gyrations in the U.S. and euro area, using the factor loadings of both relative to the two main components revealed by the PCA. With that information in hand, we then simply subtracted the European and U.S. impact from their respective LEIs. What is left reflects purely endogenous changes in the LEIs for the euro area and the U.S. This same procedure can be applied to any country. Through this exercise, we can see very well that European domestic conditions have been rebounding sharply since 2012. However, the pure domestic element of the U.S. LEIs has been falling steadily since late 2014, shortly after the U.S. dollar began its 27% rally (Chart I-4). Chart I-3The Tide That##br## Lifts All Boats Chart I-4A Look At Purely Domestic##br## Growth Dynamics To a large degree, these differentiated dynamics make sense. 2012 marked the apex of the euro area crisis. The improvement in the domestic component of the European LEIs coincided with Mario Draghi's "whatever it takes" speech. This moment was crucial as it resulted in the normalization of private sector borrowing costs across the Eurozone. Thanks to the ensuing compression in break-up risk premia, Italian and Spanish private lending rates collapsed by 110 and 240 basis points over the following 24 months, respectively. Easy money was finally being transmitted to the private sector. Chart I-5Massive Tightening In 2014 In the U.S., the deterioration began after the dollar perked up massively, but also, after the Fed began tapering its purchases of securities, events associated with a 300 basis-point increase in the Wu-Xia shadow fed funds rate (Chart I-5). The combined effect of this monetary tightening resulted in a significant brake on economic activity, one made most evident by the deceleration in the domestic component of the LEIs. These forces seems to be reversing. Today, the dollar is trading in line with its March 2015 level, and while the fed funds rate has increased by 75 basis points, this still pales in comparison to the large increase in the shadow fed funds rates recorded between May 2014 and November 2015. Meanwhile in Europe, the lagged effects of the massive 15% decline in the trade-weighted euro between June 2014 and March 2015 is dissipating. These monetary dynamics partially explain why the domestic element of the European LEIs is rolling over while the U.S. one is improving. However, we think financial conditions play a larger role. U.S. financial conditions have greatly eased in recent months, while financial conditions in Europe have been deteriorating, suggesting domestic growth conditions will follow a similar path (Chart I-6). These crosscurrents are especially evident when looking at the relative European and U.S. domestic growth impulses vis-a-vis their relative financial conditions. Currently, the purely endogenous elements of growth in the euro area look set to roll over against those of the U.S. So if the international and domestic elements of growth in Europe are set to slow relative to the U.S., when should these dynamics begin to affect market pricing? Historically, the German Ifo survey has been one of the most reliable bellwethers of European economic activity. The same can be said of the ISM in the U.S. While the ISM rolled over three months ago, the Ifo is still at all-time highs. However, historically, one of the most reliable leading indicators of the Ifo has been none other than the ISM itself. Hence, the likelihood that the Ifo rolls over sharply by September is high, especially in the context of the observations made above (Chart I-7). With expectations that European growth will remain strong but that the U.S. is incapable of generating inflation, a weak ISM is well known, but a weak Ifo would be a surprise. Chart I-6Follow The Financial Conditions Chart I-7Where The ISM Goes, The IFO Follows When the Ifo underperforms the ISM, the euro tends to suffer (Chart I-8). This was not true in 2001, but back then the euro was trading 15% below its long-term fair value, and the U.S. was entering a recession. Today, the euro is trading at a more modest 5% discount to its long-term fair value, and BCA believes the U.S. is not on the verge of a recession. Moreover, on a short-term basis, the euro is already trading 6% above its interest rate and risk-aversion implied tactical fair value. Chart I-8If No U.S. Recession Emerges, A Falling IFO Equals A Falling Euro These dynamics also imply that the massive positive skew in economic surprises between the euro area and the U.S. should soon end, which is likely to prompt a re-think of the relative monetary policy stance between the ECB and the Fed, and therefore put an end to the recent sharp rally in the euro. Bottom Line: The ECB did not surprise markets this week. Yet, Mario Draghi made it very clear that despite an upgrade to forward guidance, the path toward achieving the central bank's inflation target continues to require very easy policy. How easy? Our view is that based on global dynamics and financial conditions, European growth could slow in the coming months, delaying the point in time when the euro area output gap closes. Meanwhile, investors are too conservative regarding the U.S.'s growth and inflation prospects, and therefore are not anticipating enough rate hikes from the Fed. What To Do With Momentum? The key issue for now is that the euro's momentum is extremely powerful and hard to fight. Indeed, the euro seems to have dissociated from fundamentals. While aggregate real rate differentials continue to move in favor of the U.S. dollar, the euro is ignoring these dynamics and instead has become overtaken by powerful flows into the euro area (Chart I-9). These dynamics may be stretched, but they could still have additional room to run. Non-commercial traders have fully purged their short bets on EUR/USD, and they have accumulated the most long-euro positions in three years. Additionally, our composite sentiment indicator, based on the positioning, sentiment, and 13-week rate-of-change in the currency, is now at elevated levels relative to the past three years (Chart I-10). The violence of these shifts highlights an improving risk-reward ratio to shorting the euro, but this could be of little solace: historically, both the composite sentiment measure and positioning in the euro have hit much higher levels. Technical indicators point to similar dilemmas. Both the EUR/USD intermediate-term technical indicator and its 13-week rate of change have hit levels congruent with a reversal (Chart I-11). However, these indicators have also displayed inertia in the past, with occasions such as in 2013, where their elevated readings did not preclude a higher EUR/USD. Chart I-9EUR/USD Is A Lone Wolf Chart I-10EUR/USD Is Overbought But...(1) Chart I-11EUR/USD Is Overbought But...(2) As a result, we are highly cognizant of the risks to our positive bet on the DXY (which due to its near 60% weighting in the euro is equivalent to a short euro bet). But the good news in the euro seems well priced in. In line with the 8% surge in the euro this year, the average analyst forecast for the euro for Q4 2017 moved from EUR/USD 1.05 to EUR/USD 1.12 (Chart I-12, top panel). Recent peaks in the euro have materialized when these forecasts hit 1.13, which we are very close to. At these levels, the optimism toward Europe seems fully discounted. Chart I-12When To Be Contrarian In FX In fact, the gap between the euro itself and the forecast is now decreasing (Chart I-12, bottom panel). This suggests that each new forecast upgrade is lifting the euro less and less, implying that buyers have already internalized these increasing forecasts and need ever better news, especially on the wage and inflation front, to lift the euro higher. Hence, while worried that the EUR/USD could move to 1.15 in a blink of an eye before reversing, we remain cautiously optimistic on our negative EUR/USD and our positive DXY stances. Bottom Line: At this point, the key problem with our view is that momentum is clearly in the euro's favor, a dangerous position for euro bears. While most indicators highlight that EUR/USD is overbought, these same metrics could in fact remain overbought for longer. However, investors have already massively upgraded their EUR/USD forecasts suggesting that much news is in the price, especially as each successive upgrade is showing diminishing returns in their capacity to lift EUR/USD spot rates. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report titled "Capacity Explosion = Inflation Implosion", dated June 2, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The soft patch in the U.S. economy continues: Unit labor costs growth has softened to 2.2%, a less-than-expected pace of 2.5%; Non-Manufacturing/Services sectors are looking weak with both PMI and ISM measures underperforming; Consumer credit also grew by USD 8.2 bn, underperforming the expected USD 15.5 bn. As a result, the dollar remains weak. While the data is worrying, we stand with the Fed's view. The Fed will hike in June, and when this soft patch proves temporary, it is likely that a September hike will materialize. With the ECB constrained in its capacity to move to a hawkish stance, it is possible for the USD to see some upside sooner rather than later. Report Links: Capacity Explosion = Inflation Implosion - June 2, 2017 Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The euro has witnessed a particularly strong two months due to positive surprises in data, but momentum somewhat slowed this week due to mixed data: Services PMI in Spain, Italy and France underperformed expectations, while Germany and the overall euro area outperformed; Retail sales increased at a 2.5% annual rate; German factory orders increased by 3.5% annually, which was less than expected. Even worse they contracted by 2.1% on a monthly basis; Overall GDP growth in the euro area outperformed expectations, being revised to 1.9%. Furthermore, Draghi reiterated the need for extremely easy conditions in order to stay on the path to reach the target inflation rate, especially as inflation forecasts were downgraded. If the European data cannot keep up with its current blistering pace, investors should again begin to wonder about the ECB's capacity to move away from what remain a dovish stance. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent economic data has been mixed in Japan: Consumer confidence came in at 43.6, increasing from last month. Bank lending annual growth came in at 3.2%, beating expectations. However, GDP annualized growth was greatly revised downward to 1%. Although we continue to be bullish on the yen on a short term basis, it would be preferable to play yen strength by shorting NZD/JPY rather than USD/JPY, as we believe that the correction in the U.S. dollar has run its course. Thus, we are looking to exit our short USD/JPY trade once it reaches 108. On a cyclical basis, the yield curve target implemented by the BoJ, along with a hawkish fed will weigh on Japanese real rates vis-à-vis U.S ones and consequently push the yen downward. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data has been mixed in the U.K.: Construction PMI came in at 56, blowing past expectations. Halifax house price annual growth came in at 3.3%, also outperforming expectations. However, Markit Services PMI came below expectations at 53.8. The results of the elections happening as of the date of this writing will create some volatility in the pound. A greater majority government by the conservatives would likely be a boost to the pound, as it will give Prime Minister May more leeway when negotiating the exit of the U.K. from the European Union. On the other hand, if labor wins enough seats to create a hung parliament, the pound could suffer as political uncertainty will once again reign supreme. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Last Innings Of The Dollar Correction - April 21, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Aussie experienced an upbeat week, appreciating almost 2.5%. A few positive data was recorded: TD Securities Inflation increased at a 2.8% annual rate, more than the previous 2.6% reading; GDP growth increased 1.7% annually, beating both yearly and quarterly expectations. Chinese imports were very strong, coming in at 22% growth on an annual pace, suggesting continued intake by the Middle Kingdom of what Australia exports. The GDP was a key driver in this week's rally. However, while the headline number was great, the details were more worrisome. Inventories led GDP growth, while exports subtracted most from it. This is peculiar considering that terms of trade increased at a 24.8% annual rate. This also predates the near 40% decline in iron ore futures. The trade balance for April also missed expectations greatly, coming in at 555 million, compared to the expected 1.95 million, setting up a poor start for Australia's second quarter. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 AUD And CAD: Risky Business - March 10, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi economy continues to improve: Headline and core inflation have both surpassed the 2% threshold, reaching 2.2% and 2.3% respectively in the first quarter of 2017. Meanwhile, nominal retail sales are growing at a healthy 7.5%. Considering the continued strength in the kiwi economy, the NZD should continue to outperform the AUD on a cyclical basis, given that Australia is much more sensitive to a slowdown in Chinese economic activity, which is beginning to suffer in response to the tightening campaign by the PBoC. On the other hand the upside for the NZD against the U.S. dollar remains limited. Not only is NZD/USD overbought on a short term basis, but the tight correlation between the kiwi and commodity prices should eventually weigh on this currency. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 U.S. Households Remain In The Driver's Seat - March 31, 2017 Et Tu, Janet? - March 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The CAD went through a rough patch this week: The seasonally-adjusted measure of PMIs delivered a disappointing 53.8 reading compared to the expected 62; Building permits are contracting at a 0.2% monthly pace; Housing starts increased at 194,700, which was less than expected; On the plus side, house price growth was at 3.9% yoy, beating expectations of 3.3%. Oil was also a big player in the loonie's weakness. Crude oil inventories were higher than expectations by roughly 6 million barrels: a 3.464 million barrels decline in inventories was expected, while inventories increased at a 3.295 million barrels. The CAD remains oversold, but we remain bullish on it in the G10 space as investors have rarely been so short the Canadian currency as they currently are. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent economic data in Switzerland has been very positive: The unemployment rate came in at 3.2%, beating expectations. Headline inflation came in at 0.5%, higher than last month and beating expectations. Yesterday, the ECB underwehlmed bulls, as ECB president Mario Draghi stated that asset purchases will "run until the end of December 2017, or beyond, if necessary". We expect the ECB to ultimately find it very difficult to switch to a hawkish bias, especially relative to relative to other central banks, as pricing power in the euro area remains muted. On the other hand, Switzerland is slowly recovering, and a removal of the implied floor by the SNB on EUR/CHF could happen as early as the end of the year. Thus, we are already shorting this cross to take advantage of such an event. Report Links: Updating Our Intermediate Timing Models - April 28, 2017 The Fed And The Dollar: A Gordian Knot - April 14, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 On Wednesday, oil inventories rose by 3.3 million against expectations of a 3.5 million draw. This caused oil prices to plunge by almost 4%. Nevertheless, the response of USD/NOK has been somewhat muted. This is in part due to the fact that real rate differentials matter more than oil for USD/NOK. Indeed, while oil is down almost 15% on the year, the NOK has actually appreciated slightly in the year against the dollar, given that rates in the U.S. have decreased substantially during the year. Thus, given that we expect a more hawkish Fed than the market anticipates, we are USD/NOK bulls. Additionally, we are also bullish on CAD/NOK, as the Norges Bank is likely to have a much more dovish bias than the BoC going forward. Report Links: Exploring Risks To Our DXY View - May 26, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The SEK has been depreciating this week on the back of disappointing industrial production figures, with the yearly measure increasing at a meagre 0.8% pace, much less than the anticipated 4.2%. Moreover, IP experienced a monthly contraction of 2.4%. Additionally, the recent Financial Stability Report also highlighted that "further measures need to be introduced to increase the resilience of the household sector and reduce risks", as well as vulnerabilities in the Swedish banking system. While we think USD/SEK's weakness is nearing its end, EUR/SEK will likely see some weakness in the near future, given its expensive level. Report Links: Bloody Potomac - May 19, 2017 Updating Our Intermediate Timing Models - April 28, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Dear Client, I am visiting clients in Asia. Along with a brief Weekly Report, we are sending you this Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. Marko argues that the U.S. is vulnerable to serious socio-political instability by the 2020 election, as a result of the widening gulf between elites and the rest. Trump, thus far, seems unlikely to bridge this gap. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights The United States has produced too many elites, while popular well-being has fallen; Elite-controlled institutions have failed to protect households from the negatives of globalization and technological change; Tribalism, polarization, and money politics are preventing political compromise; Trump won by assaulting the "elites" but neither his policies, Congress, nor the economy look to improve well-being; With recession likely by 2019, the U.S. will see a revolt of some kind by the 2020 election. Feature Crime is increasing Trigger happy policing Panic is spreading God knows where We're heading Oh, make me wanna holler They don't understand Make me wanna holler They don't understand - Marvin Gaye, "Inner City Blues," 1971 If we had to explain the election of Donald Trump and the decision by U.K. voters to exit the EU with one chart it would be Chart 1. It depicts the relationship between high income inequality and low generational mobility and suggests that highly unequal societies develop structures that perpetuate unequal income through generations.1 The U.S. and the U.K. stand at the extreme of the relationship, with Italy close behind. Not surprisingly, the common people, "the plebs," in all three countries are dissatisfied with the arrangement. Low social mobility perpetuates unequal economic outcomes, throwing middle- and low-income voters into a sense of desperation. They fear that both their children's lot in life and their own is already decided, i.e. cannot and will not improve. A pre-election Gallup study of 125,000 American adults confirms that President Trump's support was strongest among voters in communities with poor health and low generational mobility.2 Of no relevance was whether respondents came from areas supposed to suffer most heavily from the ills that Trump opposed, i.e. communities exposed to global competition via trade, or those with high levels of immigration, or areas with relatively high unemployment and low incomes. America is supposed to be immune to income inequality because of social mobility. Equality of opportunity matters more than equality of outcome. This is the trade-off that has existed at the heart of America since its founding. For decades this trade-off has atrophied. Donald Trump was then elected to bring the U.S. back to its default setting. In this report, we explain why it may be too late and what will happen if he fails. If BCA's House View is correct, that a recession will occur by the end of 2019 (if not earlier), then the economic and political conditions are ripe for serious socio-political instability by the 2020 election.3 The Dynamic Of Elite Overproduction In Why Nations Fail, economist Daron Acemoglu and political scientist James Robinson tell a story of "How Venice Became A Museum."4 From the eleventh to fourteenth century, Venice was one of the richest places in the world. Behind its rapid economic expansion was the commenda, an early form of a joint-stock company formed for the duration of a single trading mission. It spurred Venice's ambitious entrepreneurs to find new trading routes by allowing them to share in the profits with the owners of capital who funded the risky journeys. As new families enriched themselves, political institutions grew more inclusive to accommodate them: in 1032, for instance, Venice held elections for its doge, or leader. An independent judiciary, private contracts, and bankruptcy laws followed. By 1330, Venice was a wealthy and strikingly modern republic with a population as large as that of Paris. The commenda system, however, had a dark side: creative destruction. Each new wave of young, enterprising explorers reduced the political privileges and profits of the established elites. In the late thirteenth century, these elites began to restrict membership in the Great Council, or legislature. Such efforts culminated in La Serrata ("The Closure") in 1297, which severely restricted access to the Great Council for new members but expanded it for families of established elites. An economic serrata quickly followed the political one, and the commenda system that underpinned Venice's wealth was replaced by a state monopoly on trade in 1314. The rest is, as they say, history. Venice rapidly declined as the newly closed economic and political institutions failed to deal with the rise of Portugal and Spain, the revolution in navigation and discovery of new trade routes to the East, and various regional attempts to encroach on its wealth and power. After the seventeenth century this decline accelerated. Today, its only source of income is tourism, which parlays the pre-Serrata wonders - such as the Doge's Palace and St. Mark's Cathedral - for cash that the city desperately needs to keep itself afloat.5 Acemoglu and Robinson make the case in their research that societies with both politically and economically inclusive institutions are rare. They cite a number of reasons for this, but the one that is most relevant to this report is "elite overproduction." Elites have a perfectly human and rational desire to perpetuate their political and economic privileges and pass them on to their children. A society that truly promotes equality of opportunity is one that leaves its elites to the fates. The elite desire to pass on privileges to future generations is a constant, but human conflict and state collapse are cyclical. Peter Turchin, a biologist who studies human conflict, has noted that periods of intense conflict in societies tend to recur within 40-to-60-year cycles. He posits that elite overproduction - and its counterpart, low societal well-being - is to blame.6 In post-industrial societies, low and falling labor costs are one of the principal conditions for elite multiplication. International trade, immigration, technological advancements, and investment in human and physical capital all suppress labor costs, benefiting the consumers of labor, i.e. the elites. Globalization has played a particularly important role in suppressing wages in the modern developed world. It expanded the global supply of labor by opening up new populations to capitalism (Chart 2), leading to suppressed wage growth for the middle classes in advanced economies (Chart 3). This process has been reinforced by technological change, particularly innovation that is biased in favor of capital (i.e. saving on labor costs) (Chart 4). Chart 2Globalization Expanded ##br##The Global Supply Of Labor... As elites capture an ever-greater share of the economic pie (even a growing economic pie), they become accustomed to ever greater levels of consumption, which drives inter-elite competition for social status. Everyone tries to "keep up with the Joneses," which for many is only achievable by supplementing wages with debt (Chart 5).7 The demand for elite goods - say homes in the "right" zip codes - exhibits runaway growth as the cost of elite membership rises and as sub-elites with rising income levels compete for access (Chart 6). Chart 5Credit Supplanted Income Chart 6Middle Class Incomes Don't ##br##Buy Middle Class Goods Focusing on the U.S., Turchin shows that Americans are today living in the second "Gilded Age." His research shows that "elite overproduction" has not been this high, and "population well-being" this low, since the early twentieth century (Chart 7). He calculates population well-being as a combination of general health, family formation, and wage and employment prospects. All indicators are currently in decline relative to history, save for health. But even life expectancy is taking a hit, albeit for select demographic groups most negatively impacted by poor job and wage prospects (Chart 8). For elite overproduction, Turchin relies on standard measures: wealth inequality, university education cost, and political polarization. This makes intuitive sense, since major policies aimed at reversing entrenched inequality can only be enacted after polarization has fallen due to events that subdued elites, such as major economic calamities or geopolitical challenges - e.g. the New Deal following the Great Depression, or the Great Society following World War II and amidst the Cold War. The danger of extreme polarization between elite prosperity and general well-being is that it is theoretically and empirically associated with political polarization, social unrest, and war. Acemoglu and Robinson detail case after case - from ancient Mayans and Romans to modern French and Japanese - in which the competition for resources between elites and the general population led to civil strife or all-out warfare. Meanwhile Turchin's research shows that politically motivated violence in the U.S. (Chart 9), which last peaked 50 years ago in the late 1960s, is associated with large gaps in well-being between elites and the masses (Chart 10).8 Bottom Line: Elite overproduction has been identified by academic research as a constant source of social instability throughout human history. Elites subvert inclusive political and economic institutions in order to stifle creative destruction, which would enrich new entrepreneurs but dilute elite privileges. As such, societies that prevent elite overproduction and promote equality of opportunity (and creative destruction) are successful in perpetuating themselves over the long term. Repatrimonialization In The U.S. Chart 11Tax Rates Were High In The Roaring '50s A sure sign that a society is in decline? When elites strive to hold onto their status and create barriers to entry for others. In the case of Venice, these barriers were overtly political. Le Serrata was followed by the introduction of Libro d'Oro (the "Golden Book"), which created an official registry of Venetian families that would be allowed to share in the deliberations of the Great Council. As the population revolted against such measures, Venice introduced a police force in 1310, with other coercive methods to follow. Today, the U.S. exhibits similar signs of institutional capture by the elites, albeit updated for the twenty-first century. Political theorist Francis Fukuyama calls this process "repatrimonialization." It occurs amidst long periods of economic prosperity and peace, as elites lose sight of their symbiotic relationship with fellow citizens and begin to serve their own "tribal" interests.9 Note in the above Chart 7 that elite overproduction, as defined by Turchin, reaches its peak after long periods of peace: the first high point came in 1902, 37 years after the Civil War, and the second came in 2007, 62 years after World War II. The latter case in particular suggests that as threats dissipate, elites lose sight of personal sacrifices - military service, income redistribution, public service, public works - that are required for geopolitical competition with peer challengers. At the height of the Cold War (1949 to 1962), for example, the top marginal tax rate in the U.S. was 92% (Chart 11).10 The point is not the tax rate, but that elites were far more acquiescent to fiscal sacrifices on behalf of the public. Fukuyama points to the U.K. and the U.S. as the two countries that have been the least politically responsive to the challenges of globalization and technological change in the developed world. In the case of the U.S., this is because interest groups are capable of steering policy towards further globalization and technological change. Both processes have also empowered elites, which have steered policy towards less redistribution and more austerity for the middle classes. The data is clear on this point. Despite Europe's being as exposed to globalization and technological advances as the U.S., European median wage growth has kept pace with GDP growth since 2000, whereas in the U.S. it not only failed to keep up but declined over the same time period (Chart 12). Chart 12Europe Shielded ##br##Households From Global Winds What are some of the mechanisms of repatrimonialization in the U.S. and can they be reversed? The good news is that elite capture of state institutions is now out in the open and easy to identify. Both Donald Trump and Democratic candidate Senator Bernie Sanders campaigned explicitly against it. The bad news is that it is unlikely to be reversed endogenously, at least not without a catalyst. What follows is a short description of the most salient problems facing the country as a result of elite entrenchment. Campaign Financing The 2010 Supreme Court decision Citizens United v. Federal Election Commission gave rise to political action committees, also known as Super PACs. These groups are allowed to receive unlimited contributions from individuals and corporations as long as they do not cooperate, coordinate, or directly contribute funding to actual candidates. This supposed firewall, however, is a fig leaf. The elimination of caps on this type of campaign financing allows single-issue groups and even single individuals with deep pockets to fund fringe candidates or support single-issue ballot measures that would otherwise lack sources of funding. This is especially important in primary elections where turnout is very low. In response, incumbent legislators have to tread carefully and avoid angering individual donors or Super PACs that could single-handedly fund a campaign against them in the primary elections, especially since the average cost of a congressional election campaign is relatively low at $1.4 million (a small amount compared to the funds that can be brought to bear by activist donors). In 2012, more than 40% of the campaign donations used in all federal elections was contributed by 0.01% of the voting-age population. That means that about 24,000 people were responsible for a near-majority of all contributions.11 Two other findings reported in the academic literature provide insight on how (and if) that money might steer policy. First, a study confirmed the general belief that the wealthiest Americans are much more conservative than the general public when it comes to tax policy and economic regulation.12 Second, another study found that when the policy preferences of the top 10% of income earners diverge from the preferences of the bottom 50%, the policy outcome is more likely to reflect the intentions of the former group.13 Polarization Political polarization benefits elites by impeding the democratic process and locking in rules that are beneficial to the status quo. Chart 13 shows that income inequality and political polarization in the sphere of economic policy are correlated.14 The simple reason the two are so highly correlated is because the right-of-center Republican Party increasingly opposes redistribution, while the left-of-center Democratic Party favors it. As the two parties diverge on matters of economic principle, compromises become virtually impossible, locking redistributive efforts at the current levels favored by the elites. Polarization is subsequently reinforced by electoral-district "gerrymandering" and an extremely bifurcated and increasingly distrusted news media. Over the last two decades, both the Democrats and Republicans (but mainly the latter due to their superior position at the state level) have redrawn administrative boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 14). Chart 13Inequality Fuels Political Polarization Chart 14Few Congressional Seats Truly Competitive Tribalization Elite overproduction often leads to the tribalization of society. Elites, to ensure that they are not torn asunder by the plebs, mobilize the population behind various causes that divert attention away from themselves, i.e. away from the real cause of social malaise. These causes are "wedge issues," in today's parlance. They can include identity politics, religious issues, as well as foreign policy. The Democratic Party has often relied on identity issues to mobilize support, but the effort kicked into high gear as it evolved from a redistributive "Old Left" party to the more centrist, "Third Way," neo-liberal orientation of Bill Clinton's presidency. Senator Bernie Sanders attempted to reverse this trend and overtly downplayed identity politics during his presidential campaign. He saw his party's neo-liberal turn as an elite-driven effort to distract from the real problems affecting low-income households. Hillary Clinton, the neo-liberal Democrat, by contrast, suffered as a result of the perception that she was an elite. The problem is that these wedge issues have begun to ossify into actual identities. For example, Pew Research showed in 2012 that the difference between Americans on a list of 48 values is the greatest between Republicans and Democrats, as opposed to other elements of identity. This has not always been the case, as Chart 15 shows. We suspect that this data will grow even starker after the divisive, borderline hysterical 2016 campaign. This means that "Republican" and "Democrat" labels have become almost tribal in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Bottom Line: America's repatrimonialization is advanced. The democratic process, which is supposed to adjudicate between interest groups and regulate elite economic and political privileges, has been drawn to a halt by polarization, the political influence of big money, and emerging tribalism between non-elites. It is extremely difficult to see how these hurdles can be overcome via America's regular political process. As such, they will be resolved only after some kind of crisis, whether endogenous or exogenous. Will Trump Fix It? President Donald Trump famously said in his nomination speech at the Republican Convention, "I alone can fix it." In a way, he may be correct. Although he is very much part of the American economic elite, he has no links to the D.C. establishment and owes no favors to special interest groups.15 His entire campaign personified the conclusions of this report: that the U.S. economy has been captured by economic and political elites and that the well-being of regular citizens is in the doldrums. It is unfair to judge President Trump's record and legacy based on a little over four months in office. However, we lean heavily towards the conclusion that his efforts to undermine American patricians will ultimately fail. Here is why: Policy President Trump does not have much of a legislative record. Nonetheless, his first major piece of legislation - the Obamacare repeal and replace bill - would, in its current form, leave 14 million people without health care - and an estimated 24 million by 2026. If not substantially revised, the bill is likely to impose a roughly $445 billion burden on U.S. households in order to pay for the "hyuge" tax cuts that Trump has promised (Chart 16). Further throwing Trump's plebeian credentials into doubt is his second signature legislative act: tax reform. His campaign proposal fell largely in line with previous Republican efforts, which, it should be noted, have contributed greatly to elite overproduction in the U.S. (Chart 17). Trump's original proposal would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of middle-class Americans with an increase, or no change, to their marginal tax rate.16 We expect that his White House team will adjust this original plan to offer middle-class tax cuts, but the main thrust of the effort is still to eliminate estate taxes and lower the top marginal rates significantly. Chart 17Tax Reform Always Benefits Elites On trade and immigration, Trump has little record to show. His meeting with President Xi Jinping of China revealed that he is like previous presidents in talking tough about Chinese trade on the campaign trail yet lacking the desire to take aggressive action once in office. We expect that Trump will eventually pivot towards greater protectionism, but it is not clear that it will be executed in a way that actually improves household well-being.17 Congress So far Trump has shown that he is more interested in getting legislation passed than shaping it in a populist way. For example, he has urged Congress to pass the Obamacare replacement even though many conservative Senators are wary of its negative impact on households. If he adopts the same strategy with tax reform, we would suspect that he will err on the side of "getting things done," rather than fulfilling his campaign pledges to blue-collar workers. The problem for Trump is the same problem President Obama had: polarization. Trump would be far more successful in passing populist legislation if he developed a working relationship with Democrats, who ostensibly have discarded the elitism of the Clinton years. Yet to do so he would have to "betray" his only friends, leaving himself vulnerable should the Democrats refuse to play ball. He is thus stuck with partisan Republican policies, which means voters are stuck with a lack of compromise. Macroeconomics Populists everywhere have one overarching goal when they come to power: boosting nominal GDP growth (Chart 18). We suspect that Trump will ultimately get tax reform through Congress and that it will be moderately stimulative.18 The problem is that the U.S. economic recovery is already far advanced. As such, even moderate stimulus could hasten the timing of an economic recession. Given the lack of major economic imbalances, it is unlikely that such a recession would freeze the financial system and be as painful as that of 2008-9. Nonetheless, the trade-off between moderate stimulus and a quicker recession is unlikely to benefit Trump's voters. Bottom Line: Donald Trump has tapped into the deep social malaise in the U.S. and responded to the populace's demands that elite overproduction be curbed. Unfortunately, his track record during the campaign and as president gives little evidence that he will be successful in restraining America's elites. Especially because he is forced to cooperate with them through Congress, and in a way that does not encourage broad compromise. Investment Implications We suspect that polarization will grow throughout Trump's term and that he will largely be unsuccessful in pursuing an agenda that genuinely increases opportunity or well-being. In fact, we would bet that most of his policies will contribute to, not reduce, elite overproduction in the U.S. What happens when Donald Trump fails to reform America and resolve its elite overproduction problem? If a recession occurs by 2019 - our House View at BCA - then the economic and political conditions suggest that a serious revolt is in the cards by the time of the 2020 election. By this we mean not just an electoral revolt, like Trump's election, but also a concrete increase in social tension and unrest. A repeat of the 2011 Occupy Wall Street protests, yet more violent, could be in cards. By the 2020 election, we would also suspect that our clients may look back fondly, with nostalgia, for Senator Bernie Sander's campaign platform, which by that point may look downright centrist. Investors should prepare for an increase in economic populist policy proposals, from both the left and the right. If economic policy begins to steer towards populism, investors should bet on higher inflation and thus higher nominal - but potentially lower real - Treasury yields. The independence of the Fed could also suffer, putting considerable downward pressure on the USD. In this environment, equities will outperform bonds, but global assets should outperform those of the U.S. Gold, which has failed as a safe-haven asset in the contemporary deflationary era, should become attractive once again.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see Miles Corak, "Income Inequality, Equality of Opportunity, and Intergenerational Mobility," Forschungsinstitut zur Zukunft der Arbeit, Discussion paper no. 7520, July 2013, available at iza.org. 2 Please see Jonathan Rothwell and Pablo Diego-Rosell, "Explaining Nationalist Political Views: The Case Of Donald Trump," Gallup, dated November 2, 2016, available at papers.ssrn.com. 3 Please see BCA's The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com, and Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 4 Please see Daren Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Publishers, 2012). 5 Literally. 6 Please see Peter Turchin and Sergey Nefedov, Secular Cycles (Princeton, NJ: Princeton University Press, 2009). 7 Please see Neal Fligstein et al, "Keeping up with the Joneses: Inequality and Indebtedness, in the Era of the Housing Price Bubble, 1999-2007," presented at the Annual Meetings of the American Sociological Association, August 2015. 8 Please see Peter Turchin, "Dynamics of political instability in the United States, 1780-2010," Journal of Peace Research 49:4 (2012), pp. 577-91. 9 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus, and Giroux, 2014). 10 Today's dispersed terrorist threat does not even come close to approximating the threat that the Soviet Union during the Cold War presented to the U.S., and as such we do not consider it seriously as an existential threat to either the U.S. or the West. Please see BCA Global Investment Strategy and Geopolitical Strategy, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. 11 Please see Adam Bonica et al., "Why Hasn't Democracy Slowed Rising Inequality?" Journal of Economic Perspectives 27:3 (Summer 2013), pp. 103-24. 12 Please see Benjamin Page et al., "Democracy And The Policy Preferences Of Wealthy Americans," Perspectives On Politics 11:1 (March 2013), pp. 51-73. 13 Please see Martin Gilens, "Inequality And Democratic Responsiveness," Public Opinion Quarterly 69:5 (2005), pp. 778-796. 14 The latter measure of polarization is one of Turchin's factors in elite overproduction. 15 Save for the Kremlin! We jest, we jest. At least, we think we jest ... 16 Several groups would have seen no substantial tax cuts under his original campaign plan. Those making $15,000-$19,000 would have seen their tax rate increase from 10% to 12%. Those making $52,500-101,500 would have seen their rate stay the same at 25%, while those making $127,500-$200,500 would have seen their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. For our original discussion, see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 19 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.