Euro Area

Highlights Fed: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. ECB: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. Feature Chart Of the WeekFed Vs. ECB: Still Diverging Fed vs. ECB: Still Diverging Fed vs. ECB: Still Diverging Central bank watching used to be a fairly black and white endeavor for investors and analysts. Policies were either "hawkish", "dovish" or perhaps "neutral". New buzzwords have entered the lexicon in the post-crisis era, however, as central banks have often struggled to adjust policy settings without upsetting financial markets. Now, the combination of action on interest rates and central bank communications can create additional types of policy moves, like a "hawkish hold" or a "dovish hike". With the Federal Reserve and the European Central Bank (ECB) announcing policy moves last week, we dedicate this Weekly Report to our assessment of the actions taken by each bank, while trying to throw a few more monetary policy buzzwords into the mix to describe their decisions. Our conclusion is that while there is a need to see tighter monetary conditions on both sides of the Atlantic, the Fed is still delivering a combination of rate changes and language that is creating more upside for bond yields in the U.S. than in Europe (Chart of the Week). The Fed: Hawkishly Hawkish The Fed sounded a confident tone at last week's policy meeting, delivering another 25bp rate hike while also upgrading its growth and inflation forecasts for 2018. In the press conference following the FOMC meeting, Fed Chairman Jerome Powell expressed a very upbeat view on the state of the economy and even sounded a bit surprised as to how resilient growth has been. Yet it appears that the Fed is still erring a bit on the cautious side when it comes to its economic growth projections and, by association, its inflation forecast. The Fed now expects U.S. real GDP growth of 2.8% in 2018, up a mere 0.1 percentage point from its projection from last March. Yet the economy has accelerated in the recent months and the Atlanta Fed's GDPNow model is calling for growth to hit a whopping 4.8% in the second quarter. While that model tends to over-predict actual growth outcomes, it does underscore how strong the current run of U.S. data has been and how the risks on the economy are tilted to the upside. That strength is also manifesting itself in robust business confidence, as evidenced by the latest read on small business optimism from the National Federation of Independent Business (NFIB) that was released last week.1 The overall NFIB Optimism Index reached the second highest level in its 45-year history in May, while a record number of respondents felt that now was a "good time to expand" (Chart 2). Reports of positive earnings trends also hit a record high, while reports of positive sales growth were the highest since 1995. At the same time, concerns about labor quality hit the second highest level in the history of the NFIB survey, while reports of compensation increases hit a record high. This booming economy is also impacting price-setting behavior, with reports of actual and planned price increases hitting the highest levels in a decade. Against this backdrop of very robust growth, the Fed did lower its forecast for the unemployment rate for 2018 (now 3.6%), 2019 (3.5%) and 2020 (3.5%). Yet its 2018 projections for headline and core PCE inflation were only nudged up by 0.2 percentage points (to 2.1%) and 0.1 percentage points (to 2.0%), respectively. Inflation is expected to remain around those levels in 2019 and 2020. Does the Fed still believe that NAIRU in the U.S. is 4.5%? If so, there is a serious disconnect between its unemployment and inflation forecasts - one that is more likely to be resolved via higher inflation, especially if those readings from the NFIB data are to be taken at face value. The FOMC did send a mildly hawkish message last week through its interest rate projections (the "dots"). They added one more expected rate increase to 2018, which would bring the total amount of hikes this year to 100bps. However, no cumulative additional increases were added beyond 2018, which means that the Fed merely pulled forward a rate hike that would have occurred in 2020. We still anticipate that a 25bps-per-quarter pace of hikes is the most likely outcome for the Fed over the next year, especially now that the inflation-adjusted funds rate is hovering around the Fed's own estimate of the neutral "r-star" level. That path of rates is still not fully discounted in U.S. money markets (Chart 3), however, which suggests that Treasury yields will remain under upward pressure from a higher front-end of the yield curve. Chart 2U.S. Economy Is On Fire U.S. Economy Is On Fire U.S. Economy Is On Fire Chart 3Market Still Not Fully Converged To Fed Dots Market Still Not Fully Converged To Fed Dots Market Still Not Fully Converged To Fed Dots The Fed will likely err on the side of caution regarding the pace of rate increases, however, given the fact that a) wage growth is still relatively subdued given how tight the labor market is; b) TIPS breakevens are not yet at levels consistent the with the market believing that the Fed has achieved its inflation target; c) the rising U.S. dollar is tightening monetary conditions at the margin; and d) the growing threat of a U.S.-vs-The-World trade war may pose a more serious risk to global growth. Yet all those factors are likely not enough to derail the booming U.S. growth locomotive. Only a move to an outright restrictive Fed monetary policy will make that happen. However, at the moment, the Fed seems more willing to tolerate a potential overshoot of its inflation target than to try and slow an overheating economy. This means that Treasury yields will likely rise through higher inflation expectations, as well as through a convergence of market pricing to the Fed's interest rate projections. Stay below-benchmark on U.S. Treasury market duration exposure. Bottom Line: The Fed delivered a confidently hawkish rate hike last week, but its projections for growth and, more importantly, inflation appear too cautious. With the market still not fully priced to the Fed's interest rate "dots", and with inflation expectations likely to continue rising to levels consistent with the Fed's inflation target, Treasury yields will remain under upward pressure. Maintain a defensive, below-benchmark U.S. duration stance. The ECB: Dovishly Hawkish The ECB announced last week what had widely been expected by the market - that there would be no net new bond buying in its Asset Purchase Program (APP) after December of this year. Yet at the same time, the central bank was able to convey a dovish signal on the timing and pace of rate hikes after the bond purchases stop. Financial markets latched onto the latter message, triggering a rally in euro area bond markets and a daily decline of two big figures on EUR/USD. The central bank sounded a very confident tone - perhaps, surprisingly so - on both the growth and inflation outlook. ECB President Mario Draghi described the deceleration of the euro area economy in the first quarter as a "soft patch" and that the 0.4% (non-annualized) growth in real GDP was "still high growth". Draghi went even further in his description of the strong economy seen last year, and the slowing seen so far in 2018, as being largely driven by external demand: "Basically, it's a pullback from the very high levels of growth in 2017, mostly justified by an extraordinary pickup in exports, which is unlikely to repeat itself now, compounded by an increase - an undeniable increase in uncertainty - and for a variety of reasons really, mostly geopolitical reasons, and some temporary and supply-side factors at both the domestic and the global level as well as weaker impetus from external trade." That assessment for the cause of the Q1/2018 growth slowdown is accurate, as the peak in euro area data such as the manufacturing PMI, industrial confidence and the OECD's leading economic indicator all occurred alongside a slowing of export growth (Chart 4). Yet the ECB may be too optimistic in thinking that the softening in export demand will prove to be "temporary". In the ECB's updated macroeconomic projections, the forecast for real GDP growth in 2018 was revised down from 2.4% to 2.1%, largely due to a reduction in expected export growth from 5.3% to 4.2%. Yet the GDP forecasts for 2019 (+1.9%) and 2020 (+1.7%) were unchanged, and the export growth projection for 2019 was upgraded from 4.1% to 4.4%. That is a view that may prove to be too optimistic. Global trade activity is slowing fast at the moment, primarily on the back of diminished Chinese demand (bottom panel), and leading economic indicators (outside of the U.S.) have rolled over. With U.S. President Donald Trump now turning his protectionist trade rhetoric into actual tariff actions - aimed not just at China but also Europe - the risks are all to the downside for the ECB's growth projections. We find it a bit surprising that the market reacted so strongly to the ECB's indication that interest rates would be kept at current levels "at least through the summer of 2019".2 That language is consistent with the message that the ECB had been signaling prior to last week that any rate hikes would not take place soon after the net new bond purchases end. Taking the ECB's statement at face value, it would suggest that September 2019 is the first possible "live" meeting where a rate hike could occur. According to a survey of economists taken in early June by Bloomberg, the consensus view was that the net bond purchases would stop in December, the ECB would raise the deposit rate in the second quarter of 2019, and then raise the main refinancing rate (the ECB's primary policy rate) from 0% in the third quarter of 2019.3 This is broadly consistent with the pricing we see in our own "months-to-hike" indicator for the euro area, which shows that a 10bp rate increase is priced into the euro Overnight Index Swap (OIS) curve by August 2019, but with a full 25bps of increases not discounted until March 2020 (Chart 5). That date for the 10bp hike was at June 2019 on the day prior to last week's policy meeting, so the market repriced more or less in line with the ECB's messaging on the potential timing of that first hike. Chart 4Is The ECB Too Optimistic On Growth? Is The ECB Too Optimistic On Growth? Is The ECB Too Optimistic On Growth? Chart 5Market & ECB Are In Agreement Market & ECB Are In Agreement Market & ECB Are In Agreement Draghi gave no specific indication as to which of the ECB's policy rates would be moved first - when the ECB finally does decide to move - nor what the size of that first move could be. Yet even if the ECB "goes small" on that first move and does not move in 25bp increments like the Fed has been doing, that outcome has now been largely been discounted in the money market yield curve. Our view remains that there will be no rate hikes from the ECB until euro area core inflation and, more importantly, inflation expectations are much higher (Chart 6). As a rough rule of thumb, the ECB's previous rate hikes during the mid-2000s tightening cycle, and even the much-criticized hikes in 2011 that played a role in triggering the European Debt Crisis, did not occur until market-based inflation expectations measures like the 5-year CPI swap, 5-years forward were above 2% (bottom panel). Realized core euro area inflation was pushing toward 1.5-2% during those prior two episodes, which the ECB is not projecting to occur until later in 2019. So with core inflation only at 1.1%, and with inflation expectations still mired at 1.7%, the market is correct to take the ECB at its word that it will not even consider raising rates until next September. So why did bond yields and the euro decline after last week's ECB meeting? Perhaps it was Draghi mentioning in his press conference that bond purchases could be restarted, if needed: "[...] APP is not disappearing; it remains part of the toolbox. It's a new instrument of monetary policy that will be used for contingencies that we don't see now, and that's what we anticipate. But it remains now as a normal instrument to monetary policy." This is not a provocative statement, of course. The Bank of England did exactly that - restarting its quantitative easing (QE) program after the shock of the 2016 Brexit vote - while the Fed has also stated that it could do more rounds of QE in the future if the situation required it (but only after the funds rate had been cut back to the zero once again). Perhaps by leaving the door open a crack to ramping up the APP again, at a time when euro area growth is decelerating and core inflation remains well below target, the ECB was seen by the market to be hedging its bets with regards to exiting the current extraordinarily accommodative monetary policy settings. The ECB has been trying to communicate consistently over the past few months that the decisions on stopping bond purchases and hiking interest rates should be treated separately. In other words, a decision on the former would not have any sort of immediate implications for the latter. We discussed the possibility of the ECB avoiding a Fed-style Taper Tantrum when it exited its APP program back in March.4 Our conclusion was that while the ECB had been absorbing a greater share of government bond issuance than the Fed ever did during its QE programs, the "flow effect" of the ECB buying fewer bonds as it exited the APP would still push up euro area bond yields through the normalization of negative term premia (Chart 7). The ECB has been arguing that the "stock effect" of it owning such a large share of the euro area bond market has created a scarcity of risk-free assets that will keep yields subdued. Yet as was shown in the U.S. experience, the bigger impact on U.S. Treasury yields from its QE program was the signaling effect on the expected path of interest rates post QE. That can be seen by the very tight correlation between the term premium on 10-year U.S. Treasury yields and our measure of the market's expectation for the neutral rate fed funds rate - the 5-year U.S. OIS rate, 5-years forward minus the 5-year U.S. CPI swap rate, 5-years forward (Chart 8). A similarly tight correlation exists in the euro area interest rate markets (bottom panel), suggesting that the ECB may have a tougher time keeping a lid on bond yields than they expect if the market starts to raise the expected path of interest rates at a faster pace than the ECB would like to see. Chart 6ECB Will Not Hike Until Inflation ##br##Expectations Are Much Higher ECB Will Not Hike Until Inflation Expectations Are Much Higher ECB Will Not Hike Until Inflation Expectations Are Much Higher Chart 7The 'Flow Effect' Of Less ECB Buying##br## Will Boost Bond Yields The 'Flow Effect' Of Less ECB Buying Will Boost Bond Yields The 'Flow Effect' Of Less ECB Buying Will Boost Bond Yields Chart 8Markets Do Not Treat Tapering ##br##& Rate Hikes Separately Markets Do Not Treat Tapering & Rate Hikes Separately Markets Do Not Treat Tapering & Rate Hikes Separately For now, the uncertainty of the current state of euro area economic growth, combined with core inflation that is still undershooting the ECB's target, suggests that euro area bond yields will remain subdued in the near term. Yet as the ECB begins to cut its pace of asset purchases after September of this year, a slow drift higher in euro area bond yields is still the most likely outcome. If the euro area economy rebounds as the ECB expects, then the risk of an even bigger move higher in yields would increase as the market reprices the ECB rate hike cycle, although only if accompanied by an acceleration in core inflation and inflation expectations. We are maintaining our strategic recommendation to stay below-benchmark on duration risk within euro area bond portfolios. In terms of country allocation, we are sticking with our modest underweight stance, however, although we do still prefer owning core European bonds over U.S. Treasuries (especially on a currency hedged basis into U.S. dollars), as the risks of higher bond yields are still much greater in the U.S. than in Europe. Bottom Line: The ECB finally signaled the end of its current Asset Purchase Program, while sticking with its message that interest rate hikes are not likely until at least September 2019. The ECB's optimistic growth and inflation forecasts for the next couple of years may not be realized, but that will not prevent euro area bond yields from drifting higher as the ECB stops buying. Stay below-benchmark on euro area duration exposure. ­­ Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 https://www.nfib.com/surveys/small-business-economic-trends/ 2 http://www.ecb.europa.eu/press/pressconf/2018/html/ecb.is180614.en.html 3 https://www.bloomberg.com/news/articles/2018-06-07/draghi-s-bond-buying-era-seen-ending-as-ecb-gears-up-for-talks 4 Please see BCA Global Fixed Income Strategy Weekly Report, "Bond Markets Are Suffering Withdrawal Symptoms", dated March 20th 2018, available at gfis.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Hawks & Doves And Everything In Between Hawks & Doves And Everything In Between Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global Inflation has upside on a cyclical basis, but this narrative is well known and investors have already placed their bets accordingly, buying inflation protection in a wide swath of markets. However, global growth has not yet found its footing, suggesting a mini-deflation scare, at least relative to expectations, is likely this summer. The U.S. dollar will benefit in such a scenario, and NOK/SEK will depreciate. While GBP/USD has downside, the pound should rally versus the euro. Weakness in EUR/CAD has not yet fully played out; the recent bout of strength was only a countertrend move. Feature Inflation is coming back, and this will obviously have major consequences for both asset and currency markets. However, macro investing is not just about forecasting fundamentals correctly; often, just as importantly, it is about understanding how other investors have priced in these expected economic developments. Therein lies the problem. While we understand why inflation could pick up, so too have most investors, and they have positioned themselves accordingly. With global growth currently looking shaky, we believe a better entry point for long-inflation plays will emerge in the coming months. In the meanwhile, a defensive, pro-U.S. dollar posture still makes sense. Investors Are Long Inflation Bets We have long argued that inflation was likely to make a cyclical comeback, a return that would begin in the U.S. before spreading to the rest of the globe. This story is currently playing out. However, in response these developments, investors have placed their bets accordingly, and the story currently seems well baked in. Prices of assets traditionally levered to inflation have already moved to discount a significant pick-up in inflation. The most evident dynamics can be observed in the U.S. inflation breakevens. Both the 10-year breakevens as well as the 5-year/5-year forward breakevens just experienced some of their sharpest two-year changes of the past 20 years, notwithstanding the pricing out of a post-Lehman, depression-like outcome (Chart I-1). Breakevens are not alone. Other assets have displayed similar behavior. In the U.S., investors have aggressively sold their holdings of utilities stocks, which have been greatly outperformed by industrial stocks. Traditionally, investors lift the price of XLI relative to that of XLU when they anticipate global inflation to pick up (Chart I-2). Chart I-1Markets Are Positioning Themselves##br## For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Markets Are Positioning Themselves For Higher Inflation Chart I-2U.S. Sectoral Performance Suggests Investors ##br##Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... U.S. Sectoral Performance Suggests Investors Have Already Bet On Higher Inflation... It is not just intra-equity market dynamics that support this assertion. The behavior of the U.S. stock market relative to Treasurys further buttresses the idea that investors have already aggressively discounted an upturn in global consumer prices (Chart I-3). Potentially, the best illustration of investors' preference for inflation protection is currently visible in EM assets. A seemingly paradoxical phenomenon has been puzzling us: How have EM equities managed to avoid the gravitational pull that has caused EM bonds to nearly flirt with the nadir of early 2016? After all, EM equities, EM currencies and EM bonds are normally closely correlated, driven by investors' wagers on the direction of global growth. A simple variable can explain this strange dichotomy: anticipated inflation. As Chart I-4 illustrates, the performance of a volatility adjusted long EM stocks / short EM bonds portfolio tends to anticipate fluctuations in global inflation. The current price action in this basket indicates that investors have made their bets, and they think inflation is going up. Chart I-3...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio ...So Does The Stock-To-Bond Ratio Chart I-4Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Inflation Bets Explain Why EM Stocks And EM Bond Prices Have Diverged Anecdotal evidence suggests that in recent quarters, pension plans have been aggressive buyers of commodities - a move that normally coincides with these long-term investors putting in place some inflation hedges. Moreover, positioning in the futures markets corroborates these stories: speculators are still very long commodities like copper and oil - commodities traditionally perceived as efficient protectors against inflation spikes (Chart I-5). Finally, despite the potentially deflationary risks created by Italy three weeks ago, speculators remain short U.S. Treasury futures, bond investors are underweight duration, and sentiment toward the bond market remains near its lowest levels of the past eight years (Chart I-6). Again, this behavior is consistent with investors being positioned for an inflationary environment. Chart I-5Money Has Flown Into Resources Money Has Flown Into Resources Money Has Flown Into Resources Chart I-6Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bond Market Positioning Is Still Very Short Bottom Line: There is a well-defined case to be made that a global economy that was not so long ago defined by the presence of deflationary risks is now morphing into a world where inflation is on the upswing. However, based on inflation breakevens, sectoral relative performance, equities relative to bonds in both DM and EM as well as on the positioning of investors in commodity and bond markets, this changing state has been quickly discounted by investors. The Decks Are Stacked, But Where Does The Economic Risk Lie? The problem facing investors already long inflation protection every which way they can be is that the global economy is slowing, which normally elicits deflationary fears, not inflationary ones. This seems a recipe for disappointment, albeit one that is likely to help the dollar. Our global economic and financial A/D line, which tallies the proportion of key variables around the world moving in a growth-friendly fashion, has fallen precipitously. This normally heralds a slowdown in global economic activity (Chart I-7). Chart I-7Global Growth Is Losing Traction Global Growth Is Losing Traction Global Growth Is Losing Traction In similar vein, global leading economic indicators have also begun to roll over - a trend that could gain further vigor if the diffusion index of OECD economies experiencing rising versus contracting LEIs is to be believed (Chart I-8). The global liquidity picture has also deteriorated enough to warrant caution. Currency carry strategies - as approximated by the performance of EM carry trades funded in yen - have sagged violently. This tells us that funds are flowing out of EM economies and moving back to countries already replete with excess savings like Japan or Switzerland (Chart I-9). Historically, these kinds of negative developments for global liquidity have preceded industrial slowdowns, as EM now accounts for the lion's share of global IP growth. Finally, China doesn't yet look set to bail out the world's industrial sector. This month's money and credit numbers were weaker than anticipated, and our leading indicator for the Li-Keqiang index - our preferred gauge of industrial activity in the Middle Kingdom - points to further weakness (Chart I-10). This makes it unlikely that China's imports will rise, lifting global growth. Additionally, China has re-stocked in various commodities, suggesting it is front-running its own domestic demand, highlighting the risk that its commodities intake could become even weaker than what domestic growth implies. Chart I-8More Weakness In LEIs More Weakness In LEIs More Weakness In LEIs Chart I-9Global Liquidity Tightening Global Liquidity Tightening Global Liquidity Tightening Chart I-10China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World China Not Yet Set To Bail Out The World With this kind of backdrop, we expect the current slowdown in global growth to run further before ebbing, probably in response to what will be a policy move out some kind from China to put a floor under growth. As a result, the current infatuation with inflation hedges among investors may wane for a bit as slower growth could shock inflation expectations downward, especially in a global context that has been defined by excess capacity since the late 1990s. An environment where global inflation expectations could be downgraded in response to slower growth is likely to be an environment where the dollar performs well, particularly as U.S. growth continues to outperform global growth (Chart I-11). This also confirms our analysis from two weeks ago that showed that when bonds rally the dollar tends to outperform most currencies, with the exception of the yen.1 Moreover, with the Federal Open Market Committee upgrading its path for interest rates by one additional hike in 2018, this reinforces the message from our previous work noting that once the fed funds rate moves in the vicinity of r-star, the dollar performs well, nearly eradicating the losses it incurred when the fed funds rate rises but is well below the neutral rate (Table I-1). This is especially true if vulnerability to higher rates rests outside - not inside - the U.S., as is currently the case.2 Chart I-11The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation The Dollar Likes Lower Global Inflation Table I-1Fed And The Dollar: Where We Stand Matters As Much As The Direction Inflation Is In The Price Inflation Is In The Price Beyond the dollar, one particular currency cross has historically been a good correlate to investors betting on higher inflation: NOK/SEK. As Chart I-12 illustrates, when investors buy inflation hedges such as going long EM equities relative to EM bonds, this generates a rally in NOK/SEK. These dynamics played in our favor when we were long this cross earlier this year. However, not only are EM equities extended relative to EM bonds, the current economic environment portends a growing risk of investors curtailing these kinds of bets. The implication is bearish for NOK/SEK, and we recommend investors sell this cross at current levels. Chart I-12NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound NOK/SEK Suffers If Inflation Bets Are Unwound Bottom Line: Investors have quickly and aggressively positioned themselves to protect their portfolios against upside inflation risks. However, the global economy is still slowing - a development that has further to run. As a result, this current anticipation of inflation could easily morph into a temporary fear of deflation, at least relative to lofty expectations. This would undo the dynamics previously seen in the market. This is historically an environment in which the dollar performs well, suggesting the greenback rally is not over. Moreover, NOK/SEK could suffer in this environment. The Bad News Is Baked Into The Pound There is no denying that the data flow out of the U.K. has been poor of late. In fact, despite what was already a low bar for expectations, the U.K. economy has managed to generate large negative surprises (Chart I-13). One of the direct drivers of this poor performance has been the complete meltdown in the British credit impulse (Chart I-14). Additionally, the slowdown in British manufacturing can be easily understood in the context of slowing global growth (Chart I-15). Chart I-13Anarchy In The U.K. Anarchy In The U.K. Anarchy In The U.K. Chart I-14The Credit Impulse Has Bitten The Credit Impulse Has Bitten The Credit Impulse Has Bitten Chart I-15U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth U.K. Exports Are Slowing Because Of Global Growth But, the bad new seems well priced into the pound, especially when compared to the euro. Not only is the GBP trading at a discount to the EUR on our fundamental and Intermediate-term timing models, speculators have accumulated near-record short bets on the pound versus the euro (Chart I-16). This begs the question: Could any positive factor come in and surprise investors, resulting in a fall in EUR/GBP? We think the answer to this question is yes. First, despite the negatives already priced in, incremental bad news have had little traction in dragging the pound lower versus the euro in recent weeks, suggesting that EUR/GBP buying has become exhausted. Second, a falling EUR/USD tends to weigh on EUR/GBP, as the pound tends to act as a low-beta version of the euro (Chart I-17). Chart I-16Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Investors Are Well Aware Of Britain's Problems Chart I-17EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens EUR/GBP Sags When EUR/USD Weakens Third, the economic outlook for the U.K. is improving. It is true that in the context of slowing global growth, the manufacturing and export sectors are unlikely to be a source of positive surprises for Great Britain. However, the domestic economy could well be. As Chart I-14 highlights, the credit impulse has collapsed, but the good news is that outside of the Great Financial Crisis it has never fallen much below current levels, suggesting that a reversion to the mean may be in offing. Additionally, U.K. inflation is peaking, which is lifting British real wages (Chart I-18). In response, depressed consumer confidence is picking up. This is crucial as consumer spending, which represents roughly 70% of the U.K.'s GDP, has been the key drag on growth since 2016. Any improvement on this front will lift the whole British economy, even if the manufacturing sector remains soft. Fourth, Brexit is progressing. This week's vote in the House of Commons was confusing, but it is important to note than an amendment that gives Westminster the right to force a renegotiation between the U.K. and the EU if no deal is reached in 2019 has been passed. This also decreases the risk of a completely economically catastrophic Brexit down the road, but increases the risk that PM Theresa May could be ousted over the next 12 months. Our positive view on the pound versus the euro (or negative EUR/GBP bias) is not mimicked in cable itself. Ultimately, despite the GBP/USD's beta to EUR/GBP being below one, it is nonetheless greater than zero. As such, it is unlikely that GBP/USD will be able to rally if the DXY rallies and the EUR/USD weakens (Chart I-19). Therefore, while we recommend selling EUR/GBP, we are not willing buyers of GBP/USD. Chart I-18A Crucial Support To Growth A Crucial Support To Growth A Crucial Support To Growth Chart I-19Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Cable Will Not Avoid The Downward Pull Of A Strong Dollar Bottom Line: The British economy has undergone a period of weakness, which is already reflected in the very negative positioning of investors in the GBP versus the EUR. However, the bad data points are losing their capacity to push EUR/GBP higher, and the British economy may begin to heal as consumer confidence is rebounding thanks to improving real wages. The low beta of GBP/USD to the euro also implies that a falling EUR/USD will weigh on EUR/GBP. However, while the pound has upside against the euro, it will continue to suffer against the dollar if EUR/USD experiences further downside. What To Do With EUR/CAD? One weeks ago, we were stopped out of our short EUR/CAD trade. Has EUR/CAD finished its fall, or was the recent rally a pause within a downward channel? We are inclined to think the latter. Heated rhetoric on trade has hit the CAD harder than the EUR, as exports to the U.S. represent a much larger share of Canada's GDP than of the euro area, forcing the pricing of a risk premium in the loonie. However, even after a rather explosive G7 meeting, we do believe that a compromise is still feasible and that NAFTA is not dead on arrival. A deal is still likely because, as Chart I-20 demonstrates, Canadian tariffs on U.S. imports are not only marginally in excess of U.S. tariffs on Canadian imports, they are also in line with international comparisons. This suggests only a small push is needed to arrive to a deal that salvages NAFTA, which ultimately is much more important to Canada than the dairy industry. Chart I-20Canada And The U.S. Can Find A Compromise Inflation Is In The Price Inflation Is In The Price Despite this reality, we cannot be too complacent, U.S. President Donald Trump is likely to be playing internal politics ahead of the upcoming mid-term elections. U.S. citizens are distrustful of free trade (Chart I-21), a trend especially pronounced among his base. However, a good result for the GOP in November is contingent on the Republican base showing up at the polls. Firing this base up with inflammatory trade rhetoric is a sure way to do so. This means that risks around NAFTA are still not nil. Chart I-21America Belongs To The Anti-Globalization Bloc Inflation Is In The Price Inflation Is In The Price However, EUR/CAD continues to trade at a substantial premium to fair-value on an intermediate-term horizon (Chart I-22). Moreover, as the last panel of the chart illustrates, speculators remain massively short the CAD against the EUR. This creates a cushion for the CAD versus the EUR if global growth slows. Moreover, technicals are still favorable of shorting EUR/CAD. Not only is EUR/CAD still overbought on a 52-week rate-of-change basis, it seems to be in the process of forming a five-wave downward pattern, with the fourth one - a countertrend wave - potentially ending (Chart I-23). Chart I-22EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable EUR/CAD Is Still Vulnerable Chart I-23Wave Pattern Not Completed Wave Pattern Not Completed Wave Pattern Not Completed Finally, EUR/CAD tends to perform poorly when the USD strengthens, which fits with our current thematic for the remainder of 2018. Bottom Line: The headline risk surrounding NAFTA has weighed on the loonie against the euro, stopping us out of our short EUR/CAD trade with a small profit. However, the valuation, positioning and technical dynamics suggest the timing is ripe to short this cross once again. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Rome Is Burning: Is It The End?", dated June 1, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different", dated May 25, 2018, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 U.S. data was stellar: NFIB Business Optimism Index climbed to 107.8, outperforming expectations; the price changes and good times to expand components are also very strong; Headline and core PPI both outperformed expectations, auguring well for future consumer inflation; Headline and core retail sales grew by 0.8% and 0.9% in monthly terms, beating expectations; Both initial and continuing jobless claims also came out below expectations, highlighting that the labor market is still tightening, and wage growth could pick up further. The Fed raised interest rates this week to 2%, and added one additional rate hike to its guidance for 2018. FOMC members once again highlighted the "symmetric" target, suggesting that the Fed expects the economy to overheat slightly. An outperforming U.S. economy relative to the rest of the world is likely to propel the greenback this year. Report Links: This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Economic data was largely disappointing: Italian industrial output contracted by 1.2% on a monthly basis, and grew only by 1.9% on a yearly basis; The German ZEW Survey declined substantially across all metrics; European industrial production increased by 1.7% annually, less than the expected 2.8% increase; However, Spanish headline inflation spiked up from 1.1% to 2.1%. Yesterday, ECB President Mario Draghi announced the ECB's plan to taper asset purchases to EUR 15 bn a month in September, and phase them out completely by year-end. Moreover, Draghi highlighted that the ECB was not anticipating to implement its first hike until after the summer of 2019. Furthermore, the ECB President highlighted the current slowdown in global growth, as well as the rising protectionist risk from the U.S. potentially negatively impacting the European economy and the ECB's decisions going forward, suggesting that the plans are not set in stone. 2018 is likely to remain a volatile year for the euro. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 This Time Is NOT Different - May 25, 2018 Updating Our Intermediate Timing Models - May 18, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Japanese data has been strong this week: Machine orders increased on a 9.6% annual basis, and a 10.1% monthly basis, in April, outperforming expectations by a large margin; The Domestic Corporate Goods Price Index also increased by 2.7% annually, higher than the expected 2.2% increase. As political and economic risks in Europe and South America having subsided for now, the yen has lost some of its glitter. However, with ongoing uncertainty on trade and populism across the globe, we maintain our tactically bullish stance on the yen, especially against commodity currencies and the euro. However, beyond the short-term horizon, the BoJ will remain determined to cap any excess appreciation in the yen, as a strong JPY tightens Japanese financial conditions, weighing on the BoJ's ability to hit its inflation target. This will ultimately limit the yen's upside on a cyclical basis. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Data from the U.K. was somewhat disappointing: Manufacturing and industrial production both increased less than expected, at 1.4% and 1.8%, respectively; The goods trade deficit widened to GBP 14.03bn from GBP 12bn, and the overall trade deficit widened to GBP 5.28bn from GBP 3.22bn; Average earnings grew by 2.8%, less than the expected 2.9%; However, headline inflation came in at 2.4%, less than the expected 2.5%, while retail price inflation also underperformed expectations. This means that the uptrend in real wages continues. Given the limited movement in the pound, it seems that a lot of the bad news was already priced in by last month's depreciation. However, Theresa May's ongoing blunders in parliament represent a continued source of risk for the pound. While the GBP has downside against the EUR, it is unlikely to see much upside against the greenback. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Do Not Get Flat-Footed By Politics - March 30, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Australian data was weak: NAB Business Confidence and Conditions surveys both declined, also underperforming expectations; Australian employment grew by 12,000, less than expected. Moreover, full-time employment contracted. While the unemployment rate dropped as a result, this was largely due to a fall in the participation rate. RBA's Governor Lowe, in a speech on Wednesday, announced that any increase in interest rates "still looks some time away" as the slack in the labor market does not seem to be diminishing. Annual wage growth has been constant at 2.1% for the past three quarters, and did not pick up despite an improvement in full-time employment earlier this year. We remain bearish on the AUD. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The NZD is likely to face significant downside against the greenback along with the other commodity currencies as global growth slows down. However, due to its weaker linkages to Chinese industrial demand, the kiwi is likely to see less downside than the AUD. Nevertheless, it is likely to weaken against the CAD and the NOK as the NZD is expensive against these oil currencies, and oil's is likely to continue to outperform other commodities will support this view. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 USD/CAD has been on an uptrend given the greenback generally strong performance since February year, a force magnified by the volatile rhetoric surrounding NAFTA negotiations. However, the Canadian economy has been accelerating this year, thanks to robust growth in the U.S., to a strong Quebecer economy, and to a pickup in Alberta. In addition, the Canadian labor market is tightening further and wage growth is above 3%. Furthermore, risks surrounding NAFTA seem already reflected in the CAD's behavior and valuation. There is more clarity on the CAD versus its crosses than on the CAD versus the USD. Outperforming U.S. and Canadian growth relative to the rest of the world mean that the CAD should outperform most other G10 currencies. Report Links: Rome Is Burning: Is It The End? - June 1, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland was decent: Industrial production increased by 9% in annual terms, albeit less than the previous 19.6% growth; Producer and import prices increased by 3.2% year on year, in line with expectations, however the monthly increase underperformed markets anticipations. With global trade tensions rising, and Germany having entered President Trump's line of sight, the CHF could experience additional upside against the euro in the coming months. However, the SNB is unlikely to deviate from its ultra-accommodative stance, which means that any downside in EUR/CHF will proved to be short lived. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 The SNB Doesn't Want Switzerland To Become Japan - March 23, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Both headline and core inflation underperformed, coming in at 2.3% and 1.2%, respectively. However, the Regional Network Survey hinted at a pickup in capacity utilization as expectations for industrial output remained robust, as well as at an additional strength in employment. This led to a forecast of a resurgence in inflationary pressures. We expect the NOK to outperform the EUR. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Swedish inflation rose from 1.7% to 1.9%, coming in line with expectations. Additionally, Prospera 1-year inflation expectations survey rose to 1.9% from 1.8% in the March survey. This is likely to provide the Riksbank with reasons to turn gradually more hawkish, which should support the very cheap krona. Report Links: Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Who Hikes Again? - February 9, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights After having written about the role of the U.S. yield curve in forecasting recessions, we are devoting this Special Report to addressing the widely asked question on the effectiveness of the yield curve in determining asset allocation. A naïve, rules-based approach is applied to the yield curve in each of seven countries/regions to produce a dynamic allocation signal between equities and bonds in each country/region. Despite its simplicity, we find that the dynamic portfolio systematically outperforms the 60/40 equity/bond benchmark portfolio in the U.S., Canada, euro area, Switzerland, U.K. and Australia from a long-term perspective (four years), with Japan being the outlier. Despite the dominance of the U.S. in the global economy and also in global asset markets, the equity/bond performance cycle outside the U.S. does not necessarily follow the U.S. Instead, the yield curve in each country provides a consistently better signal than just following U.S. decisions alone. Currently, signals from yield curves still favor equities over bonds. Feature U.S. yield curve inversion has been a good leading indicator for recessions in the U.S. Since the mid-1950s, every U.S. recession has been preceded with curve inversion, as shown in Chart 1. The lead time, however, varies from one month to 18 months. In addition, even though it is true that stocks underperform bonds in a recession, stocks can begin to underperform bonds long before a recession starts and can also continue to underperform long after a recession ends. For example, U.S. stocks/bonds performance ratio peaked in December 1999 and then troughed in September 2002 with a more than 50% drawdown, yet only about 6% occurred between March 2001 and November 2001 - the NBER official dates for the 2001 recession. So could information from the U.S. yield curve itself systematically add value to a stock-bond allocation decision in the U.S.? Even if it could in the U.S., could the same apply elsewhere, given that yield curves in different countries do not move in a synchronized fashion? (Chart 2) Chart 1U.S. Yield Curve Vs. Recession U.S. Yield Curve Vs. Recession U.S. Yield Curve Vs. Recession Chart 2Global Yield Curve Cycle Global Yield Curve Cycle Global Yield Curve Cycle In this Special Report, we use a simplified naïve, rules-based approach to attempt to demonstrate if information from yield curves in seven countries - the U.S., Japan, the U.K, Euro Area, Canada, Australia and Switzerland - can systematically add value in asset allocation decisions. Yield Curves Are An Effective Indicator For Long-Term Asset Allocation The test results are quite encouraging, despite the simplicity and need for further refinement. Except in Japan, yield curves in all six other countries provide value-add information for stock-bond allocation decisions. The solid lines in Chart 3 are the relative total return performance of the active stock/bond portfolio versus the benchmark for each country. The active portfolio is simply constructed based on a naïve rule such that a 10% underweight is given to equities and a 10% overweight is given to bonds when the yield curve reaches the lower band from above. Once the yield curve reaches the upper band from below, the allocation is reversed. The upper and lower bands are explained in our methodology section on page 5, we omit Japan from these charts because, as explained on page 9, its stock/bond ratio has not had a consistent relationship with the yield curve. The dash lines in Chart 3 are the monthly four-year rolling return differentials between the active portfolios and the benchmarks. It is encouraging to see that the four-year rolling performance in each country has suffered only very limited downside. Chart 4 is the same as Chart 3 except that the active bet is maxed out to 40% over- or underweight relative to the 60/40 equity/bond benchmark - i.e. when the signal is bullish for stocks, 100% is in stocks, and when it is bullish for bonds, the weights are 80% bonds and 20% stocks. This is a more extreme version of risk-taking, though the upside/downside trade-off is still quite impressive. This simple approach illustrates that in the long run, the yield curve is a useful indicator for equity/bond allocations. However, it does not do very well on a shorter-term time horizon. As shown in Chart 5, the one-year performance differentials are less appealing. Chart 3Backtest Base Case Backtest Base Case Backtest Base Case Chart 4Backtest Aggressive Case Backtest Aggressive Case Backtest Aggressive Case Chart 5Short-Term Risk Reward Less Appealing Short-Term Risk Reward Less Appealing Short-Term Risk Reward Less Appealing So how are the back tests conducted? The Methodology The Passive Benchmark: A 60/40 fixed-weight equity/bond benchmark is constructed for each country using the MSCI equity total return index and Bloomberg/Barclays Treasury Total Return Index, all in local currencies. The Active Allocation Rule: For each country, a range is set for its yield curve with an upper band and a lower band. The bands are set based on yield curve cycles and also their correlation with stock/bond performance cycles. When the curve reaches the upper band from below, an overweight is assigned to equities until the yield curve reaches the lower band from above, at which point the overweight then shifts to bonds. To determine how the size of the over- and underweight positions impacts the efficacy of the signal, we tested four different bet sizes - from 10% to 40% - in 10% increments, since no short selling is allowed. Objective: The active portfolio in each country is aimed to outperform its passive benchmark with a minimal four-year rolling drawdown. The same approach is applied to all seven countries. In terms of yield curve, the 3M/10 curve works better than the 2/10 curve for the U.S. because the former has better cyclicality. For all other countries, 2/10 yield curves are used. Despite the simplicity of our approach, some interesting observations are worth highlighting: U.S. And Canada: Reduce Risk When Yield Curve Inverts As shown in Chart 6, yield curve inversion in these two countries has historically been a good indication to reduce risk in equities. Bonds in general start to outperform equities after the curve is inverted and continue to do so as the yield curve steepens. However, when the curves steepens near to its cyclical high, then it's time to add risk in equities. Historically, the upper threshold for the U.S. 3M/10 is 3.4%, while for the Canadian 2/10 it is 1.8%. Currently, this indicator alone still favors equities in these two countries. Chart 6AU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (I) U.S. & Canada: Curve Inversion Triggers Risk Reduction (I) U.S. & Canada: Curve Inversion Triggers Risk Reduction (I) Chart 6BU.S. & Canada: Curve Inversion ##br##Triggers Risk Reduction (II) U.S. & Canada: Curve Inversion Triggers Risk Reduction (II) U.S. & Canada: Curve Inversion Triggers Risk Reduction (II) Euro Area And Switzerland: Reduce Risk Before Yield Curve Approaches Inversion As shown in Chart 7, the yield curve of the euro area does not invert often, while the Swiss curve has never gone into inversion during the short period for which we have historical data. However, both curves have good cyclicality, which makes the 0.2%-1.8% range works very well for both. Chart 7AEuro Area & Swiss: Reduce Risk##br## Before Curve Inverts (I) Euro Area & Swiss: Reduce Risk Before Curve Inverts (I) Euro Area & Swiss: Reduce Risk Before Curve Inverts (I) Chart 7BEuro Area & Swiss: Reduce Risk ##br##Before Curve Inverts (II) Euro Area & Swiss: Reduce Risk Before Curve Inverts (II) Euro Area & Swiss: Reduce Risk Before Curve Inverts (II) U.K And Australia: Reduce Risk After Yield Curve Has Inverted 2/10 yield curves in both the U.K. and Australia invert more often than in other countries. However, unlike other countries, equities can continue to outperform bonds even after the curve is inverted. The turning point is about minus 50 basis points, as shown in Chart 8. The upper band for Australia is 1.25% and 0.9% for the U.K. Chart 8AU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (I) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (I) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (I) Chart 8BU.K. & Australia: Reduce Risk ##br##After Yield Curve Has Inverted (II) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (II) U.K. & Australia: Reduce Risk After Yield Curve Has Inverted (II) Japan: Yield Curve Does Not Provide Consistent Information The Japanese stock/bond ratio does not have a consistent relationship with the 2/10 yield curve, as shown in Chart 9. This makes it very difficult to apply the simple approach employed here. Country Divergence U.S. economic cycles have been widely studied. But as shown in Chart 1, correctly identifying recessions in the U.S. does not systematically capture equity/bond relative performance cycles because even U.S. equities can underperform bonds before a recession starts and after a recession ends. Using the yield curve, on the other hand, does a much better job in capturing the equity/bond performance cycle in each country. Chart 10 shows that investors in different countries should pay more attention to local yield curve cycles other than just following a U.S.-centric analysis, even though the U.S. does play a dominant role in the global economy and in global equity and bond indices. Chart 9Japan Is The Outlier Japan Is The Outlier Japan Is The Outlier Chart 10Country Divergences Country Divergences Country Divergences Bottom Line: The yield curve is an effective indicator for equity/bond allocation in most developed countries from a long-run perspective. Currently, yield curve-based signals from the U.S., Canada, Euro Area, Switzerland, the U.K. and Australia all still favor equities over bonds. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com

Highlights The following four investment themes are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos. Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Feature What connects last Sunday's dysfunctional G7 Summit with this week's ECB policy meeting? The answer is the euro area's €450 billion export surplus. Specifically, the €300 billion export surplus in Germany which equals 8% of its GDP - an export surplus that is squarely in President Trump's cross-hairs (Chart of the Week). Chart of the WeekECB Policy Has Driven Up Germany's Export Surplus ECB Policy Has Driven Up Germany's Export Surplus ECB Policy Has Driven Up Germany's Export Surplus The interesting thing is that the euro area hasn't always run an export surplus. Before 2012, the euro area's trade with the rest of the world was more or less in balance. Even Germany's export surplus was half of its current size. To put it in Trumpian terms, fewer Mercedes were "rolling down New York's Fifth Avenue." What caused the imbalance to surge in recent years? Was it punitive tariffs or restrictive trade practices in Germany? No, the answer is much simpler than that. ECB Policy Has Driven Up Germany's Export Surplus The export surplus in the euro area and in Germany is just a mirror-image of the euro exchange rate (Chart I-2). As the euro became undervalued, it made euro area exports more competitive and foreign imports into the euro area less competitive. This assessment of euro area over-competitiveness comes straight from the horse's mouth. The ECB's own indicators show that the euro area remains over-competitive by around 10%, meaning the euro is still undervalued by about 10%.1 In turn, the euro's substantial undervaluation is a near perfect function of the yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts (Chart I-3). It follows that the ultimate cause of the euro area's glaring imbalance is ECB policy itself - specifically, the extreme experiment with bond buying and negative interest rates. Chart I-2ECB Policy Has Driven Up The ##br##Euro Area's Export Surplus ECB Policy Has Driven Up The Euro Area's Export Surplus ECB Policy Has Driven Up The Euro Area's Export Surplus Chart I-3The ECB's Expansive Monetary Policy Is ##br##Responsible For The Euro's Undervaluation The ECB's Expansive Monetary Policy Is Responsible For The Euro's Undervaluation The ECB's Expansive Monetary Policy Is Responsible For The Euro's Undervaluation As Germany's former Finance Minister, Wolfgang Schäuble, explained: "When ECB chief Mario Draghi embarked on the expansive monetary policy, I told him he would drive up Germany's export surplus... I promised then not to publicly criticise this policy. But then I don't want to be criticised for the consequences of this policy." The ECB counters that it targets neither the euro exchange rate nor the trade balance; it sets policy to achieve its mandate for price stability. It argues that it is further from its mandate for price stability compared with the Federal Reserve because, ostensibly, the euro area is at a different point in the economic cycle compared with the U.S. This requires the ECB to set an ultra-accommodative policy compared with other central banks. The undervalued euro and trade surplus are the unavoidable spill-overs of this relative monetary policy. ECB Spill-Overs Felt Far And Wide However, one important reason that euro area inflation is underperforming U.S. inflation has nothing to do with the economic cycle. Rather, it is because the official measures of inflation in the euro area and the U.S. are defined differently (Chart I-4 and Chart I-5). The euro area's Harmonized Index of Consumer Prices (HICP) omits the consumption costs of owner-occupied housing, whereas the U.S. consumer price basket includes them at a very substantial 25% weight. Homeowners will testify that the cost of maintaining their homes constitutes one of their largest expenses, and that these costs tend to rise faster than other prices. Using the U.S. as a guide, we estimate that a euro area inflation measure that correctly included home maintenance costs would be running higher than HICP inflation by an average of 0.5 percentage points a year (Chart I-6). Chart I-4Euro Area Inflation##br## Is Underperforming... Euro Area Inflation Is Underperforming... Euro Area Inflation Is Underperforming... Chart I-5...Because Euro Area Inflation Omits ##br##Owner-Occupied Housing Costs ...Because Euro Area Inflation Omits Owner-Occupied Housing Costs ...Because Euro Area Inflation Omits Owner-Occupied Housing Costs Chart I-6Including Owner-Occupied Housing ##br##Costs Adds 0.5% To Inflation Including Owner-Occupied Housing Costs Adds 0.5% To Inflation Including Owner-Occupied Housing Costs Adds 0.5% To Inflation Just because the statisticians do not measure owner-occupied housing costs in the euro area HICP, it doesn't mean that homeowners do not feel these costs. In Germany, measured inflation is now running at 2.3%, so the true inflation that households feel is running closer to 3%. Meanwhile, interest rates on savings accounts are stuck near zero, which means that German savers are seeing the real value of their savings erode by 3% every year. As Der Spiegel magazine put it to ECB Chief Economist, Peter Praet: "Can you understand why so many Germans regard the ECB as the greatest threat to their personal wealth?" Spill-overs from the ECB's ultra-accommodative policy have also been felt across the Baltic Sea. The Riksbank and the Norges Bank have had to shadow the ECB to prevent a sharp appreciation of their currencies versus the euro. The trouble is that ultra-low and negative interest rates have been absurdly inappropriate for the booming Scandinavian economies. So ECB policy may have generated spill-over housing bubbles in Sweden and Norway (Chart I-7 and Chart I-8). Chart I-7ECB Spill-Overs Felt In Scandinavia ECB Spill-Overs Felt In Scandinavia ECB Spill-Overs Felt In Scandinavia Chart I-8Scandinavian Real Estate Appears Richly Valued Scandinavian Real Estate Appears Richly Valued Scandinavian Real Estate Appears Richly Valued Hence, a seemingly innocuous 'definitional' difference between the consumer price baskets in the euro area vis-à-vis the U.S. explains: the bulk of the shortfall in euro area inflation; the ECB's justification for ultra-accommodation; the undervalued euro; the euro area's €450 billion trade surplus; deeply negative real interest rates in Germany; and putative housing bubbles in Sweden and Norway. The main argument we hear in the ECB's defence is that the central bank is at the mercy of its treaty. If the treaty demands ultra-accommodation then the ECB must deliver it. But this argument is wrong. The ECB treaty only asks that the central bank delivers "price stability", leaving the ECB with substantial flexibility in how it precisely defines price stability. With this in mind, the ECB - and other central banks - should use this definitional flexibility to minimize differences with other central banks. Because in a world of integrated capital markets, the spill-overs from seemingly innocuous definitional differences are felt far and wide, resulting in political backlashes and economic imbalances. Imbalances Must Correct In The Long Run Ultimately though, economic imbalances must correct, and the corrective mechanism is economic, financial, or political feedback loops, or some combination of these. On this basis, we reiterate four investment themes that are likely to play out over the next couple of years: The yield shortfall on German long-dated bunds versus the equivalent U.S. T-bonds and U.K. gilts will narrow, one way or the other. The 10% undervaluation of the trade-weighted euro - as assessed by the ECB itself - will eventually correct. As the euro area's structural over-competitiveness gradually adjusts, euro area sectors that are domestically-oriented, like travel and leisure, will structurally outperform those that are export-oriented, like autos (Chart I-9). Chart I-9As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters As The Euro's Undervaluation Corrects, It Will Help Euro Area Domestics And Hurt Exporters Swedish real estate and Swedish real estate equities, which are both very richly valued, will underperform. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see https://www.ecb.europa.eu/stats/balance_of_payments_and_external/hci/html/index.en.html The ECB uses three metrics to assess the euro area's competitiveness versus its major trading partners: GDP deflators, CPIs, and unit labour costs. The average of the three metrics suggests that the euro is undervalued by around 10%.The assessment of euro undervaluation assumes that the major euro area economies entered the monetary union at a broadly correct level of competitiveness against each other and against their other major trading partners. This assumption seems valid, given that the net external position of these economies were all in equilibrium at the onset of monetary union. Fractal Trading Model We are pleased to report that our long SEK/GBP currency position hit its profit target of 3% and is now closed. This week we note that the relative performance of two classically cyclical sectors, oil and gas versus financials, is technically stretched and at a 65-day fractal dimension which has accurately predicted the last two major reversals. Hence, our recommended trade is short euro area oil and gas versus euro area financials. Set a profit target of 6% with a symmetric stop-loss. 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 Short oil and gas versus financials Short oil and gas versus financials 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 II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Contagion risk from Italy to its European peers presents a buying opportunity; Italian policymakers are constrained by the bond market and avoiding brinkmanship; In a game of chicken between Berlin and Rome, Chancellor Angela Merkel is behind the wheel of a 2.5-ton SUV; Italy's ultimate constraint is its bifurcated economic system - staying in the EU helps manage this problem; Underweight Italian bonds in a global portfolio and short Italian bonds versus their Spanish equivalents. Feature Chart 1Is Contagion Warranted? Is Contagion Warranted? Is Contagion Warranted? On May 31, Italy formed the second overtly populist government in the Euro Area. The first was the short-lived SYRIZA government in Greece, which lasted from January to September 2015. Under the leadership of Prime Minister Alexis Tsipras and his colorful finance minister Yanis Varoufakis, Athens took Greece to the brink of Euro Area exit in the summer of 2015. Ultimately, Greek politicians blinked, folded, and re-ran the January election in September, transforming SYRIZA from an overtly euroskeptic party to a europhile party in just eight months. Investors are concerned that "this time will be different." We disagree. To use a poker analogy, Italian policymakers are better positioned to "bluff" their European counterparts as their chip stack is larger. But they are still holding a bad hand, and other players at the table still hold big stacks. The recent turbulence in Italian bond markets has spilled over into other Mediterranean countries (Chart 1). This contagion is unwarranted, as there has been much improvement across the region over the past few years, both politically and economically. As for Italy itself, it is positive that populists have come to power today, for several reasons. First, it will force them to actually run the country, a sobering process that often tempers anti-establishment zeal, as it did in Greece. Second, they will run the country at a time when popular support for the Euro Area and EU remains strong enough to deter an overt attempt to exit those institutions. Third, Italy remains massively constrained by material forces outside of their control, which will force compromises in negotiations with Brussels and fellow EU member states. There Will Be No Contagion From Italy Markets overreacted to the political risks emanating from Italy in recent weeks. Fundamentally, Italy's peripheral peers have emerged stronger from the Euro Area crisis. Since the onset of the Euro Area crisis, Greece, Portugal, Ireland, and Spain - the hardest-hit economies in 2010 - have seen their unit labor costs contract by an average of 8.7%. Over the same period, the rest of the Euro Area inflated its labor cost structure by around 10.9% (Chart 2). Italy remains saddled with a rigid, under-educated, and rather unproductive workforce that has seen no adjustment in labor costs.1 Meanwhile, its Mediterranean peers have practically closed their once-enormous unit labor-cost gap with Germany. Furthermore, all southern European countries now run primary surpluses, reducing the need for external funding (Chart 3). It is fair that the market should apply a fiscal premium to Italy, given the new government's plans to blow out the budget deficit. But no such fiscal plan is in the works in the rest of the Mediterranean. The cyclically-adjusted primary balance - for Italy, Spain, Portugal, and Greece - has gone from a deficit of 4.4% during the height of the debt crisis, to a surplus of 1.4% today. One can argue about whether such fiscal austerity was really necessary. The advantage, however, is that the improvement in structural budget balances has diminished the need for additional austerity measures and could also provide greater fiscal space during the next recession. Finally, household balance sheets have been on the mend for some time. Consumer debt levels as a percentage of disposable income in Spain, Portugal, and Ireland - the epicenter of the original Euro Area debt crisis - have now dipped below U.S. levels. In the case of Italy, importantly, the household sector was never over-indebted to begin with (Chart 4). Chart 2Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Italy Has Had No Labor-Cost Adjustment Chart 3Mediterranean Austerity Is Over Mediterranean Austerity Is Over Mediterranean Austerity Is Over Chart 4No Household Credit Bubble In Italy No Household Credit Bubble In Italy No Household Credit Bubble In Italy On the political front, Italians are clearly more euroskeptic than their Euro Area peers (Chart 5). Although only 30% of Italians oppose the common currency, in line with Greece, this is still considerably higher than in Spain and Portugal (Chart 6). Italians also feel less "European" than the Spanish or the Portuguese - i.e., they identify more exclusively with their unique nationality. Again this is in line with Greek sentiment (Chart 7). Italians were not always this way: in the early 1990s, they felt the most European. Chart 5Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Italy Lags In Support For The Euro... Chart 6...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out ...But Only 30% Of Italians Want Out Chart 7Italians Are Feeling More Italian Italians Are Feeling More Italian Italians Are Feeling More Italian In Portugal and Spain, parties across the political spectrum have responded to improving political and economic fundamentals. In Spain, the mildly euroskeptic Podemos is polling below its June 2016 election result. Its leadership has also abandoned any ambiguity on its support of the common currency, although it still campaigned in 2016 on restructuring Spain's foreign debt. The leading party in the Spanish polls is the centrist Ciudadanos (Chart 8), led by 38-year old Albert Rivera. Much like French President Emmanuel Macron, Rivera has a background in finance - he worked as a legal counsel at La Caixa - and presents a centrist vision for Europe, favoring more integration. The rise of Ciudadanos is important as Spain could have new elections soon. Conservative Prime Minister Mariano Rajoy resigned following a vote of no-confidence engineered by the Spanish Socialist Party (PSOE) leader Pedro Sánchez. However, PSOE only holds 84 seats of the 350-seat parliament. As such, it is unclear how the Socialist minority government will govern, particularly with the budget vote coming in early fall. But investors should welcome, not fear, early elections in Spain. With Ciudadanos set to join a governing coalition, it is clear that Spain's commitments to the Rajoy structural reforms will remain in place while no discussions of Spanish exit from European institutions is on any investment-relevant horizon. In Portugal, the minority government of Prime Minister António Costa has overseen a brisk economic recovery. Costa's center-left Socialist Party has received support in parliament from the far-left, euroskeptic Left Bloc, plus the Communists and Greens. Despite the involvement of the Left Bloc, the minority government has not initiated any euroskeptic policy. The latest polling suggests that Costa could win a majority in 2019. An election has to be held by October of that year, thus potentially strengthening the pro-European credentials of the Portuguese government (Chart 9). Finally, in Greece, the once overtly euroskeptic SYRIZA is polling well below their 2015 levels of support. Ardently europhile and centrist New Democracy (ND) is set to win the next election - which must be held by October 2019 - if polling remains stable (Chart 10). The fascist and euroskeptic Golden Dawn remains a feature of Greek politics, but has a support rate under 10%, as it has over the past decade. In fact, the rising player in Greek politics is the centrist and europhile Movement for Change, an alliance that includes the vestiges of the center-left PASOK, which polls around 10%. Chart 8There Is No Populism In Spain... There Is No Populism In Spain... There Is No Populism In Spain... Chart 9...Or Portugal... ...Or Portugal... ...Or Portugal... Chart 10...And Surprisingly None In Greece ...And Surprisingly None In Greece ...And Surprisingly None In Greece Bottom Line: Italy stands alone in the Mediterranean as a laggard on both economic and political fundamentals. Contagion risk from Italy to the rest of its European peers should be faded by investors. It represents a buying opportunity every time it manifests itself. What Car Is Italy Driving In This Game Of Chicken? The new ruling coalition in Rome has a democratic mandate for a confrontation with Brussels over fiscal spending. The coalition consists of the Five Star Movement (M5S) and the League (Lega), formerly known as the "Northern League." In his inaugural speech to the Italian Parliament, Prime Minister Guiseppe Conte emphasized that the mandate of the new coalition includes "reducing the public debt ... by increasing our wealth, not with austerity."2 So, the gloves are off! Not really. Almost immediately, Conte pointed out that "we are optimistic about the outcome of these discussions and confident of our negotiating power, because we are facing a situation in which Italy's interests... coincide with the general interests of Europe, with the aim of preventing its possible decline. Europe is our home." PM Conte subsequently focused in his speech on increasing social welfare payments to the poor, conditional on vocational training and job reintegration. Talk of a "flat tax" was replaced with an eponymous concept that is anything but a "flat tax."3 And there was no mention of overturning unpopular pension reforms, but merely "intervening in favor of retirees who do not have sufficient income to live in dignity."4 We may be reading too much into one speech. However, the time for brinkmanship is at the beginning of a government's mandate. And Conte's opening salvo suggests that the M5S-Lega coalition has already punted on three of its most populist promises: wholesale change to retirement reforms, a flat tax of 15%, and universal basic income. The back-of-the-envelope cost of these three proposals is €100bn, which would easily blow out Italy's budget deficit by 5% of GDP, putting the total at 7%. There was also no mention of issuing government IOUs that would create a sort of "parallel currency" in the country. Conte's relatively tame speech represents one of three concessions that Rome has made before it even engaged Brussels in brinkmanship. The two others were to replace the original economy minister designate - euroskeptic Paulo Savona - and to form a government in the first place. The latter is particularly telling. Polls have shown that the two populist parties would have an even stronger hand if they waited until the fall to re-run the election (Chart 11). In particular, Lega has seen its support rise by 9% since the election. It is politically illogical to form a governing coalition with less political capital when a new election would strengthen the hand of both populist parties. So why the concessions? Because Italian policymakers are not interested in brinkmanship. The populist campaign rhetoric and hints of euroskepticism were an act. And perhaps the act would have continued, but the bond market reaction was so quick and jarring (Chart 12) - including the largest day-to-day selloff since 1993 (Chart 13) - that it has disciplined Italy's policymakers almost immediately. Chart 11Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Lega Gave Up A Lot By Forming A Coalition Chart 12Bond Vigilantes Are... Bond Vigilantes Are... Bond Vigilantes Are... Chart 13...A Massive Constraint On Rome ...A Massive Constraint On Rome ...A Massive Constraint On Rome This is instructive for investors. In 2015, Greece decided to play the game of brinkmanship with Europe and ultimately lost. Our high-conviction view at the time was that Athens would back off from brinkmanship because it was massively constrained.5 Not only would an exit from the Euro Area mean a government default and the redenomination of all household saving into "monopoly money," but the level of euroskepticism in Greece was not high enough to support such a high-risk strategy. At the time, we pointed out that most investors - and practically all pundits - were wrong when they argued that brinkmanship between Greece and Brussels was "unpredictable." This conventional view was supported by an incorrect reading of game theory, particularly the "game of chicken." Game theory teaches us that a game of chicken is the most dangerous game because it can create an equilibrium in which all rational actors have an incentive to stick to their guns - to "keep driving" in the parlance of the game - despite the risks.6 In Diagram 1, we can see that continuing to drive carries the most risks, but it also carries the most reward, provided that your opponent swerves. Since all actors in a game of chicken assume the rationality of their opponents, they also expect them to eventually swerve. When this does not happen, the bottom-right quadrant emerges, one of chaos and deeply negative payouts for everyone involved in the crash. The problem with this analysis is that - as with most game theory - its parsimony belies deep complexity that often varies due to a number of factors. The first such factor is replayability. The decisions of Italian policymakers will be informed by the outcomes of the 2015 Greek episode, which did not go well for Athens. Another factor that obviously varies the payout matrix is the relative strength of each player; or, to stick with the analogy, the type of vehicle driven by each actor. Greece and its Euro Area peers were not driving the same car. The classic game of chicken only produces the payouts from Diagram 1 if all participants are driving the same vehicle. However, if Angela Merkel is behind the wheel of a Mercedes-Benz G-Class SUV, while Greek PM Alexis Tsipras is riding a tricycle, then the payouts are going to be much different in the case of a crash. In that case, the payouts should approximate something closer to Diagram 2. Diagram 1Regular Game Of Chicken Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? Diagram 2Greece Versus Euro Area In 2015 Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? So the crucial question for investors is what vehicle are Italian policymakers driving? We do not doubt that it is an actual car, unlike Tsipras's tricycle. But it is more likely to be a finely-crafted Italian sportscar, adept at hugging the twists and turns of Rome's policy, rather than an SUV capable of colliding with Merkel's ominous truck. Why doesn't Rome have more capability than Greece? Because of time horizons. An Italian exit from the Euro Area would undoubtedly shake the foundations of the common currency and the European integrationist project. But Rome actually has to exit in order to shake those foundations. As we have learned with Brexit, such an "exit" scenario could take months, if not years. In the process of trying to exit, the Italian banking system would become insolvent, turning household savings and retirements into linguini. This would occur immediately and would exert economic, financial, and - most importantly - political pressure on Italian policymakers instantaneously. Our colleague Dhaval Joshi, BCA's Chief European Strategist, has argued that a 4% Italian bond yield is the "line in the sand" regarding the survival of Italy's banks.7 As Dhaval points out, investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). Based on this rule, the largest Italian banks now have €165 billion of equity capital against €130 billion of net NPLs, implying excess capital of €35 billion (Chart 14). Although the net NPL figure has improved much from the peak in 2015, it remains large. It follows that there would be fresh doubts about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of just a tenth from the recent peak. Dhaval estimates that this equates to the 10-year BTP yield breaching and remaining above 4% (Chart 15). Chart 14Italian Banks' Equity Capital ##br##Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Italian Banks' Equity Capital Exceeds Net NPLs By Euro 35 Bn Chart 15Italian Banks' Solvency Would Be In ##br##Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year BTP Yield Breached 4% Additionally, while Italian support for the common currency is relatively low, there is still a majority of around 60% that support the euro. This is similar to the level of support for the euro in Greece in 2015. We would suspect that the support for the currency would rise - and that populist parties would decline in popularity - if Italian policymakers set off a bond market riot that caused the insolvency of Italian banks. Does this mean that the bond market is a permanent constraint on Italian exit from the Euro Area? No. At some point in the future, after a deep recession that raises unemployment levels substantively, popular support for the common currency could tank precipitously. But we are far from that point. In fact, Italy has enjoyed a relatively robust recovery over the past 18 months. As such, any economic crisis today will be blamed on the populist policymakers themselves, yet another reason for them to moderate and seek the path of calm negotiations with the EU. Bottom Line: With regards to any potential "game of chicken" negotiations with the rest of Europe, Italian policymakers are not riding a tricycle like their Greek counterparts were in 2015. Italians are behind the wheel of a finely-crafted, titanium-chassis, Italian roadster. Unfortunately, Chancellor Angela Merkel is still in a Mercedes SUV that weighs 2.5 tons. This is a high-conviction view based on the actions of Italian policymakers over the past month. Despite an improvement in polling, populists have backed off from calling for a new election (which would have been perfectly logical) and that would have been advantageous to them and have abandoned some of the most controversial - and expensive - platforms of their coalition agreement. Unlike their peers in Greece, Italian populists have proven to have little stomach for actual confrontation. The Ultimate Constraint: Risorgimento In a report published back in 2016, we argued that Italy's original sin was its unification in 1861.8 Risorgimento brought together the North and South in a political and economic union that made little sense. The North had developed a market economy during the Middle Ages (and gave the West its Renaissance!), while the South had remained under feudalism well into the early twentieth century. Given the limited resources, governance, and technology of the mid-nineteenth century, the scope, ambition, and yes, folly of uniting Italy were probably several orders of magnitude greater than the effort to forge a common currency union in Europe in the twenty-first century. To this day, Italy remains an economically bifurcated country. Map 1 shows that the four wealthiest and most-productive regions of Europe, outside of capital cities, are the German Rhineland, Bavaria, the Netherlands, and Northern Italy. Meanwhile, the Italian South - or Mezzogiorno - is as undeveloped as Greece and Eastern Europe. Map 1Core Europe Extends Well Into Northern Italy Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? The units of analysis in Map 1 are the so-called EU "nomenclature of territorial units for statistics" (NUTS).9 These regions matter because Brussels uses them to determine how much "structural funding" - essentially development aid - each country receives from the EU. The EU "regional and cohesion" funding - totaling €351.8 billion for the 2014-2020 budget period - is not distributed based on the aggregate wealth of each country, since that would favor the new entrants into the union. The EU's discerning eye when it comes to distributing development funds is not accidental. It is a product of decades of lobbying by Italy (and Spain) to prevent a shift of structural funding to Eastern European member states. From Rome's perspective, the real European development project is not in Poland or Greece, but in the Mezzogiorno. Chart 16Italy Shares The Burden Of The Mezzogiorno With The EU Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? To this day, Italy and Spain receive the second and third largest amount of EU development aid (Chart 16). Despite contributing, in gross terms, 13% to the EU's total revenues, Italy's net contribution per person is smaller than those of the Netherlands, Sweden, Denmark, Finland, and Austria (Chart 17). Given that Italy is a wealthy EU state, its net budget contribution of approximately €3 billion, 0.2% of GDP, essentially means that it gets the benefits of EU membership for free. Chart 17Italy Gets To Join The Club For Free Mediterranean Europe: Contagion Risk Or Bear Trap? Mediterranean Europe: Contagion Risk Or Bear Trap? And EU membership comes with many benefits. Membership in the Euro Area - combined with sharing the same "lender of last resort" with Germany, the European Central Bank - allows Italy to finance its budget deficits at low interest rates and to issue government debt in the world's second largest reserve currency (Chart 18). These financial benefits are even greater than the rebate it gets from Europe. Access to cheap financing allows Italy to carry the costs of Mezzogiorno on its own. Chart 18The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today The Big Difference Between 2011 & Today It is somewhat ironic that Lega is today preaching populism and euroskepticism. In the early 1990s, its main target of angst was not the EU and Brussels, but Italy's South and profligate Rome, which funneled the North's taxes to the South. This early iteration of the party was quite pro-EU, as it saw Italy's North as genuinely European and worthy of membership in EU institutions. Some of its politicians and voters hoped that Northern Italy could meld into the EU, leaving the Mezzogiorno to fend for itself. Hence there is no deep, ideological euroskepticism in Lega's DNA. The party's evolution also illustrates how opportunistic and pragmatic Italian policymakers can be. The reality is that if Italy were to act on its threat of "exit," it would undoubtedly become far worse off economically. Not only would Northern Italy have to support the Mezzogiorno alone, but any structural reforms that could lift productivity and education in the South would become far less likely as anti-establishment forces took hold. Bottom Line: Our high-conviction view is now the same as it was in 2016. Italy is "bluffing." Leaving the EU or the Euro Area makes no sense given its economic bifurcation, which is the result of Risorgimento. Both policymakers and voters understand this. The real intention in the game of chicken between Brussels and Rome is to see an easing of austerity. We expect that Italian policymakers will ultimately succeed in getting leniency from Brussels on allowing deficit-widening fiscal stimulus, but the stimulus will be much smaller than their original plans that spooked the bond market laid out. To European and Italian politicians, Italy's economic bifurcation is well understood. Jean-Claude Juncker, the President of the European Commission, specifically referred to it when he said, "Italians have to take care of the poor regions of Italy." He was later forced to apologize for his comments, with leaders of M5S and Lega faking outrage. But given that the ideological roots of Lega are precisely in the same intellectual vein as Juncker's comments, investors should understand that politicians in Rome are well aware of their fundamental constraints. Juncker's comments were a dog whistle to Rome. The actual message was: we know you are bluffing. Investment Implications Our analysis suggests that the path of least resistance for the M5S-Lega coalition is to negotiate some austerity relief from the EU Commission, but to definitively pivot away from talk of "exit" from European institutions. PM Conte has reaffirmed that exiting the euro is off the table and that it was never on the table to begin with. The new economy minister, Giovanni Tria, followed this up with a comment that "the position of this government is clear and unanimous... there are no discussions taking place about any proposal to leave the euro." Meanwhile, Lega leader and new Italian interior minister Matteo Salvini has focused his early efforts and commentary on the party's promise to check illegal immigration to Italy. This will be a policy upon which Lega will test its populist credentials, not a fight with Brussels. Is the worst of the crisis therefore "over"? Is it time to buy Italian assets? Not yet. Both Italian bonds and equities rallied throughout 2017. Italian equities, for example, have a higher Shiller P/E ratio than both Spanish and Portuguese stocks (Chart 19). As such, a sell-off was long overdue. Chart 19Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Why Did Italian Equities Rally So Much? Chart 20Italy's Binary Future Italy's Binary Future Italy's Binary Future Furthermore, we do not expect Rome's negotiations with Brussels to proceed smoothly. It is very likely that the bond market will have to continue to play the role of disciplinarian. The government debt-to-GDP ratio could quickly become unsustainable if the current primary budget balance is thrown into a deficit (Chart 20). According to the IMF and BCA Research calculations, Italian long-term debt dynamics are stable even with real interest rates rising to 2% - from just 0.5% today - and real GDP growth remaining at a muted 1%. But this stability requires the country to continue to run a primary budget surplus of around 2% of GDP (Chart 21). Conversely, running a persistent primary deficit of 2% would result in an explosive increase in Italy's debt dynamics. Even if that stimulus produces real GDP growth of 3%, the "bond vigilantes" could protest the surge in debt and drive real interest rates to 3.5% or higher. As such, the country's fiscal space will ultimately be determined by the bond market. Rome can afford to lower its primary budget surplus, but only so far as the bond market does not riot. Our colleague Dhaval Joshi believes that the math behind an Italian fiscal stimulus would make sense if it provides enough of a sustainable boost to economic growth without blowing out the budget deficit.10 We suspect that the bond market will eventually agree, but only if Brussels and Berlin bless the ultimate fiscal package as well. While investors wait to see the outcome of Rome-Brussels budget talks, which will likely last well into Q4, we prefer to play Mediterranean politics by shorting Italian government bonds versus their Spanish equivalents. BCA's Global Fixed Income Strategy initiated such a trade on December 16, 2016, which has produced a total return of 5.8%. The original logic for the trade was based on an assessment that Italy's medium-term growth potential, sovereign-debt fundamentals, and political stability were all much worse than those of Spain (Chart 22). These differences were not reflected in relative bond prices. Chart 21Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Three Factors Will Influence Italy's Debt Trajectory Chart 22Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Spain Trumps Italy On All Fronts Ongoing political turmoil in Italy has justified sticking with the trade. Looking ahead, there is potential for additional spread widening between Italy and Spain in the coming months. Spain is enjoying better economic growth; the deficit outlook will invariably worsen for Italy with the new coalition government; and Spanish support for the euro and establishment policymakers remains far higher and more buoyant than in Italy. All these factors justify a wider risk premium for Italian debt over Spanish bonds (Chart 23). Chart 23Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Stay Short 5-Year Italy Vs. 5-Year Spain Chart 24Stay Underweight Italian Debt Stay Underweight Italian Debt Stay Underweight Italian Debt One final critical point - the timing of any budget related uncertainty could not be worse for Italy. Economic growth is slowing and leading indicators say that this trend will continue, which suggests that Italian government bonds should continue to underperform global peers (Chart 24). Our Global Fixed Income Strategy team has argued that government debt in the European "periphery" should be treated more like corporate credit rather than sovereign debt.11 Faster economic growth leads to fewer worries about debt sustainability and increased risk-taking behavior by investors, both of which lead to reduced credit risk premiums and eventually, stronger growth. In other words, think of Italian BTPs as a BBB-rated corporate bond rather than a "risk-free" Euro Area government bond. So as long as the Italian economy continues to lose momentum, an underweight stance on Italian government bonds is justified. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 2 Please see Repubblica, "Il discorso di Conte in Senato, la versione integrale," dated June 6, 2018, available at repubblica.it. 3 Conte's exact quote was "the objective is the 'flat tax,' that is a tax reform characterized by the introduction of rates that are fixed, with a system of deductions that can guarantee that the tax code remains progressive." This is our own translation from Italian and therefore we may be missing something. However, a "flat tax" that has a number of different rates and that remains progressive is, by definition, not a flat tax. 4 In fact, the speech could be read with an eye towards some genuine supply-side reforms, particularly in bringing the country's youth into the labor force, improving governance, reforming the judiciary, cracking down on corruption and privileges of the political class, and generally de-bureaucratizing Italy. If successful, these would all be welcome reforms. 5 Please see BCA Geopolitical Strategy Monthly Report, "After Greece," July 8, 2015, available at gps.bcaresearch.com. 6 The game derives its name from a test of manhood by which two drivers drive towards each other on a collision course, preferably behind the wheel of a 1950s American muscle car. Whoever swerves loses. Whoever keeps driving, wins and gets the girl. 7 Please see BCA European Investment Strategy Weekly Report, "Italy's 'Line In The Sand,'" dated May 31, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 The acronym stands for Nomenclature des Unités Statistiques. 10 Please see BCA European Investment Strategy Special Report, "Italy Vs. Brussel: Who's Right?" dated May 24, 2018, available at eis.bcaresearch.com. 11 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?" dated May 22, 2018, available at gfis.bcaresearch.com.

Highlights Since the end of the Bretton Woods system in 1971 there have been five major episodes where U.S. dollar moves were not uniform across all currencies. These episodes share common features: a rallying broad trade-weighted U.S. dollar, desynchronized global growth and falling commodity prices. The above conditions will likely be met in the coming months, producing a period of global currency divergence. Commodity and EM currencies will weaken the most against the U.S. dollar, then against the yen, and finally depreciating the least against the euro. Feature It is often assumed that the dollar behaves like a monolith. However, this is not always the case: some currencies do manage to occasionally buck the dollar's general trend (Chart 1). Interestingly, the yen is most often the currency that manages to avoid the broad dollar's general directionality. Chart 1Episodes Of Currency Divergence ##br##Versus the Dollar Episodes Of Currency Divergence Versus the Dollar Episodes Of Currency Divergence Versus the Dollar Our view has been and remains that the broad trade-weighted U.S. dollar still has meaningful upside this year, and that the EM currency complex will be under heavy selling pressure in the coming months. That said, it is worth asking whether all other currencies will share the same fate against a rising broad trade-weighted U.S. dollar, or whether some could diverge from the general dollar trend. This is essentially akin to trying to understand the pecking order of currencies outside the USD. To address these challenges, we believe it is important to understand how global growth will evolve, how relative growth dynamics among regions will shift, and how commodity prices will perform over the coming six to 12 months. When The Dollar Wears Many Masks There have been five major periods of currency divergence versus the U.S. dollar. These have lasted anywhere from one to three years (Table 1). Table 1Summary Of Currency Divergence Episodes Can There Be More Than One U.S. Dollar? Can There Be More Than One U.S. Dollar? Interestingly, they share some common features, heeding important insights for global investors. These features are as follows: 1) Common feature #1: A Rising Broad Trade-Weighted Dollar With the exception of the 2005-2007 episode, all other episodes where some currencies diverged from the general trend in the USD occurred when the broad trade-weighted U.S. dollar was in a bull market. 2) Common feature #2: Desynchronized Global Growth All episodes of divergence in the FX market occurred when global growth was desynchronized. This underscores the importance of growth as a key driver of FX movements. During the 1991-1993 period, the yen was able to buck the dollar's strength (Chart 2) even though Japanese growth was falling quite fast relative to the U.S. Explaining this seeming inconsistency was the policy conducted by the Bank of Japan at the time. The BoJ was cutting rates, from 6% in 1991 to below 2% in 1993, but it was not doing so fast enough to alleviate budding deflationary pressures. As a result, Japanese real interest rates did not fall. This caused real rate differentials to move firmly in favor of the yen. In the final months of 1991, Japanese 2-year and 10-year real rate spreads versus the U.S. were 50 basis points and -75 basis points respectively, but by June 1993, these spreads became 145 basis points and 115 basis points. In the 1995-1996 episode, all the economic blocks experienced a slowdown in growth relative to the U.S. While this time the yen plunged versus the dollar, commodity currencies managed to appreciate against the dollar. This was because commodity prices rose during this timeframe, creating a positive terms-of-trade tailwind that lifted these currencies (Chart 3). Chart 2Episode 1: The Yen Diverges Episode 1: The Yen Diverges Episode 1: The Yen Diverges Chart 3Commodity Currencies Diverge Commodity Currencies Diverge Commodity Currencies Diverge In 1997 and 1998, the euro was the currency that managed to remain stable versus the U.S dollar, while the yen and commodity currencies sagged meaningfully (Chart 4).The euro was able to defy the gravity of a strong dollar because the euro area's relative growth differential versus the U.S. remained stable. Essentially, in the late '90s, as the euro area periphery was enjoying the full dividend of convergence toward the living standards of core Europe, European domestic demand was left unaffected by the Asian crisis. Meanwhile, commodity producers and Japan - two groups with much deeper links with EM economies - were experiencing deeper repercussions from the EM economic contraction. The 2005-2007 period of de-synchronized currency action against the dollar is somewhat of an outlier (Chart 5). First, this particular episode of currency divergence materialized in an environment where the dollar was weak. Chart 4Episode 3: The Euro Diverges Episode 3: The Euro Diverges Episode 3: The Euro Diverges Chart 5Episode 4: The Yen Diverges Again Episode 4: The Yen Diverges Again Episode 4: The Yen Diverges Again Second, the outlier was the yen, which managed to depreciate against the dollar while all other currencies were strengthening against the greenback. Chart 6Episode 5: The Euro Diverges again Episode 5: The Euro Diverges again Episode 5: The Euro Diverges again Third, while Japanese growth was below that of the U.S. it was not falling versus the U.S. However, this still caused Japan to be the odd man out in terms of growth performance, as other economic blocs delivered better growth than the U.S. Moreover, Japan was not experiencing the same growth dividend from China's miraculous boom as emerging Asian or commodity producers were. Adding fuel to the fire was the endemic implementation of carry trades. The low FX and rate volatility of that era was an invitation to engage in this kind of strategy.1 But Japan's deflation, along with its sub-par economic performance when compared to non-U.S. economies, re-assured investors that the BoJ would keep rates at rock-bottom levels for the foreseeable future. This was an invitation to investors to sell the yen to fund these carry trades in EM and commodity currencies as well as the euro. Finally, during the 2012-2013 episode the euro area was the global growth laggard. However, the euro was the currency that was able to strengthen against the dollar, defying the greenback's broad appreciation (Chart 6). It is true that euro area domestic demand growth was slightly improving versus the U.S. More importantly though, this was the time period that followed European Central Bank President Mario Draghi's "whatever it takes" speech. These soothing words caused the break-up risk premia across euro area member states to collapse, lifting the euro in the process. 3) Common feature #3: Commodity Prices Were Falling In three out of five episodes, commodity prices were falling, which is consistent with the fact that four out of the five episodes were periods of broad trade-weighted U.S. dollar strength. The only exceptions were the 1995-1996 and 2005-2007 episodes, where commodities rallied. The latter period was further marked by a weak broad trade-weighted U.S. dollar. Bottom Line: Looking back at history, there have been five episodes where some major currencies diverged from the U.S. dollar's broad trend. In the majority of these episodes, the broad trade-weighted U.S dollar was rising, global growth was desynchronized, and commodity prices were falling. When Is The Next Episode On The Air? The aforementioned three common features can be thought of as pre-conditions for some currency divergence to transpire. So, when can investors expect the next episode to hit the proverbial airwaves? In our view, this scenario is most likely to materialize over the coming six to 12 months. Our main macro themes have been and remain2 that the global macro landscape over the coming months will be shaped by two tectonic shifts: on the one hand, America's fiscal stimulus will sustain robust U.S. growth, and on the other hand, the continued slowdown in money and credit in China will culminate in a relapse in capital spending. The Chinese leg of the scenario will depress commodity prices and consequently emerging market economies; meanwhile, thanks to considerable fiscal stimulus, easy financial conditions and relative economic insularity, U.S. growth will remain steady, leaving it as the global growth outperformer. These dynamics are bullish for the broad trade-weighted U.S. dollar: The U.S. economy is growing robustly despite rising interest rates. In fact, interest rate-sensitive sectors are showing no signs of slowing down, confirming the resilience of the economy at this stage of the cycle. Both the housing market and commercial lending standards are not flagging growth risks (Chart 7). Chart 8 demonstrates that BCA's broad money measure (M3) for China leads import volumes and industrial metals prices by about six months. Based on the indicator's track record, odds are that industrial commodity prices will fall meaningfully over the coming months. Chart 7U.S. Economy Is Weathering##br## Rising Interest Rates U.S. Economy Is Weathering Rising Interest Rates U.S. Economy Is Weathering Rising Interest Rates Chart 8China's Money/Credit Is Bearish ##br##For Industrial Metals bca.fes_sr_2018_06_08_c8 bca.fes_sr_2018_06_08_c8 While oil prices could hold out for longer due to supply dynamics and geopolitics, positioning remains extremely elevated. As such, we are not ruling out a meaningful pullback in crude as traders head for the exits - all in the context of slowing global demand. Bottom Line: Pieces are falling in place to create the conditions necessary for some currency decoupling: global growth is set to become desynchronized, and commodity prices are likely to weaken - all in the context of a rising broad trade-weighted U.S. dollar. A Reverse Currency Pecking Order Slowing global trade as well as a growth deceleration in China's capital spending and demand for commodities will have the biggest repercussions for commodity and EM Asian currencies (Chart 9). This leaves the euro and the yen as the two most likely candidates to potentially diverge from the broad U.S. dollar in this coming episode. In our view, we think the yen could win this title. First, while the euro area economy is less leveraged to a slowdown in China/EM than Japan, it is still extremely vulnerable. Investors are still very long the euro, and therefore are vulnerable to negative surprises. Euro area industrial production could be the impulse to continue generating underwhelming economic numbers, as it is very much leveraged to China (Chart 10), mainly due to Germany's own deep trade links with EM and China. Notably, the German IFO index for business expectations in German manufacturing - a good leading indicator for global trade - is pointing to a further slowdown in global exports (Chart 11, top panel). Furthermore, German manufacturing new orders from non-euro area countries are starting to roll over, suggesting German exports will weaken imminently (Chart 11, middle panel). Lastly, the Swiss KOF leading indicator has come in below 100 (Chart 11, bottom pane Chart 9EM Asia & Commodity Currencies To Remain Weak EM Asia & Commodity Currencies To Remain Weak EM Asia & Commodity Currencies To Remain Weak Chart 10When China Decelerates, So Does Europe When China Decelerates, So Does Europe When China Decelerates, So Does Europe Chart 11Global Trade Is Slowing Down Global Trade Is Slowing Down Global Trade Is Slowing Down Second, it seems that historically the yen has a greater ability to rally than the euro when commodity prices are falling or when the broad trade-weighted U.S. dollar is in a bull market, highlighting the counter-cyclical nature of the Japanese currency. This happened in the early to mid-'90s and in 2008 (Chart 12). The only exception was in 1998, when the euro was able to rally amid a selloff in commodity prices and a strengthening dollar because domestic growth was so resilient. Today, euro area domestic growth is healthier than it was in 2012-2013, but it is still much weaker than is the case in the U.S., especially as the latter is receiving a shot in the arm thanks to a large dose of late-cycle stimulus. Chart 12The Yen Has Counter Cyclical Attributes The Yen Has Counter Cyclical Attributes The Yen Has Counter Cyclical Attributes Chart 13Euro Long Positioning Is Higher Than For The Yen Euro Long Positioning Is Higher Than For The Yen Euro Long Positioning Is Higher Than For The Yen As such, we believe the euro has more downside than the yen against the U.S. dollar in this coming episode. Furthermore, speculators remain too long the euro versus the yen (Chart 13). Third, the yen is a crucial funding currency in global carry trades, while the euro has not been used by traders for this purpose over the past 18 months.3 As such, a selloff in EM and commodity currencies, which is our base case, could spur a rush to the exits for short yen positions, while the euro is not likely to benefit from a similar short squeeze. Additionally, Japan sports a large positive net international investment position of US$3.1 trillion, while Europe's stands at -US$0.6 trillion. Consequently, Japanese investors have proportionally more funds held abroad than European investors to repatriate home in the event of an upsurge in global/EM market volatility, adding a further impetus for the yen to buck the dollar trend. One of the best currency valuation metrics is the real effective exchange rate based on unit labor costs, because it takes into account both wages and productivity. Unfortunately, this data set does not exist for all countries. On this metric, the U.S. dollar is not expensive (Chart 14, top panel). Adding credence to our view that the yen will be more resilient than the euro this year, according to the unit labor costs-based measures, the JPY appears to be cheap in trade-weighted terms and relative to the EUR (Chart 14, bottom panel). Chart 14The Yen Is Cheaper Than the Euro,##br## Dollar Is Fairly Valued The Yen Is Cheaper Than the Euro, Dollar Is Fairly Valued The Yen Is Cheaper Than the Euro, Dollar Is Fairly Valued Chart 15The Korean Won##br## Is Expensive The Korean Won Is Expensive The Korean Won Is Expensive Chart 16Commodity Currencies ##br##Are Not Cheap Commodity Currencies Are Not Cheap Commodity Currencies Are Not Cheap The Korean won - the only emerging Asian currency for which this measure is available - seems to be expensive (Chart 15). Chart 16 demonstrates that commodity currencies including those of Australia, New Zealand and Chile are on the expensive side, while the Canadian dollar and the Colombian peso are fairly valued. Bottom Line: Putting all the pieces together, our reverse pecking order for global investors from the weakest to strongest currency against the U.S. dollar is as follows: commodity currencies, non-commodities EM currencies (primarily Asian), the euro, and the yen. Investment Conclusions We recommend the following strategy to best navigate the coming global currency divergence episode over the coming six to 12 months: Global asset allocators should underweight the following currencies, from most to least, in the following order: First, the extremely vulnerable commodity currencies (BRL, IDR, ZAR, CLP, COP, AUD, NZD, NOK, and CAD); second, the EM Asian currencies (KRW, MYR, SGD, TWD, and PHP); third, the euro; and lastly, the yen. Currency traders stand to benefit the most in this coming episode by going short commodity and EM Asian currencies versus the U.S. dollar. That said, Japanese and European investors also stand to benefit by selling or underweighting commodity and EM currencies. The yen and the euro will depreciate significantly less than commodity and EM currencies, with the yen potentially ending flat versus the U.S. dollar. To capture these dynamics we suggest a new currency trade: long JPY / short SGD. The rationale behind this trade is that the Monetary Authority of Singapore (MAS) manages the Singapore dollar against a basket of currencies of its major trading partners. Consequently, if as we anticipate the Japanese yen strengthens versus all other currencies with the exception of the greenback, the MAS will likely have to depreciate the Singapore dollar versus the yen. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report, titled "Two Tectonic Macro Shifts", dated January 31, 2018, available at ems.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Euro: Risk On Or Risk Off?", dated November 17, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights One of Europe's major success stories is the structural and broad-based increase in female labour participation rates. The trend is set to continue for the next decade. Stay overweight the Personal Products sector as a long-term position. Italy's decade-long stagnation is not a deep-seated structural malaise. It is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Buy exposure to Italian real estate as a new long-term position either directly or through Italy's small real estate equity sector. Feature Some analysts persist on comparing economic performances on the basis of real GDP per head of total population. But the total population includes children and the elderly who cannot contribute to economic output. Therefore, a correct assessment of economic performance should look at real GDP per head of working-age population. Chart I-1AWomen Are Powering The European Economy... Women Are Powering The European Economy... ...Less So In The U.S. Women Are Powering The European Economy... ...Less So In The U.S. Chart I-1B ...Less So In The U.S. Women Are Powering The European Economy... ...Less So In The U.S. Women Are Powering The European Economy... ...Less So In The U.S. Admittedly, as the retirement age rises, the definition of 'working-age' will gradually change, but the general principle still holds: only count in the denominator those who can contribute to economic output. GDP per head of working-age population can grow in several ways. One way is to get more output or better output from each hour worked through improvements in efficiency and/or quality. As this improvement is theoretically limitless, it is the main source of productivity gains in the long run. A second way is for each worker to work more hours. But given the physical and legal constraints on productive working time, there is only limited scope to increase output in this way. How Women Are Powering The European Economy There is one other way to increase GDP per head of working-age population: increase the percentage of the working age population that is in the labour force.1 In other words, structurally increase the labour participation rate. If this participation rate is already high - as it is for men - then there is little scope to increase it much further. But if the participation rate is low - as it is for European women - then there is considerable scope to increase it. This brings us to one of Europe's major, and largely untold, success stories - the structural and broad-based increase in female participation rates (Chart I-1-Chart I-5). Over the past twenty years, the EU28 female participation rate has risen from 57% to 68%, with an especially large contribution from the socially conservative southern countries. In Spain, female participation has surged from 47% to 70%. In Italy, it has shot up from 42% to 56% and has clear scope to rise much further. Chart I-2Italy: Labour Force Participation Rate Italy: Labour Force Participation Rate Italy: Labour Force Participation Rate Chart I-3Spain: Labour Force Participation Rate Spain: Labour Force Participation Rate Spain: Labour Force Participation Rate Chart I-4Germany: Labour Force Participation Rate Germany: Labour Force Participation Rate Germany: Labour Force Participation Rate Chart I-5France: Labour Force Participation Rate France: Labour Force Participation Rate France: Labour Force Participation Rate What is driving this structural trend? Two things. First, the employment sectors that are growing structurally - healthcare, social care, and education - tend to employ more women than men. Second, European countries have legislated a raft of policies encouraging women to join and remain in the labour force: generous paid maternity leave and subsidised childcare. The trend is for further improvements, with the focus now on improving paternity leave. Sharing parental and family responsibilities between mothers and fathers allows more women to enter and stay in the labour force.2 For the ultimate end-point in the trend, look to the Scandinavian countries which started such policies in the early 1970s. In Sweden, labour force participation for women and men is almost identical: 81% versus 84%. If the EU eventually adopts the Scandinavian model, it would mean another 20 million European women in employment and contributing to economic output (Chart I-6). Chart I-6Another 20 Million European Women ##br##Could Join The Labour Force Another 20 Million European Women Could Join The Labour Force Another 20 Million European Women Could Join The Labour Force Dispelling Two Myths: The Euro Area And Italy Having established that economic performances should be compared on the basis of GDP per head of working age population, we can now dispel two common myths. The first myth is that the U.S. generates superior productivity growth than the euro area. It is true that the U.S. has been better at getting more output from each hour worked, so on this measure, the U.S. does win. Against this, the euro area has been much better at getting more of its working-age population - albeit mostly women - into employment. So on this measure, the euro area wins (Chart of the Week). The net result is that, over the past twenty years, the U.S and the euro area have generated exactly the same growth in real GDP per working-age population (Chart I-7). Of course, the euro area's structural improvement in female participation rates cannot continue forever, but it can certainly continue for another decade or so, and this is generally the longest time horizon that most investors care about. Chart I-7The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The Euro Area And The U.S.: Identical Growth In Real GDP Per Head Of Working-Age Population The second myth concerns the subject du jour: Italy. Many people claim that Italy's economic stagnation is due to deep-seated structural problems which differentiate it from other major economies. The problem with this narrative is that from the mid-1990s until 2008 the growth in Italy's real GDP per head of working age population was little different to that in Germany, France or the U.S. (Chart I-8). Chart I-8Italy Performed In Line With Other Major Economies Until 2008 Italy Performed In Line With Other Major Economies Until 2008 Italy Performed In Line With Other Major Economies Until 2008 Italy's economic stagnation only started after the 2008 global financial crisis. After a financial crisis which cripples the banking system, there are two golden rules: unleash fiscal stimulus; and repair the banking system as quickly as possible. The U.S. and U.K. followed the golden rules perfectly and immediately; Ireland followed a couple of years later; Spain waited until 2013. But in each case, the economies rebounded very strongly as the fiscal stimulus kicked in and the banks recuperated. Italy neither unleashed fiscal stimulus, nor repaired its banks - so its economy has stagnated for a decade. Moreover, if output stagnates for a decade, it follows arithmetically that productivity growth will also look poor. In a back-to-front argument, critics have pounced on this as evidence of excessive 'red tape' and 'structural problems'. But this is a misdiagnosis of the malaise. To reiterate, Italy's real GDP per working-age population was growing very respectably before 2008. Italy's misfortune is that its indebtedness has an unusual profile: more public debt than private debt. France and Spain (and other major euro area economies) have the usual profile: less public debt than private debt. So the EU's fiscal rules - which can see only public debt and are blind to private debt - have severely and unfairly constrained Italy's ability to respond to financial crises. While every other major economy followed the golden rules to recover from the 2008 crisis, Italy could neither unleash fiscal stimulus to kick start the economy nor recapitalise its dysfunctional banking system. We expect Italy's new government to push back against the EU's misguided fiscal rules and correct this decade-long error. Two Structural Investment Conclusions This week's two investment conclusions are both long term, and require a buy and hold mentality. The first conclusion reiterates a structural position: overweight the Personal Products sector. This is based on our expectation that, in Europe, female participation rates will continue their structural uptrend; while in the U.S. we expect female participation rates to continue outperforming male participation rates. Therefore the sales and profits of the Personal Products sector, in which female spending dominates, will benefit from a multi-year tailwind, at least relative to other sectors. And the extent of this tailwind is not fully discounted in valuations. The second conclusion is a new long-term recommendation: buy exposure to Italian real estate. This is based on our assessment that Italy's decade-long stagnation is not a deep-seated structural malaise. Instead, it is a protracted cyclical downturn resulting from a banking system that was never repaired after the 2008 financial crisis combined with wholly inappropriate fiscal austerity. Removing these shackles will allow a long-term recovery, just as it did for Spain in 2013. If we are right, the best multi-year buy and hold play is Italian real estate which has been in a decade-long bear market (Chart I-9). For those that cannot directly invest in property, Italy has a small real estate equity sector which faithfully tracks the long term profile of real estate prices (Chart I-10), and whose main component is Beni Stabili. The caveat is that the stock has a market cap of just €2 billion; the appeal is that it offers a juicy dividend yield of 4.5%. Chart I-9Italian Real Estate Has Suffered ##br##A Decade-Long Bear Market Italian Real Estate Has Suffered A Decade-Long Bear Market Italian Real Estate Has Suffered A Decade-Long Bear Market Chart I-10Italian Real Estate Equities##br## Track Real Estate Prices Italian Real Estate Equities Track Real Estate Prices Italian Real Estate Equities Track Real Estate Prices Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 And in employment. 2 Please see the European Investment Strategy Special Report "Female Participation: Another Mega-Trend" published on April 6, 2017 and available at eis.bcaresearch.com Fractal Trading Model* This week, we note that the 130-day fractal dimension for platinum versus nickel is close to its lower bound, a level which has consistently predicted a tradeable countertrend move over the following 130 days. Hence, this week's trade is long platinum/short nickel on a 130 horizon before expiry. The profit target is 14% with a symmetric stop-loss. Our two other open trades, long SEK/GBP and long PLN/USD, are both in profit. 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-11 Long Platinum / Short Nickel Long Platinum / Short Nickel 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 II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Will A Rising U.S. Dollar Alter The Fed's Tightening Plans? U.S. economic growth appears to be accelerating, the labor market continues to tighten, core inflation is approaching the Fed's target and wage growth is grinding higher. A much higher dollar is needed to seriously derail any of those trends. Will The Italian Turmoil Alter The ECB's Tapering Plans? The ECB has been vocal about separating a decision to taper its asset purchases from any subsequent decision to hike interest rates. Delaying the taper would not have a meaningful impact on boosting euro area economic growth, but keeping policy rates stable for longer would help support the recovery at a time of increasing divergence of inflation rates within the euro area. Feature Chart of the WeekThe Year Of Living Dangerously The Year Of Living Dangerously The Year Of Living Dangerously The latter half of May was a wild wide for global financial markets, which had finally shown signs of healing after the VIX shock from earlier in the year. The cause this time was Italian political turmoil as the populist 5-Star Movement/League coalition attempted to form a government full of fiscal largesse, sprinkled with a hint of euroskepticism. Investors got spooked into thinking that a 2011-style euro "redenomination" (i.e. breakup) risk premium might once again need to be priced into Peripheral government bond yields. The rout in Italian BTPs felt like a classic sovereign debt crisis, emerging markets style. There were even reports of Italian banks providing no price quotes for Italian debt on electronic trading platforms - the 21st Century version of dealers "not answering their phones" during a crisis. All that was missing was an IMF delegation heading to Rome with checkbook in hand. The announcement late last week that the coalition would get another shot at forming a government, rather than throwing Italy into fresh elections that could turn into a referendum on euro membership, restored order to Italian financial markets. The meltdown in Italian yields was almost as rapid as the melt-up, with the 2-year BTP yield ending last week around 1%, almost two full percentage points lower than the peak in yields seen just a few days earlier, but still much higher than the sub-zero yields seen as recently as May 15th. We made a timely decision to cut our recommended stance on Italian debt to underweight two weeks and we are maintaining that call despite the respite from the political turmoil.1 (NOTE: we are putting out a joint Special Report next week with our colleagues at BCA Geopolitical Strategy on June 13th, a day later than our usual Tuesday publishing slot, which will discuss the political outlook for Peripheral Europe and what it potentially means for their bond markets). Our more pessimistic view on Italian bonds was based on our assessment that Italian growth was slowing and would continue to do so. For a country like Italy with a large debt stock and structurally low growth, cyclical downturns always lead to increased worries about debt sustainability. Coming at a time when the ECB is looking to begin the long process of exiting its hyper-easy policies, the growth and monetary backdrop was also becoming more challenging for Italian government bonds. The same thing can be said for the rest of the world. The rapid coordinated acceleration in global growth seen in 2017 has clearly peaked, as has the pace of central bank asset purchases that helped support that recovery through low bond yields (Chart of the Week). The growth convergence has turned into a divergence between growth in the still-strong U.S. and most other major economies. This poses a new threat to financial markets - a rising U.S. dollar - which, combined with some cooling of global growth, is already triggering underperformance of emerging market assets. So after the tumultuous market price action of the past few weeks, we think the most critical potential impact on the direction of bond yields, and our recommended below-benchmark overall portfolio duration stance, can be boiled down to two big questions. Will A Rising U.S. Dollar Alter The Fed's Tightening Plans? NO. The U.S. economy continues to exhibit impressive resilience of late, even as the rest of the world has seen some softening in growth. The Payrolls report for May released last Friday showed another sturdy gain of 223,000 jobs, with upward revisions of 15,000 to the prior two months. This pushed the unemployment rate to 3.8% - the lowest level since April 2000 - while boosting the annual growth in Average Hourly Earnings up to 2.7% (Chart 2). The overall employment/population ratio also inched higher. Both wage growth and the employment/population ratio are well below the peaks seen in the past two business cycles, even with similarly low levels of unemployment. During those cycles, the Fed was forced to raise the funds rate to restrictive levels to cool growth to rein in overshooting inflation. The real fed funds rate was consistently above equilibrium measures like the Williams-Laubach "r-star" (bottom panel), which eventually crimped growth and led to a recession in both cases. In the current cycle, wage inflation is struggling to reach 3% and core PCE inflation at 1.8% has still not returned back to the Fed's 2% target. There is no need for the Fed to push harder on the brakes by raising rates faster than inflation is accelerating and pushing the real rate above r-star. If a growing economy continues to absorb labor market slack, however, the Fed could be chasing a higher level of r-star to prevent inflation from continuing to accelerate (bottom panel). Looking ahead, it does look like the Fed will continue to play a bit of catch-up to an accelerating U.S. economy. Leading economic indicators (both from the OECD and Conference Board), as well as our forward-looking models for employment and capital spending, all point to faster growth in the next couple of quarters (Chart 3). This will only support the case for the Fed to continue with its current rate "measured" pace of one rate hike per quarter over the next year. Chart 2Labor Market Tightening##BR##Leads To Fed Tightening Labor Market Tightening Leads To Fed Tightening Labor Market Tightening Leads To Fed Tightening Chart 3U.S. Growth Still##BR##In Good Shape U.S. Growth Still In Good Shape U.S. Growth Still In Good Shape With the U.S. dollar now reconnecting to the widening interest rate differentials between the U.S. and other major economies, there is a risk that the implied tightening of monetary conditions from a higher greenback could limit the need for the Fed to continue with its rate hike plans. Yet at the moment, the trade-weighted dollar is still not accelerating on a year-over-year basis, in contrast to the +15% appreciation seen during the 2014/15 dollar bull run (Chart 4). At the peak of that episode, net exports were a drag on real GDP growth of -1% and headline CPI inflation hit 0% (aided by collapsing oil prices). While an appreciation of that magnitude is unlikely, it would still take a much larger increase in the dollar to meaningfully dent growth in a way that could cause the Fed to pause on the rate hikes. A bigger dollar rally could also raise financial instability, primarily by hitting emerging markets where currency weakness versus the dollar would trigger tighter monetary policy and slower growth. That is certainly a risk for the Fed to consider. Yet given the underlying strength of the U.S. economy today, the Fed would only react to any turmoil in emerging markets if it meaningfully impacted U.S. financial markets, but not before then. While the Fed is still likely to continue on its rate hike path over the rest of 2018, the market has largely discounted that outcome - even after the late May decline in U.S. interest rates on the back of Italy-fueled risk-aversion (Chart 5). The market is still not completely priced to the Fed's interest rate projections over the next year, however, which does raise the potential for a return to the +3% level on the 10-year U.S. Treasury yield that was seen before the Italy crisis flared up. However, our colleagues at our sister publication, BCA U.S. Bond Strategy, continue to point out the risks to a continued near-term period of declining (or at least, consolidating) Treasury yields given persistent short positioning in the Treasury market at a time of slowing data surprises (Chart 6). We remain bearish on Treasuries over a strategic horizon, however. Chart 4USD Rally Not Yet##BR##Enough To Impact The U.S. USD Rally Not Yet Enough To Impact The U.S. USD Rally Not Yet Enough To Impact The U.S. Chart 5Market Still Priced Close To##BR##The Fed's Interest Rate Projections Market Still Priced Close To The Fed's Interest Rate Projections Market Still Priced Close To The Fed's Interest Rate Projections Chart 6UST Yields Likely To##BR##Consolidate In The Near-Term UST Yields Likely To Consolidate In The Near-Term UST Yields Likely To Consolidate In The Near-Term Bottom Line: U.S. economic growth appears to be accelerating, the labor market continues to tighten, core inflation is approaching the Fed's target and wage growth is grinding higher. A much higher dollar is needed to seriously derail any of those trends. Will The Italian Turmoil Alter The ECB's Tapering Plans? PROBABLY NOT. The latest volatility in European financial markets stemming from the Italy crisis came at a difficult time for the ECB. The central bank has been incrementally preparing the market for an eventual tapering of its asset purchase program after it expires in September. Yet the slowdown in euro area growth in the first quarter of the year, amid sluggish readings on inflation, has raised some doubt that the ECB would even be able to announce any sort of withdrawal of monetary stimulus. Chart 7Market Buying Into The ECB's##BR##'Low Rates For Longer' Message Market Buying Into The ECB's 'Low Rates For Longer' Message Market Buying Into The ECB's 'Low Rates For Longer' Message It is now a consensus expectation that the ECB will taper its net new asset purchases fully to zero by the end of 2018. What has moved, however, is the market's expectation for the timing of the first rate hike by the ECB. That has now been pushed out to April 2020 after the Italy turbulence (Chart 7). The ECB has been consistently signaling to the markets that it views the two decisions - tapering and rate hikes - as separate choices to make. In other words, tapering does not mean that rate hikes will come soon afterward. So far, the market appears to be listening to the ECB's signals by moving out the timing of any rate hike to nearly two full years from today. Given the magnitude of the slide in euro area growth seen in the first few months of 2018 (2nd panel), that may be taken as a sign that the market thinks the slump can continue. This also is consistent with the market believing the ECB's views on seeing through any impact on euro area inflation from changes in oil prices and the euro. The annual growth of the Brent oil price, in euro terms, has climbed to nearly 50% over the past few months (3rd panel). There has always been a strong correlation of that growth rate to overall headline euro area inflation, as evidenced by the early read on May CPI inflation released last week that came in at 1.9%. Yet core CPI inflation in the euro area is still only 1.1%, well below the ECB's inflation target of "just below" 2%. Market-based inflation expectations are still below the level as well, with the 5-year euro CPI swap, 5-years forward now sitting at 1.7%. So the market pricing is consistent with an ECB that will be very slow to begin raising interest rates. That would also be consistent with the behavior of the ECB when it comes to its past tightening cycles. In Chart 8, we show diffusion indices at a country level for euro area industrial production growth (as a proxy for economic growth), headline inflation and core inflation. These show the percentage of all euro area countries that are seeing accelerating growth or inflation versus those countries seeing slowing growth and inflation. A higher diffusion index means that any acceleration in growth or inflation is broad-based, and vice versa. Chart 8ECB Rate Hikes Happen During Broad-Based Inflation Upturns ECB Rate Hikes Happen During Broad-Based Inflation Upturns ECB Rate Hikes Happen During Broad-Based Inflation Upturns As can be seen in the chart, the ECB's past tightening cycles since the beginning of the euro in 1998 have all occurred when the diffusion indices for inflation have risen into the 60-80% zone. In other words, the ECB is more aggressive on lifting rates when a large majority of countries in the euro zone is seeing accelerating inflation. During those same tightening cycles, however, the diffusion indices for growth have been decelerating, suggesting less broad-based economic strength. The implication from this analysis is that the ECB cares more about inflation than growth when making its monetary policy decisions. The ECB's reputation for sometimes making overly hawkish policy mistakes, like in 2010-11, is well deserved. Looking ahead, the current readings on the diffusion indices for both growth and, more importantly, inflation are all quite depressed. This suggest that the slowing growth seen in the overall euro area data so far in 2018 has been broad-based, while the increase in the overall euro area inflation data has not been broad-based. This can be seen when looking at the some of the individual country data for the major core euro area countries (Chart 9) and Peripheral countries (Chart 10). For example, Netherlands and Portugal stand out as having inflation trends that are much weaker than the other countries. Yet the more divergent trends in euro area inflation does not mean that the ECB will decide to defer any decision to taper, however. The ECB will have to make that decision at either the June or July meetings, with the current program set to end in September. Absent a significant drop in euro area inflation, the ECB is still likely to signal a full taper by the end of the year. Yet even if they did extend the current program into 2019, at the same pace of 30 billion euros per month, this would likely not have a meaningful impact on the level of euro area bond yields. We have found that is the growth rate of those purchases, and not the absolute level, that is most correlated to the level of euro area bond yields (Chart 11). Even if the current program were to be extended to March 2019, to be followed by a tapering of net purchases to zero by September 2019, then the annual growth rate of the ECB's balance sheet (driven by the asset purchases) would remain mired below 10% - a far slower pace compared to the peak years of ECB bond buying. Chart 9Growth Convergence,##BR##Inflation Divergence In Core Europe... Growth Convergence, Inflation Divergence In Core Europe... Growth Convergence, Inflation Divergence In Core Europe... Chart 10And In##BR##Peripheral Europe And In Peripheral Europe And In Peripheral Europe Chart 11Extending ECB Bond Purchases##BR##Into 2019 Would Have Limited Impact Extending ECB Bond Purchases Into 2019 Would Have Limited Impact Extending ECB Bond Purchases Into 2019 Would Have Limited Impact In other words, an extension of the asset purchases would not drive euro area bond yields any lower, and would entail operational constraints on country sizes, etc. The ECB will have better success at driving down yields by keeping policy rates lower for longer, as it is signaling it will do. Bottom Line: The ECB has been vocal about separating a decision to taper its asset purchases from any subsequent decision to hike interest rates. Delaying the taper would not have a meaningful impact on boosting euro area economic growth, but keeping policy rates stable for longer would help support the recovery at a time of increasing divergence of inflation rates within the euro area. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Is It Partly Sunny Or Mostly Cloudy?", dated May 22nd 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Two Big Questions After Two Wild Weeks Two Big Questions After Two Wild Weeks Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update A Series Of Unfortunate Events Markets have taken a series of hits in recent months - sharp drops in emerging market currencies, a political crisis in Italy, and the ongoing trade war between the U.S. and China - not to mention a slowdown in cyclical growth. But risk assets have been remarkably resilient: the U.S. stock market is in the middle of its year-to-date range, and U.S. small cap stocks (more attuned to domestic conditions) are at record highs (Chart 1). The uncertainty is set to continue for a while. But, with global growth likely to settle at an above-trend pace, fiscal and monetary policy still accommodative, and earnings continuing to grow strongly, the recent resilience says to us that risk assets are likely to grind higher and to outperform bonds over the next 12 months. A major underlying cause of the recent volatility has been the growing disparity between growth in the U.S. and in the rest of the world (Chart 2). This is partly due to the strength of the euro and yen last year, which is now dampening activity in these regions, but the slowdown in Chinese industrial growth and a higher oil price may also be having a disproportionate effect on growth outside the U.S. This growth disparity has widened interest rate differentials, which have again become the major driver of currencies, pushing up the U.S. dollar (Chart 3). Chart 1Small Cap Stocks At A Record High Small Cap Stocks At A Record High Small Cap Stocks At A Record High Chart 2Disparity Between The U.S. And The Rest... Disparity Between The U.S. And The Rest... Disparity Between The U.S. And The Rest... Chart 3...Means Dollar Has Further To Rise ...Means Dollar Has Further To Rise ...Means Dollar Has Further To Rise In combination with rising U.S. interest rates (the 10-year Treasury yield rose above 3% last month, before correcting a little), dollar appreciation is a threat for emerging markets. EM assets have long shown a consistently strong inverse correlation with the dollar (Chart 4). We expect the EM sell-off to continue. Further Fed hikes and rising inflation expectations in the U.S. (relative to the euro area and Japan) will increase interest-rate differentials and push the dollar up further: we forecast 1.12 for euro/dollar. Investors are still far from capitulating on EM assets after several years of large purchases (Chart 5). Many EM central banks are being forced to raise rates to defend their currencies, which will dent growth. Some may even be forced into reintroducing capital controls. Several emerging economies besides Argentina and Turkey remain vulnerable, having worryingly high amounts of foreign currency debt (Chart 6). Chart 4Strong Dollar Is Bad For Em Assets Strong Dollar Is Bad For Em Assets Strong Dollar Is Bad For Em Assets Chart 5Em Is Still A Consensus Favorite Em Is Still A Consensus Favorite Em Is Still A Consensus Favorite Chart 6Worrying Levels Of FX Debt Monthly Portfolio Update Monthly Portfolio Update Chart 7Not Surprising That Italians Are Fed Up Not Surprising That Italians Are Fed Up Not Surprising That Italians Are Fed Up Geopolitics is likely to remain a drag on markets for a while, too. Italy remains the biggest threat. The discontent of the Italian population is unsurprising given the country's stagnation since it joined the euro (Chart 7). The probable coalition government of the Lega and Five Star Movement would introduce aggressive fiscal stimulus, putting it in confrontation with the EU's budgetary rules. But BCA's geopolitical strategists see little risk of Italy exiting the euro in the next two years (though 10 years might be a different story).1 Political gyrations may continue for some months, particularly if the new government persists with its plan to blow the fiscal deficit out to 7% of GDP, but the sell-off in short-term Italian bonds looks to be overdone. Developments in trade tariffs, Iran and North Korea could also weigh on markets in coming months. But ultimately economic fundamentals almost always outweigh geopolitical risk. Global growth is slowing, but to an above-trend pace. Fiscal policy is particularly stimulative this year, with 17 of the 33 OECD countries undertaking large fiscal easing, and a further 11 some easing. The overall cyclically-adjusted primary budget balance in OECD countries is forecast to ease by 0.5% of GDP this year and 0.4% next (Chart 8). Monetary policy remains accommodative almost everywhere. The FOMC, in its May statement, by adding the word "symmetric" to describe its 2% inflation objective, was clearly emphasizing that it sees no need to accelerate the pace of rate hikes, despite the recent pickup in core PCE inflation. We expect the Fed to continue to raise rates once a quarter, meaning that monetary policy will not become restrictive until around Q1 next year. With inflation expectations not yet fully normalized (Chart 9), the Fed could still exercise its "put option" by holding for a quarter or two if global risk were to rise significantly. Italy's problems also make it more likely that the ECB will stay easier for longer, and the probability is rising of its deciding to extend asset purchases into next year. Chart 8Fiscal Stimulus (Almost) Everywhere Monthly Portfolio Update Monthly Portfolio Update Chart 9Inflation Expectations Have Further To Rise Inflation Expectations Have Further To Rise Inflation Expectations Have Further To Rise With the consensus already forecasting global GDP to grow 3.4% this year, and U.S. earnings by 22%, there is no obvious catalyst for risk assets to rebound sharply (Chart 10). However, we find it inconceivable that equity markets will not be higher in 12 months' time - and will not have outperformed bonds over that time - if the macro environment plays out as we expect. We, therefore, continue to recommend an overweight on equities and underweight on fixed income, but might start to turn more defensive around the end of the year if the signs are in place that the recession we expect in 2020 is still on the cards. Equities: For the reasons described above, we remain cautious on EM equities. Within EM, our preference would be for markets such as China, Korea and India, which are likely to be less affected by investors' concerns about current account deficits and foreign-currency denominated debt. In DM, our preference remains for late-cyclical sectors, especially energy, financials and industrials. We mainly view regional and country selection as a derivative of the sector call: this supports our preference for euro zone and Japanese stocks over those in the U.S. and U.K. Fixed Income: A combination of quarterly Fed rate hikes, a further normalization of inflation expectations, and moderate rises in the real rate and term premium are likely to push the 10-year U.S. Treasury yield up to 3.5% by year-end (Chart 11). We, therefore, remain underweight duration and prefer TIPs to nominal bonds. We keep our overweights on spread product within the fixed-income bucket, since it should continue to outperform for another couple of quarters. U.S. high-yield spreads are likely to remain steady, giving an attractive carry even after accounting for defaults; investment grade spreads might start to recover, given that the sell-off of quality bonds by companies repatriating short-term investments held offshore ($35 Bn from the 20 largest U.S. companies in Q1) is now mostly over (Chart 12). Chart 10Can Growth Beat These Expectations? Can Growth Beat These Expectations? Can Growth Beat These Expectations? Chart 11Treasury Yield To Rise To 3.5% Treasury Yield To Rise To 3.5% Treasury Yield To Rise To 3.5% Chart 12Selective Spread Product Remains Attractive Selective Spread Product Remains Attractive Selective Spread Product Remains Attractive Currencies: Interest-rate differentials, as described above, are likely to push the dollar up further, especially against the euro. This should continue until the effect of a strong dollar/weak euro starts to rebalance growth surprises back to the euro area, perhaps around the end of the year. We see less chance of dollar appreciation against the yen (which is still undervalued against its PPP value of 98, and may benefit from its safe-haven status) and against the Canadian dollar (given the Bank of Canada's hawkish stance). Commodities: Industrial commodities are likely to continue to struggle against headwinds from the appreciating dollar, and the continuing moderate slowdown in China (Chart 13). The oil price has become a tougher call recently, with talk that OPEC may agree later this month to bring back as much as 1 million barrels/day in production, but Venezuelan and Iranian supply likely to exit the market. BCA's energy strategists now forecast WTI and Brent to average $70 and $78 in 2H18, and $67/$72 in 2019, but expect higher volatility in the price over coming months (Chart 14).2 Chart 13Continuing Signs Of China Slowdown Continuing Signs Of China Slowdown Continuing Signs Of China Slowdown Chart 14Forecasting Oil Is Getting Harder Forecasting Oil Is Getting Harder Forecasting Oil Is Getting Harder Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see BCA Geopolitical Strategy Client Note, "Italy, Spain, Trade Wars... Oh My!," dated 30 May 2018, available at gps.bcaresearch.com 2 Please see BCA Commodity & Energy Strategy Weekly Report, "OPEC 2.0 Guiding To Higher Output: Volatility Set To Rise ... Again," dated 31 May 2018, available at ces.bcaresearch.com GAA Asset Allocation